SOME ASPECTS OF SOURCES OF LONG TERM FINANCE
The principal sources of long term finance for a firm are:
Â· Retained earnings,
Â· Equity capital,
Â· Preference capital,
Â· Debenture capital, and
Â· Term loans.
Retained earnings represent the profits ploughed back in the business. From the firmâ€™s point of view retained earnings represent a very convenient source of financing. However, this may lead to some inefficiency in its use.
Equity capital represents ownership capital as equity shareholders collectively own the firm. Equity shareholders enjoy the rewards, as well as bear the risk, of ownership. The rights of equity shareholders consist of (i) the right to residual income, (ii) the right of control (iii) the pre-emptive right to purchase additional equity shares issued by the firm (iv)the residual claim over assets in the event of liquidation.
The advantage of equity capital is that it represents a permanent source of finance, does not carry any fixed burden, and enhances the creditworthiness of the firm. The disadvantages, on the other hand, are that its cost is very high and issue of equity to outsiders causes dilution of control.
Preference capital represents a hybrid form of financing it partakes of some characteristics of equity and some attributes of debt capital. The features attached to preference shares may vary along the following dimensions: accumulation of dividends, participation in surplus profits, redeem ability, call ability, and convertibility. Preference capital carries no definite legal obligation to py dividends and enhances the creditworthiness of the firm. It is, however costly source of financing.
Cumulative convertible preference (CCP) shares, introduced in 1985, carry a dividend rate of 10 percent and are compulsorily convertible into equity shares.
Akin to promissory notes, debentures are instruments for raising long term debt capital. The obligation of a company towards its debenture holders is similar to that of a borrower who promises to pay interest and principal at specific times. When a debenture issue is made a trustee is appointed to protect the interest of debenture holders.
Thanks to the latitude that companies enjoy in designing debt instruments, a variety of debt instrument have been employed. They have put and call options; they have convertibility feature; they are sweetened with warrants; they carry floating rates of interest; so on and so forth.
Term loans represent a source of debt finance which is generally repayable in more than one year but less than ten years. The important features of term loans are:
(a) They are secured borrowings
(b) The interest and principal repayment burden are definite obligations which are payable irrespective of the financial situation of the firm
(c) Term loans carry a number of restrictive covenants with them.