Module 5

1 Explain the difference between internal and external sources of finance.

2 Provide examples of internal sources of finance that a company can utilize.
3 Define long-term finance and give examples of long-term financial instruments.
4 What is short-term finance, and why is it essential for businesses?
5 Discuss the advantages and disadvantages of using short-term loans for financing working
capital needs.
6 What is project finance, and how does it differ from traditional corporate finance?
7 Why is project finance often used for large infrastructure and capital-intensive projects?

1 Discuss the merits and demerits of equity shares

Merits
The important merits of raising funds through issuing equity shares are given as below:
(i) Equity shares are suitable for investors who are willing to assume risk for higher
returns
(ii) Payment of dividend to the equity shareholders is not compulsory. Therefore,
there is no burden on the company in this respect
(iii) Equity capital serves as permanent capital as it is to be repaid only at the time of
liquidation of a company. As it stands last in the list of claims, it provides a cushion
for creditors, in the event of winding up of a company
(iv) Equity capital provides credit worthiness to the company and confidence to
prospective loan providers
(v) Funds can be raised through equity issue without creating any charge on the assets
of the company. The assets of a company are, therefore, free to be mortgaged for
the purpose of borrowings, if the need be
(vi) Democratic control over management of the company is assured due to voting
rights of equity shareholders.
Limitations
The major limitations of raising funds through issue of equity shares are as follows:
(i) Investors who want steady income may not prefer equity shares as equity shares
get fluctuating returns
(ii) The cost of equity shares is generally more as compared to the cost of raising funds
through other sources
(iii) Issue of additional equity shares dilutes the voting power, and earnings of existing
equity shareholders
(iv) More formalities and procedural delays are involved while raising funds through
issue of equity share.
2 Discuss the symbols and their implications used by CRISIL India for rating debentures.
CRISIL, which stands for Credit Rating Information Services of India Limited, is one of the
leading credit rating agencies in India. When it comes to rating debentures and other financial
instruments, CRISIL uses a variety of symbols and notations to communicate the
creditworthiness and risk associated with these instruments. These symbols are designed to
provide investors and other stakeholders with a quick and easy way to assess the credit quality
of a particular debenture issue. Here are some of the symbols and their implications used by
CRISIL for rating debentures:
 AAA: This is the highest rating assigned by CRISIL, and it signifies the highest degree of
safety for debenture holders. It implies that the issuer has a very low risk of defaulting
on interest and principal payments.
 AA: This rating represents a high level of safety but is slightly lower than AAA. It
indicates a strong ability of the issuer to meet its debt obligations, though it may be
slightly more vulnerable to adverse economic conditions.
 A: A rating of A signifies a moderate degree of safety. Issuers with this rating are
considered to have an adequate capacity to meet their financial commitments, but
they may be more susceptible to adverse economic conditions.
 BBB: This rating is in the investment-grade category but represents a lower level of
 safety compared to the higher-rated categories. It indicates that the issuer has a good
capacity to meet its financial commitments but is more vulnerable to economic
fluctuations.
 BB, B, C, and D: These are non-investment grade or speculative ratings, indicating
increasing levels of risk. BB and B ratings suggest a higher risk of default, while C and D
indicate that the issuer is already in default or at high risk of default.
 + and -: CRISIL uses these symbols to provide further granularity within each rating
category. For example, AA+ signifies a rating that is slightly higher than AA, while AA- is
slightly lower than AA.
 NR (Not Rated): This symbol is assigned when CRISIL has not rated a particular
debenture or when there is insufficient information available to assign a rating.
3 Define credit rating. What is its function?
a. Credit rating is a symbolic indicator of the relative ability of the issuer of the debt
instruments to meet obligations when due.
b. credit rating provides a simple system of gradation by which the relative capacities of
companies (borrowers) to make timely payment of interest and repayment of principal on
a particular type of debt instrument can be noted
c. As a fee-based financial advisory service, credit rating is, obviously, extremely useful to
investors, corporates (borrowers), banks, and financial institutions. For the investors, it is
an indicator expressing the underlying credit quality of a (debt) issue programme.
d. The investor is fully informed about the company as any effect of changes in
business/economic conditions on the company is evaluated and published regularly by the
rating agencies.
e. The corporate borrower can raise funds at a cheaper rate with a good rating. It minimises
the role of ‘name recognition’ and lesser-known companies can also approach the market
on the basis of their rating. The fund ratings are useful to the banks and other financial
institutions when they decide on lending and investment strategies.
4 What are the features of trade credit as a short-term source of working capital finance?
a. Trade credit is the credit extended by one trader to another for the purchase of goods and
services.
b. Trade credit facilitates the purchase of supplies without immediate payment. Such credit
appears in the records of the buyer of goods as ‘sundry creditors’ or ‘accounts payable’.
c. Trade credit is commonly used by business organisations as a source of short-term
financing. It is granted to those customers who have reasonable amount of financial
standing and goodwill.
d. The volume and period of credit extended depends on factors such as reputation of the
purchasing firm, financial position of the seller, volume of purchases, past record of
payment and degree of competition in the market.
e. Terms of trade credit may vary from one industry to another and from one person to
another. A firm may also offer different credit terms to different customers.
Merits The important merits of trade credit are as follows:
(i) Trade credit is a convenient and continuous source of funds
(ii) Trade credit may be readily available in case the credit worthiness of the customers is
known to the seller
(iii) Trade credit needs to promote the sales of an organisation
(iv) If an organisation wants to increase its inventory level in order to meet expected rise in
the sales volume in the near future, it may use trade credit to, finance the same
(v) It does not create any charge on the assets of the firm while providing funds
5 Discuss briefly commercial papers as source of working capital finance.
a. Commercial paper is a form of financing consisting of short-term unsecured promissory
notes issued by a firm with high credit rating.
 b. It is generally issued by companies as a means of raising short-term debt and, by a process
of securitisation, intermediation of the bank is eliminated.
c. A CP, as a short-term financial instrument, has several advantages both to the issuers and
the investors. It is a simple instrument and hardly involves any documentation between the
issuer and the investor.
d. It is additionally flexible in terms of maturities of the underlying promissory note, which can
be tailored to match the cash flow of the issuer. Further, a well rated company can diversify
its sources of finance from banks to the short-term money market at a cheaper cost.
e. A CP can be issued for maturities between a minimum of 7 days and a maximum up to one
year from the date of issue. The maturity date of the CP should not go beyond the date up
to which the credit rating of the issuer is valid.
f. A CP can be issued in denominations of Rs 5 lakh or multiples thereof. The amount invested
by a single investor should not be less than Rs 5 lakh (face value).

6 How would you compute the cost of commercial papers?

a. Commercial paper is a form of financing consisting of short-term unsecured promissory
notes issued by a firm with high credit rating.
b. As CPs are issued at discount and redeemed at their face value, their effective pre-tax
interest yield

c. where net amount realised = face value – discount – issuing and paying agent (IPA) charges,
that is, stamp duty, rating charges, dealing bank fee and fee for stand by facility.
d. Assuming face value of a CP to be Rs 5,00,000, maturity period to be 90 days, net amount
realised = Rs 4,80,000, discount and other charges associated with the issue of CP = 1.5 per
cent, the pre-tax effective cost of CP

7 Discuss Relation between Capital Structure and Corporate Value

The capital structure of a company refers to the mix of debt and equity financing it uses to fund
its operations and investments. This mix has a significant impact on the corporate value of a
company. The relationship between capital structure and corporate value is a crucial concept in
corporate finance and has been studied extensively. Here are some key points to consider:
 Optimal Capital Structure: The optimal capital structure is the balance between debt
and equity that maximizes the overall value of the company. This balance is not a fixed
formula but varies depending on a company's circumstances, industry, and economic
conditions. Finding the right mix is essential to enhance corporate value.
 Tax Shield: Debt financing offers a tax advantage as the interest payments on debt are
tax-deductible. This tax shield can reduce a company's overall cost of capital and
increase its after-tax profits, thereby increasing its value. However, excessive debt can
also lead to financial distress if not managed properly.
 Financial Flexibility: Maintaining a mix of equity and debt can provide financial
flexibility. Equity can be used to infuse capital in times of need, while debt can be used
to take advantage of investment opportunities. Having this flexibility can enhance
corporate value by allowing a company to make strategic decisions without being
overly constrained by its capital structure.
 Risk and Return: Debt introduces financial risk to a company, as interest payments
must be made regardless of the company's financial performance. Equity, on the other
 hand, does not have a fixed payment obligation. By using more debt, a company can
magnify its returns, but it also increases its financial risk. The optimal capital structure
balances risk and return to maximize corporate value.
 Market Perception: The capital structure can also affect how investors and creditors
perceive a company. A company with a high proportion of debt may be seen as riskier,
leading to a higher cost of debt and a lower stock price. This, in turn, affects corporate
value. Conversely, a company with a lower debt ratio might be viewed as more stable
and, thus, might have a higher stock price.
 Agency Costs: Debt financing can lead to agency costs, such as conflicts of interest
between shareholders and bondholders. Companies may need to spend resources on
mechanisms to mitigate these costs, which can impact corporate value. Equity
financing, in contrast, does not carry such agency costs.
 Financial Distress Costs: If a company takes on too much debt and is unable to meet its
obligations, it can lead to financial distress costs, such as bankruptcy or reorganization
expenses. These costs can significantly reduce corporate value.
In summary, the relationship between capital structure and corporate value is complex and
dynamic. While some degree of debt can enhance corporate value through the tax shield and
financial leverage, excessive debt can increase risk and lead to financial distress. Finding the
optimal capital structure is a continuous process that depends on various factors, including the
company's risk tolerance, industry conditions, and market perceptions. A well-balanced capital
structure that matches the company's specific needs and goals is key to maximizing corporate
value.

1 Discuss briefly the features of equity shares as sources of long-term finance

Equity shares is the most important source of raising long term capital by a company. Equity
shares represent the ownership of a company and thus the capital raised by issue of such
shares is known as ownership capital or owner’s funds. Equity share capital is a prerequisite to
the creation of a company. Equity shareholders do not get a fixed dividend but are paid on the
basis of earnings by the company. They are referred to as ‘residual owners’ since they receive
what is left after all other claims on the company’s income and assets have been settled. They
enjoy the reward as well as bear the risk of ownership. Their liability, however, is limited to the
extent of capital contributed by them in the company. Further, through their right to vote,
these shareholders have a right to participate in the management of the company.
Merits
The important merits of raising funds through issuing equity shares are given as below:
(i) Equity shares are suitable for investors who are willing to assume risk for
higher returns
(ii) Payment of dividend to the equity shareholders is not compulsory. Therefore,
there is no burden on the company in this respect
(iii) Equity capital serves as permanent capital as it is to be repaid only at the time
of liquidation of a company. As it stands last in the list of claims, it provides a
cushion for creditors, in the event of winding up of a company
(iv) Equity capital provides credit worthiness to the company and confidence to
prospective loan providers
(v) Funds can be raised through equity issue without creating any charge on the
assets of the company. The assets of a company are, therefore, free to be
mortgaged for the purpose of borrowings, if the need be
(vi) Democratic control over management of the company is assured due to voting
rights of equity shareholders.
Limitations
The major limitations of raising funds through issue of equity shares are as follows:
 (i) Investors who want steady income may not prefer equity shares as equity
shares get fluctuating returns
(ii) The cost of equity shares is generally more as compared to the cost of raising
funds through other sources
(iii) Issue of additional equity shares dilutes the voting power, and earnings of
existing equity shareholders
More formalities and procedural delays are involved while raising funds through issue of equity
share.

2 What are the main attributes of debentures/bonds? What are their merits and demerits?
a. Debentures are an important instrument for raising long term debt capital. A company can
raise funds through issue of debentures, which bear a fixed rate of interest.
b. The debenture issued by a company is an acknowledgment that the company has
borrowed a certain amount of money, which it promises to repay at a future date.
c. Debenture holders are, therefore, termed as creditors of the company. Debenture holders
are paid a fixed stated amount of interest at specified intervals say six months or one year.
d. Public issue of debentures requires that the issue be rated by a credit rating agency like
CRISIL (Credit Rating and Information Services of India Ltd.) on aspects like track record of
the company, its profitability, debt servicing capacity, credit worthiness and the perceived
risk of lending.
Merits
The merits of raising funds through debentures are given as follows:
(i) It is preferred by investors who want fixed income at lesser risk
(ii) Debentures are fixed charge funds and do not participate in profits of the company
(iii) The issue of debentures is suitable in the situation when the sales and earnings are
relatively stable
(iv) As debentures do not carry voting rights, financing through debentures does not dilute
control of equity shareholders on management
(v) Financing through debentures is less costly as compared to cost of preference or equity
capital as the interest payment on debentures is tax deductible.
Demerits
Debentures as source of funds has certain limitations. These are given as follows:
(i) As fixed charge instruments, debentures put a permanent burden on the earnings of a
company. There is a greater risk when earnings of the company fluctuate
(ii) In case of redeemable debentures, the company has to make provisions for repayment on
the specified date, even during periods of financial difficulty
(iii) Each company has certain borrowing capacity. With the issue of debentures, the capacity
of a company to further borrow funds reduces
3 Briefly outline the main elements of the emerging system of bank financing of industry.
a. Commercial banks occupy a vital position as they provide funds for different purposes as
well as for different time periods.
b. Banks extend loans to firms of all sizes and in many ways, like, cash credits, overdrafts,
term loans, purchase/discounting of bills, and issue of letter of credit.
c. The rate of interest charged by banks depends on various factors such as the characteristics
of the firm and the level of interest rates in the economy.
d. The loan is repaid either in lump sum or in instalments. Bank credit is not a permanent
source of funds.
e. Though banks have started extending loans for longer periods, generally such loans are
used for medium to short periods. The borrower is required to provide some security or
create a charge on the assets of the firm before a loan is sanctioned by a commercial bank.
The merits of raising funds from a commercial bank are as follows:
 (i) Banks provide timely assistance to business by providing funds as and when needed by
it.
(ii) Secrecy of business can be maintained as the information supplied to the bank by the
borrowers is kept confidential
(iii) Formalities such as issue of prospectus and underwriting are not required for raising
loans from a bank. This, therefore, is an easier source of funds
(iv) Loan from a bank is a flexible source of finance as the loan amount can be increased
according to business needs and can be repaid in advance when funds are not needed.
The major limitations of commercial banks as a source of finance are as follows:
(i) Funds are generally available for short periods and its extension or renewal is uncertain
and difficult
(ii) Banks make detailed investigation of the company’s affairs, financial structure etc., and
may also ask for security of assets and personal sureties. This makes the procedure of
obtaining funds slightly difficult
(iii) In some cases, difficult terms and conditions are imposed by banks. for the grant of loan.
For example, restrictions may be imposed on the sale of mortgaged goods, thus making
normal business working difficult.
4 Briefly Factors Affecting an Entity ‘s Capital Structure
An entity's capital structure, which is the mix of debt and equity it uses to finance its operations
and investments, is influenced by several factors. These factors can vary from one company to
another and play a crucial role in determining the optimal capital structure. Here are some of
the key factors affecting an entity's capital structure:
 Business Risk: The nature of the entity's business and its risk profile play a significant
role. More stable and less risky businesses may use higher debt levels, while riskier
businesses may opt for lower debt to reduce financial distress.
 Cost of Capital: The cost of debt and equity financing affects capital structure decisions.
Companies consider the cost of borrowing (interest rates) and the cost of equity
(required returns to shareholders) when determining the optimal mix.
 Tax Considerations: Debt financing often comes with tax benefits because interest
payments are typically tax-deductible. Companies in higher tax brackets may be more
inclined to use debt to take advantage of these tax shields.
 Profitability and Cash Flow: Companies with strong and stable cash flows are better
positioned to service debt, making them more likely to use debt financing. Profitable
entities can also retain earnings to fund operations or investments.
 Liquidity Needs: Companies with significant short-term liquidity needs may prefer
equity financing to avoid the obligation of repaying debt in the short term.
 Industry Norms: Capital structure decisions can be influenced by industry standards
and peer benchmarks. Companies may follow similar capital structures to remain
competitive or meet industry expectations.
 Market Conditions: Economic conditions, interest rates, and the availability of financing
in the market can impact capital structure decisions. Favourable market conditions may
encourage more debt financing.
 Growth Prospects: High-growth companies often rely on equity financing to fund
expansion and future projects, as they may not want the burden of high debt payments
during growth phases.
 Asset Structure: The type and value of a company's assets can also influence capital
structure. Companies with more tangible assets may find it easier to secure debt
financing, as these assets can serve as collateral.
 Management Philosophy: The personal preferences and risk tolerance of the
company's management and board of directors can play a role. Some executives may
have a preference for conservative capital structures with lower debt levels, while
 others may be more comfortable with higher leverage.
 Legal and Regulatory Constraints: Regulations and legal constraints can impact a
company's capital structure choices. For example, certain industries may have
limitations on the amount of debt they can use.
 Credit Rating and Investor Perception: A company's credit rating and how investors
perceive its financial health and stability can affect its ability to access debt markets
and the terms it can obtain.
Finding the right capital structure involves considering these and other factors to achieve a
balance between risk and return, with the ultimate goal of maximizing shareholder value and
the long-term financial health of the entity. It's important to note that the optimal capital
structure may change over time as market conditions and business circumstances evolve.

5 Explain Concept of Optimal Capital Structure

The concept of optimal capital structure is a financial management theory that refers to the
ideal mix of debt and equity a company should employ to maximize its value and minimize its
cost of capital. In other words, it's the combination of debt and equity financing that allows a
company to strike a balance between risk and return, leading to the highest possible stock price
and shareholder value. Finding the optimal capital structure is a critical decision for a company,
as it can have a significant impact on its overall financial performance and sustainability.
Key components and principles of the concept of optimal capital structure include:
a. Debt and Equity: The two primary sources of capital for a company are debt and equity.
Debt represents borrowed funds that must be repaid with interest, while equity
represents ownership in the company. The mix of these two sources determines the
company's capital structure.
b. Cost of Capital: The cost of capital refers to the overall cost a company incurs to obtain
and use funds for its operations. It includes the cost of debt (interest expense) and the
cost of equity (required return to shareholders).
c. Risk and Return: Debt is cheaper than equity because the interest paid on debt is tax-
deductible, but it comes with an obligation to repay the principal and interest,
increasing financial risk. Equity does not have an obligation for repayment but requires
a return to shareholders in the form of dividends or capital appreciation.
d. Trade-off Theory: The concept of optimal capital structure is often explained by the
trade-off theory. This theory suggests that companies should balance the benefits of
using debt (tax advantages, lower cost) against the potential financial distress and
bankruptcy costs that come with higher debt levels.
e. Pecking Order Theory: Another theory that plays a role in determining the optimal
capital structure is the pecking order theory. It states that companies prefer to finance
their operations and investments with internal funds (retained earnings) first, then use
debt, and finally issue equity when no other options are available.
f. Modigliani and Miller Propositions: Franco Modigliani and Merton Miller developed a
set of propositions related to capital structure. The Modigliani-Miller theorem suggests
that, under certain assumptions, the value of a company is independent of its capital
structure. However, real-world factors like taxes and bankruptcy costs make this
theorem less applicable in practice.
g. Business Risk: The optimal capital structure depends on the nature of the business and
its risk profile. Riskier businesses may choose lower debt levels to reduce financial
distress, while more stable businesses can afford higher debt levels.
h. External Factors: Economic conditions, interest rates, industry norms, and the
company's growth prospects can also influence the choice of capital structure.
In practice, finding the exact optimal capital structure is challenging. It often involves a trade-
off between minimizing the cost of capital (by using more debt) and managing financial risk (by
 having less debt). Companies regularly evaluate their capital structure and adjust it as needed
based on changing circumstances and goals.
Ultimately, the goal of determining the optimal capital structure is to maximize shareholder
wealth and ensure the long-term financial stability and success of the company.
6 Explain following approach of capital structure theory
a) Net Operating Income
This Approach is diametrically opposite to the NI Approach. The essence of this Approach is
that the capital structure decision of a firm is irrelevant. Any change in leverage will not
lead to any change in the total value of the firm and the market price of shares as well as
the overall cost of capital is independent of the degree of leverage
The NOI Approach is based on the following propositions.
• Overall Cost of Capital/Capitalisation Rate (k0) is Constant
• Residual Value of Equity
• Changes in Cost of Equity Capital
• Cost of debt has two parts
 Explicit cost is the rate of interest paid on debt.
 Implicit cost is the increase in cost of equity due to increase in debt
b) Traditional Approach
• The Traditional Approach is midway between the NI and NOI Approaches. It partakes of
some features of both these Approaches. It is also known as the Intermediate
Approach.
• It resembles the NI Approach in arguing that cost of capital and total value of the firm
are not independent of the capital structure. But it does not subscribe to the view (of
NI Approach) that value of a firm will necessarily increase for all degrees of leverage
• In one respect it shares a feature with the NOI Approach that beyond a certain degree
of leverage, the overall cost increases leading to a decrease in the total value of the
firm. But it differs from the NOI Approach in that it does not argue that the weighted
average cost of capital is constant for all degrees of leverage.
7 Explain following approach of capital structure theory
a) Modigliani-Miller Approach
The Modigliani-Miller Thesis3 relating to the relationship between the capital structure,
cost of capital and valuation is akin to the NOI Approach.
The MM proposition supports the NOI Approach relating to the independence of the cost
of capital of the degree of leverage at any level of debt-equity ratio.
There are three basic propositions of the MM Approach:
• The overall cost of capital and the value of the firm are independent of its capital
structure.
• Debt financing increases financial risk. The cost of equity depends on business risk
and financial risk. Business risk is affected by the business operations of the firm
and is independent of its financing pattern. Financial risk is determined exclusively
by the financing pattern/ capital structure
• The cut-off rate for investment purposes is completely independent of the way in
which an investment is financed.
b) Traditional Approach
• The Traditional Approach is midway between the NI and NOI Approaches. It
partakes of some features of both these Approaches. It is also known as the
Intermediate Approach.
• It resembles the NI Approach in arguing that cost of capital and total value of the
firm are not independent of the capital structure. But it does not subscribe to the
 view (of NI Approach) that value of a firm will necessarily increase for all degrees
of leverage
• In one respect it shares a feature with the NOI Approach that beyond a certain
degree of leverage, the overall cost increases leading to a decrease in the total
value of the firm. But it differs from the NOI Approach in that it does not argue
that the weighted average cost of capital is constant for all degrees of leverage