Long Term Financing

Need for Finance:

Finance is required in the business in order to sustain in the
long run, to cope up with the changing circumstances i.e.
technological advancement, expansion of business, R & D
activities, etc.
The finance which is required by the business can be
classified into three types:
1) Long-term finance
2) Intermediate term / medium-term finance and
3) Short-term finance.

4) Meaning of Long-term Finance:

The finance which is required to meet the capital expenditure
is called L.T. Finance and is repayable after 5 years. If the
finance is obtained from the Bank /other financial Institutions,
the repayment of first instalment of loan amount will start
after 24 months, but interest has to be paid at frequent
intervals, as and when it falls due.

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 I) Sources of L.T. Financing
Corporate securities can be classified under two
categories, namely
(1) “Traditional Method”.
(2) “Modern Method”.

I) Traditional Method:
(a) Issue of Ownership Securities –Equity and Preference Shares
(b) Creditorship Securities –Debentures
(c ) Borrowings from Banks and Financial Institutions which may

be on long term basis or short term basis.

(II) Modern Method:

(a) Issue of Bonds –Zero Coupon Bonds and Deep Discount Bonds
(b) Acceptance of Deposits from the Public
(c) Forfaiting
(d) Factoring
(e) Venture Capital
(f) Lease Financing
(g) Retained Earnings

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I) Traditional Method:
This is the most common method of financing adopted by a
Company by issue of Ownership Securities, by issue of
Creditor ship Securities.

a) Ownership Securities: This is issued in the form of

“Shares” and is of two types namely
(i) Equity and (ii) Preference.

i) Equity Share capital is the ownership interest , the

residual claim to assets and assume the ultimate risk
associated with ownership. However, their liability is
restricted to the amount of their investment. In the event of
liquidation, these shareholders have a residual claim on the
assets of the company, after the claim on assets of all
creditors and preferred shareholders are settled in full.

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Ordinary shares occupy a primary position in
the capital market and may be regarded as
the corner stone of capital structure. They
are in an advantageous position when the
company is in prosperity and disadvantageous
when the company is facing depression and in
financial crunch.
Thus, the ordinary shareholders provide the
venture capital to the company or business
unit.

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Rights of Equity Shareholders
1) Right to Vote
2) Right to Income
3) Right against ultravires acts of the
company
4) The pre-emptive right – the first
option to buy the existing shares.
5) Right to transfer the shares
6) Right to have knowledge of
corporate affairs
7) Miscellaneous rights –
proportionate share in the N.A.V.
for distribution.
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 Advantages
 Cushion of Safety in payment of dividends.
 Permanent source of funds for raising capital
 No creation of charge by the company.
 Helps the company to exploit the opportunity of Debt Equity
ratio
 The obligation to repay the equity capital arises only at the
time of liquidation of the company.
 Helps the shareholders to increase their liquidity position,
by selling it in the stock exchange.
 Helps to participate in the management of the company
through voting rights.

Different terms used in Equity Shares:

a) Authorized capital
b) Issued Capital
c) Called up Capital
d) Subscribed Capital
e) Paid up capital

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 Book Value: It is the net-worth of a corporation less the
par value of preference shares outstanding, divided by the
number of ordinary shares outstanding.
 Liquidating Value: It is the value at which the shares
can be realised. This value will be less than the Market
value only.
 Market Value: It is the current price at which the stock is
traded, which depends on the expected future dividends of
the company and the perceived risk of share on the part
of investors.

b) Preference Shares: Preference shares are those

type of shares who have an edge over the equity, in respect of
dividend and repayment of capital at the time of winding up of
the company. The dividend payable on preference shares is
determined by the Company, while it is issued . Eg.: 9%
preference shares of Rs.1000 per share.

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Special Features of Preference Shares:
1) Preference as regards to income
2) Preference as regards to assets
3) Preference as regards to control
4) --- do – Conversion
5) --- do --- redeemable preference shares.

(b) Creditorship Securities: which are represented in the

form of Debentures and Bonds, which have a definite and
significant place in the financial plan of a company.
i) Debentures: A debenture is a written acknowledgement of
debt under the seal of a company, duly signed by its authorised
representative. It carries a fixed rate of interest and is usually
secured by a charge on the company’s assets, which may be
repayable within a specified period or after a specified date or
irredeemable during the existence of the company.

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 Types of Debentures
1) Simple Debentures
2) Mortgaged Debentures
3) Redeemable “
4) Irredeemable “
5) Convertible “
6) Non-convertible “ (You will be
learning more about all these in
Company’s Act in L.A.B.)

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(c ) Borrowings from Banks and Financial
Institutions:
which may be on long term basis or short term basis.
Commercial Banks in India constitute a vital segment of
the Indian Financial System. They have expanded their
area of business activity and have assumed a significant
proportion in providing finance to business enterprises
or firms.
The Banks provide loans on long term basis towards the
following purposes:
a) Purchase of Fixed Assets by Term Loans, up to
Rs.3crores, under the refinancing schemes by Govt. of
India to the banks.
b) Underwriting of Capital Issues on ad hoc basis.
c) Direct Subscription in their shares and debentures up to
a limited amount.
d) Merchant Banking Facility.

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C) Lease Financing:
Leasing involves the use of an asset without the desire to
assume or intend to assume ownership.
 A firm acquiring an asset is called the “lessee” and the
owner of the asset is called the “Lessor”.
 The lessor gets a money rental at regular intervals for
its use from the lessee.
 It is not essential to purchase assets in order to use
them. Assets may be rented on rentals for some
periodicals basis.
 The lessor can enjoy depreciation benefit and can enjoy
tax concessions. The lessee has to produce certain
documents to release the funds by the lessor.
 It is off the Balance Sheet financing to the lessee, which
does not affect the Debt/Equity Ratio of the borrowed
company.

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d) Retained Earnings:
 Retaining excess profits of a company or
retaining a portion of divisible profits for
future financial requirement is known as
“Retained Earnings” / “Ploughing Back
of Profits”.
 It is a cheaper means of financing, which
does not involve cost of floatation and
reflects the financial soundness of a
company.
 It helps in tax planning and does not affect
the normal functioning of the company.

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5) Venture Capital:
Acc. to International Finance Corporation (IFC),
“Venture Capital is equity or equity featured capital
seeking investments in new ideas, new companies, new
production, new process or new services that offer the
potential of high returns on investments.”

 Regulation 2(m) of SEBI (Venture Capital Funds)

Regulation, 1996, “Venture Capital fund means a fund
established in the form of a company or trust which raises
money through loans, donations, issue of securities or
units, as the case may be and makes / proposes to make
investments in accordance with these regulations.”

 In general, it can be described as, “The capital invested

in young, rapidly growing or changing companies that
have the potential for high growth. The Venture Capital
may also invest in a firm that is unable to raise finance
through the conventional means.”

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II) Short Term Financing

It means funds used to meet day-to-day expenses of a

company or funds used to meet working capital requirement.

The short term loan is repayable within 1 to 3 years from the

date of borrowing. The Working Capital requirement can be
estimated / calculated by adopting the following measures:
a) Elimination of non-current elements from current assets
b) Short term finance requirement
c) Self-generation of Funds
d) Management of Current Assets.

Sources of Short Term Financing:

1)Trade Credit –obtained from suppliers, which is allowed

on purchase of goods on credit, the credit period ranging
from 1 day to 180 days.

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2) Bank Credit- Companies take loans to
meet the need of working capital. The Banks provide
loans on short term basis towards the following
purposes:
 Overdrafts
 Cash Credits (also called as Working Capital Loan)
 Discounting of Bills

These loans are secured and the rate of interest is low

and has to be paid at quarterly intervals.

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3) Factoring: It is an agreement with the “Factor”
and his client in which receivables arising out of sale of
goods or services are sold to the factor as a result of
which the title to the goods / services represented by
the
said receivables passes on to the factor.
The Factoring services include:
i) Finance
ii) Maintenance of accounts
iii) Collection of Debts
iv) Protection against Credit Risks.
The various types of Factoring are
a) Full service factoring
b) Factoring with recourse
c) Maturity factoring
d) Invoice discounting
e) Bulk factoring
f) Agency factoring
g) Undisclosed factoring
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4) Money Market: deals with
short-term instruments with a period of
maturity of one year or less. It deals
with instruments like call money market,
Commercial Paper, Treasury Bills,
Certificate of Deposits, etc.,
-----

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 Module V
Capital Structure
 Meaning: Capital Structure refers to the “Composition of
the Capital”, i.e., the mix of sources from which the long term
funds required by a business are to be collected or are raised.

 Goals / Principles /Determinants of

Capital Structure:
It is necessary to consider certain basic principles, which are
militant to each other, before the deciding a suitable pattern of
capital structure. It is necessary to find a golden mean by
giving proper weight age to each of them.

The following are some of the principles:

1. Cost Principle
2. Risk Principle
3. Control Principle
4. Flexibility Principle
5. Timing Principle
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1) Cost Principle: Acc. to this principle, the ideal
capital structure should minimize the cost of financing
and maximize “earning per share”. Debt Capital is a
cheaper form of capital due to two reasons:
Firstly, the expectations of the returns of debt capital
holders are less than, those of equity shareholders.
Secondly, interest is a deductible expense, for tax
purposes, whereas dividend is an appropriation of
profits.
2) Risk Principle: Acc. to this principle, an ideal
capital structure should not accept an unduly high risk.
Debt capital is a risky form of capital, as it involves
contractual obligations to the payment of interest and
repayment of principal sum irrespective of profits /
losses of the business.
If the organization issues a large amount of preference
shares out of its earnings, a lesser amount will be left
out for equity shareholders, as dividend on preference
shareholders is required to be paid before any dividend

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is paid to equity shareholders. Raising the capital
through equity shares involves the least risk, as there
is no obligation as to the payment of dividend.
3) Control Principle: Acc. to this principle,
an ideal capital structure should keep intact the
controlling position of the owners. As preference
shareholders and debenture holders carry limited or no
voting right, they hardly disturb the controlling position
of the residual owners. Issuing the equity shares
disturbs the controlling position directly, as the
control of the residual owners is likely to get
diluted.
4) Flexibility Principle: Acc. to this
principle, an ideal capital structure should be able to
cater to the additional requirements of funds in future,
if any. Eg: If a company has already raised a too
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Heavy debt capital by mortgaging all its asset, it will
be
difficult for it to get further loans in spite of good
market conditions for debt capital and it will have to
depend on equity shares only to do so.

Moreover, an organization should avoid capital on such

terms and conditions which limit the company’s ability
to procure additional funds. Eg: If the co., accepts
debt capital on the condition that it will not accept
further loan capital or dividend on equity shares will
not be paid beyond a certain limit, then it loses
flexibility.

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5) Timing Principle: Acc. to this principle,
an ideal capital structure, should be able to seize
market opportunities, minimize cost of raising funds
and obtain substantial savings.
Accordingly, during the days of boom and prosperity,
the company can issue equity shares to get the benefit
of investors desire to invest and take the risk.

During the days of depressions, debt capital may

be used to raise the capital, as the investors are
afraid to take any risk.

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 Characteristics of an Ideal
Capital Structure
 Simplicity: A few varieties of securities.
 Liquidity: Sufficient cash to pay current
liabilities.
 Flexibility: Increase / decrease.
 Balance: Ordinary and preference shares,
ownership capital and borrowed capital.
 Economical: Cost of Capital
 Provision against contingencies.
 Business soundness
 Consistent with objectives.

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 Factors affecting Capital Structure
 Before deciding the mix of long term sources of
funds, it is necessary to consider the various
factors which can be broadly classified as:
A. Internal factors
B. External factors
C. General factors

A) Internal factors: The following are the

internal factors which affect the capital structure of
a company, namely:
1. Cost of Capital
2. Risk factors – Payment of interest on
Debentures / Bank borrowings, dividend to
Preference share holders.
3. Control factors.

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B. External factors:
The following are the external factors
which affect the capital structure of
a company, namely:
1. General economic conditions
2. Level of Interest Rates
3. Policy of Lending Institutions
4. Taxation Policy –which depends on the
interest rates.
5. Statutory Restrictions – The company
has to decide the capital structure
within the framework as prescribed by
the Govt., and various statutes.

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C. General Factors: The following are
the external factors which affect the
capital structure of a company,
namely:
1.Constitution of the Company – A Pvt. Ltd.,
Co., or a Public Ltd., Co.,
2. Characteristics of the Company: Size, age
and credit policy of the co.,
3. Stability of earnings
4. Attitude of the Management – Liberalised
Policy or Conservative Policy.

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Objectives of Capital Structure
Planning
 To maximize the profits of the owners of the co.
This can be ensured by issuing the securities
carrying a lower or lesser cost of capital.
 To issue the securities which are easily transferable.
This can be ensured by listing the securities on the
stock exchange.
 To issue the further securities in such a way that the
share of shareholding of the present owners is not
affected.
 To issue such kinds of securities which are
acceptable to the lenders of the capital.

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Optimum Capital Structure
 The Capital Structure is said to be
optimum, when the real cost, i.e. explicit
as well as implicit cost, if each source of
financing is identified. With an optimum
debt and equity mix, the cost of capital is
minimum and market price per share is
maximum.

 It is however, difficult to find out an

optimum debt/equity mix, where the
capital structure would be optimum,
because it is difficult to measure a fall in
the market value of an equity share on
a/c. of increase in risk due to high debt
content.
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 The following are some of the important
features of an Optimal Capital Structure:
a) Profitability
b) Flexibility
c) Conservation
d) Solvency
e) Control
Conclusion:
In theory, one can speak of an optimum capital
structure but in practice, an appropriate capital
structure is a more realistic term than the former.

------

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 Capital Structure Theories
 Introduction:
The introduction of Debt in the Capital Structure
increases the earning per share of equity shareholders.
It also increases the risk, which is the risk of
insolvency due to non-availability of cash and
variability of earnings available to equity shareholders.

As the debt component beyond a certain limit, the

expectation of the lenders of money also increases due
to the involvement of risk factor. Similarly, the
shareholders also will demand a higher rate of return
on their investment to compensate for the risk arising
out of an additional amount of debt in the capital
structure.
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 As such, introductions of a heavy amount of debt
capital in the capital structure will not only reduce
the valuation of the firm, but will also increase the
cost of capital.
 The Management may aim to have an optimum
capital structure by selecting a financing or debt
equity mix, which can maximize the value of the
firm. The valuation of a firm and its cost of capital
may be affected by the change in the financing
mix. Different views have been expressed in this
context.
Among them, the following four approached
are very important and are very relevant,
during any situation, which are as follows:
1) Net Income Approach (NI Approach)
2) Net Operating Income Approach (NOI Approach)
3) Traditional Approach
4) Modigliani and Miller Approach.

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Basic Assumption of Approaches:
The following are the assumptions of this approach,
which helps to understand the relationship b/w. debt
and equity or interest and dividend.
1) Firms use only 2 types of Capital, i.e. Long term
debt capital and equity share capital to raise
funds.
2) Corporate income tax does not exist and there are
no bankruptcy costs.
3) Firms follow policy of 100% of its earnings by way
of dividend. So, there will be no retained
earnings.
4) Operating earnings of the firm is given and
expected to grow.
5) The investment decisions are constant, i.e. the
total assets of the business unit remain constant,
so also its total financing.

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 6) There is perpetual life of the unit, i.e. there are
no closures due to strikes and lockouts.
7) The business risk is independent of capital
structure and financial risks and the same remains
constant.
8) The variations in capital structure are made
immediately and there are no transaction costs.
9) The different investors in the market anticipate the
same values of the subjective probability distbn. of
the anticipated future operating earnings of each
business unit.

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 1) Net Income Approach (NI Approach)

Mr. David Durand, has proposed 2 important

approaches, viz, Net Income Approach (NI Approach) and
Net Operating Income Approach (NOI Approach), to the
valuation of an organization. These two represent the
extremes in valuing an organization with regard to its
degree of financial leverage.

1) Net Income Approach (NI Approach):

By introducing the additional debt capital in the capital
structure, the valuation of the firm can be increased and
cost of capital can be reduced, which will be reflected in
the enhanced value of the company and also the market
price of the equity shares and vice-versa.
In other words, if the degree of financial leverage increases, the
weighted average cost of capital will decline with every increase
in the debt content in total funds employed, while the value of
the firm increases.

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 This approach is based on the following
assumptions:
i. There is no Corporate taxation
ii. The Cost of Debt is less than cost of equity.
iii. The use of Debt content does not change the risk
perception of investors, as a result of both, cost
of debt and cost of the equity remaining
constant.
iv. No hidden costs exist, when more and more debt
is introduced.
This theory can be well understood by presenting in a
diagram:
Kg
Ko
Cost of
Capital (%)
Kd

% of Debt in
financing mix 35
Here the value of the firm can be
ascertained as follows:
Overall Cost of Capital = EBIT / V,
where V = S + B.
S = Market Value of equity shares
B = Market Value of debt
V = Total Market value of the firm
EBIT = Net Operating Income
I = Total Interest payment NI = Net Income
available to equity shareholders, i.e., EBIT - I

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i) Cost of Debt = Annual interest charges
Market value of debt
= I/B

OR

Value of debt = Annual interest charges

Cost of Debt

ii) Cost of Equity = NI / S

iii) Overall Cost of Capital = EBIT

V
= Operating Profits
Value of the firm

37