Breifly explain the various long term sources of funds

1 – Equity Capital
It represents the interest-free perpetual capital of the company raised by
public or private routes. Either the company may raise funds from the
market via IPO or may opt for a private investor to take a substantial
amount of stake in the company.

 In equity financing, there is a dilution in the ownership and the

controlling stake rest with the largest equity holder.

 The equity holders have no preferential right in the dividend of the

company and carries the higher risk across all the buckets.

 The rate of return expected by the equity shareholders is higher than

the debt holders due to the excessive risk they bear in terms of

repayment of their invested capital.

2 – Preference Capital
Preference shares are those who carry preferential rights over equity
shareholders in terms of receiving dividends at a fixed rate and getting
back the invested capital in the company in case if the same is wound up.

 It is a part of the Net Worth of the Company thus increasing the

creditworthiness and improving the leverage as compared to the

peers.

#3 – Debentures
Is a loan taken from the public by issuing debenture certificates under the
common seal of the company? debentures can be placed via public or
private placement. If a company wants to raise money via NCD from the
general public, it takes the debt IPO route where all the public subscribing
to it gets allotted certificates and are creditors of the company. If a
company wants to raise money privately, It may approach the major debt
investors in the market and borrow from them at higher Interest Rates.

 They are entitled to a fixed payment of interest as per the agreed

upon terms mentioned In the term sheet.

 They do not carry voting rights and are secured against the assets of

the company.

 In case of any default in payment of debenture interest, the

debenture holders can sell the assets of the company and recover

their dues.

 They can be redeemable, irredeemable, convertible and non-

convertible.

4 – Term Loans
They are given generally by banks or financial institutions for more than
one year. They have mostly secured loansgiven by banks against strong
collaterals provided by the company in the form of land & bldg, machinery,
and other fixed assets.

 They are a flexible Source of finance provided by the banks to meet

the long term capital needs of the organization.

  They carry a fixed rate of interest and gives the borrower the

flexibility to structure the repayment schedule over the tenure of the

loan based upon the cash flows of the company.

 It is faster as compared to the issue of equity or preference shares in

the company as there are fewer regulations to abide and less

complexity.

5 – Retained Earnings
These are the profits that are been kept aside by the company over a
period of time to meet the future capital needs of the company.

 These are free reserves of the company which carries nil cost and are

available free of cost without any interest repayment burden.

 It can be safely used for business expansion and growth without

taking additional debt burden and diluting further equity in the

business to an outside investor.

 They form part of the net worth and have an impact directly on

the equity share valuation.

What are the factors affecting cost of capital ?

When company wants to get any new fund from outside resource, it checks
its cost of capital. Company can get the new money through shares and debt.
For getting debt, we have to pay cost of debt in the form of interest payment.
For getting equity or preference share capital, we have to pay dividend to
shareholders.

So, for making optimal model of cost of capital in which cost of capital will be
minimum, we have to study the factors affecting cost of capital. Following are
the main factors which affects cost of capital.

1. Current Economic Conditions

If banks are growing, they can easily give loan at low rate of interest because
they need to increase the sale for stability of their products. At that time,
company's cost of debt will decrease which is the part of company's cost of
capital. Not just bank but whole economic conditions should be ok for this. If
there is big recession in the market, no financial institute will decrease the rate
of interest because they also have to pay the return to their customers. It
means, every loan providing company has also cost of capital. If there will be
stability in the market, cost of debt will decrease and cost of equity capital will
increase.

2. Current Capital Structure 

When we have studied optimal capital structure, we have to study the cost of

capital because for optimal capital structure, we need to calculate weighted
average cost of capital. But if company did not consider cost of capital as factor,
we can include the study of current capital structure as the factor for cost of
capital. Current debt equity ratio will effect the cost of capital. If debt is more
than share capital, we have to pay more cost of debt. If share capital is more
than debt, we have to pay cost of equity or pref. share capital.

3. Current Dividend Policy

Every company has to make dividend policy. What amount of total earning,
company is interested to pay as dividend. For this, we have to study Price-
Earning Ratio (Dividend/EPS). If Price earning ratio will increase, cost of retained
earning will decrease because we will less money which have retained and use
for promoting of business as source of fund.

4. Getting of New Fund 

Company's new fund's requirement will also affect the cost of capital. If
company needs $ 20 million dollars immediately for business promotion,
company will have to pay high rate of interest because with this, risk of financial
institution will increase. Every loan provider works with patience, he needs to
analyze the company before providing big loan. If he will give big loan
immediately, it is sure, he will get more return from company and company has
to pay more cost of this. Except this, every time, when company will go to market
for getting fund, company company will get the money at new market rate. So,
company has also to follow new rate of cost of capital. It may increase or
decrease company's current cost of capital rate.

4. Financial and Investment Decisions 

When we get new share capital or debt, we have to tell to fund providers about
the usage of their fund. If there is more risk in the investment, both
shareholders andcreditors will get high reward for this. So, our financial and
investment decisions will effect the cost of capital.

5. Current Income Tax Rates

We know, we charge the interest before tax charges. When we earn money, we
deduct our interest charges, then we deduct tax charges. So, if tax rate will high,
it will effect the cost of share capital because with high tax charges, our net earn
will decrease and it will decrease earning per share. So, we will give less dividend
to our shareholders.

6. Breakpoint of Marginal Cost of Capital 

Marginal cost of capital is the cost raising one more unit of capital. Its breakpoint
will affect the cost of capital. Before studying, how marginal cost of capital
affects current cost of capital, we have to understand the breakpoint of marginal
cost of capital

What is weighted average cost of capital, and what are its

components?
The weighted average cost of capital (WACC) is a calculation of a firm's cost
of capital in which each category of capital is proportionately weighted. All
sources of capital, including common stock, preferred stock, bonds, and any
other long-term debt, are included in a WACC calculation.

Components
Debt
Advantages:
 no loss of control (voting rights)
 upper limit is placed on share of profits
 flotation costs are typically lower than equity
 interest expense is tax deductible
Disadvantages:

 legally obliged to make payments no matter how tight the funds on hand are
 in the case of bonds, full face value comes due at one time
 taking on more debt = taking on more financial risk (more systematic risk) requiring
higher cash flows

The firm's debt component is stated as kd and since there is a tax benefit from interest payments
then the after tax WACC component is kd(1-T); where T is the tax rate.

Equity
Advantages:

 no legal obligation to pay (depends on class of shares)

 no maturity
 lower financial risk
 it could be cheaper than debt, with good prospects of profitability
Disadvantages:

 new equity dilutes current ownership share of profits and voting rights (control)

 cost of underwriting equity is much higher than debt
 too much equity = target for a leveraged buy-out by another firm
 no tax shield, dividends are not tax deductible, and may exhibit double-taxation