Unit: 8

Corporate Finance (II)

In this unit:

 Financial assistance
 Debenture
 Charges
 Capital maintenance
 Reduction of capital

1. Financial assistance

Financial assistance refers to help a company gives in purchasing its own shares. It may also include
help in the purchase of the shares of its holding companies.

In many jurisdictions, helping in the purchase of shares is either illegal or restricted.

2. Debentures

Debentures are a debt instrument used by companies to issue the loan. The loan is issued to
corporates based on their reputation at a fixed rate of interest. Debentures are also known as a
bond which serves as an IOU ( I owe you) between issuers and purchaser. Companies use
debentures when they need to borrow the money at a fixed rate of interest for its expansion.

Types of Debenture

Debenture is classified on the basis of :

a. On the basis of security given: secured and unsecured debentures

b. On the basis of registration: registered and bearer debentures
c. On the basis of conversion: convertible and non-convertible debentures
d. On the basis of priority in payment: first debentures and second debentures
e. On the basis of redemption: redeemable and irredeemable debentures
a. Secured and Unsecured:

When at the time of issue of debentures the assets of company are mortgaged in favour of
debenture holders, such debentures are known as secured debentures. The charge on assets of
company is of two types – (i) Fixed charge (ii) Floating charge. In fixed charge, company cannot sell
or buy but can use for business purpose. When the company goes into liquidation, the charge is
fixed. But in floating charge, the secured debenture holders have right to claim before preferential
creditors but before the unsecured debenture holders.

if at the time of issue of debentures no fixed or floating charge is created, debentures are called
unsecured.

b. Registered and Bearer:

A registered debenture is recorded in the register of debenture holders of the company. A regular
instrument of transfer is required for their transfer. In contrast, the debenture which is transferable
by mere delivery is called bearer debenture.

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 c. Convertible and Non-Convertible:

Convertible debenture can be converted into equity shares after the expiry of a specified period. On
the other hand, a non-convertible debenture is those which cannot be converted into equity shares.

d. Redeemable and irredeemable debenture: They are those which are repayable in a
lump sum at the end of a specified period or in instalment during the existence of the
company.

The term “irredeemable debentures” does not mean that these debentures are not to be repaid. It
only means that there is no fixed time for the repayment of these debentures. As such, ordinarily
these debentures are not repaid during the existence of the company. They are repaid only when
the company goes into liquidation.

e. First debentures and second debentures

First debentures are those which are paid in priority over other debentures. Second debentures are
those which are paid after the redemption of first debentures.

Advantages and Disadvantages of Debentures

a. Advantages of Debentures
 Investors who want fixed income at lesser risk prefer them.
 As a debenture does not carry voting rights, financing through them does not dilute
control of equity shareholders on management.
 Financing through them is less costly as compared to the cost of preference or equity
capital as the interest payment on debentures is tax deductible.
 The company does not involve its profits in a debenture.
 The issue of debentures is appropriate in the situation when the sales and earnings are
relatively stable.
b. Disadvantages of Debentures
 Each company has certain borrowing capacity. With the issue of debentures, the
capacity of a company to further borrow funds reduces.
 With redeemable debenture, the company has to make provisions for repayment on the
specified date, even during periods of financial strain on the company.
 Debenture put a permanent burden on the earnings of a company. Therefore, there is a
greater risk when the earnings of the company fluctuate.

3. Charges

When a company borrows money, the lender / bank usually takes some security for that debt. This is
designed to protect the lenders' position and also to try and get the lenders' money back if the
borrower fails. These types of security are termed fixed and floating charges.

What is a Fixed Charge?

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The bank or lender may have provided money to acquire specific asset(s) like property, printing
press, car, etc. The company cannot sell this without the lenders permission. The debt must be
repaid as per the loan agreement or facility letter. Example: a mortgage, goodwill payment

What is Floating Charge?

A floating charge is held over assets that can change over time in the normal course of business. 
Although the assets may be physical, the number of them, or the value, condition, or other
properties can change.  So fixtures and fittings can be subject to a floating charge as they are difficult
to quantify. A debtor book is constantly changing. It would not be practical to stick a fixed charge
over every item of stock or desks and chairs, would it? So, the floating charge allows the lender to
recover some money if the assets are sold. For example: stock, work in progress, vehicles, finished or
raw materials etc. the price of these cannot be fixed at present. A car may cost 50 lakh at present
but in future the same car (due to depreciation) may not cost the same.

4. Capital Maintenance

Definition

Capital maintenance, also known as capital recovery, is an accounting concept based on the principle
that a company's income should only be recognized after it has fully recovered its costs or
its capital has been maintained. A company achieves capital maintenance when the amount of its
capital at the end of a period is unchanged from that at the beginning of the period. Any excess
amount above this represents the company's profit.

Types of Capital Maintenance

a. Financial Capital Maintenance

According to financial capital maintenance, a company earns a profit only if the amount of its net
assets at the end of a period exceeds the amount at the beginning of the period. Financial capital
maintenance is only concerned with the actual funds available at the start and the end of a specified
accounting cycle and does not include the value of other capital assets. The two ways of looking at
financial capital maintenance are money financial capital maintenance and real financial capital
maintenance.

Under money financial capital maintenance, profit is measured if the closing net assets exceed the
opening net assets, with both measured at historical cost. The historical cost refers to the value of
the assets at the time they were acquired by the company. Under real financial capital maintenance,
profit is measured if the closing net assets exceed the opening net assets, with both measured at
current prices.

b. Physical Capital Maintenance

Physical capital maintenance is not concerned with the cost associated with the actual maintenance
required on tangible items, such as equipment. Instead, it focuses on a business's ability to
sustain cash flows into the future by maintaining access to income-generating assets in use within
the business's infrastructure.

The definition of physical capital maintenance implies that a company only earns a profit if its
productive or operating capacity at the end of a period exceeds the capacity at the beginning of the
period, excluding any owners' contributions or distributions.

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 5. Reduction of capital (share)

Definition: The Reduction of Share Capital means reduction of issued, subscribed and paid up share
capital of the company.

A. Need of Reduction of Share Capital

 Returning of surplus to shareholders;

 Eliminating losses, which may be preventing the payment of dividends;
 As a part of scheme of compromise or arrangements;
 simplify capital structure;

When the company is making losses, the financial position does not present a true and fair view of
the company. The assets are overvalued and the balance sheet consists of fictitious assets with debit
balance in profit and loss account. In order to reduction of capital will write-off (dismiss) that portion
of capital which is already lost and will make the balance sheet look healthy.

B. Modes of Reduction of share capital

1. Extinguish or reduce the liability

Company may reduce share capital by reducing or extinguishing the liability on any of its
partly paid up shares. For e.g:  if the shares are of face value of Rs. 100 each of which Rs. 50
has been paid, the company may reduce them to Rs. 50 fully paid-up shares and thus relieve
the shareholders from liability on the uncalled capital of Rs. 50 per share.
1. Cancel any paid-up share capital
Company may reduce share capital by cancelling any shares which are lost or is
unrepresented by available assets. For e.g: if the shares of face value of INR 100 each fully
paid-up is represented by Rs. 75 worth of assets. In such a case, reduction of share capital
may be effected by cancelling Rs. 25 per share and writing off similar amount of assets.
2. Pay off any paid-up share capital
Company may reduce share capital by paying off fully paid up shares which is in excess of the
wants of the company. For e.g: shares of face value of Rs. 100 each fully paid-up can be
reduced to face value of Rs. 75 each by paying back Rs. 25 per share.
3. Prohibition on Reduction
No reduction of share capital shall be made if the company is in arrears in the repayment of
any deposits accepted by it either before or after the commencement of this Act or the
interest payable thereon.