Long Term Sources of Funds
Long Term Sources of Funds
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Ordinary SharesPros and
Cons
Advantages
1. Permanent Capital: ordinary share capital is
not redeemable. So company has no
liability for cash outflow associated with its
redemption.
2. Borrowing Base: the equity capital
increases the companys financial bases,
and thus its borrowing limit.
3. Dividend Payment Discretion: A company is
not legally obliged to pay dividend. In times
of finacial difficulties it can reduce or
suspend payment of dividend.
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Pre-Emptive Rights
The pre-emptive right entitles a
shareholder to maintain his proportionate
share of ownership in the company.
The law grants shareholders the right to
purchase new shares in the same
proportion as their current ownership.
For eg, if the shareholder has 1% shares,
he has the right to purchase 1% of new
shares issued.
A shareholder may decline to exercise this
right.
Limited Liability : their liability is limited to
the amount of their investment in shares.
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Disadvantages
Cost: Shares have a higher cost because
dividends are not tax deductible as are interest
payments, and the floatation costs on ordinary
shares are higher than those on debt.
Risk: Ordinary shares are riskier from investors
point of view as there is uncertainty regarding
dividend and capital gains.
Earning dilution: Issue of new ordinary share
dilutes the existing shareholders earning per
share if the profits do not increase
proportionately to the increase in the no of
ordinary shares
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Debentures
A debenture is a long-term promissory note
for raising loan capital.
The firm promises to pay interest and
principal as stipulated.
The purchasers of debentures are called
debenture holders.
An alternative form of debenture in India is a
bond.
Mostly public sector companies in India
issue bonds.
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DebenturesFeatures
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Yield:
The yield on a debenture is related to its market price;
therefore, it could be different from the coupon rate of
interest.
Two types of yields can be distinguished.
The current yield on a debenture is ratio of the annual
interest payment to the debentures market price. For
example, a debenture is issued for Rs.1000 face value with a
coupon rate of 12% and market value of Rs.750. The Current
yield = Annual interest/market price= Rs.120 / 750 = 0.16 or
16%
The yield to maturity takes into account the payments of
interest and principal, over the life of the debentures. It is the
Internal Rate of Return of the debenture.
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Debenture features.
Indenture: or debenture trust deed
Is a legal agreement between the company issuing
debentures and the debenture trustee who represents
the debenture holders.
It provides the specific terms of the agreement,
including a description of debentures, rights of
debenture holders, rights of the issuing company and
responsibilities of the trustee.
Security :
Debentures are either secured or unsecured. A secured
debenture is secured a lien on the companys specific
assets.
If the company defaults , the trustees can seize the
security on behalf of debenture holders.
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Types of Debentures
Non Convertible Debentures: NCDs
are pure debentures without the feature
of conversion. They are repayable on
maturity.
Fully Convertible Debentures: FCDs
are converted to shares as per terms of
the issue with regard to the price and
time of conversion. Normally interest
rate is less for FCDs.
Partly Convertible Debentures two
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DebenturesPros and Cons
Advantages
1. Less Costly
2. No ownership Dilution
3. Fixed payment of interest
4. Reduced real obligation
Disadvantages
1. Obligatory Payment
2. Financial Risk
3. Cash outflows
4. Restricted Covenants
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Preference Shares
Similarity to Ordinary Shares:
1. Non payment of dividends does not force
company to insolvency.
2. Dividends are not deductible for tax
purposes.
3. In some cases it has no fixed maturity
dates.
Similarity to Debentures:
1. Dividend rate is fixed.
2. Do not share in residual earnings.
3. Usually do not have voting rights.
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Preference SharesFeatures
Claim on Income and Assets
Fixed Dividend
Cumulative Dividend
Redemption
Sinking Fund
Call Feature
Participation Feature
Voting Rights
Convertibility
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Preference SharesPros and
Cons
Advantages
1. Risk less Leverage advantage
2. Dividend postponability
3. Fixed dividend
4. Limited Voting Rights
Disadvantages
1. Non-deductibility of Dividends
2. Commitment to pay dividends
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Term LoansFeatures
Maturity
Direct Negotiations
Security
Restrictive Covenants
1. Asset related covenants
2. Liability related covenants
3. Cash flow related covenants
4. Control related covenants
Repayment Schedule
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Public Deposits
Accepting deposits from the public
has gained popularity with the public
and companies.
Company deposits have been a very
old source of finance in India.
Company fixed deposits are deposits
placed by investors with companies
for a fixed term and carry a
prescribed interest rate which is
above the rates offered by banks.
Public deposits
Public deposit implies funds received by a
company in the forms of deposits or loans
collected from the public.
The word public includes the general
public, employees, and share holders of the
company.
Company deposits are normally unsecured,
so more risky.
When companies face cash crunch, they
offer deposits at attractive rates.
Features of public deposits
Who can accept company
deposit?
Under Companies Act, 2013, only the
following entities are allowed to invite,
accept and renew public deposits:
Public limited companies having the
prescribed net worth of Rs.100 crore or turn
over of Rs.500 crore.
Banking companies
Non-Banking Financial Companies (NBFCs)
Minimum Investment
Varies from company to company
Normally minimum is Rs.5000
No upper ceiling
In case of recurring deposits, minimum is Rs.100
per month.
Duration of the deposits vary from a minimum of six
months to three years.
Interest payment
Fixed interest rate governed by RBI rule.
Higher than that of bank and postal deposits.
Interest payable on monthly or quarterly
In cse of cumulative deposits, interest is accumulated
and paid along with the principal on maturity.
Recurring deposits are similar to RDs of banks.
Mode of holding
A physical receipt is issued to the depositor.
Security
Company deposits are not secured normally.
The New Companies Act, 2013, permits the
companies to issue secured as well as unsecured
deposits, while it was not under the companies
Act,1956.
Liquidity: Some companies offer loans against
deposits and a premature withdrawal facility .
But there will be a loss of interest.
Advertisement: required if deposits are accepted
from general public.
Only a circular is required if accepted from
shareholders or employees.
Rating: Unser the Companies Act, 2013,
companies have to obtain credit rating before
they issue deposits to the public.
CRISIL rating of FAAA is considered to carry the
highest safety rating.
Dividend payment: If the company fails to comply
with the provisions related to acceptance of
deposits and in the event of default in repayment
of deposits, the companies are not allowed to
declare dividend.
Appoint trustee : a company before accepting
deposits has to appoint one or more trustees and
execute the trust deed.
The trustee act and protect the interest of the
public.
TDS: Tax is not deducted if the
interest per depositor is less than
Rs.10,000 per annum.
Nomination facility: available for
company deposits also.
Marketing : can be done through
agents who get commission.
Advantages
Simple and safe: no legal
formalities
Cheaper source of finance:
Cheaper than bank loans
Income Tax advantage: the interest paid on deposits is
a deductible expense to companies for income tax
purpose.
Trading on equity: return on equity increases.
No loss of control: deposit holders have no voting
rights. They cannot interfere in the internal matters.
Additional source of finance: public deposits are not
backed by any charge on the assets of the company. So
these assets can be used for borrowing.
Flexibility: it provides flexibility to the financial
structure of the company. There is no risk of over
capitalization and the company can repay the deposits
when they are not required.
Larger base: contact with a large no. of investors.
Good return to depositors: higher rate of interest to
the investor .
Disadvantages of public
deposits
Undependable source of finance
Available for short- term only , not a long-term source.
Misuse : since it is unsecured, co. may misuse them, raised
when not required. Diversion of funds.
New companies: public deposits are not available to new
companies and those with uncertain earnings.
Legal restriction: there are legal restrictions on the
acceptance and renewal of public deposits. A co. cannot
raise unlimited amounts from this source.
Hindrance to growth of capital market.
No security for depositors.
Less capital appreciation.
No tax advantage : interest is taxable.
Hire Purchase
Hire Purchase Act 1972, defines a
hire purchase as an agreement under
which goods are let on hire and
under which the hirer has an option
to purchase them in accordance with
the terms of the agreement.
Hire Purchase Agreement
The hire purchase agreement contains the
following clauses:
The owner delivers possession of goods to a person, a
hirer, with the condition that such a person pays the
agreed amount in periodic instalments which is in the
nature of rental.
Instalment is inclusive of the principal and interest.
Specify the rights and obligations of the owner as well as
the hirer.
The ownership of the goods passes to the hirer only on
the payment of the last instalment.
The hirer has a right to terminate the agreement at any
time, before receiving the title in the property.
Features of Hire Purchase
A higher rate of interest can be charged .
As the calculation is on the original advance, higher
would be realized.
As the company is the owner of the asset in hire
purchase, attachment of the asset and subsequent
sales, even by private auction would keep the non-
performing assets low.
The possibility of defaults is very less in hire
purchase, as the borrowers would end up losing the
installments paid as well as the asset.
The company can effectively recycle the funds
recovered in hire purchase.
Tax consideration of Hire
Purchase
Income tax aspect : the hirer is entitled to the tax
shield on depreciation and on the consideration for
the hire.
Sales tax aspects:
For the purpose of levying sales tax, a sale is
deemed to take place only when the hirer exercises
an option to purchase.
When the hirer exercises the purchase option, the
amount of sales tax must be determined with
reference to the depreciated value of the goods.
The State in which the goods have been delivered is
entitled to levy and collect sales tax.
Sales tax cannot be levied on hire purchase transactions
structured by finance companies, provided these
companies are not dealers in the class of goods let on
hire.
There is no uniform rate of sales tax applicable to hire
purchase transactions as the rate varies from state to
state.
Interest Tax Aspects: the interest tax implications are:
Interest tax is payable on the total amount of interest
aggregating to a hire purchase company in the previous
year at the rate of 3 per cent.
The interest tax payable by the hire purchase company is
treated as tax deductible expenses for the purpose of
computing the taxable income under the Income Tax act.
VENTURE CAPITAL