SOURCES OF LONG TERM FINANCE
The sources from which a finance manager can raise long-term funds are broadly classified as 1) External Sources 2) Internal Sources.
Internal sources include retained earnings, depreciation (as depreciation only represents reduction in the value of the asset through wear and tear, obsolescence etc, and is not an actual cash outflow).
The focus in this article is on the long-term external source of finance.
Various sources of long-term finance are
* Equity share capital
* Preference share capital.
* Non-Convertible Debentures (NCD)
* Fully Convertible Debentures (FCD)
* Partly Convertible Debentures (PCD)
* Rupee term loans
* Foreign currency terms loans.
There are many other sources of long-term finance like deferred credit, unsecured loans and deposits, suppliers credit scheme, leasing and hire purchase which are beyond the scope of this article.
Equity capital represents the ownership capital. The equity shareholders collectively own the company and enjoy all the rewards and the risks associated with the ownership. However, unlike the sole proprietor or the partner of the firm, the downside risk of the shareholders is limited to their capital contribution.
Residual Claim: It refers to the residual income on which the shareholders have a right. Residual income is the income left after the claims of all others lenders of long-term finance in the form of interest and taxes have been met. It is the figure of profit after tax less dividend to be paid to preference shareholders.
The equity shareholders have a residual claim on the income of the company. The company has distributed the whole profit as dividend to the equity holders or the company may retain a part of its profit. The dividend decision is the decision of the board of directors. Equity Shareholders cannot contest it in a court of law.
Liquidation: Refers to the closure of a company. It may be due to losses and non-viability of the operations. The capital contributed by the equity shareholders cannot be redeemed until the liquidation of the company.
From the companyâ€™s point of view funds through equity capital has both advantages and disadvantages.
The main advantages are:
* It is a source of permanent capital
* Payments of dividend is not a legal obligation
* Equity capital provides the base for raising debt as equity represents the commitment of promoters to the growth of the company.
The main disadvantages are:
* Non-voting shares refer to the equity shares which do not carry voting rights. Thus, non-voting shareholders do not involve in making management decisions.
* Public offer of equity capital can result in a dilution of the effective control exercised by the existing shareholders. However, this can be avoided by issuing of non-voting shares (which no corporate is yet allowed to do).
* Unlike interest on debentures, dividends on equity are not tax deductible. Out-flow amounts on dividends will not provide any tax-shield.
Existing companies while going for public issue, for equity share capital, may decide to offer a portion of the total issue to its existing shareholders and when such an offer is made to the existing share holders, it termed as right issue. The number of shares allotted to the existing shareholders is in proportion to the number of shares already held by them.
Voting Rights give the right to participate in management decision.
Arrears: Unpaid dividends to the shareholders by the company are called dividends in arrears.
A company can also raise funds through issue of preferential shares. Preferential shares include characteristics of a debenture and an ordinary share. The holders of the preference capital have preference over equity shareholders to the earnings of the firm in the form of dividends and on assets in the event of liquidation, but only after the claims of debenture holders. So, preference shareholders will have less risk than equity shareholders and more risk than rate of dividend, and do not carry voting rights unless the preference dividend is in arrears for a specified period of time.
From the companyâ€™s point of view, preference capital offers almost the same advantages of equity capital except that it is not a permanent source of finance. An additional advantage of this source of finance is that it does not dilute the control of the existing shareholders as the preferences shares do not carry voting rights.
Secured Debentures is the debt instrument backed by asset. In case of failure of issuer to pay principal on maturity date of the instrument, the holder of the instrument will have claim on the assets.
The major disadvantage of this source of finance is, it is an expensive source of finance when compared to debt because interest on debentures like dividend on preference shares is not tax deductible Even then Corporate companies issue preference capital instead of raising loads because the preference capital can be raised without the backing of any security, whereas it is a must in issuing of secured debentures.
Second, the servicing i.e. the payment of interest on the debenture stock is a legal obligation. It is not so in case of preference capital.
Third, for raising loans, the preference share capital is counted with the equity base to determine the eligible quantum of loans (RBI stipulates the loan amount to be in proportion to the equity capital)
Another way of raising long-term funds is by issuing â€˜debenturesâ€™, also called as bonds. A debenture is a marketable legal contract whereby the company promises to pay, whoever owns it, a specified rate of interest for a defined period of time and to repay the principal on the specific date of maturity.
Debentures are usually secured by a charge on the immovable properties of the company. The interests of the debenture holders are protected by a trustee (generally bank or an insurance company or a firm of attorneys). The trustee is responsible for ensuring that the borrowing company fulfills the contractual obligations mentioned in the contract.
The debenture capital can be raised by issuing debentures with different characteristics
The major advantages of issuing debenture capital are
* Interest paid on debenture is tax-deductible.
* Does not dilute the control of existing shareholders.
Inflationary period refers to the economic situation in which prices and wages rise in turn as the supply of money is increased.
* In inflationary period the issue of debentures is advantageous because the fixed monetary commitment in terms of interest and principal repayment decreases in real terms with increases in price level.
The major disadvantages of issuing debenture capital are
* Payment of interest and capital are obligatory.
* Increases the financial risk.
Debt-Equity Ratio is the ratio of debt capital to the equity capital.
* As the ceiling is imposed by many financial institutions on the maximum debt-equity ratio of company, there is a limit on the quantum of funds that can be mobilized from this source. If the debt equity ratio permitted is 2:1 then for 2 units of debt required, one unit of existing equity is a must.
So a company having equity of Rs.10000 cannot raise debt beyond Rs 20000 without increasing its equity.
Refinancing Facility is providing financial assistance to institutions against the loans provided by them, i.e. financing the financiers.
Terms Loans represent a source of debt capital normally obtained by companies from term lending institutions. These may Term Lending Institutions sponsored by governments or reputed banks. In India Financial Institutions such as the Industrial Development Bank of India (IDBI), Industrial Finance Corporation of India (IFCI), Industrial Credit and Investment Corporation of India (ICICI) or any state level finance corporations like State Finance Corporation (SFC) and commercial banks.
Mortgage is the transfer of interest in specific immovable property for securing the payment of money advanced.
In hypothecation the goods offered as security are in the possession of the borrower but the lender has the right to sell the good and adjust the loan in case of default in repayment of the loan.
The salient features of the term-loans offered by these institutions are as follows
(a) The loan typically carries rate of interest as directed by the central bank of the country
(b) The loan is secured through a first mortgage, by way of deposits of title deeds of immovable properties, and hypothecation of movable companies
(c) The loan contract often contains restrictive covenants depending upon the nature of the project and the financial situation of the borrowing company.
(d) The loans can be converted into the equity capital of the borrowing company at the option of the financial institution subject to certain conditions.
The financial institutions also offer loans on reduced interest rate terms to projects located in industrially backward area and on the priority of the industry to the national economy.
The advantages and disadvantages of term loans are almost similar to the debenture capital.