Long Term Sources of Funds

Sources of Long Term Finance

• Internal Sources
– comprising retained earnings and depreciation
charges
• External Sources
– comprising
Owner ship Securities / Capital
Equity Capital
Preference Capital
Creditor ship Securities / Debt Capital
Term Loans
Debentures
Debt Securities / Instruments
 Internal Sources of Long Term Finance
Retained Earnings
– Features
• They are readily available.
• They do not involve Flotation / Issue cost.
• They do not dilute the control of the Firm.
• They do entail high opportunity costs in terms
of dividends foregone by the shareholders.
• Their magnitude keeps fluctuating because of
the variability of profits after tax.
• They entail no risk.
External Sources of Long Term Finance
Equity / Ordinary Share Capital
– Represents ownership position in a company.
– Are source of permanent capital having no
maturity date.
– Shareholders , are entitled for Dividends i.e. Net
profits after tax.
– Capital represented by Ordinary shares is called
Share Capital or Equity Capital.
– Capital which company can raise from
shareholders is referred as
• Authorized Share Capital - Maximum amount
• Issued Share capital - offered
• Subscribed Share capital – accepted
• Paid-up Share Capital – paid subscription
 Net Worth
Total Shareholder’s Equity is sum of:
– paid-up share capital
– share premium
– reserves & surplus

Total Shareholder’s Equity or Share capital is

also called as Net Worth.
Equity Shares used as Source of Finance.
• Advantages
– The most long term source of Financing.
– These shares are not redeemable hence company
has no liability for cash outflow, hence also known
as Permanent Capital.
– These helps in increasing the company’s financial
base and so the borrowing limits. By issuing
Equity shares company can increase its financial
capability.
– For these shares company is not legally obligated
to pay dividends.
– Least risky means of long term finance.
Equity Shares used as Source of Finance.
• Disadvantages
• These are more costly as firstly dividend being
appropriation of profit not permissible under taxation
hence no tax benefit and secondly the cost of raising
Equity Shares is more in comparison to Debts. High
cost of funds reflects high required rate of return of
investors as compensation for higher risk. High
flotation cost in terms of underwriting, brokerage etc.
• They have a tendency to dilute the control of existing
shareholders on sale of new shares to outsiders or
public.
• Further issue of Equity Shares dilutes the ownership
as well as existing shareholders earnings per share
and hence Equity capital entails to maintain relatively
higher rate of return and this makes Equity capital as
highest cost - source of external finance
Preference Shares used as Source of Finance.
• Preference Share Capital is a unique type of Long
Term financing , often referred as Hybrid Security that
combines some of the features of Equity Capital as
well as of Debentures.
• Preference shares are entitled for dividends at fixed
rates , hence they do not share the residual earnings.
• They rank higher than equity as a claimant to Income
and Assets of the company. They do not have voting
rights.
Preference Shares used as Source of Finance.

• Advantages
– They enjoy fixed and stable dividends.
– Company issuing them can enjoy following
benefits:
– No legal obligation to pay preference dividend.
– Redemption can be delayed without invoking any
penalty.
– Being component of Net Worth their presence
improves the creditworthiness thereby the
borrowing capacity.
– They do not dilute the control
Preference Shares used as Source of Finance.

• Disadvantages
– Holders of Preference Shares cannot
enforce their right to dividends /
repayments.
– They involve high cost due to non-tax
deductibility of preference dividends.
Debentures used as Source of Finance.

• These are considered as long term promissory note,

debentures / bonds for raising Loan Capital
representing creditor ship securities.
• The company issuing debentures – being secured
instrument promises to pay Interest and principal
amount as agreed upon.
• These can also be defined as written
acknowledgement of a Debt issued under the
common seal of the company. Alternative form of
debenture is Bonds.
• These are issued mostly by Public sector companies.
Debenture is long term security bearing fixed
income and financial security.
Debentures used as Source of Finance.
• The Debentures carry FIXED Interest rates , the
payment of which is legally enforceable. The
debenture interest is tax deductible.
• The length of time for redemption of par value is
usually fixed.
• Issuing company may buy them back.
• Usually executed via indenture i.e. debenture trust
deed
• Debentures are generally secured by a charge on the
present and future immovable assets of the company
by way of an equitable mortgage.
• The payment of Interest and repayment of principal is
contractual obligation enforceable by law. Failure /
default would lead to bankruptcy of the company.
• Debentures as Long Term source of Finance
Debentures used as Source of Finance.
• Advantages
– They entail lower cost due to lower risk and tax-
deductibility of interest payments.
– They do not dilute the control as they do not carry
any voting right.
– They bear fixed returns – interest.
– Secured and protected via debentures trust deed.
– Enjoy preferential claim on the Assets in relation to
shareholders.
Debentures used as Source of Finance.
• Disadvantages
– They entail increased financial risk from the point
of view of company issuing mainly
– Because they are executed via trust deed and are
under enforceable contractual obligation in respect
of interest payments and repayments
Debentures used as Source of Finance.

• Interest charges on debentures are to be paid

irrespective of earnings and also debentures are to
be redeemed i.e. principal amount is to be paid back
as per agreement. In case of default debenture
holder have charge on company’s assets.

• Debentures also entails uncertainty in expected

earnings of the Equity shareholders through
leverage effect i.e.
– if ROI is higher than interest rates equity
shareholders get higher returns and if ROI is less
than interest rates than equity shareholders get
less returns or even nothing
Debentures used as Source of Finance.
• Advantages
– They entail lower cost due to lower risk and tax-
deductibility of interest payments.
– They do not dilute the control as they do not carry
any voting right.
– They bear fixed returns – interest.
– Secured and protected via debentures trust deed.
– Enjoy preferential claim on the Assets in relation to
shareholders.
Debentures used as Source of Finance.
• Advantages
– They entail lower cost due to lower risk and tax-
deductibility of interest payments.
– They do not dilute the control as they do not carry
any voting right.
– They bear fixed returns – interest.
– Secured and protected via debentures trust deed.
– Enjoy preferential claim on the Assets in relation to
shareholders.
Debentures used as Source of Finance.
• Advantages
– They entail lower cost due to lower risk and tax-
deductibility of interest payments.
– They do not dilute the control as they do not carry
any voting right.
– They bear fixed returns – interest.
– Secured and protected via debentures trust deed.
– Enjoy preferential claim on the Assets in relation to
shareholders.
Debentures used as Source of Finance.
• Advantages
– They entail lower cost due to lower risk and tax-
deductibility of interest payments.
– They do not dilute the control as they do not carry
any voting right.
– They bear fixed returns – interest.
– Secured and protected via debentures trust deed.
– Enjoy preferential claim on the Assets in relation to
shareholders.