LONG TERM FINANCING
Definition:
Required amount of fund collected by a business enterprise for meeting up fund requirement
for acquiring important useable items from which there is long term benefit expectation. To
make investment for earning expected return over long period of time from different
available sources for more than 7/10/15 years’ time period is known as long term financing.
Examples of long-term financing include – a 30 year mortgage or a 10-year Treasury note.
Equity is another form of long-term financing, such as when a company issues stock to
raise capital for a new project.
Features of long term financing:
Longer maturity
Larger size of loan- Normally Larger size
Users of loan- Large Companies
Use of fund in capital machineries
Sources - Equity, Debt, Preferred Stock
Repayment method- Depends on type of security.
Security
Cost of financing- Higher than short and intermediate term financing
Purpose of Long Term Finance:
1. To finance fixed assets.
2. To finance the permanent part of working capital.
3. Expansion of companies.
4. Increasing facilities.
5. Construction projects on a big scale.
6. Provide capital for funding the operations. This helps in adjusting the cash flow.
Sources:
(a) Internal sources- promoter’s initial capital, retained earnings, general reserve,
dividend equalization fund, sinking fund, workmen’s compensation and welfare fund.
(b) External sources- common share capital, preferred share capital, bond/debenture,
commercial bank loan, loans from nonbank financial institutions, loans from
specialized financial institutions and leasing.
Sources of Long Term Financing (details):
Following are the various sources of long term finance are as follows –
Common stock:
The stock that’s holder has ownership claim, management participation right, voting right
and residual claim in the distribution of income and liquidation value is known as common
stock.
Bond:
A debt instrument issued for a period of more than 5/10 years with the purpose of raising
capital by borrowing.
Preferred stock:
The stock that’s holder has not ownership claim, management participation right, voting
right but has preferential claim in the distribution of income and liquidation value before
common stockholders is known as preferred stock.
Debentures:
These are also issued to the general public. The holders of debentures are the creditors of
the company.
Retained Earnings:
The company may not distribute the whole of its profits among its shareholders. It may
retain a part of the profits and utilize it as capital.
Term Loans from Banks:
Many industrial development banks, cooperative banks and commercial banks grant
medium term loans for a period of 7/10 years.
Loan from Financial Institutions:
There are many specialized financial institutions established by the government which give
long term loans at reasonable rates of interest.
Common Stock:
Common stock is a security that represents ownership in a corporation. Holders of common
stock exercise control by electing a board of directors and voting on corporate policy.
Common stockholders are on the bottom of the priority ladder for ownership structure; in
the event of liquidation, common shareholders have rights to a company's assets only after
bondholders, preferred shareholders and other debtholders are paid in full.
Common Shareholders' Six Main Rights
1. Voting Power on Major Issues
2. Ownership in a Portion of the Company
3. The Right to Transfer Ownership
4. Right to get Dividends
5. Opportunity to Inspect Corporate Books and Records
6. The Right to Sue for Wrongful Acts
Bond:
Bond is a financial assets that represent indebtedness of the bond issuer to the holders. The
most common types of bonds include municipal bonds and corporate bonds.
The bond is a debt security, under which the issuer owes the holders a debt and (depending
on the terms of the bond) is obliged to pay them interest (the coupon) or to repay the
principal at a later date, termed the maturity date.
Interest is usually payable at fixed intervals (semiannual, annual, and sometimes monthly).
Very often the bond is negotiable, that is, the ownership of the instrument can be transferred
in the secondary market. This means that once the transfer agents at the bank medallion
stamp the bond, it is highly liquid on the secondary market.
Features:
Bonds usually have the following features-
Face value: it means the value of a bond at maturity. For example, a 10%, 1000, 10-
year bond means that the bond offers $1000 at its maturity. Usually bonds have a face
value of 1000
Maturity date: it is the date at which the bond matures. As a bond is a long-term debt
instrument, its maturity is often 10 years or more. For example, if a 10-year bond is
issued at January 1, 2000, then it will mature at January 1, 2010.
Coupon rate: it is the annualized rate of interest paid on bonds. For example, a 5%,
1000 bond means that the bond provides 5% annual interest on its face value of 1000.
Types of Bond:
1. Treasury bonds: Treasury bonds are bonds issued by the govt. in a country to acquire
funds from people, including individual and organizations. As govt. can always raise
taxes to pay bond payments, these bonds have almost zero default risk and as a result,
they show excellent liquidity.
2. Municipal bonds: these are bonds issued by local municipality. These are quite similar
to govt. bonds in nature, and as municipal authority can also make payments by
collecting taxes, these bonds also have almost zero default risk.
3. Corporate bonds: these are bonds issued by corporations. Although these bonds
provide comparatively higher return than govt. or municipal bonds, they also have a
higher default risk.
4. Junk bonds or high yield bonds are corporate bonds from companies that have a big
chance of defaulting. They offer higher interest rates to compensate for the risk.
5. Investment-grade corporate bonds
6. Foreign bonds
7. Mortgage-backed bonds
Difference between Stock and Bond
BASIS FOR STOCKS BONDS
COMPARISON
MEANING Stocks are the financial Bonds are the debt instrument issued by the
instrument that carries companies or govt. to raise capital with a
ownership, issued by the promise to pay back the money after some
company. time along with interest.
ISSUED BY Companies Government institutions, companies and
financial institutions, etc.
WHAT IS IT? Equity instrument Debt instrument
RETURN Dividend Interest
IS THE RETURN No Yes
GUARANTEED?
OWNERS Stockholders Bondholders
STATUS OF Stockholders are the Bondholders are the lenders to the
HOLDERS owners of the company. company.
RISK High Comparatively low
ADD ON BENEFITS The holders get voting The holders get preference at the time of
rights. repayment.
Preferred stock:
A preferred stock is a class of ownership in a corporation that has a higher claim on its assets
and earnings than common stock. Preferred shares generally have a dividend that must be
paid out before dividends to common shareholders, and the shares usually do not carry
voting rights.
Preferred Stocks vs. Common Stocks
Feature Preferred Common
Ownership of Company Yes Yes
Voting Rights No Yes
Dividends Fixed Varies
Value if Held to Maturity Full No maturity
