CORPORATE FINANCE
Chapter 1
Introduction to Corporate finance and Introduction to Ownership
Securities
INTRODUCTION
Corporate finance is the area of finance dealing with the sources of funds and the capital
structure of corporations and the actions that managers take to increase the value of the firm to
the shareholders, as well as the tools and analysis used to allocate financial resources. The
primary goal of corporate finance is to maximize or increase shareholder value. Corporate
finance is the study of sources of finance and how to use the money raised to add maximum
value to the shareholder's wealth.
Corporate finance is the study of a business's money-related decisions, which are essentially
all of a business's. Despite its name, corporate finance applies to all businesses, not just
corporations. The primary goal of corporate finance is to figure out how to maximize a
company's value by making good decisions about investment, financing and dividends. In other
words, how should businesses allocate scarce resources to minimize expenses and maximize
revenues? How should companies acquire these resources through stock or bonds, owner
capital or bank loans? Finally, what should a company do with its profits? How much should
it reinvest into the company, and how much should it pay out to the business owners?
MEANING AND SIGNIFICANCE OF CORPORATE FINANCE
Corporate finance deals with various monetary aspects of a business organization. Every
business organization needs finance for its efficient functioning, to increase its profits, to
minimize the cost of production, to make decisions for acquisition and investment, to ensure
that there are sufficient funds etc. In short, finance is the life blood for all types of businesses;
profitable as well as non-profitable. The importance of corporate finance can be classified as
follows:
1. Decision Making: There are several decisions that have to be done on the basis of available
capital and limited resources. If an organization has to start a new project, then it has to consider
whether it would be financially viable and if it would yield profits. So while investing in a new
project or a new venture, a company has to consider several things like availability of finances,
the time taken for its completion, etc. and then make decisions accordingly.
2. Research and Development: In order to survive in a volatile market for a long duration, a
business organization needs to continuously research the market and develop new products to
attract the consumers. It may even have to upgrade its old products to compete with new
vendors in the market. Some companies employ people to conduct market surveys on a large
scale; prepare questionnaire for consumers; do market analysis, while other may outsource this
work to others. All these activities would require
3. Financial support. Corporate finance thus enhances R & D. fulfilling Long Term and
Short Term Goals: Every organization has several long term and short term goals in order to
survive in the market. The short term goals may include paying the salaries of employees,
managing the short term assets, purchase of raw materials for production etc. Some long term
goals would include acquiring bank loans and paying them off; increasing the customer base
for the company etc. Corporate finance helps in fulfilling short and long term goals of the
business.
4. Minimizing Cost of Production: Corporate finance helps in minimizing the cost of
production. With the rising cost of prices of raw materials and labour, the management has to
come up with innovative measures to minimize the cost of production. Many organizations that
spend a lot of money on large scale production, deploy professionals for this purpose. These
people tend to buy quality products from vendors who offer it at lowest possible rates.
5. Raising capital: When an organization has to invest in a new venture, it has to raise capital.
This can be done by selling bonds and debentures and issuing stocks of the company taking
loans from the banks etc. All this can be done only by managing corporate finances in a proper
manner.
6. Optimum Utilization of Resources: The resources available to organizations may be
limited. But if they are utilized efficiently, they can yield good results. For example, a business
organization needs to know the amount of money it can spend on its employees and how much
hike should be given to them. The proper management of corporate finance would also help in
utilizing its profits in such a manner that would help in increasing their efficiency for example,
investing in government bonds, keeping up with the latest technology tends to increase
efficiency.
7. Efficient Functioning: A smooth flow of corporate finance would enable businesses to
function in a proper manner. The salaries of employees would be paid on time, loans would be
cleared in time, purchase of raw materials can be done when required etc.
8. Expansion and Diversification: Corporate finance helps in expanding and diversifying in
to a new area, considering various aspects like the capital available, risks involved, the amount
to be invested for purchase of new equipment etc. All this can be done by experts and this
would be very beneficial for the organization.
9. Meeting Contingencies: Running a business involves talking several risks. Not all risks can
be foreseen. Although you can transfer some of these risks to third parties by buying an
insurance policy, you cannot have every contingency covered by your insurer. You would have
to keep some amount aside to tide over these situations.
UNDER-CAPITALIZATION:
Meaning of Under-capitalization:
A company is said to be under-capitalized when it is earning exceptionally higher profits as
compared to other companies or the value of its assets is significantly higher than the capital
raised. For instance, the capitalization of a company is Rs. 20 lakhs and the average rate of
return of the industry is 15%, But if the company is earning 30% on the capital investment, it
is a case of under-capitalization.
The assets acquired with the existing capitalization facilitate the generation of higher profits.
It so happens when:
I. The assets have been acquired at lower rates, or
II. The company has generated secret reserves by paying lower dividends to the shareholders
over a number of years.
The indicators of under-capitalization are as follows:
a) There is an unforeseen increase in earnings of the company.
b) Future earnings of the company were under-estimated at the time of promotion.
c) Assets might have been acquired at very low prices.
Causes of Under-capitalization:
Under-capitalization may be caused by the following factors:
i. Acquisition of Assets during Recession: Assets might have been acquired at low costs during
recession in the market. And now higher incomes are being earned by their use.
ii. Under-estimation of Requirements: There may be under-estimation of capital requirements
of the company by the promoters. This may lead to capitalization which is insufficient to
conduct its operations.
iii. Conservative Dividend Policy: The management may follow a conservative dividend policy
leading to higher rate of ploughing back of profits. This would increase the earning capacity of
the company.
Efficient Management: The management of a company may be highly efficient. It may issue
the minimum share capital and may meet the additional financial requirements through
borrowings at lower rates of interest.
v. Creation of Secret Reserves: A company may have large secret reserves due to which its
profitability is higher.
OVER-CAPITALIZATION:
Meaning of Over-capitalization: It is the capitalization under which the actual profits of the
company are not sufficient to pay interest on debentures and borrowings and a fair rate of
dividend to shareholders over a period of time. In other words, a company is said to be over-
capitalized when it is not able to pay interest on debentures and loans and ensure a fair return
to the shareholders.
There are three indicators of over-capitalization, namely:
a. The amount of capital invested in the company's business is much more than the real value
of its assets.
b. Earnings do not represent a fair return on capital employed.
C. A part of the capital is either idle or invested in assets which are not fully utilized.
Causes of Over-Capitalization:
Over-capitalization may be the result of the following factors:
i. Acquisition of Assets at Higher Prices: Assets might have been acquired at inflated prices or
at a time when the prices were at their peak. In both the cases, the real value of the asset would
be below its book value and the earnings very low.
ii. Higher Promotional Expenses: The company might incur heavy preliminary expenses such
as purchase of goodwill, patents, etc.; printing of prospectus, underwriting commission,
brokerage, etc. These expenses are not productive but are shown as assets.
iii. Under utilization: The directors of the company may over-estimate the earnings of the
company and raise capital accordingly. If the company is not in a position to invest these funds
profitably, the company will have more capital than is required. Consequently, the rate of
earnings per shares will be less.
iv. Insufficient Provision for Depreciation: Depreciation may be charged at a lower rate than
the original rate, and the company may not make sufficient provisions for replacement of
assets. This will reduce the earning capacity of the company.
MEANING AND FEATURES OF FIXED CAPITAL
Fixed capital is the capital required by the company for a longer period of time. It is the capital
without which the business of the company cannot run. Fixed capital is a part of the total capital
of a company and is used for buying assets like land and building, plant and machinery,
furniture and fixtures, computer equipment’s etc. These assets are acquired for permanent use
in the business and not for resale, that is, for a longer period of time.
The features of fixed capital are as follows:
1. Purchase of Fixed Assets: Normally, fixed capital is used to purchase fixed assets like land
and building, plant and machinery, furniture and fixtures. A part of the fixed capital is also
used to meet promotional and development expenses incurred at the time of promoting and
expanding the company.
2. Meeting Long Term Needs: Fixed capital is needed for meeting the long term capital needs
of a business unit. Fixed capital is required for company promotion, for purchase of fixed assets
and for expansion and diversification of business activities.
3. Permanent in Nature: Fixed capital is permanent in nature. It cannot be withdrawn as long
as the company exists. It can be withdrawn at the time of closure of the business by selling
fixed assets.
4. Low Liquidity: Fixed capital has low liquidity. Funds invested in fixed assets get blocked
up for a longer period of time. An organisation finds it difficult to convert fixed capital into
cash as a lot of time and efforts are required to sell fixed assets.
5. Sources: Fixed capital is raised through different long-term sources like issue of shares,
debentures and long term loans from financial institutions. It is necessary to raise funds through
long term resources as the funds are used for purchasing fixed assets, which are permanent
assets. The funds get blocked for a long period of time.
6. Acts as a Source of Strength: Fixed capital acts as a source of strength for the survival and
stability of a manufacturing company. It makes positive contribution for earning profits.
7. Requirement of Fixed Capital Varies: Fixed capital requirement varies from organisation to
organisation. It depends on a number of factors such as nature of business, level of technology,
scale of business operations etc. The amount of fixed capital required is much more as
compared to working capital requirement.
Fixed Capital - Total Capital Ratio: Generally, fixed capital constitutes a huge percentage of
total capital requirements in most of the organisations which are involved in manufacturing of
goods. This percentage is relatively less in many industries in the service sectors like banks,
couriers, etc.
9. Appreciation and Depreciation: The value of some fixed assets like land and building
increases in due course of time. In other words, there is an appreciation in their values. Other
assets such as machinery, furniture, equipments, etc, depreciate over a period of time.
10. Fixed Capital Management: Fixed capital needs long term planning. Many units face excess
or shortage of fixed capital or units fall sick due to ineffective management of fixed capital.
For avoiding such situations, efficient management of fixed capital is required.
SOURCES OF FIXED CAPITAL
The sources of fixed capital are as follows:
1. Equity Shares: Many companies collect huge amount of fixed capital through the issue of
equity shares. Equity shares represent ownership capital. This fund is available for a long
period of time. It is repaid only when the company closes its operations. Hence, it is the best
source of financing fixed capital.
2. Preference Shares: Fixed capital can be collected by the issue of preference shares. These
shares get a preference regarding payment of dividend and repayment of capital. They are
preferred by cautious investors.
3. Rights Issue of Shares: This is a method of raising further funds from existing shareholders
by offering additional shares to them.
4. Private Placement of Shares: This is a method of raising funds from the group of financial
institutions and others who are ready to invest in the company. In private placement shares are
not issued to public; they are only offered to large companies or institutions.
5. Debentures: Debenture capital is also an important source of raising funds. Debenture
holders are the creditors of the company since debentures are more secured; they are preferred
by the investors. Debenture holders get regular interest. Different types of debentures are issued
for the convenience of the investors.
6. Term Loans: The Company may also obtain term loans from banks and financial institutions
like IDBI, ICICI and so on. Term Loans are repayable by instalments over a long period. They
can be used for purchasing fixed assets and for expansion programmes of the company
7. Retained Earnings: They are the undistributed profits of the company. They are intemal
source of financing. If need arises, the organisation can issue bonus shares and thereby convert
reserves into permanent capital. Retained earnings can be used for expansion programmes, at
the time of replacement or for purchasing additional fixed assets.
8. Lease Financing: It is a new method of financing long-term assets. Finance and leasing
companies helps the firms by providing machinery, equipment, etc. on lease basis. The firm
can use the machinery and equipment and pay rent for the use of the same to the leasing
company. Lease financing relieves the firm from the burden of huge investment in fixed assets.
9. Venture Capital: It is a form of equity financing by specialised institutions to high risk and
high reward projects. In India, venture capital funds are operated by various institutions like
IDBI, SIDBI, ICICI, etc.
SOURCE OF WORKING CAPITAL FINANCING
1. Trade credit refers to the credit extended by the supplier of goods and services in the normal
course of transaction/business/sale of the firm. According to trade practices, cash is not paid
immediately for purchases but after an agreed period of time. Thus, deferral of payment (trade
credit) represents a source of finance for credit purchases.
2. Bank credit Working capital finance is provided by banks in five ways: (i) cash
credits/overdrafts, (ii) loans, (iii) purchase/discount bills, (iv) letter of credit and (v) Corporate
deposits
3. Cash Credit/Overdrafts Under cash credit/overdraft form/arrangement of bank finance, the
bank specifies a predetermined borrowing/credit limit. The borrower can draw/borrow up to
the stipulated credit/overdraft limit. Within the specified limit, any number of
withdrawals/drawings are possible to the extent of his requirements periodically. Similarly,
repayments can be made whenever desired during the period.
4 Loans Under, this arrangement, the entire amount of borrowing is credited to the current
account of the borrower or released, in cash. The borrower has to pay interest on the total
amount. The loans are repayable on demand or in periodic instalments.
5. Bills Purchased/Discounted the amount made available under this arrangement is covered
by the cash credit and overdraft limit. Before discounting the bill, the bank satisfies itself about
the credit-worthiness of the drawer and the genuineness of the bill. To popularise the scheme,
the discount rates are fixed at lower rates than those of cash credit, the difference being about
1-1.5 per cent. The discounting banker asks the drawer of the bill (i.e. seller of goods) to have
his bill accepted by the drawee (buyers') bank before discounting it.
6. Letter of Credit A letter of credit is a document issued by a financial institution, or a similar
party, assuring payment to a seller of goods and/or services provided certain documents have
been presented to the bank These are documents that prove that the seller has performed the
duties under an underlying contract (e.g., sale of goods contract) and the goods (or services)
have been supplied as agreed. In return for these documents, the beneficiary receives payment
from the financial institution that issued the letter of credit
The letter of credit serves as a guarantee to the seller that it will be paid regardless of whether
the buyer ultimately fails to pay. In this way, the risk that the buyer will fail to pay is transferred
from the seller to the letter of credit's issuer. The letter of credit can also be used to ensure that
all the agreed upon standards and quality of goods are met by the supplier, provided that these
requirements are reflected in the documents described in the letter of credit.
7. Commercial Paper: Commercial Paper is a money-market security issued (sold) by large
banks and corporations to get money to meet short term debt obligations, and is only backed
by an issuing bank or corporation's promise to pay the face amount on the maturity date
specified on the note.
Commercial paper is a low-cost alternative to bank loans. It is a short term unsecured
promissory note issued by corporates and financial institutions at a discounted value on face
value. They are usually issued with fixed maturity and for financing of accounts receivables,
inventories and meeting short term liabilities.
Maturity: 7days -1 year Mode of Security
At present, issuers decide on the discount rates on their CPs taking into account as well as
supply/demand forces prevailing in the market. Preconditions for issue of Commercial paper:
tangible net worth (paid-up capital plus free reserves) is not less than Rs 4 crores. has been
sanctioned working capital limit by banks or FlIs. Borrower account of the company is
classified as a Standard Asset by Banks.
Specified Credit Rating of P2 is obtained from CRISIL, A2 from ICRA and PR2 from
CAREDenomination Minimum of Rs. 5lakh and multiples thereof. Amount invested by a
single by a single investor should not be less than Rs 5 lakh (face value).
Commercial paper can be issued in demat format only.
Every company proposing to issue commercial paper should submit the proposal in the form
prescribed by the RBI to the bank which provides working capital along with the credit rating
of the company. The RBI scrutinizes the application and on being satisfied that eligibility
criteria are met and conditions stipulated are met will has to be privately place the issue within
two weeks by the company or through the good offices of a merchant banker.
OWNER SHIP SECURITIES- EQUITY SHARES
Equity shares or ordinary shares are those ownership securities which do not carry any special
right in respect of annual dividend or the return of capital in the event of winding up of the
company.
Equity shareholders are the real owners of the company. They get dividend only after the
dividend on preference shares is paid out of the profits of the company. They may not receive
any return, if there are no profits. At the time of winding up of the company equity capital can
be paid back after every claim including that of preference shareholders has been settled.
According to Hoagland, Equity shareholders are the residual claimants against the assets and
income of the corporation. The financial risk is more with equity share capital. So equity shares
are also called "Risk Capital."
As the equity shareholders have higher risk, they also have a chance of getting higher dividend
if the company earns higher profits. Equity shareholders control the affairs of the company
because by possessing the voting rights they elect the directors of the company.
Advantages of Equity Shares:
No Charge on Assets: The Company can raise the fixed capital without creating any charge
over the assets.
No-Recurring Fixed Payments: Equity shares do not create any obligation on the part of
company to pay fixed rate of dividend.
Long term Funds: Equity capital constitutes the permanent source of finance and there is no
obligation for the company to return the capital except when the company is liquidated.
OWNER SHIP SECURITIES- PREFRENCE SHARES
Preference Shares are those shares which carry priority rights with regard to payment of
dividend and return on capital.
According to Sec. 85 of the Indian Companies Act, preference share is that part of the share
capital of the company which is endowed with the following preferential rights:
Preference with regard to the payment of dividend at fixed rate.
Preference as to repayment of capital in the event of company being wound up.
Thus, Preference shareholders enjoy two preferential rights over the equity shares. Firstly, they
are entitled to receive a fixed rate of dividend out of the net profits of the company prior to the
declaration of dividend on equity shares.
Secondly, the assets remaining after the payment of debts of the company under liquidation are
first distributed for returning preferential capital (contributed by the preference shareholders).
Types of Preference Shares:
i. Cumulative preference shares: The holders of cumulative preference shares are sure to
receive dividend on the preference shares held by them for all the years out of the earnings of
the company. Under this the amount of unpaid dividend is carried forward as arrears and
becomes the charge on the profits of the company.
ii. Non-cumulative preference shares: If in any particular year they are not paid dividend, they
will be paid such arrear in the next year before any dividend can be distributed among the
equity shareholders. But the non- cumulative preference shareholders are entitled to their yearly
dividend only if there is sufficient net profit in that year. In case the earnings are not adequate,
dividends are not paid and the unpaid dividend is not carried forward for payment out of profits
in subsequent years.
III. Participating preference shares: The holders of these preference shares are entitled to fixed
rate of dividend and in addition they are also granted the right to share the surplus net profits
of the company, left after paying a certain rate of dividend on equity shares. Thus, participating
shareholders obtain return on their investments in two forms (a) fixed dividend (b) share in
surplus profits.
iv. Non-participating preference shares: The preference shares which do not carry the right to
share in the surplus profits are known as non-participating preference shares. Redeemable
preference shares: Redeemable preference shares are those which, in accordance with the terms
of issue, can be redeemed or repaid after a certain date or at the discretion of the company.
vi. Irredeemable preference shares: The preference shares which cannot be redeemed during
the life time of the company are known as irredeemable preference shares.
vii. Convertible preference shares: If the preference shareholders are given the option to
convert their shares into equity shares within a fixed period of time, such shares will be known
as convertible preference shares.
viii. Non-convertible preference shares: The preference shares which cannot be converted into
equity shares are called non- convertible preference shares.
ix. Guaranteed Preference Shares: In case of conversion of a private concern into a limited
company or in case of amalgamation and absorption, the seller guarantees a particular rate of
dividend on preference shares for certain years. These shares are called guaranteed preference
shares.
Advantages of preference shares:
Suitable to Conservative Investors: Preference shares mobilize the funds from such investors
who prefer safety of their capital and want to earn income with greater certainty.
Retention of Control: Control of the company is vested with the management by issuing
preference shares to outsiders because such share- holders have restricted voting rights.
Trading on equity: Preference shares bear a fixed yield and enable the company to adopt the
policy of "trading on equity" to increase the rate of dividend on equities out of profits remaining
after paying fixed rate of dividend on preference shares.
Flexibility in the Capital Structure: In case of redeemable preference shares, company may feel
at ease to bring flexibility in the financial structure as they can be redeemed whenever a
company desires.
No charge on Assets of the Company: The Company can raise capital in the form of preference
shares for a long term without creating any charge on its assets.
CREDITORSHIP SECURITIES OR DEBENTURES:
A company can raise finance by issuing debentures. A debenture may be defined as the
acknowledgement of debt by a company. Debentures constitute the borrowed capital of the
company and they are known as creditorship securities because debenture holders are regarded
as the creditors of the company. The debenture holders are entitled to periodical payment of
interest at a fixed rate and are also entitled to redemption of their debentures as per the terms
and conditions of the issue.
Debentures
A Debenture is a document issued by the company. It is a certificate issued by the company
under its seal acknowledging a debt. According to the Companies Act 1956, "debenture
includes debenture stock, bonds and any other securities of a company whether constituting a
charge of the assets of the company or not."
Advantages of Debenture
Debenture is one of the major parts of the long-term sources of finance which of consists the
following important advantage:
Long-term sources: Debenture is one of the long-term sources of finance to the company.
Normally the maturity period is longer than the other sources of finance.
Fixed rate of interest: Fixed rate of interest is payable to debenture holders, hence it is most
suitable for the companies that earn higher profit. Generally, the rate of interest is lower than
the other sources of long-term finance.
Trade on equity: A company can trade on equity by mixing debentures in its capital structure
and thereby increase its earning per share. When the company applies the trade on equity
concept, cost of capital will reduce and value of the company will increase.
Income tax deduction: Interest payable to debentures can be deducted from the total profit of
the company. So it helps to reduce the tax burden of the company.
Protection: Various provisions of the debenture trust deed and the guidelines issued by the
SEB1 protect the interest of debenture holders.
