LONG TERM FINANCE
Depreciation charges and retained earnings represent the internal sources of finance available to the company. If depreciation charges are used for replacing worn-out equipment, retained earnings represent the only internal source for financing expansion and growth. Companies normally retain 30 percent to 80 percent of profit after tax for financing growth. Hence, retained earnings can be an important source of long term financing.
Companyâ€™s Point of View retained earnings are viewed very favorably by most corporate managements for the following reasons:
Â· Retained earnings are readily available internally. They do not require talking to outsiders who can be lenders or shareholders.
Â· Retained earnings effectively represent infusion of additional equity in the firm. Use of retained earnings, in lieu of external equity, eliminates issue costs and losses on account of under pricing.
Â· There is no dilution of control when a firm relies on retained earnings.
The disadvantages of retained earnings are:
Â· The amount that can be raised by way of retained earnings may be limited. Further, the quantum of retained earnings tends to be highly variable.
Â· The opportunity cost of retained earnings is quite high. Remember that retained earnings in essence, represent dividends foregone by equity shareholders.
The advantages of retained earnings from the shareholdersâ€™ point of view are:
Â· Compared to dividend income, the capital appreciation that arises as a sequel to retained earnings is subject to a lower rate of tax.
Â· Reinvestment of profits may be convenient for many shareholders as it relieves them to some extent of the problem of investing on their own.
From the point of view of shareholders the disadvantages of retained earnings are:
Â· Shareholders who want a current income higher than the dividend income may be highly averse to, or may find it inconvenient to, convert a portion of capital appreciation which results from retention of earnings into current income, as it calls for selling some share.
Â· Many firms do not fully appreciate the opportunity cost of retained earnings. They impute a low cost to it. As a result, they may be comforted by the easy availability of retained earnings, invest in sub-marginal projects that have a negative NPV. Obviously such a sub-optimal investment policy hurts the shareholders.
Equity capital represents ownership capital as equity shareholders collectively own the company. They enjoy the rewards and bear the risks of ownership. However, their liability, unlike the liability of the owner in a proprietary firm and the partners in a partnership concern, is limited to their capital contributions.
Some terms the investors and shareholders must know:
Authorized, Issued, Subscribed, and Paid-up Capital >>>>>
The amount of capital that a company can potentially issue, as per its memorandum, represents the authorized capital. The amount offered by the company to the investors is called issued capital. That part of issued capital which has been subscribed to by the investors is called the subscribed capital. The actual amount paid up by the investors is called the paid-up capital. The issued, subscribed, and paid-up capital are the same.
Par Value, Issue Price, Book Value, and Market Value >>>>>
The par value of an equity share is the value stated in the memorandum and written on the share scrip. The par value of equity shares is generally Rs. 10 (the most popular denomination) or Rs. 100. Infrequently, one comes across parvalues like Re. 1, Rs. 2, Rs. 5, Rs. 50, and Rs. 1,000.
The issue price is the price at which the equity share is issued. Generally the issue price and par value are one and the same for new companies. An existing company may sometimes set its issue price higher than the par value. E. Merck (India) Limited, for example, set its issue price at Rs. 13 per share as against the par value of Rs. 10 per share. When the issue price exceeds the par value, the difference is referred to as the share premium. The issue price cannot be, as per law, lower than the par value.
The Book Value of an equity share = Paid up equity capital + Reserves and surplus / Number of outstanding equity shares
Quite naturally, the book value of an equity share tends to increase as the ratio of reserves and surplus to paid up equity capital increases.
The market value of an equity share is the price at which it is traded in the market. This price can be easily established for established for a company which is listed on the stock market and actively traded. For a company which is listed on the stock market but traded very infrequently, it is difficult to obtain a reliable market quotation. For such a company, the market quotation may reflect the sale of a few shares in a past period and hence may not reflect the current market value of the firm. For a company which is not listed on the stock market, one can merely conjecture as to what its market price would be if it were traded. The market price is determined by a variety of factors like earnings potential, dividend policy, risk, and company size.