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Long-term funds are needed by the firm either to replace existing capital
assets or to add to its existing capacity or both. The nature of long-term funds is
static and permanent. As a matter of fact, it is this capital which bears the ultimate
risk of the business. That is why, a major portion of long-term capital is collected
through the sale for equity shares, preference shares, and obtaining long-term
loans. Equity shares constitute the most important source of funds to a new
business, and provides basic support for existing firm’s borrowing. After
sometime, the retained earnings may also become a good source of a firm’s long-
term requirements of funds. When long-term needs are not fully met through
shares, the long-term loans are also utilized. So the real bases for division of fund
requirements are the time, conditions of its use, and the degree of risk attached to
it. If management gets ample time to plan and provide for the repayment of funds,
and if management can appropriate these funds for a very long time, it must be
included in long-term financing no matter whether it is ownership claim or a
creditorship claim. Now, we will discuss these sources in somewhat detail.
Shares are the universal and typical form of long-term capital raised
through capital market. All companies (except companies limited by guarantee)
have statutory right to issue shares to raise capital after incorporating provisions
thereof in the capital clause of the Memorandum of Association. Capital procured
by issue of shares is termed as ’Ownership
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Capital’.
The shares do not involve any fixed charge, nor the company is
under obligation to pay dividends. The company has to pay dividends only if
it has sufficient profits to do so. The company may even use whole of its
earnings for reinvestment and shareholders have no right to object or
interfere. The company seeking share capital has not to mortgage its assets
for acquiring share capital.
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directors are appointed by the share-owners of the company. But their liability (in
case of limited companies) is limited to the part value of shares held by them.
Liability is unlimited in case of unlimited company.
A company can issue only two kinds of shares, viz., (i) Equity
Shares and (ii) Preference Shares (U/S 86 of the Companies Act, 1956). We shall
now discuss the characteristics of these two types of shares separately and
examine their significance as source of finance.
Preferred Stock :
As the name implies, preference shares are those share which carry
preferential right and privileges with respect to income and assets over equity
stock. Section 85 of the Indian Companies Act, 1956 defines preference share as
the one which fulfits the following two conditions :
(e) Maturity : Most preferred stock issues have no maturity. It, therefore
brings in permanent capital. Frequently, provision for retirement of stock is
made by call or redemption feature in preference stock. This gives an option
to the company of redeeming or buying back the stock from the stockholders
under the terms and conditions specified in the Articles of Association. This
type of shares are called redeemable preference shares. The right of
redemption rests with the company only, no shareholder compels the
company for
redemption of their shares. The companies (Amendment) Act, 1988 has
prohibited a company limited by shares from issuing any preference shares which
is irredeemable or redeemable after the expiry of a period of ten years from the
date of its issue. Preference share issued before the commencement of this
Amendment Act shall be redeemed by the Company within a period not
exceeding five years from such commencement.
(f) Controlling Power : Most preferred stock does not contain provisions
to allow its shareholders to vote or have other voices in the management of
the company. However, under the companies Act, 1956 (Sec 87) preference
shareholders have been given right to vote on resolutions which directly affect the
rights attached to his preference shares and in this connection, any resolution for
winding up the company or reduction of its share capital is to be regarded as
directly affecting the rights attached to the preference shares. Some other
provisions for voting are also found.
Fixed dividend rate provision on the preferred stock has reduced the
utility of this kind of security particularly for company earning less than the
dividend rate because that will reduce returns to the residual owners. This is why
residual owners are mostly indifferent to issuance of this stock.
Managerial Issues
The use of this stock will be strongly favoured if the use of debt
entails the risk of insolvency in the enterprise and issuance of common stock
poses a threat of parting control with new equity stockholders.
The cost factor should also receive the attention of the management.
While the cost of preferred stock is likely to be lower than that of the common
stock, the use of preferred stock is conditioned essentially by the prevailing
interest rates. Therefore, the current interest rates should be compared with the
average dividend rates on common stock to take a decision.
Equity Shares
(a) Maturity : Equity capital is the permanent capital for the company.
Company has no contractual obligation to repayment of capital during its
working life. The shareholders have a right of demanding refund of their
capital only at the time of liquidation of the company and that too when funds
are left after meeting all prior claims. The shareholders cannot be compelled
by a
company to sell back their shares if they were fully paid-up and the shareholders
not engaged in competitive business to the business of the company.
(c) Voting Power : The common stockholders being the owner of the
company, they are entitled to elect a board of directors. The board, in turn,
selects the management which actually controls the operations of the
company. In a proprietorship, partnership firm and a small corporation, the
owners directly control the operations of the business. But in a large
corporation, the owners have an indirect control over the affairs of the
company. Outside stockholders have the right to expect that the directors
will administer the affairs of the corporation properly on their behalf.
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has complete discretion in distributing as much of the earnings in dividends as it
wishes. Since the company is under no legal obligation to pay dividends to the
shareholders, the management can retain its earnings entirely for their investment
in the business of the enterprise. Thus, a new and growing company seeking large
funds for its expansion programmes secures ample resources at cheaper cost and
without any inconvenienced and obligations.
DEBENTURES :
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debentures have not been defined under the Indian O’s Act, 1956. It simply states
that a debenture includes debenture stock, bonds and any other securities of a
company whether constituting a charge on the assets of the company or not.
Features of Debentures
(a) Maturity : Virtually all bonds have a maturity date and the company
agrees to pay off in cash the outstanding bonds at a fixed date. Such bonds which
are repayable at fixed date are called ’Redeemable bonds’. Other which have no
maturity date are called ’Irredeemable bonds’. Irredeemable debentures are rare in
use in India. An indebenture also contains the provisions about the repayment of
debt. Companies generally set aside funds out of earnings of the company at
periodic interval for retiring all or a portion of bonds before or at maturity. This
type of provision is known as "Sinking Fund Provision’ and bonds carrying
sinking fund provision are called ’Sinking Fund Bonds’.
Capital raised through the primary market has been showing a declining trend for
the last 4 years. In 1994-95, Rs. 27,632 crore were raised through 1692 public
and right issues. In 1995-96 the amount raised declined to Rs. 20803.7 crores. In
1996-97, there was a further decline in amount raised to Rs. 14,276 crores as also
in the number of issues to 882. The down trend also continued in 1997-98. The
total amount raised was Rs. 4570 crore approximately through only 111 issues
registering a sharp fall of 68 percent and 87 per cent respectively as compared to
the previous year.
4. Finance From Central and State Governments :
IFCI was the first national level development bank set up in 1948
by an Act of Parliament to make medium and long-term funds readily available to
industrial concerns particularly when the normal banking support is inappropriate
or going to the capital market is impracticable.
IFCI caters to the needs of medium and large projects either singly
or jointly with other all-India Financial Institutions. Normally, the Corporation
considers projects consting upto Rs. 5 crore independently. In respect of projects
cosisting over Rs. 5 crores, the Corporation invites other all-India institutions to
finance such projects under the system of consortium financing.
The basic idea underlying the creation of ICICI was to meet the
needs of industry for permanent and long-term funds in the private sector. Thus,
the Corporation aims at :
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shares or debentures.
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3) ) Guaranteeing deferred payment due from industrial concerns to
third parties and loans raised by them in the open market or from
financial institutions.
SFCs are the state level development banks set up in India under
State Financial Corporations Act, 1951 for the purpose of providing financial
assistance to new as well as existing industrial concerns for purpose of
establishment, modernisation, renovation, expansion and diversification. These
institutions assist a concern in following ways :
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activities including mining, transport by rope ways and development of industrial
areas are entitled to get assistance from this institution. SFCs generally provide
loans secured by way of legal mortgage of fixed assets and executed in favour of
the institution. Forty per cent margin is usually maintained on loans. However,
SFC’s policy in this respect has been very flexible. In certain cases particularly
those coming up in less developed regions, they lend without any margin.
2. Fixed versus Floating Rate : The interest that is due on term loan
with a commercial bank is determined in advance, using one of the two
methods. A fixed-rate loan has a single interest rate for the entire period
much more common, a floating-rae loan has interest charge that is tied to
current money market rate and varies with changes in interest levels. For
example, a rate of "2.5 per cent above prime quarter" would vary as the prime
rate varies.
Insurance Companies :
Pension Funds :
1. Trade Credit :
There are three types of trade credits : open account, notes payable,
and trade acceptances. Among these the most common type is the open-account
arrangement, and are known as accounts payable. The seller ships goods to the
buyer and sends an invoice that specifies the goods shipped, the price, the total
amount due, and the terms of sale. There is no formal agreement nor there is
specific document recognizing the buyer’s liability to the seller. The only
evidence with the seller is that credit has been intended on the buyer’s order and
shipping invoices. Open-account credit is ordinarily extended only after the seller
conducts a fairly extensive investigation of the buyer’s credit standing and
reputation.
Loan : In a loan account entire advance is disbursed at one time either in cash or
by transfer to his current account. It is a single advance. Except by way of
interest and other charges no further withdrawals are allowed in this account.
Since loan accounts are not running accounts like overdrafts and cash credit
accounts, no cheque books are issued.
Overdraft : Under this facility, the customers are allowed to withdraw in excess
of credit balance standing in their Current Deposit Account. A fixed limit is
therefore granted to the borrowers within which the borrower is allowed to
overdraw his account. Though overdrafts are repayable on demand, they
generally continue for long periods by annual renewals of the limits. Interest on
overdraft is charged on daily balances.
Only the companies which satisfy the following requirement are eligible to issue
CP :
i) The tangible net worth of the company is not less than Rs. 10 crores
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(Rs. 5 crores w.e.f. 24.4.90) as per the latest balance sheet;
ii) The Fund Based Working Capital (FBWC) facilities enjoyed by the
company from the banking system are not less than Rs. 25 crores (Rs. 15
crores
w.e.f. 24.4.90);
iii) Equity shares of the company are listed in one or more stock
exchanges. Government companies are exempt from this condition.
iv) The company obtains a credit rating from an agency approved by RBI
for the purpose from time to time. The Credit Rating Information Services of
India Ltd. (CRISIL) has been approved by RBI as the agency for issuing the
credit rating certificate. The minimum credit rating for issue of CP shall be
PI + (PI
w.e.f. 24.4.90). At the time of issue of CP, the rating should not be more than 2
months old.
vi) As per the latest audited balance sheet, the company maintains a
minimum current ratio of 1.33:1 based on the classification of current assets
and current liabilities as per the RBI’s guidelines, issued from time to time.
4. Commercial Factoring :
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operate a separate credit and collection department.
6. Customers advances :
Self-Assessment Questions
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