BA3204 – Financial Management

Unit I – Long Term Sources of Funds

 Introduction
◉ Financial institutions play a vital role in channelizing money from one
point to another point in the financial system.
◉ Corporations obtain finances from different sources and the choice is
made based on several constraints, such as cost, control, and risk.
◉ Equity holders are the last recipients of the firm’s income, thus having
residual claims.
◉ Debt holders have the first right to the firm’s income.
◉ Financing structure of a firm is determined by the firm’s priorities in
terms of cash-flow rights, control rights, collateral, and risk.
LONG TERM FINANCE

◉ Why companies need long-term finance?

○ When they are being set up for the first time
○ At the time of expansion
○ For diversification into other areas
○ For modernizing its equipment and process technology
○ For taking over of another unit and so on.
◉ When a firm wants to invest in long-term assets, it must
find means to finance them.
◉ In most cases, internal resources are not enough to
support investment plans.
◉ So they have to seek external funding.
Factors affecting the choice of source of funds

◉ Cost
◉ Financial strength and Stability of operations
◉ Form of organisation and legal status
◉ Purpose and Time period
◉ Risk profile
◉ Control
◉ Effect of credit worthiness
◉ Flexibility and ease
 Sources of long term finance
◉ The following are the sources of long term finance commonly
employed by business firms.

1. Retained Earnings / Ploughing back of profits

2. Equity share capital
3. Preference share capital
4. Debentures Capital
5. Term loans
 1. Retained Earnings / Ploughing back of profits

◉ Depreciation and retained earnings represents internal sources of

finance.
◉ Companies usually retain 30% to 80% of profits after tax.
◉ Depreciation is used for replacing worn-out machinery.
◉ So retained earnings is the only internal source for financing growth.
◉ Ex: Microsoft
◉ Ex: Infosys is a debt-free company. It doesn't have any
outstanding debt or fixed deposits. The company presently
generates sufficient cash internally to finance all its operational,
financing and investment requirements.
 Retained Earnings - Company’s point of view
Merits:
◉ retained earnings are readily available internally
◉ eliminates issue costs and losses on account of under pricing –
external equity
◉ no dilution of control
◉ useful for financing expansions
◉ enhances reputation and increases capacity of business to absorb
sudden business shocks
◉ no fixed obligation to pay interest or dividend
Demerits:
◉ amount of retained earnings may be limited and highly variable
◉ opportunity costs of retained earnings is quite high
 Retained Earnings - Shareholders’ point of view

Merits:
◉ subject to lower rate of tax (capital appreciation) than dividend
◉ reinvestment of profits
Demerits:
◉ conversion of capital appreciation into current income is
inconvenient
◉ suboptimal investment policy hurts the shareholders
 2. Equity Share Capital

◉ A share is the share in the capital of the company and

includes stock except where a distinction made between
stock and share is expressed or implied.
◉ A share is one of the units into which the share capital of a
company has been divided.
◉ A public company can issue two types of shares – equity
and preference.
◉ Equity shares are shares which are not preference shares.
◉ They do not carry any preferential right.
◉ They will rank after preference shares for the purposes of
dividend and repayment of capital in the event of winding
up (residual claim).
◉ The rate of dividend is not fixed – depends on the
availability of divisible profits and intention of directors.
◉ Equity shareholders control the company – entitled to vote
at the general meeting of the company.
◉ These shares cannot be redeemed until liquidation and the
liability of the shareholders is limited to capital contribution.
 Equity Share Capital - Company’s point of view
Merits: Demerits:
1. no legal obligation for company 1. cost of equity is high – rate of
regarding payment of dividend return is high due to high risk
2. not repayable during lifetime of 2. equity dividends are not tax
company – permanent capital deductible payments – no tax
3. do not carry any charge against shield
assets. 3. cost of issuing equity is high –
4. losses are not magnified during underwriting commission,
periods of adversity brokerage, issue expenses are
5. enhances credit worthiness of
high
company – larger the equity 4. sale of equity stock may result
base, higher is ability to raise in dilution of control
debt.
 Equity Share Capital - Shareholders’ point of view
Merits:
◉ Enjoy controlling power
◉ Liability is limited to extent of capital contribution
◉ Rewards of equity capital can be very high
Demerits:
◉ Since equity shareholders are scattered – control exercised by them is
weak.
◉ Cannot contest the dividend decision of Board of Directors
◉ Have residual claim – lowest priority
◉ Equity stock prices fluctuate widely – risky
 3. Preference share capital
◉ Preference shares are those which carry following preferential right
over other classes of shares.
○ Preferential right in respect of fixed dividend
○ Preferential right as to repayment of capital – during winding up
◉ It is a hybrid form of financing.
◉ Preference dividend is payable out of distributable profits, not an
obligatory payment and not tax deductible payment.
◉ Dividend rate is usually fixed, do not enjoy the right to vote.
◉ In past three years there are many reputed companies such as Tata
Capital, L & T Finance Holding company, IL & FS, have issued
preference shares under private placement.
◉ The dividend rate offered by them are very attractive for an investor,
who are looking forward to fixed tax free return.
Classes of Preference shares
1. On basis of cumulative dividend payable:
◉ i. Cumulative preference shares
◉ ii. Non Cumulative preference shares
2. On basis of Callability:
◉ i. Redeemable preference shares – called back by company
◉ ii. Irredeemable preference shares – not called back during its lifetime
3. On basis of Convertibility
◉ i. Convertible preference shares – convertible into equity shares
◉ ii. Non Convertible preference shares
4. On basis of Participation in surplus profits and assets – after paying equity
shareholders.
◉ i. Participating preference shares
◉ ii. Non-participating preference shares
 Preference shares - Company’s point of view
Merits:
◉ no legal obligation to pay dividend
◉ no redemption liability – except redeemable shares
◉ it is a part of net worth – enhances credit worthiness
◉ no dilution of control – no voting right
◉ no collateral is pledged.
Demerits:
◉ Compared to debt capital – very expensive
◉ Not a permanent source of finance
◉ Least preferred avenue of investment
Preference Shareholders’ point of view

Merits:
◉ Earns stable dividend rate – less risky
◉ Tax exempt
Demerits:
◉ Can enforce their right to dividend.
◉ Preference dividend rate is rather modest.
◉ Price fluctuation of preference shares greater than debentures.
 4. Debentures Capital
◉ Debentures are marketable legal contract whereby the
company promises to pay whoever earns it, a specified rate
of interest for a certain period of time.
◉ It is a document issued by a company as an evidence of
debt due from the company with or without a charge on
company’s asset.
◉ Ex: Kosamattam Finance, Muthoot Finance, Srei Equipment
Finance, Dewan Housing Finance Corp, JM Financial Credit
Solutions and Shriram Transport Finance Company together
mopped up Rs 190 billion through retail issuance
of non-convertible debentures (NCDs) during 2018.
 Debentures - Company’s point of view

Merits:
◉ interest on debentures is tax deductible
◉ no dilution of control
◉ fixed monetary burden on company
Demerits:
◉ failure to pay interest can cause great deal of embarrassment
◉ enhances financial risk- increases cost of equity capital
 Debentures - Investor’s point of view
Merits:
◉ earn stable rate of return
◉ enjoy high order of priority in event of liquidation
◉ protected by various provisions of debenture trust deed
◉ generally have fixed maturity period
Demerits:
◉ interest on debentures fully taxable
◉ Debenture prices are vulnerable to increase in interest rates.
◉ Do not carry right to vote
 5. Term loans

◉ Term loans represent a source of debt finance which is generally

repayable in more than one year but less than 10 years.
(Medium term-1 to 5 years)
◉ Security – assets financed with proceeds of loan – prime
security and other assets – collateral security
◉ Interest payment and principal repayment – definite obligation
◉ Restrictive conditions – are imposed by banks and financial
institutions upon borrowers
 Term Loans - Company’s point of view
Merits:
◉ cost is lower than equity or preference
◉ no dilution of control – no right to vote
Demerits:
◉ Interest and principal repayment – obligatory
◉ Restrictive conditions may reduce managerial freedom
◉ Entitles lenders to put their nominee on board
◉ Increases financial risk of the firm
◉ Convertibility claim – debentures can be converted into equity
shares
 Term Loans - Lender’s point of view

Merits:
◉ earn fixed rate of interest and have definite maturity period
◉ secured lending
◉ restrictive conditions to protect interest
Demerits:
◉ No right to vote
◉ Not represented by negotiable securities