MBA SEM II

Financial Management
Unit - III

(Syllabus - Instrume nts of Long Term Finance, Share Capital, Debentures/ Bonds, Hybrid
Instruments, Venture Capital)

Concept of Business Finance

The term finance means money or fund. The requirements of funds by business to carry out its various
activities are called business finance. Finance is needed at every stage in the life of a business. A business
cannot function unless adequate funds are made available to it.

Finance is a broad term that describes activities associated with banking, leverage or debt, credit, capital
markets, money, and investments.

Concept of Financing
Financing is the process of providing funds for business activities, making purchases, or investing.

Need of Business Finance

1. Fixed Capital Require ment: In order to start a business, funds are needed to purchase fixed assets
like land and building, plant and machinery. The funds required in fixed assest remain invested in the
business for a long period of time.

2. Working Capital Require ment: A business needs funds for its day to day operation. This is known
as working Capital requirements. Working capital is required for purchase of raw materials, to pay
salaries, wages, rent and taxes.

3. Diversification: A company needs more funds to diversify its operation to become a multi-product
company e.g. ITC.

4. Technology up gradation: Finance is needed to adopt modern technology for example uses of
computers in business.

5. Growth and expansion: Higher growth of a business enterprise requires higher investment in fixed
assets. So finance is needed for growth and expansion.

Parameter for choosing sources of fund

1. Cost of source of fund.
2. Tenure.
3. Leverage planned by the company.
4. Financial condition prevalent in the economy.
5. Risk profile of both the company as well as the industry in which the company operates.
Classification of Sources of Funds
Businesses can raise capital through various sources of funds which are classified into three
categories.
1. Based on Time / Period – The period basis is further divided into three dub-divisions.

 Long Te rm Source of Finance – This long term fund is utilized for more than five years.
The fund is arranged through preference and equity shares and debentures etc. and is
accumulated from the capital market.
 Medium Term Source of Finance – These are short term funds that last more than one
year but less than five years. The source includes borrowings from a public deposit,
commercial banks, commercial paper, loans from a financial institute, and lease financing,
etc.
  Short Term Source of Finance – These are funds just required for a year. Working Capital
Loans from Commercial bank and trade credit etc. are a few examples of these sources.
2. Based on Owne rship – These sources of finance are divided into two categories.

 Owner’s Fund – This fund is financed by the company owners, also known as owner’s
capital. The capital is raised by issuing preference shares, retained earnings, equity shares,
etc. These are for long term capital funds which form a base for owners to obtain their right
to control the firm’s management and operations.
 Borrowed Funds – These are the funds accumulated with the help of borrowings or loans
for a particular period of time. This source of fund is the most common and popular
amongst the businesses. For example, loans from co mmercial banks and other financial
institutions.
3. Based on Gene ration – This source of income is categorized into two divisions.

 Inte rnal Sources – The owners generated the funds within the organization. The example
for this reference includes selling off assets and retained earnings, etc.
 External Source – The fund is arranged from outside the business. For instance, issuance of
equity shares to public, debentures, commercial banks loan, etc.

Methods of Raising Finance

Shares
Issue of Share: The capital obtained by issue of shares is known as share capital. The capital of a
company is divided into small units called share. If a company issue 10,000 shares of Rs. 10/- each
then the share capital of company is 1, 00,000. The person holding the share is known as
shareholder. There are two types of share (I) Equity share (II) preference share.

a) Equity Share: Equity shares represent the ownership of a company. They have right to vote
and right to participate in the management.
Advantages/Merits
1. Permanent Capital: Equity share capital is important source of finance for a long term.
2. No charge on assets: For raising funds by issue of equity shares a company does not need
to mortgage its assets.
3. Higher returns: Equity share holder get higher returns in the years of high profits.
4. Control: They have right to vote and right to participate in the management.
5. No burden on company: Payment of equity dividend is not compulsory.

Limitations/Demerits
1. Risk: Equity shareholder bear higher risk because payment of equity dividend is not
compulsory.
2. Higher Cost: Cost of equity shares is greater than the cost of preference share.
3. Delays: Issue of Equity shares is time consuming.
4. Issue depends on Share Market Conditions: Equity Shareholders are the primary risk bearer
therefore the demand of equity shares is more in the boom time.
b) Preference Share – Preference shares are considered safer in investment. (as compare to
equity shares) They receive dividend at a fixed rate. Preference shareholders are like creditors.
They have no voting right.

Types of Preference Shares

1. Cumulative preference shares.
2. Non cumulative preference shares.
3. Participating preference shares.
4. Non participating preference shares.
5. Convertible preference shares.
6. Non Convertible preference shares.

Merits of Preference Shares:

1. Investment is safe: Preference shareholders’ investment is safe. They have preferential right
to claim dividend and capital.
2. No Charge on assets: The company does not need to mortgage its assets for issue of
preference shares.
3. Control: It does not affect the control of equity share holders because they have no voting
right.
4. Fixed dividend: They get fixed dividend. So, they are useful for those investor who want
fixed rate of return.

Limitations /Demerits

1. Costly sources of funds: Rate of preference dividend is greater than rate of interest on
debenture, for a company it is costly source of funds than Debentures.
2. No tax saving: Preference dividend is not deductible from profit for income tax. Therefore,
there is no tax saving.
3. Not suitable for risk takers – Preference shares are not suitable for those who are willing to take
risk for higher return.
4. As dividend on these shares is to be paid only when the co mpany earns profit, so investors may
not be very attractive to these.

Difference between Equity Shares and Preference Shares

Base Equity Shares Preference Shares

1. Dividend After preference shares Priority over equity share

2. Voting Right Dividend is paid full voting rights. No voting right.

3. Risk Risk bearing securities Less risk

4. Rate of Return Fluctuates with profit Fixed Rate of Dividend

5. Control Control on the management. No control on the management.

 Debentures

Debentures are the important debt sources of finance for raising long term finance. Debenture
holders get fixed rate of interest on Debentures. Interest is paid after every six months or one year.
They are like creditors of a company.
Type of Debentures

1. Secured Debentures
2. Unsecured Debentures
3. Convertible Debentures.
4. Non Convertible Debentures
5. Redeemable Debentures.
6. Registered Debentures.

Merits of Debentures
1. Investment is Safe: Debentures are preferred by those investor who do not want to take risk and
interested in fixed income.
2. Control: Debenture holder does not have voting right. No control over the management.
3. Less Costly: Debentures are less costly as compared to cost of preference shares.
4. Tax Saving: Interest on Debentures is a tax deductable expense. Therefore, there is a tax saving.

Limitation of Debentures

1. Fixed Obligation: There is a greater risk when there is no earning because interest on
debentures has to be paid if the company suffers losses.
2. Charge on assets: The Company has to mortgage its assets to issue secured Debentures.
3. Reduction in Credibility: With the new issue of debentures, the company’s capability to
further borrow funds reduces.

Difference between Shares and Debentures

Base Shares Debentures

1. Nature Shares are the capital Debentures are a loan

2. Return Dividend Interest

3. Voting Right Full voting right No voting right

4. Holder Owner is called shareholder. Creditor

5. Types There are two types of shares More than two types

Secured and generally carry a charge on

6. Security Not secured by any charge
the assets of the company
 Retained Earnings
A portion of company’s net profit after tax and dividend, which is not distributed but are retained
for reinvestment purpose, is called retained earnings. This is also called sources of self- financing.

For example: X Ltd. has total capital of Rs. 50,00,000 which consists of 10% Debt of
Rs.20,00,000, 8% preference share capital Rs. 10,00,000, and equity share capital Rs. 20,00,000.
Tax rate is 40%, company’s return on total capital is 20%.

Particulars Rs.

Net profit before inte rest and tax (PBIT) (20% of Rs. 50,00,000) 10,00,000
Less: Interest on debentures(10% of 20,00,000) (-) 2,00,000

Net profit before tax(PBT) 8,00,000

Less: Tax provision @ 40% (-) 3,20,000

Net profit after Tax(PAT) 4,80,000

Less: pre dividend(9% of 10,00,000) (-) 80,000

Net profit after tax and pre dividend 4,00,000

Less: Equity Dividend (-) 2,00,000

Retained Earnings 2,00,000

Merits
1. No costs: No costs in the form of interest, dividend, advertisement and prospects, to be incurred
by the company to get it.
2. No charges on assets: The company does not have to mortgage its assets.
3. Growth and expansion: Growth and expansion of business is possible by reinvesting the
retained profits.

Demerits
1. Uncertain Source: It is uncertain source of fund because it is available only when profits are
high.
2. Dissatisfaction among shareholder: Retained profits cause dissatisfaction among the shareholder
because they get low dividend.

Loans
Commercial Banks : Commercial Banks give loan and advances to business in the form of cash
credit, overdraft loans and discounting of Bill. Rate of interest on loan is fixed.

Financial Institution: The state and central government have established many financial
institutions to provide finance to companies. They are called development Bank. These are IFCI,
ICICI, IDBI, LIC and UTI. etc.
 International Source of Business Finance

1. Commercial Bank: Commercial Bank provides foreign currency loan for business all-over the
world. Standard chartered Bank is an important organization for foreign currency loan to the
Indian industry.
2. Inte rnational Agencies and Development Bank: A number of international agencies and
development Bank e.g. IFC, ADB, provide long term loan.
3. Inte rnational Capital Market:
I. GDR: When the local currency shares of a company are delivered to the depository bank,
which issues depository receipt against shares, these receipt denominated in US dollar are caller
GDRs.
II. ADR: The depository receipt issued by a company in USA is known as ADRs (American
Depository Receipts)
III. Foreign Currency Convertible Bonds (FCCBs): The FCCBs are issued in a foreign
currency and carry a fixed interest rate. These are listed and traded in foreign stock exchange
and similar to the debenture.
4. Indian Depository Receipts (IDRS)
IDRs are like GDR or ADR except that the issuer is a foreign company raising funds from
Indian Market. IDRS are rupee dominated. They can be listed on any Indian stock Exchange.
Issue Procedure of IDRS

Hybrid Instruments
Concept
A single financial security that combines two or more different financial instruments. Hybrid
securities, often referred to as "hybrids," generally combine both debt and equity characteristics.
The most common type of hybrid security is a convertible bond that has features of an ordinary
bond but is heavily influenced by the price movements of the stock into which it is convertible.

An investment product that combines the attributes of an equity security with a debt security.
Generally, hybrid instruments are designed as debt-type instruments with exposure to
the equities market. Examples of hybrid instruments are convertible bonds, preferred
stocks, equity default swaps and structured notes linked to an equity index. Also called hybrid
securities.

The history of hybrid securities may well be divided into two periods: pre- financial crisis and post-
financial crisis. Before the crisis, hybrid issuances were quite significant and product structuring
efforts resulted in a vast array of hybrid products.

Definition of 'Hybrid Security'

A security that combines two or more different financial instruments. Hybrid securities generally combine
both debt and equity characteristics. The most common example is a convertible bond that has
features of an ordinary bond, but is heavily influenced by the price movements of the stock into which
it is convertible. Often referred to as "hybrids".

'Hybrid Security'

New types of hybrid securities are being introduced all the time to meet the needs of sophisticated
investors. Some of these securities get so complicated that it's tough to define them as either debt
or equity.

Overview of the principal structuring – In particular, it:

 Provides a general overview of hybrid securities.
 Considers some specific examples of hybrid securities.
 Examines how hybrid securities performed during the financial crisis.
 Outlines the regulatory reform that has been introduced in the wake of the crisis.
 Considers the emergence of contingent capital instruments and their potential to replace hybrid
securities like trust preferred securities.
 The chapter is a summary and does not purport to be a full discussion of the regulatory and tax
issues, which are quite complex and differ jurisdiction by jurisdiction.

Hybrid Financing and Various Such Instruments

1. Preference Shares
Preference share is also a long-term source of equity finance. It is commonly known as hybrid
financing instrument because it shares certain characteristics of debt also.
Like debt has fixed interest rate, preference shares have fixed dividend and they also have a
preference of payment at the time of liquidation just as debt holders get. They do not have any
say in the management in the form of voting rights also do not have any share in the residual
profits also.
Certain attributes of preference shares resemble the equity shares. The preference dividend
is also paid out of net profits after taxes but the only difference is that the dividend is fixed. In
the weak financial situations, management may consider not paying the dividend to preference
shareholders. If the shares are cumulative preference shares, the said dividend may be
postponed but will have to pay if the next year financials are good. A specific type of preference
share i.e. irredeemable preference share does not have a certain maturity also.
2. Convertible Debentures
These are a different type of debentures which are also categorized as hybrid financing. In
addition to the normal debenture features, these debentures have the option to convert the
debenture into equity on certain terms and conditions. These debenture holders enjoy the regular
income of interest till the time they exercise their right or the option of converting it into equity
shares.
3. Warrants
Similar to debentures, warrants also have the right to purchase equity shares of a company.
Warrants are not a debenture or equity till the time they are exercised and equity is purchased.
They are just a right or option to purchase equity which the holder has.
4. Options
There are debt instruments which accompany options that may be either call or put. These
options convert the debt into equity. This kind of instruments remains debt at the time of issue
until the time they are exercised. The post they are exercised, they become equity. A call option
allows the holder of the option to buy something at a certain price and on or before a certain
date whereas put option allows selling.
Hybrid capital securities, or securities that have some equity characteristics and some debt
characteristics, have been popular for over a decade. Hybrid securities lie somewhere along the
equity-debt continuum, but where exactly, is the subject of great debate, and depends largely on the
terms of the instruments as well as the provisions of applicable national laws.

Hybrid Securities include:

 Certain classes of preferred stock.
 Trust preferred securities.
 Convertible debt securities.
 Debt securities with principal write-down features.
 Mandatorily convertible instruments.

Objectives / Purpose
 Issuers like hybrid securities because they are considered an attractive, cost-efficient means of
raising non-dilutive capital.
 Hybrid securities are issued by financial institutions, including banks and insurance companies,
as well as by corporate issuers, which are generally utilities. Hybrid securities often receive
favorable treatment by ratings agencies and regulators when they analyze an issuer’s capital
structure. Many hybrids also provide a lower after-tax cost of capital for issuers compared to
common stock.
Venture Capital
Evolution of Venture Capital in India
In 1983, the first analysis was reported on risk capital in India. It indicated that new companies
often face barriers while entering into the capital market and also for raising equity finance which
weakens their future expansion and growth. It also indicated that on the whole, there is a need to
assess the equity cult by ensuring competitive return on equity investment. This all came out as
institutional inadequacies and resulted in the evolution of Venture Capital.

In India, IFCO was the first institution to initiate the idea of Venture Capital when it established the
Risk Capital Foundation in 1975. It provided the seed capital to all small and risky projects.
However, the concept of Venture Capital got its recognition for the first time in the budget for the
year 1986-87.

Venture Capital (VC) industry has 4 main entities, which are mentioned below

1. Entrepreneurs who need funding

2. Investors with an objective of securing very high returns.
3. Investment bankers who need companies to sell.
4. Venture Capitalists (VC) who make money for themselves by creating a market for the above 3
players in the industry.

Meaning of Venture Capital

 Entrepreneurs need investments for their start-up companies. The investments or the capital that
these entrepreneurs receive from wealthy investors is called Venture Capital and the investors are
called Venture Capitalists.
VC firms reduce the risk of investments by co- investing with other VC firms. Usually, there will be
the main investor called the ‘lead investor’ and other investors will be called ‘followers’.

How does Venture Capital Fund work

1. Venture Capital Fund is made up of investments from wealthy individuals or companies who
give their money to a VC firm to manage their investment portfolios for them and to invest in
high-risk start- ups in exchange for equity.
2. The basic idea is to invest in a company’s balance sheet and infrastructure.
3. Venture Capitalist nurtures the idea of an entrepreneur for a short per iod of time and exits with
the help of an investment banker.
4. In a start-up company, VC will receive an equity partnership in exchange for investments in
the start-up company.
5. VC’s receive liquidation preference; it means in the worst-case scenario where the company
fails, VCs are given the first claim to all the company’s assets and technology. It also offers
voting rights over key decisions like Initial Public Offer (IPO) or even sale of the company.

Types of Venture Capital funding

As per the ideation stage, age of Start-up Company and its performance over the years, venture
capital funding can be categorised into different types.
Below table gives a list of the types of venture capital funding and their features

Type of Objective of Funding

Funding

Pre-seed 1. Funding provided when a startup is less than a year old.

funding 2. Supports R&D, Market Research.
3. Recruit new members.

Seed Capital 1. Start- up company will need a product that will be viable in the market

Series A 1. The start- up company needs to have a market-proven product that will help in
funding scaling up fast.

Series B 1. This round is considered to be less risky.

funding 2. Funding is used for Business Development, advertising.

Series C 1. Funds for developing more products and services, acquiring another company
funding

Series D 1. Few start-ups reach this stage.

funding 2. Positive reasons could be the company wants to stay private for some more
time or they need to go for more expansion before going for IPO.
 3. The negative reason could be the company did not hit the expected growth
plans.
4. This is down round funding as trust in the companies abilities has been eroded.

Advantages of Venture Capital

1. Banks usually prefer to finance a new business which has hard assets. In the current information-
based economy, new start-ups hardly have any hard asset. Venture Capitalists step in under these
circumstances.
2. They can provide more insights into the market.
3. Can help in strategy formulation.
4. Can help in developing strategic networks

Importance of Venture Capital

Venture Capital institutions lets entrepreneurs convert their knowledge into viable projects with the
assistance of such Venture Capital institutions.

 It helps new products with modern technology become commercially feasible.

 It promotes export oriented units to earn more foreign exchange.
 It not only provide the financial institution but also assist in management, technical and others.
 It strengthens the capital market which not only improves the borrowing concern but also creates a
situation whereby they can raise their own capital through capital market.
 It promotes modern technology through the process where financial institutions encourage
business ventures with new technology.
 Many sick companies get a turn around after getting proper nursing from such Venture Capital
institutions.

Features of Venture Capital

1. High-risk investment: It is highly risky and the chances of failure are much higher as it provides
long-term startup capital to high risk- high reward ventures.
2. High Tech projects: Generally, venture capital investments are made in high tech projects or areas
using new technologies as they have higher returns.
3. Participation in Management: Venture Capitalists act complementary to the entrepreneurs, for
better or worse, in making decisions for the direction of the company.
4. Length of Investment: The investors eventually seek to exit in three to seven years. The process
takes several years for having significant returns and also need the talent of venture capitalist and
entrepreneurs to reach completion.
5. Illiquid Investment: It is an investment that is not subject to repayment on demand or a repayment
schedule.
Top 10 Venture Capital Firms in India
The Indian startup ecosystem highly relies on venture capital fund ing. However, many
entrepreneurs are confused, hesitant, and sometimes find it difficult to ascertain which investors are
reliable. Therefore, we have made a list of the top 10 venture capital firms in India and also
provided some basic information about these firms below:

1. Accel Partners

With over 3 decades of experience in the field of venture capital financing, Accel Partners have
helped hundreds of companies evolve. Its vision is to provide assistance to the global
entrepreneur community.

Investment structure - Invests between $0.5 million and $50 million.

Industries - Infrastructure, Storage Technologies, Data-Driven technologies, Cloud-based

services, Mobile and Software, SaaS, Biotechnology, Healthcare, Education.

Startups funded - BookMyShow, Urbanclap, Swiggy, Rentomojo, Freshdesk, Myntra,

Commonfloor, Flipkart, BabyOye, TaxiForSure.
2. Helion Venture Partners

Based in Mauritius, Helion Venture Partners aids entrepreneurs to develop a strategy to

accomplish their plan in the marketplace. Apart from financing startups, Helion also helps
companies to solve complex business problems.

Investment structure - Invests between $2 million to $10 million.

Industries - Retail services, Outsourcing, E-commerce, Consumer Services, Mobile,

Advertising, Healthcare, Enterprise Software, Travel and Tourism, Internet, Education.

Startups funded - MakeMyTrip, Yepme, NetAmbit, PubMatic, RedBus, SimpliLearn, EzeTap,

Wooplr.

3. Sequoia Capital India

A venture capital firm that is specialised in funding startups, seed, early, series-A funding, etc.,
Sequoia Capital India, is an affiliate of Sequoia Capital based in California.

Investment structure - Invests between $100,00 to $1 million in seed stage, between $1 million
to $10 million in the early stage, and between $10 million to $100 million in the growth stage.

Industries - Financial, Outsourcing, Public Sector, Energy, Healthcare, Technology, Mobile,

Enterprise Software.

Startups funded - Practo, JustDial, Zomato, OYO Rooms, Groupon India, MobiKwik,
Grabhouse, Knowlarity, iYogi, BankBazaar.
4. Nexus Venture Partners

This venture capital firm looks for passion, innovation, feasibility, and differentiability in
enterprises and has a decade of experience in guiding entrepreneurs.

Investment structure - Invests between $0.5 million and $10 million in the early growth stage.
In their seed program, they invest up to $0.5 million.

Industries - Data Security, Infrastructure, Storage, Rural Sector, Mobile, Agribusiness, Energy,
Media, Technology, Consumer and Business Services, Food, Tourism, Lifestyle.

Startups funded - Stayzilla, Craftsvilla, Delhivery, Snapdeal, Komli, Housing.com, PubMatic.

5. Venture East
It is a venture capital firm that focuses on Indian startups. With over 15 years of experience,
Venture East prefers to invest in fresh, strange, and potential ideas while also helping them to
establish and be competent in the market.
Investment structure - Invests between $1 million to $10 million in multiple rounds.
Industries - Financial Services, Digital Healthcare, Internet of Things (IoT), Education, E-
commerce, Life Sciences, Information Technology.
Startups funded - Portea, Seclore, Goli Vada Pav, Little Eye Labs, 24 Mantra.
6. Blume Ventures
Termed as ‘Founder’s VC’, Blume Ventures helps startups with funding, mentoring, and
support. It was founded in 2011 and has over 60 active companies.
Investment structure - Invests between $0.05 million to $0.3 million in the seed stage.
Industries - Telecommunications Equipment, Mobile Applications, Data Infra structure,
Logistics, E-commerce, Fin- Tech, Hospitality Services, Gaming.
Startups funded - HealthifyMe, Instamojo, TaxiForSure, Cashify, Chillr, Explara, EKI
Communications, Audio Compass, Exotel, Printo.
7. Inventus Capital Partners
This venture capital firm primarily invests in technology-based startups and was founded in
2007. It is managed by industry veterans and entrepreneurs,
Investment structure - Invests between $1 million to $2 million in the first venture round and
with the growth in business, it invests between $0.25 million to $10 million.
Industries - Hotels, Restaurants and Leisure, Healthcare, Information Technology,
Telecommunications, Media, Hardware, and Equipment.
Startups funded - CBazaar, Poshmark, Savaari, Poshmark, PolicyBazaar, Insta Health Solutions.
8. Fidelity Growth Partners
Fidelity Growth Partners is the investment arm of Fidelity International Limited and has been
rechristened as Eight Roads Ventures. It has invested in many sectors including technology,
healthcare and life sciences, etc. since 2008 and focuses on the Indian startup ecosystem.
Investment structure - Invests between $10 million to $50 million.
Industries - Energy and Industrial Technology, Food and Agriculture, Data and Business
Services, Education and Skills Development, Consumer and Enterprise Technology.
Startups funded - Yebhi, NetMagic, Coastal Projects, Milk Mantra Dairy Pvt. Ltd.
9. Qualcomm Ventures
This venture capital firm was founded in 2000 and has more than 140 active portfolio
companies under its belt. It is the private equity arm of Qualcomm Incorporated and has focus
on investing in automotive, data center, mobile, and digital health sectors.
Investment structure - Not Applicable
Industries - Consumer Software, Business Software, Infrastructure, Automotive, Internet of
Things (IoT).
Startups funded - Fitbit, Invensense, Appsdaily, Deck, Portea, Capillary, Cruise Automation.
10. IDG Ventures India
IDG Ventures India holds a portfolio of more than 220 companies and has an experience of 15
years in the venture capital space.
Investment structure - Invests between $1 million to $10 million.
Industries - Consumer Media, Mobile, Media and Technology, Enterprise Software,
Engineering, Fin- Tech, Health-Tech.
Startups funded - Lenskart, Zivame, Yatra, FirstCry, Ozone Media, UNBXD, Myntra.