SOURCES AND FORMS OF LONGTERM FINANCING

THE NEED FOR FUNDS No business can live without funds. Throughout the life of a business, money is needed continuously. Firms raise money mainly to meet the following three types of need: 1. To start a business as initial expenditure 2. To fund continuous business activities

3. To expand the business

SOURCES OF FUNDS
Sources of Funds

Internal Sources

External Sources

Short term:
Long-term:

Profit

Depreciation

Sales of assets

Share Capital Loan Capital

Overdraft Leasing Credit card

THE MONEY AND CAPITAL MARKETS

Two types of external markets for funds:
1.

Money market

Short-term debt securities: maturity of less than 1 year T-bills, commercial paper, bankers acceptances, and short-term certificates of deposit Intermediate-term securities: maturity of more than 1 but less than 10 years Long-term securities: maturity of 10 or more years Equity securities: preferred and common stock have longest time horizon since they are issued for life of corporation

2.

Capital market (focus of this chapter)

BUSINESS FINANCE: EXTERNAL

Long Term

Shares
Ordinary Shares Preference Shares New share issues Rights Issue Bonus or Scrip Issue

Loans
Debentures Bank loans (mortgage) Merchant or Investment Banks

Grants by Government i.e. research and development

agreements

Ordinary Shares

Contributed by the owners of the company This capital forms the backbone of the
It is the risk capital of the company No fixed rate of dividend is attached
financial structure of the company

New share issues

Methods
An initial public offering (IPO) or stock market launch is a type of public offering where shares of stock in a company are sold to the general public, on a securities exchange, for the first time. Through this process, a private company transforms into a public company Placing: Shares are issued at a fixed price to a number of institutional investors, such as insurance companies, pension fund etc

Rights Issues

Sale

of shares for cash to existing owners in

proportion to their existing holdings;

Law requires shares which are to be issued for

cash to be offered first to existing shareholders (pre-

emptive rights)

Control and ownership is not diluted cheaper than other methods prevents greater competition

Bonus/script issue

involves issuing new shares to existing

shareholders in proportion to their existing shareholdings

However the shareholders do not have

to pay for the new shares issued

INTERMEDIATE- AND LONG-TERM DEBT

Term loans

Paid off over some number of years Usually negotiated with commercial bank or some other financial institution Fully amortized (principal and interest are paid off in installments over life of loan)

INTERMEDIATE- AND LONG-TERM DEBT

Debentures

Intermediate to long term debt agreements issued by governments, corporations, and other organizations Issued in units of Rs.1,000 principal value per debenture Two promises to:

Repay Rs.1,000 principal value at maturity Pay stated interest rate (coupon rate) when due

Most bonds pay interest semiannually at a rate equal to one-half of the annual coupon rate

LEASE FINANCING

Business has the use of the asset and incurs an obligation either to pay off loan or meet monthly lease payment. At the end of lease term, residual value of asset belongs to lessee. Leasing is a form of debt financing.

LEASE FINANCING
Capital leases meet any one of these four conditions:
1.

2.
3.

4.

Title is transferred to lessee at end of lease term. Lease contains bargain purchase option (an option to buy asset at very low price). Term of lease is greater than or equal to 75% of estimated economic life of asset. Present value of minimum lease payment is greater than or equal to 90% of fair value of leased property.

PREFERRED STOCK
Two important preferences over common stock:
1.
2.

Payment of dividends Stockholders claims on assets of business in event of bankruptcy

PREFERRED STOCK
Preferred stock combines some of the characteristics of bonds and some of the characteristics of common stock

Fixed in amount Holders do not participate in growth of corporate earnings, but rather collect only dividends promised in indenture Payments must be voted on and approved by board of directors of corporation Issues are cumulative (missed dividends accumulate as arrearages and must be paid off before dividends on common stock can be paid)

COMMON STOCK
Each share of common stock has one vote in electing members of corporations board of directors. Board is responsible to stockholders. Board selects president. President reports to board. If one person is a majority stockholder, he/she may serve as both president and chairman.

In large, publicly held corporations, no single individual or small group holds enough shares to exercise voting control of corporation.

COMMON STOCK
Common stock serves as corporations equity cushion

Money paid to corporation for common stock does not have to be repaid. Board declares when dividends are paid. Dividends do not accumulate as arrearages. Stockholders cannot legally claim any specified dividend level. As corporation prospers, board votes to increase dividend along with increased growth in earnings. As dividends increase, value of stock increases.

External short-term sources of loans

Major Types
Bank overdraft

Main Characteristics
This is a short term financing from banks. The amount to be overdrawn depends on the needs of the business at the time and its credit standing. Interest is calculated from the time the account is overdrawn.. This is a loan which requires a rigid agreement between the borrower and the bank. The amount borrowed must be repaid over a certain period or in regular installments. Sometimes, banks change persistent overdrafts into loans, so borrowers must repay at regular intervals. Leasing allows businesses to buy plant, machinery or equipment without paying large sums of money immediately. The leasing company or bank hires or buys the equipment and for the use of the hire company for a certain period of time. If the user can never owns the equipment, it is an operating lease, while if it is given the choice to own the equipment at the expiry time, it is a finance lease. Lease payments are made by the hire company yearly or monthly, etc.

Bank loan

Leasing

Major Type Main characteristics Credit card Credit cards can be used to pay for hotel bills, meals, shopping and materials, etc. They are convenient, and secure because it can avoid the use of cash and the payment of interests within credit periods. Cards may not be suitable for certain purchases, especially a large sum of order because they have a credit limit. Trade credit It is a common method for businesses to buy materials and to pay for them at a later date, usually between 30 and 90 days. Such trade credit given by the seller is usually an interest free way of short term financing.

FACTORS AFFECTING THE CHOICE OF FUNDS

Costs of the fund Costs in terms of interest payments and other expenses: Long term and short term.

Use or purpose of funds For example, the building of a new plant is usually financed by mortgage or share capital, while the purchase of raw materials by trade credit or bank overdraft.

Status and size of the business For a large firm, there are more sources of finance and often with lower interest rates.

Financial situations of a firm

For example, a business in poor financial situation is forced to pay high interest rate for loans. And the bank often requires security or collaterals for their financing.

FACTORS CONTINUED

Gearing condition (ratio) of the firm

Gearing is the relationship between the loan capital and share capital of a business. High geared companies have a larger share of loan capital to share capital. Low geared ones have a small amount of loan capital. Impact over a firm: High gearing may mean no loss of ownership but high risk of liquidity since interest rates may change and loans must be repaid in time. Low gearing may mean some loss of ownership but no burden of loans and interest payments.