Sources of Finance

An Overview

Prepared by:

YOGESH MITTAL

Yogesh_mittal2@yahoo.co.in

+ 91 9892160126
 Subject Index
General Classification
Equity Capital
Debentures
Preference Share Capital
Banks
Capital Financing
Venture Capital Financing
Debt Securitisation
Lease Financing
Negotiable Instruments
Factoring
Short term sources
Foreign Investments
Derivative & New Instruments
Ideal Capital Structure
 Corporate Financing

Internal Sources External Sources

Retained earnings
Promoters Long Term Medium Short Term
Contribution Term

Bank Loans
Security Financing
Financial Instruments
Leasing
Other Sources
 Equity Share Capital
Permanent Source of Finance
Raised from common public or internal sources as per the goodwill of concern
Signifies part ownership & prime risk element in an enterprise
Merits:
A basic investment in business providing security to other investors and
suppliers of money
Low risk element:
- Redemption only on the liquidation of the business entity
- Payment of dividend when sufficient profits are generated

Flexibility:
- Options of bonus and right issue
- Non- voting equity shares can also be issued
- Company can buyback its own shares from the market
Security to the Shareholders of maintaining control over company
More aggressive market dealings and high market price
 Equity Share Capital
Demerits:
More cost to the payer company:
- Dividends are paid out of the post tax profits
- A Dividend distribution tax of 12.5% is additionally payable
Administrative and procedural compliances for serving the equity is
complicated
Risk of dilution of Control of Management in the company

Conclusion:
- Cost: High
- Repayment terms: Flexible
- Control: High risk of dilution

An Inevitable Source of Finance

 Debentures
Derived from the latin word Debre meaning to owe
Serves as an acknowledgement of debt to the investor
Fixed rate of interest paid and redemption as per commitments
Enjoys priority in Dissolution of the Company
Generally secured against assets. Can be convertible into equity
Merits:
No dilution of control since Debenture holders are never given voting rights
Cost Effective:
- Tax Shield on the interest paid on debentures
Flexibility:
- Scheme of Debt can be framed as per the companys needs
* Due consideration to the Paari Passu clause
- No complicated compliances serving the debt
- Own Debentures
 Debentures
Convertible Debentures:
- Effective substitute when the equity market is not very effective

Demerits:
Very High Risk:
- Interest payments at fixed rates
- Redemption as per the commitments
Effect on Equity Capital:
- With increase in the financial risk, expected rate of return rises and resultantly, the
cost of equity
- Capitalization rate rises reducing the market price of the Equity share capital
Effect on Companys Assets:
- Debentures are generally secured against the companys assets, hence, the
borrowing capacity is substantially affected

Conclusion:
- Cost: Moderate
- Repayments Terms: Rigid
- Control: Not Affected
 Preference Share Capital
Special type of shares enjoying priority over payment of dividends and
redemption
Should be redeemed in a period of maximum 20 years
A fixed rate of dividends paid before equity shareholders
A hybrid of both debt and equity mix
Merits:
A part of share capital of the company, hence a favorable debt equity ratio
can be maintained
Preference Capital carries no voting rights
Payment of dividend only if sufficient profits are generated
An attractive investment scheme for the investors:
- A more secured investment
- A fixed rate of dividends is paid on priority basis
- Speculation tends to be generally less
 Preference Share Capital
Demerits:
High cost of serving the capital:
- Administrative and legal compliances
- Fixed rate of dividends payable at priority basis
- No tax shield on dividends. Further, a dividend distribution tax of 12.5%.
Can acquire voting rights if dividends not paid for over certain years
The unpaid dividends accumulate over the years of lower profits and a
consolidated liability is discharged when sufficient profits are generated

Conclusion:
- Cost: High
- Repayments Terms: Negotiable
- Control: Moderate risk

An emerging source of finance

 Banks Financing

Loans Cash Credits Overdrafts Secured

Advances
A single advance Bank credits a Customers
disbursed entirely fixed sum to loan allowed to draw Advances given
at one time account in excess of their on security of
bank account confirmed orders,
Interest charged Withdrawal as government
balances
on the amount per needs tenders etc.
sanctioned Interest charged
Secured against Letter of credit
on Daily balance
Recovery of loan stock can also be given
at specified time Secured by
Interest charged Interest &
Fixed Deposit
Can be secured or on the sum Repayment terms
receipts, stock
unsecured withdrawn as per standards
etc.
Not a running Government
Can be
account agencies also
unsecured (Clean
OD) provide such loans
 Capital Financing
Seed Capital Assistance
Provided by all recognized banks
By means of loans and grants
Terms of loans sanction and repayments etc. are specified
Mainly for small and medium scale projects costing up to 1-2 Crores. A minimum
10% of promoters contribution is generally kept
A nominal interest along with a service charge varying with the volume of business
Capital Incentives
An economy promotion tool employed by the Government
Mainly for the promotion of the backward areas
Assistance is provided to the new undertakings either by way of a lumpsum subsidy
or exemption from taxes
Mechanism is governed through State Finance Corporations and the provisions of the
applicable tax laws
Normally takes 1-2 years for the release of revenue. So, bridge finances can be
availed up to 85% of the sanction
 Venture Capital Financing
Started in 1987-88 by creation of Technology Development Fund and
guidelines for venture capital companies
To finance the upcoming modern and risky projects in sunrise sectors
Mainly in the fields of IT, Energy conservation, Quality up gradation
Main financing agencies are Asset Management Companies, FII, State
Finance Corporations, banks and private companies
Common Methods of Financing:
- Equity Financing: Generally up to 49% of the total capital
- Conditional loans: Repayable as royalty ranging between 2-15%
- Income Note: Both Interest and Royalties are charged at lower rates
- Participating Debentures: Varying interest as per the operations
Venture Capital companies can claim income tax exemption under section
10(23FB) of the Income Tax Act, 1961
RB I and SEBI guidelines for registration and operations of venture capital
companies to be observed
 Debt Securitisation
Mainly a function of Non banking finance corporations (NBFC)
Recycling of funds by issue of securities against the pools of assets generating
steady cash flow
Securitisation Process
- Locating the borrower as per credit worthiness and efficiency
- Pooling Function:
* Clubbing the receivables & advances into pools
* Structuring the pools with specific terms and conditions
* Transferring the pools to Special purpose vehicle (SPV)
- SPV to issue securities based on the Asset pool
Generally SPVs are Merchant bankers and Investors in such scheme are
mutual funds, insurance companies etc.
Transfer of ownership of Assets( Receivables) to SPV and the risk of non
payment to the investors of such schemes
 Lease/Franchise
Leasing:
An arrangement with the leasing company wherein particular assets are provided
against periodic rent
Can be an effective alternative to purchasing the asset out of owned or borrowed
funds
Tax benefits on depreciation and lease rentals can be claimed by the respective
parties to agreement
Provisions of Hire Purchase Act, 1972 to be observed

Franchising:
A method of expanding business on less capital than would otherwise be needed
Under a franchising agreement, a franchisee pays a franchisor for the right to operate
a local business, under the franchisors trade name
The Franchisor bears all initial establishment costs
The franchisee makes regular payments to the franchisor based on the turnover &
after the agreed number of years, the ownership of business is transferred to
franchisee
 Negotiable Instruments
Discounting of Bills
Trade bills acknowledging the dues can be obtained from the customers
Credit worthiness of the parties can be exploited effectively
Banks discount the trade bills so obtained for a nominal charge
The payment due after 2-3 months can be obtained instantly
Drafting an operation of the promissory notes or bills receivable to be governed
by Indian Negotiable Instrument Act, 1881
Commercial Papers
An unsecured promissory note issued as per provisions of Indian Negotiable
Instruments Act,1881
Can be issued to any extent but in the multiples of Rs. 5 Lakhs. An individual
investor cannot invest more than 25 Lakhs
Issued for a period of 30-180 days
No RBI restrictions or section 58Aof the Companies Act shall apply
Only for the companies having stock exchange lisitng and a tangible net worth of
5 crores or more
Issuer to bear all the preliminary charges
 Factoring
Factoring
Provision of specialized services of credit investigation, sales management, credit
collection etc. by factor to the client under an agreement
In the agreement, the receivable accounts are sold to the factors who charges
commission & bear all the risks associated with it
For every account, factor assumes all the responsibilities and pays to the client at the
end of credit period or when the account is settled
Generally on recourse basis

Asset Reconstruction Companies (ARC)

Asset Reconstruction Companies acquires bad loans/NPAs from Banks at a steep
discount and sell them eventually to the bidders
Banks and Financial Institutions sell their NPAs to take them out of their loan books &
improve their balance sheets
This move is different from the Corporate Debt Restructuring
The borrower cannot oppose the sell of by the Banks and Finance Institutions
Generally the ARC issues security receipts as pass through certificates of certain rights
& entitlements to the investors in the assets held by the ARC
Arcil is the only functional Asset Reconstruction Company in the country
 Short Term Sources
Trade credit Inter-corporate Public Short term
deposits unsecured
Credit period for
Flow of funds Debentures
payment
between entities Deposits For less than 18
Granted by
Not Public Deposits Unsecured months
supplier of goods
u/s 58A Deposits A higher rate of
By Customers
Interest as per terms From 6 months interest charged
before placing the
agreed to 3 years No credit rating
order
Can be secured by Renewable on is required
15-90 days
personal guarantee maturity Terms should be
No cost of debt
Generally up to 6 Covered under as per acceptable
Varies with months section 58A standards
business volume
Restrictions under Maximum limit
Regional & section 372A of the of borrowing,
Industry Standard Co. Act Interest etc. is
prescribed
 Foreign Investments
Foreign Direct and Institutional Investment is allowed subject to the sectoral caps
Investment through Portfolio investment, foreign technology agreements, External
commercial borrowings
Active Involvement of FIPB, RBI and SEBI
Investor can take automatic route for simplified procedures
ADRs are traded in American Markets and GDRs worldwide
Mechanism of ADR/GDR:
Indian Co. issues shares to an overseas depository bank having office in India
Physical shares remain in India with custodian who acts as agent of the depository
bank
Against the underlying shares, depository issues receipts to foreign investors
Depository receives dividends from Indian co. in rupees and pass on to the investors
in Dollars
Foreign investor can sell the depository receipts in foreign stock exchange or can sent
back to depository & get the shares of underlying Rupee denomination
Depository receipts are convertible into equity not vice-versa
Investors in ADR/GDR are entitled to benefits of dividends, right and bonus issue
Voting rights remain with the depository who can exercise it on behalf of investors
 Derivative Market
Derivative: A financial instrument whose pay off depend on another financial instrument or
security.
Derivatives can be used effectively for Hedging the payment risk and also for the speculation
purpose. Derivatives are of various types.
Forwards: It involves a contract initiated at one time and its performance in accordance with
the terms of contract at a subsequent time
Futures: A highly standardized & closely specified contract. They are traded on the stock
exchanges with an active involvement of the clearing houses
Options: Trading of the right to buy or not to buy the underlying goods. Call option &
currency options are its types.
Swaps: An agreement between two or more parties to exchange sequence of cash flow over a
period of time in the future.
Spot Contracts: To cover the exposure on the date of receipt/payment. Premium / discount
is already included in exchange rate & risk of currency fluctuations is to the companys accounts
Roll Over Contracts: To cover the long term foreign exchange liabilities/ assets.
Premium/discount is a function of interest rate differentials between US Dollar and other currency
Arbitrage: The process of buying a financial instrument in one market & selling the same in
another market. A method of making profits in an unstable market that brings the market to
equilibrium
 New Instruments
Secured Premium Notes
Issued with a Detachable warrant
Redeemable after 4-7 years. Can be convertible into equity

Option Bonds
For Principal or Interest sum or both
Redemption premium is offered
Investor has the option to sell the bonds as per market situations

Junk Bonds
For organizations with lower credit ratings and high risk projects
3-5% more than the normal market interest is charged
Wide usage in takeovers & buyouts

Deep Discount Bonds

Issued by IDBI in 1992
Zero interest bonds sold at a nominal sum
Redeemable after 25 years at Rs. 1 lakh with the exit option to investor in 5 th, 10th, 15th
& 20th year
Inflation and floating rate bonds
Prior agreement for interest payment subject to inflation or market conditions
 Miscellaneous sources
Bridge Financing:
Short term loans provided on the basis of loans pending disbursements
Repaid after the sanction of original loan
Generally provided against the Hypothecation of Current Assets, personal guarantee
& promissory notes
Generally a higher rate of interest is charged
Provided by both Banks and NBFC
Underwriting:
An agreement with the parties known as underwriters to secure the realization of
minimum subscription of the public issue of shares
Underwriters can help finding the potential investors for the issuing company
The underwriters charge a nominal commission to arrange the requisite funds
Generally Banks & Pvt. Cos. Are active as underwriters in the market
With their market contacts, underwriters can also help in proper allotment of units and
arranging other sources of finance as well
 Ideal Debt Equity Mix
Cost of Finance: With a lower arrangement cost and being a tax deductible item, is
usually cheaper than equity finance
Capital Gearing of Business: Though debt is a cheaper source of finance, it
carries a fixed repayment obligation for interest & principal amounts
Security available: Money lenders require certain assets to be pledged against the
borrowings. In the absence of good asset security, further borrowings may not be an option
Voting control: Shareholders often deny those sources which tends to dilute their
control
Business risk: Companies with highly volatile profits should avoid heavy
borrowings. High risk ventures are normally financed by the equity as there is no legal
obligation of repayment
Operating Gearing: It refers to the proportion of a companys fixed operating
costs against its variable costs. Higher operating gearing signify a higher fixed cost element
& a more volatile operating profits.
Market State: Bearish run in the market often results in lesser returns to the entity
Currency of Borrowing: Currency fluctuations may add to the cost of the loan
Thank You