UNIT II

SOURCES OF FINANCE
To support its investments, a firm must find the means to finance
them.

There are different sources of long-term funds available to a firm.

Mainly there are two broad sources of long-term finance, i.e.,

equity and debt.

Equity, referred to as shareholder’s fund, consists of equity capital,

retained earnings and preference capital.

Debt, referred to as loan funds, consists of term loans, debentures,

and short-term borrowings.

The key differences between equity and debt are :

i) Debt claim is on contractual set of cash flow (Interest + Principal)

while equity claim is the residual one.
ii) Interest, paid to debt holders, is tax-deductible while the
dividend, paid to equity holders, is not.

iii) Debt has a fixed maturity whereas equity has an infinite life.

iv) Equity holders control the affairs of the firm while debt holders
play a passive role.

Comparison of Debt and Equity as a Source of Finance :

Characteristics Debt Equity

Claim on profits & assets Fixed claim Residual claim
Tax treatment Tax deductible Not tax deductible
Priority in repayment High Lowest
Maturity Fixed Infinite life
Control in management No control Controls the mgmt
In this unit we will discuss different sources of long-term finance
such as –

• Equity capital
• Retained earnings
• Preference capital
• Term loans
• Debentures
• Lease financing
• Venture capital

1. Equity Capital :

It is the primary or basic source of finance to any company.

It represents ownership capital as equity holders collectively own

the company and do not have any maturity date.
They enjoy rewards and bear the risks of ownership.

Their liability is limited to their capital contribution.

Some Terms Associated with Equity Capital :

Authorised capital – the amount of capital that a company can

potentially issue, as per its memorandum.

Issued capital – the amount offered by the company to the

investors.

Subscribed capital – that part of issued capital which has been

subscribed to by the investors.

Paid-up capital – the actual amount paid by the investors.

Normally issued, subscribed and paid-up capital are the same.

Par value – value stated in the memorandum and is written on the
share scrip.

Issued price – the price at which equity share is issued.

Premium/Discount – when the issue price exceeds the par value,

the difference is called as premium; and if
issue price is lower than the par value, the
difference is called as discount.

Book value – book value of an equity share is defined as –

Paid - up equity capital  Reserves and surplus
Number of outstanding equity shares

Market value – is the price at which equity is traded in the market.

Applicable for those companies which is listed on
the stock exchange.
Rights and Position of Equity Shareholders :

i) Right to Income :

- residual claim on the income.

- income may be paid out as dividend or may be retained.
- equity earnings which are ploughed back in the firm, tend
to increase the market value of equity shares.
- the dividend decision is prerogative of board of directors
and equity shareholders can not challenge this decision.

ii) Right to Control :

- they elect the board of directors and have the right to vote
on every resolution placed before the company.
- the board of directors elect the management which control
the operation of the firm. Thus indirectly equity
shareholders have control over the operation of the firm.
iii) Pre-emptive Right :

- it enables equity shareholders to maintain their

proportional ownership by purchasing the additional
equity shares by the firm.
- by law, company will offer the existing shareholders the
first opportunity to purchase, on pro-rata basis.
- this right protects the existing equity shareholders from
the dilution of their financial interest as a result of
additional equity issue.

iv) Right in Liquidation :

- residual claim at the time of liquidation.

- they will be paid after paying to everyone – debenture
holders, secured lenders, unsecured lenders, other
creditors, and preferred shareholders.
v) Right to Receive the Annual Report –

- According to Section 219 of the Companies Act, 1956,

requires the Annual Report of the company, comprising of
balance sheet, income statement, directors’ report,
auditors’ report, cash flow statement, and other statements,
should be sent not less than 21 days before the general
meeting, to every shareholder of the company.

vi) Right to Sell or Transfer Equity Shares –

- equity share holders have the right to sell or transfer their

holding to other person.
- they may sell their holding by merely signing an agreement
(called transfer deed), or they may sell it through stock
exchange, if the share is listed.
Shareholder Voting :

Two systems of voting may be followed – majority rule voting or

proportionate rule voting.

i) Majority Rule Voting :

In this case, each share carries one vote and each director
position is filled individually.

Thus for each director shareholders will have to cast their vote
separately.

This is the most common method of voting used in India.

In this system of voting, the person / group which is having more

than 50 percent outstanding equity shares can select the director
of its own choice.
ii) Proportionate Rule Voting :

In this system of voting, the number of votes enjoyed by a

shareholder is equal to the number of shares held by him times the
number of directors to be elected.

For example – if a shareholder holds 1000 shares and the number

of directors to be elected is 7, the shareholder will have 7000
votes. He may cast all his 7000 votes for one candidate or for
more than one candidates.

The major difference between these two methods is that in former

case only majority is able to elect all its member while this is not so
in the latter case.

In proportionate rule voting system even a significant minority can

elect members of board if they use their votes intelligently.
Minimum number of shares required to elect a certain number of
directors, can be calculated as -
No. of shares outstanding  No. of directors desired to be elected
1
Total number of directors to be elected  1

For example – suppose number of outstanding shares is 1mn,

director position is 7, and directors desired to be elected is 2,
then number of shares required to guarantee the election of two
directors is -
1000000  2
 1  250001
7 1

Advantages of Equity Capital –

- permanent source of finance as it has no maturity date.

- no compulsion to pay dividends.
 - provides cushion to lenders thus enhances
creditworthiness of the company.
- increases corporate flexibility from the point of view of
capital structure planning. One such strategy may be to
retire debt financing out of the funds received from the
issue of equity capital.

Limitations of Equity Capital :

- sale of equity shares to outsiders dilutes the control of

existing shareholders.
- the cost of equity capital is usually highest.
- equity dividends are not tax-deductible, this makes the
relative cost of equity more.
- the cost of issuing equity shares is generally higher than
the cost of issuing any other types of securities.
- new issue of equity capital may reduce the EPS and thus
may have an adverse effect on the market price of shares.
2. Retained Earnings :

Depreciation charges and retained earnings represents the

internal sources of finance available to a firm.

Depreciation charges may be used for replacing or repairing of

worn-out equipment.

Thus, retained earnings is the only internal source of financing.

It is the sacrifice made by the equity shareholders.

Advantages :

- readily available
- do not have any issue cost, issue timing and so on
- no dilution of control while using retained earnings.
- do not have any risk as in the case of equity.
Limitations :

- limited amount
- opportunity cost is high

3. Preference Capital :

Represents a hybrid form of financing – equity as well as debt.

Fixed dividend paid from PAT, before equity shareholders.

No voting right. They may get voting right only in certain cases,
like non-payment of dividend for more than two years.

Has priority over equity shareholders, in income and assets of the

company.
Advantages :

- no legal obligation to pay dividend

- not much redemption liability because periodic sinking
funds are not required and redemption can be delayed
without much penalties.
- it is regarded as a part of net worth, hence it increases the
creditworthiness of the firm.
- under normal condition, do not carry voting right.
- its cost of capital is lesser than that of equity capital.
- preference share financing is beneficial specially in the
case of rising inflation.

Limitations :

- compared to debt, it is expensive source of finance.

- though there is no legal obligation to pay preference
dividend, skipping them can pose some problems.
4. Term Loans :

Financial Institutions and banks are the primary source of giving

long-term loans to private and most public firms.

It is used to finance fixed assets.

It has following features –

- Currency - it may be in rupee or in foreign currency.

- Security – normally they are secured borrowings. The

financed assets provide prime security, and
other assets provide collateral security. It may
also be secured by both immovable and
movable properties of the firm, both present
and future.
 - Interest Payment and Principal Repayment –
they are definite obligations and FIs may charge
penalty to the firm in case of default.

- Restrictive Covenants –
it is the restrictive conditions imposed by the FIs,
on the borrower, to protect their interests. These
covenants will depend on the nature of project,
type of FIs, financial condition of borrower,
amount of loans.

Advantages :

- interest on loan is tax-deductible.

- does not result in dilution of control.
- limited payment.
- lower issue cost and lower cost of financing
Limitations :

- it entails fixed principal and interest payment, failing in

which may pose great problem to the firm.
- it increases the financial leverage which increases the
cost of equity capital.
- may impose certain restrictions on the borrowing firm.
- if the rate of inflation turns out to be unexpectedly low, the
real cost of debt will be greater than expected.

5. Debentures / Bonds :

These are instruments for raising long-term debt.

Debenture holders are the creditors of company.

It is an instrument issued by a borrowing company for a price which

may be less than, equal to or more than face value.
The obligation of a company toward its debenture holders is
similar to that of a borrower who promises to pay interest and
principal at specified time.

Features of Debentures :

Trustee : When a debenture is sold to the public, a trustee is

appointed to protect the interest of public. It may be bank
FIs or insurance agencies.

Security : Mostly debentures issued in India are secured by

mortgages / charges on the immovable properties of the
company.

Interest Rate : It may carry fixed interest rate, floating interest rate
or zero interest rate. Interest rate is also called as
Coupon Rate.
Maturity and Redemption : Maturity for short-term debenture may
be up to 1 year, for medium term it is
1-5 years and for long-term 5-15 years
or even more.

For all debentures with a maturity of

more than 18 months, a debenture
redemption reserve (DRR) has to be
created.

Call and Put Feature : Call features means – the issuing company
has the option to redeem the debenture at
certain price before the maturity date.
Put feature provides the right to the holder
that he can redeem at specified time at
predetermined rate.
Convertibility : It means, at the time of redemption, debenture may
be converted into equity share at the option of
debenture holder. The ratio and time of conversion
will be specified at the time of issue.

Types of Debt Instrument :

- Secured and Unsecured Debentures

- Convertible and Non-Convertible Debentures

- Zero Interest Fully Convertible Debentures

- Secured Premium Notes (SPN)

- Deep Discount Bonds

Advantages :

- tax deductible
- low cost of capital
- no dilution of control

Limitations :

- no flexibility
- risky source of finance
The owner of the asset is called as lessor while the other party
that uses the assets is known as lessee.

In lease agreement, the ownership is remains with the lessor and

after the specified time, the asset will be transferred to lessor.

In hire-purchase, the seller hands over the assets to the buyer but
the title to goods is not transferred. The buyer becomes the owner
of goods and acquire the title of goods only when he makes all
the payment of all the installments.

In installment sale, the title to goods is immediately transferred to

the buyer though the payment of price is to be discharged in
future.
Raising Long-Term Finance :

Different ways of raising long-term finances are –

• Venture capital
• Initial public offering
• Public issue by listed companies
• Rights issue
• Private placement
• Preferential allotment
• Dilution
• Obtaining a term loan

1. Venture Capital :

It refers to the investment of capital in relatively high risk

enterprises. It is normally young private companies that is not yet
ready or willing to tap public financial market.
Features :

- venture capital firm (VCF) assumes high risk in the anticipation

of high return.
- VCF, in addition to providing funds, guides the assisted firm also.
- VCF liquidates its investment after 3 to 7 years, initially by
offering the promoters, in the form of equity.

Instrument of Financing :

- Equity capital
- Conditional loan
- Conventional loan
- Income note

2. Initial Public Offering (IPO) :

The first public issue of equity shares by an unlisted company.

After IPO, the shares of the company will become listed on the
stock market.

Benefits of going public :

- access to capital
- respectability
- investor recognition
- liquidity
- signals from the market

Costs of going public :

- under pricing securities

- dilution
- loss of flexibility
- disclosure
- accountability
Eligibility for IPOs :

- track record
- listing
- promoters’ minimum contribution
- lock-in-period

Principal Steps in an IPO :

- approval of boards
- appointment of lead managers
- filing of prospectus with SEBI and Registrar of Companies
- filing of initial listing agreement
- statutory announcement
- collection and processing of applications
- allotment of shares
- listing of the issue
3. Public Issue by Listed Companies :

The procedure for a public issue by a listed company is similar to

that of an IPO.

However they face some more regulations, as –

- the company must be listed on the stock exchange for at

least three years
- the company must have a track record of dividend
payment for at least three immediate preceding years
- there are no pricing norms for a public issue by a listed
company

4. Right Issue :

It involves selling securities in the primary market by issuing rights

to the existing shareholders.
Characteristics :

- the number of rights a shareholder gets is equal to the

number of shares held by him.
- the issuing price will be decided by the company
- rights are negotiable. The holder of rights can sell them.
- rights can be exercised only during a fixed period which
is usually about 30 days.