S 17,18 –

Long Term Sources of Financing

 

B.B.Chakrabarti
Professor of Finance

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 Capital Market Instruments
• Equity Shares
• Preference Shares
• Debentures / Bonds
• Sources:
• Equity
1) Domestic market
2) Foreign market – ADR / GDR
• Debt (Bonds and Loans)
1) Domestic Market
2) Euro market
3) Foreign market
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 Types of Issues in Primary Market
• Primarily, issues made by an Indian company in
primary market can be classified as public,
rights, bonus and private placement. While right
issues by a listed company and public issues
involve a detailed procedure, bonus issues and
private placements are relatively simpler.
• The classification of issues is as below:
(a) Public issue
(i) Initial Public offer (IPO)
(ii) Further or Follow-on public offer (FPO)
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 Types of Issues in Primary Market
(b) Rights issue
(c) Bonus issue
(d) Private placement
(i) Preferential issue
(ii) Qualified institutional placement

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 Public Issue
• When an issue / offer of securities is made to new investors for
becoming part of shareholders’ family of the issuer it is called a
public issue. Public issue can be further classified into Initial public
offer (IPO) and Further public offer (FPO). The significant features
of each type of public issue are illustrated below:
• (i) Initial public offer (IPO):
When an unlisted company makes either a fresh issue of securities
or offers its existing securities for sale or both for the first time to
the public, it is called an IPO. This paves way for listing and trading
of the issuer’s securities in the Stock Exchanges.
• (ii) Further public offer (FPO) or Follow on public offer:
When an already listed company makes either a fresh issue of
securities to the public or an offer for sale to the public, it is called
a follow on offer (FPO).

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 Rights Issue and Bonus Issue
• Rights Issue:
An issue of securities made by an issuer to its existing
shareholders on a particular date fixed by the issuer
(record date). The rights are offered in a particular ratio
to the number of securities held as on the record date.
• Bonus Issue:
An issue of securities made by an issuer to its existing
shareholders as on a record date, without any
consideration from them. The shares are issued out of
the Company’s free reserves or share premium account
in a particular ratio to the number of securities held on
a record date.
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 Private Placement
• When an issuer makes an issue of securities to a selected group of
persons not more than 50, and which is neither a rights issue nor a
public issue, it is called a private placement. Private placement of
shares or convertible securities by a listed issuer can be of two
types:
(1) Preferential allotment :
When a listed issuer issues shares or convertible securities, to a
selected group of persons, it is called a preferential allotment. The
issuer is required to comply with various provisions which inter-alia
include pricing, disclosures in the notice, lock-in etc, in addition to
the requirements specified in the Companies Act.
(2) Qualified Institutions Placement (QIP):
When a listed issuer issues equity shares or securities convertible in
to equity shares to qualified institutions buyers only it is called a
QIP.
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 Steps in IPO Process
• Selection of Merchant / Investment Bank: The first job is to find a
merchant / investment bank to assist in the IPO process.  
Step 1: Preparation of Registration Statement: To begin an IPO
process, the company must submit a registration statement to the
SEBI, which includes a detailed report of its fiscal health and business
plans.
Step 2: Getting the Prospectus Ready: While awaiting the approval,
the company must create a preliminary 'Red Herring' prospectus. It
includes detailed financial records, future plans and the specification
of expected share price range. This prospectus is meant for
prospective investors who would be interested in buying the stock. It
also has a legal warning about the IPO pending SEBI approval. 

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 Steps in IPO Process
Step 3: The Road show: Once the prospectus is ready, underwriters
and company officials go on countrywide 'road shows', visiting the
major trade hubs and promote the company's IPO among select few
private buyers (Usually corporates or HNIs). They are fed with detailed
information regarding company's future plans and growth potential.
They get a feel of investor response through these tours and try to
woo big investors. 
Step 4: SEBI Approval & Go Ahead : Once SEBI is satisfied with the
registration statement, it declares the statement to be effective, giving
a go ahead for the IPO to happen and a date to be fixed for the same.
Sometimes it asks for amendments to be made before giving its
approval. The prospectus cannot be given to the public without the
amendments suggested by SEBI. The company needs to select a stock
exchange where it intends to sell its shares and get listed. 

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 Steps in IPO Process
• Step 5: Deciding On Price Band & Share Number: After
the SEBI approval, the company, with the assistance from
the underwriters decide on the final price band of the
shares and also decide the number of shares to be sold. 
In a Fixed price issue, the company decides the price of
the share issue and the number of shares being sold. Ex:
ABC Ltd public issue of 10 lakh shares of face value Rs.
10/- each at a premium of Rs. 55/- each.  
In a Book built issue, the company decides a price band
and it gives the investor an option to choose the price at
which he/she wishes to bid for the company shares. Ex:
ABC Ltd issue of 10 lakh shares of face value Rs. 10/-
each at a price band of Rs. 60 to 70.
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 Steps in IPO Process
Step 6: Available to Public for Purchase: On the dates mentioned in the
prospectus, the shares are available to public. Investors can fill out the
IPO form and specify the price in book built issue at which they wish to
make the purchase and submit the application.
Step 7: Issue Price Determination & Share Allotment: Once the
subscription period is over, members of the underwriting banks, share
issuing company etc will meet and determine the price at which shares
are to be allotted to the prospective investors. The price would be
directly determined by the demand and the bid price quoted by
investors. Once the price is finalized, shares are allotted to investors
based on the bid amounts and the shares available. In case of
oversubscribed issues, shares are not allotted to all applicants. 
Step 8: Listing & Refund: The last step is the listing in the stock
exchange. Investors to whom shares were allotted would get the shares
credited to their DEMAT accounts and for the remaining the money
would be refunded. 

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 Offer Documents
• ‘Offer document’ is a document which contains all the relevant
information about the company, the promoters, projects, financial
details, objects of raising the money, terms of the issue etc and is
used for inviting subscription to the issue being made by the
issuer. ‘Offer Document’ is called “Prospectus” in case of a public
issue or offer for sale and “Letter of Offer” in case of a rights issue.
Terms used for offer documents vary depending upon the stage or
type of the issue where the document is used. The terms used for
offer documents are defined below:
• Draft offer document:
It is an offer document filed with SEBI for specifying changes, if
any, in it, before it is filed with the Registrar of companies (ROCs).
Draft offer document is made available in public domain including
SEBI website, for enabling public to give comments, if any, on the
draft offer document.
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 Offer Documents
• Red herring prospectus :
It is an offer document used in case of a book built public
issue. It contains all the relevant details except that of price or
number of shares being offered.
• Prospectus :
It is an offer document in case of a public issue, which has all
relevant details including price and number of shares being
offered. This document is registered with Registrar of
Companies before the issue opens in case of a fixed price issue
and after the closure of the issue in case of a book built issue.
• Letter of offer:
It is an offer document in case of a Rights issue and is filed with
Stock exchanges before the issue opens.

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 Offer Documents
• Abridged prospectus:
It is an abridged version of offer document in public issue and is
issued along with the application form of a public issue. It
contains all the salient features of a prospectus. Abridged letter
of offer is an abridged version of the letter of offer. It is sent to all
the shareholders along with the application form.
• Shelf prospectus :
It is a prospectus which enables an issuer to make a series of
issues within a period of 1 year without the need of filing a fresh
prospectus every time. This facility is available to Public sector
banks /Public Financial Institutions.
• Placement document:
It is an offer document for the purpose of Qualified Institutional
Placement and contains all the relevant and material disclosures.
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 Entry Norms for Making Public Issue
• A) An unlisted issuer making a public issue is required to satisfy
the following provisions:
• Entry Norm I (Profitability Route):
(a) Net Tangible Assets of at least Rs. three crores in each of the
preceding three full years.
(b) Distributable profits in at least three of the immediately
preceding five years.
(c) Net worth of at least Rs. one crore in each of the preceding
three full years.
(d) If the company has changed its name within the last one
year, at least fifty percent revenue for the preceding one year
should be from the activity suggested by the new name.
(e) The issue size does not exceed five times the pre- issue net
worth as per the audited balance sheet of the last financial year.
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 Entry Norms for Making Public Issue
• Entry Norm II (QIB Route)
(a) Issue shall be through book building route, with at least fifty
percent to be mandatorily allotted to the Qualified Institutional
Buyers.
(b) The minimum post-issue face value capital shall be Rs. ten
crores or there shall be a
compulsory market-making for at least two years.
• B) A listed issuer making a public issue (FPO) is required to
satisfy the following requirements:
(a) If the company has changed its name within the last one
year, at least 50 percent revenue for the preceding one year
should be from the activity suggested by the new name.
(b) The issue size does not exceed five times the pre- issue net
worth as per the audited balance sheet of the last financial year.
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 Some Other Details
• Minimum Promoter’s contribution and lock in: The promoters
shall contribute not less than 20 percent of the post issue capital
which should be locked in for a period of three years.
• Categories of Investors:
i) Retail individual investors
ii) Non-Institutional investors
iii) Qualified Institutional Buyers
• In retail individual investor category, investors can not apply for
more than Rs. two lakh in an IPO. Retail Individual investors have
an allocation of 35% of shares of the total issue size in Book Built
IPO's.
• QIBs are Public FIs, FIIs, Banks, MFs, PFs, Pension Funds,
Insurance companies and others.
• Investors who do not fall within the definition of the above two
categories are categorized as “Non-Institutional Investors”.
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 Some Other Details
• Application Supported by Blocked Amount (ASBA) means an
application for subscribing to a public issue or rights issue,
along with an authorization to Self Certified Syndicate Bank to
block the application money in a bank account.
• Issue Period:
For Fixed price public issues: 3 to 10 working days
For Book built public issues: 3 to 7 working days extendable
by further 3 days in case of a revision in the price band
For Rights issues: 15 to 30 days.
• Minimum subscription:
The minimum subscription to be received in an issue shall not
be less than 90% of the offer through offer document
• Book building means a process undertaken to elicit demand
and to assess the price for determination of the quantum or
value of specified securities
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 Some Other Details
• Green shoe Option: Price stabilizing mechanism in which
shares are issued in excess of the issue size, by max. 15%.
• Safety Net: Issuer discloses that if the price of the shares
of the company post listing goes below a certain level the
issuer will purchase back a limited number of shares at a
pre specified price from each allottee.
• Face value of equity shares:
(a) If the issue price is Rs. 500 or more, the issuer
shall have the option to determine the face value at
less than Rs.10, provided that the face value shall not
be less than Re. 1 per equity share.
(b) If the issue price is less than Rs. 500, the face
value shall be Rs.10 per equity share.
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Issue of Long-term Securities to the Public

Adobe Acrobat
Document

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IPO Process Timeline

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 Intermediaries
The intermediaries in the issue of securities
to the public are as follows:-
a) Merchant Banker
b) Co-Managers of the issue
c) Underwriters
d) Brokers
e) Bankers to the issue
f) Registrar to the issue

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 IPO Pricing
• Indian primary market ushered in an era of free
pricing in 1992.
• SEBI does not play any role in price fixation.
• The issuer in consultation with the merchant banker
on the basis of market demand decides the price.
• The offer document contains full disclosures of the
parameters which are taken in to account by merchant
banker and the issuer for deciding the price.
• The parameters include EPS, PE multiple, return on
net worth and comparison of these parameters with
peer group companies.
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 IPO Underpricing
• May be difficult to price an IPO because there is
not a current market price available.
• Private companies tend to have more asymmetric
information than companies that are already
publicly traded.
• Underwriters/investors want to ensure that, on
average, their clients/they earn a good return on
IPOs.
• Under pricing causes the issuer to “leave money
on the table.”
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 Issue of Debt Instruments
Some additional guidelines for offering
convertible/non-convertible debt instruments
through an offer document are:
a) Credit Rating of Debt Instruments
b) Debenture Trustee
c) Debenture Redemption Reserve (DRR)
d) Creation of Charge

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 Offer for Sale
• Offer for sale means offer of securities by
existing shareholders of a company to the
public for subscription, through an offer
document.
• In offer for sale, fresh capital is not raised but
many shareholders substitute some of the
existing shareholders.

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 Employee Stock Options (ESOPs)

• Under ESOP, key employees are given options to

purchase equity shares of the company based on a
plan of service to the employer.
• The employees can get equity shares at a specified
future period at a predetermined price.
• The plan of service could include completion of a
specified service period and/or on achieving a
specified performance goal.

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 Term Loan
• Companies can raise Term loans from financial
institutions and banks.
• Term loans are direct business loans.
• The maturity period of loan is usually long
term (more than one to around ten years).
• The loans carry market interest rate and the
principal is repaid in installments after a
period of moratorium.

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 Venture Capital
• Promoters without any track record of performance
but with good project ideas can approach venture
capital funds to raise capital for launching and
developing a business.
• Venture capital (VC) funds invest in long-term equity
and debt capital in risky projects with expectation of
high return. The underlying sources of funds for
them are from high net worth individuals, pension
funds, insurance companies, banks, large
corporations and others.

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 Venture Capital
• VC funds usually provide financing in stages. At each
stage, they invest enough money to reach the next
stage.
• For example, they may provide seed capital or first
stage financing to build a prototype. If that is
successful, then they may provide second stage
financing to buy plant and machinery for commercial
manufacturing and marketing.
• Some VC funds specialize in certain stages of funding.
Some even actively participate in running the
business.
• At present, many VC funds operate in India.

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 Leasing
• The Basics
– A lease is a contractual agreement between a lessee and lessor.
– The lessor owns the asset and for a fee allows the lessee to use
the asset.
• Operating Lease
- Usually not fully amortized
- Usually require the lessor to maintain and insure the asset
- Lessee enjoys a cancellation option
• Financial Lease
- Do not provide for maintenance or service by the lessor.
- Financial leases are fully amortized.
- The lessee usually has a right to renew the lease at expiry.
- Generally, financial leases cannot be cancelled.

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 Leasing
• Sale and Leaseback
- A particular type of financial lease.
- Occurs when a company sells an asset it already owns to
another firm and immediately leases it from them.
- Two sets of cash flows occur:
The lessee receives cash today from the sale.
The lessee agrees to make periodic lease payments,
thereby
retaining the use of the asset.

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 Leasing
• Leveraged Lease
A leveraged lease is another type of financial lease.
A three-sided arrangement between the lessee, the lessor,
and lenders:
The lessor owns the asset and for a fee allows the lessee to
use the asset.
– The lessor borrows to partially finance the asset.
– The lenders typically use a nonrecourse loan. This means
that the lessor is not obligated to the lender in case of a
default by the lessee.

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 Lease vs Buy
Consider a firm, ClumZee Movers, that wishes to
acquire a delivery truck.
The truck is expected to reduce costs by $4,500
per year. The truck costs $25,000 and has a
useful life of 5 years. If the firm buys the truck,
they will depreciate it straight-line to zero.
They can lease it for 5 years from Tiger Leasing
with an annual lease payment of $6,250.
Tax rate is 34%. After-tax cost of debt is 5%.

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 The Cash Flows of Leasing
• Cash Flows: Buy
Year 0 Years 1-5
Cost of truck –$25,000
After-tax savings 4,500×(1-.34) = $2,970
Depreciation Tax Shield _ 5,000×(.34) = $1,700
–$25,000 $4,670

• Cash Flows: Lease

Year 0 Years 1-5
Lease Payments –6,250×(1-.34) = –$4,125
After-tax savings 4,500×(1-.34) = $2,970
–$1,155

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 The Cash Flows of Leasing
Cash Flows: Leasing instead of Buying
Year 0 Years 1-5
$25,000 –$1,155 – $4,670 = –$5,825
NPV (Lease-Buy)@5% = -219.2

Decision - Buy

The discount rate is the after-tax rate on the firm’s

secured debt.

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 Multiple Choice Question - 1
True or False?
a) A company pays preference shareholders after payment of
dividend to equity shareholders.
b) In case of cumulative preference shares, dividends if not paid in
a particular year are paid in a subsequent year before payment
of equity dividends.
c) Equity shareholders lose all their money in case of winding up
of a company.
d) A debenture is a debt instrument.
e) Partly convertible debentures are converted into equity shares
in full at a pre-specified time.
f) Offer for sale of shares to public is undertaken to increase share
capital.
g) A start-up software company can approach VC funds for initial
capital.

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 Multiple Choice Question - 1
h) Equity warrants are equity shares.
i) Book building of shares is done to issue shares at a
fair value to both investors and issuer.
j) SEBI is the regulator for all capital market issues in
India.
k) Equity shares issued to the public need not be listed
in a stock exchange for trading.
l) Credit rating of a debt instrument issued to public is a
must.

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 Multiple Choice Question - 1
Ans.
(a)False (f) False (k)False
(b) True (g)True (l) True
(c)True (h) False
(d) True (i) True
(e)False (j) True

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 Multiple Choice Question - 2
Issue costs for debt issues are generally
less than those for equity issues because:
a) Debt issues are generally privately placed.
b) Debt issues are fixed period instruments.
c) Debt capital is raised after raising equity
capital.
d) Debt issues carry regular interest payments.

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 Multiple Choice Question - 2
Ans. (a)

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 Multiple Choice Question - 3
Book-building of equity shares is undertaken:
a) To create demand for the equity shares of the
company.
b) To raise capital speedily.
c) To determine the fair market price of the equity
shares of the company.
d) To prepare a list of prospective subscribers who may
be approached later to raise capital.

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 Multiple Choice Question - 3
Ans. (c)

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