Subject: Financial Management

Unit 4 : Financing Decision:

Sources of Long Term and Domestic Finance

Faculty: Dr. Anuradha Yesugade,

Faculty, BVIMED,Pune
 Sources of Long Term Domestic Finance

Equity Shares,

Preference Shares

Debentures,

Retained Earnings,
Equity Shares?
Preference Shares?
Debentures?
Retained Earnings?
 EQUITY SHARES:
Meaning of Equity Shares:

Equity share is one of the sources of raising long term finance.

e.g. If the requirement of capital is Rs. 5, 00,000 and it is divided into 5000 units of Rs. 100/- each, thus
each unit of Rs. 100 is termed as a share.

An equity shareholder is the absolute owner of the company.

Equity shares represent ownership position in the company. Holders of equity shares are termed as equity
shareholders.

The capital represented by equity shares is called as “share capital” or “equity capital”.

Equity shares are the permanent source of the capital, they do not have maturity period.

The equity shareholders are entitled for dividend, the amount of dividend is not fixed.
 Features:

1) Redemption:

Equity shares provide permanent capital to the company.

It means that it is not repayable during the life time of the company but
payable at the time of winding up.

The shareholders have the right to transfer or sell their shares to another
person; in this case also the company will keep getting the capital.
 Features:

2) Claim on Income:

Equity shareholders have residual ownership claim.

It means earnings will be available to equity shareholders after the

claims of all others have been settled.

Earnings in the form of dividend will be available to equity

shareholders only after payment of interest charges, taxes and
preference dividend if any.
 Features:
3) Claim on Assets:

Equity Shareholders also have the residual claim on company’s assets in case of winding up
or liquidation of the business.

Liquidation can occur on account of business failure or in case of sale of the business.

Equity shareholders can get claim on assets only after all outside obligations are settled.

Out of the realized value of the assets, first the claims of debenture holders and preference
shareholders are satisfied and remaining balance if any is paid to equity shareholders.

This also means that, if no assets are left out after satisfying claims of debenture holders and
preference shareholders, equity shareholders may not get any assets.
 Features:

4) Right to Control:

Equity shareholders are assigned with the power to control the affairs of the
company by exercising voting right.

Every equity shareholder enjoys supreme control on the operations of

company through voting powers.

Every equity shareholder has a right to vote on every matter placed before the
company and his/her voting right is in proportion to his/her share in the
capital of the company.
 Features:

5) Voting Right:

Each equity share carries one vote.

Thus an equity share holders can vote equal to the number of shares
held by him/her.

Shareholders can vote in person or proxy in the annual general meeting

or any other special meeting convened for voting purposes.
 Features:

1) Pre-emptive Rights:

When the company decides to raise additional capital by issuing new shares,

as per the legal obligation the company has to offer, these shares to the
existing shareholders first,

before announcing the public issue of shares in share market.

This right of equity shareholders is called “Pre-emptive right”.

.
 Features:

1) Pre-emptive Rights:

When the company decides to raise additional capital by issuing new shares,

as per the legal obligation the company has to offer, these shares to the
existing shareholders first,

before announcing the public issue of shares in share market.

This right of equity shareholders is called “Pre-emptive right”.

.
 Merits of Equity Shares :

To the company:
1) There is no obligation of payment of dividend to the equity shareholders. The
company may pay dividend if they are in profits. In case of financial
difficulties it can reduce or suspend the payment of dividend, still generally
every company tries to pay dividends regularly.
2) Equity shares are permanent source of capital and available for use
throughout the life of the company.
3) Equity Capital increases the company’s financial base and the borrowing
limits. Hence company can borrow as per their additional requirements.
Merits of Equity Shares :

To the share holders

As per the statutory provisions, the liability of the equity shareholder is

restricted only to the face value of the shares.

Ordinary shareholders liability is limited to the amount of her/his

investment in shares.

The personal properties of the equity shareholder are not at stake even
if the company fails to meet its obligations.
 Demerits of Equity Shares :

•Demerits of Equity Shares:

1) It is costlier source of raising capital as compared to other sources.

2) Dividend is paid to the shareholder which is a portion of profits and

amount of dividend is also not fixed.

3) The issue of new share can dilute the existing shareholders earnings per
share. This is because the profit does not immediately increase in
proportion to increase in number of ordinary shares.
Preference Shares:
Another important source of raising long term finance is preference
shares.

These are the shares which enjoys preferential treatments as compared

to the equity shares.

Preference shareholders get priority over equity shareholders

regarding payment of dividends and repayment of share capital at
the time of liquidation of the company.
Types of Preference Shares:
1) Cumulative v/s Non-cumulative:

If the company fails to pay dividend in any year, the dividends go on accumulating in
case of Cumulative Preference shares.

When the company is in position to pay dividend, then the arrears of preference
dividends are required to be paid first, then it is to be paid to equity shareholders.

In case of Non- Cumulative Preference Shares, preference shareholders won’t get the
right to accumulate the dividend. If the company fails to pay dividend in any year, it
lapses.
2) Convertible v/s Non-Convertible :

In case of Convertible Preference Shareholders, they get a right, which is

optional to convert their preference shares into equity shares at a later stage.

On the contrary in case of non-convertible preference shares, the holders of

preference shares do not enjoy a right to convert their preference shares into
equity shares.
3) Redeemable v/s Non-Redeemable:

In case of redeemable preference shares, these shares can be repaid by the

company during its life time, as per the terms of issue, either after a specified
period is over or whenever the company so chooses after giving proper
notice.

In case of non-redeemable preference shares, these shares can be repaid

only on the winding up of the company.
The above classification of preference shares is not exclusive one it is inclusive
one.

E.g. A Company can issue cumulative convertible preference shares

 Features of Preference Shares:
1) Maturity:

The preference shares are categorized into two groups.

One is redeemable preference shares and another is non-redeemable

preference shares.

Redeemable preference have specified maturity date and are to paid

on that particular date, or whenever the company chooses to do so
but after giving proper notice in advance.
2) Claims on Assets or Income:

Preference shareholders get priority over equity shareholders in case of

payment of dividend that is they have prior claim on income.

Secondly, preference shareholders get the prior claim on company’s assets

in case of liquidation or winding up of the company.

only participating preference shareholders enjoy a claim on the residual

income or assets of the company

This residual claim is not available to non-participating preference

shareholders.
3) Control and Voting Rights:

Preference shareholders do not have any role in controlling affairs

of the company.

They do not get voting rights.

However, as per Companies Act 1956, preference shareholders are

entitled to vote in following cases:
3) Control and Voting Rights:

i) e.g. in case of winding up of a company, or reduction in share capital of the

company , if there is any resolution which is directly affecting the rights of
preference shareholders, then in such cases, preference shareholders can vote on
such resolutions.
3) Control and Voting Rights:

ii) Secondly if the preference share dividend is outstanding, not paid for few
consecutive years, the preference shareholders can vote on all the matters placed
before company in the meeting of equity share holders.
4 ) Fixed Dividend:

In case of preference shares the rate of dividend is fixed.

They are called as fixed income bearing securities.

Payment of preference share dividend is not a legal obligation.

The past unpaid dividends can be paid before the payment of dividends to
equity shareholders.
❑ Merits of Preference Shares:

1) The rate of dividend to be paid to preference shareholders is fixed.

2) Preference shareholders won’t be able to access extra profits earned by the

business unlike the equity share holders.

3) This makes this source relatively cheaper source of raising finance, as compared to
equity shares.

4) Preference shareholders do not enjoy voting rights, Hence controlling interests of

the equity shareholders will not get disturbed by issuance of preference shares.
5) If the company’s earnings are not stable, company can raise capital by issuing the
preference shares, as there is no strict obligation towards payment of dividend like
payment of interest on borrowed capital.

If the company is passing through financial difficulties, then payment of dividend

can be postponed and cumulative dividends can be paid in subsequent future years.

This is one of the advantage of raising funds through preference shares

Demerits of Preference Shares:

1. It is relatively costly source of raising finance, as the cost paid to

preference shareholders is fixed amount of dividend.

2. This dividend is not tax deductible unlike the interest paid on the
borrowed capital. Hence it is one of the disadvantages for the
company.

3. Preference shareholders do not enjoy the voting rights, hence they can
exercise control in company’s affairs only to a limited extent. Hence it
is a disadvantage for the preference share holder.
Demerits of Preference Shares:

4. Generally, the companies do not issue participative preference shares.

Hence holders of preference shares do not get the right to enjoy the
excess income and assets of the company. Hence it is a disadvantage for
the preference share holder.

5. As per the amendment to the Companies Act 1988, no company will

be able to issue non-redeemable preference shares. As such preference
shareholders may be required to get their shares redeemed even though
they want to retain their investment in the company.
Debenture:
• Meaning of Debentures:

A company can also raise funds through issuing debentures.

Debenture is an acknowledgement of debt given by the company.

It is an undertaking given by the company to repay the debt at specified

date along with payment of interest at a fixed rate as per regular intervals
as stated in the debenture.
 Hence debenture is a borrowed capital.

debenture holder becomes creditor for the company.

(Creditor means the parties to whom business has to pay money, because business has already
borrowed funds from them)

Hence unlike equity shareholders, debenture holders can’t be the owner of the
business, they do not enjoy voting rights too.

As a suppliers of funds to the company, debenture holders are entitled to get

interest as a return on their investment in the company.

The rate of interest is fixed and interest is to be paid at fixed intervals, before
making payment of dividend to the shareholders.
❑ Hence a Debenture is Long Term Promissory Note for raising loan
capital.

❑ The firm promises to pay interest and principle as stipulated.

They are called as “long term fixed income financial securities”
Types of Debentures:

1) Secured v/s Unsecured:

Secured debentures means they are secured by some charge on the assets
of the company.

Whereas unsecured debentures are not secured by any charge on the

assets of the company.
 2) Registered v/s Bearer:

✔ Registered debentures means the holders are registered with the

company as debenture holders and debentures can be transferred to
another person only through the company.

✔ On the contrary bearer debentures are not registered with the company
and can be freely transferred to anybody by mere delivery.
3) Redeemable v/s Non-Redeemable:

In case of redeemable debentures, the principal sum is required to

pay either on specific date or on demand.

On the other hand in case of non-redeemable debentures, there is

no fixed date of maturity is decided by the company.

The holders cannot demand the repayment, so long as the company is

working.
4. Convertible v/s Non- Convertible:

In case of convertible debentures they enjoy the right to convert their

debentures into equity shares of the company, whereas the holders of
non-convertible preference shares do not get such right.
Features of debentures:

1) Maturity:

The debentures have fixed maturity date for repayment.

The date is stipulated in the debenture by the company.

2 ) Claim on Income :

The debenture holders get the claim on companies’ earnings prior to

the claim of shareholders.

The interest on debenture is to be paid before making payment of

dividend to preference share and equity share holders.

This is because debenture is borrowed form of raising funds and

holders are creditors to the company. Hence their claims have to be
settled prior to the claims of shareholders.
3) Claim on Assets:

In case of winding up of the company, the debenture holders get priority

claim on the assets of the company over the claim of shareholders.

Again this is due to the fact that the debenture holders are creditors of the
company.

Hence in case of winding up of the company before making any payment

of dividend to shareholders, the claims of debenture holders are settled first.
4) Control:

Debenture holders are the creditors of the company, they do not

get any voting rights hence they cannot exercise any control
over the affairs of the company.

In case of non-payment of interest or principal amount, they can

take legal action against the company.
5) Interest Rate:

Rate of interest on debenture is fixed and known.

Payment of interest is legally binding on the company and

interest on debenture is tax deductible.
6) Redemption of debentures:

At the time of maturity debentures are redeemable.

Redemption is mostly done through two ways.

First one is by creating Sinking Fund, it means the cash kept aside
periodically for repayment of debentures.

Second one is Buy Back Provision it enables the company to redeem

debentures at a specified price before maturity date
Merits of Debentures:

• To the Company:

1) No ownership Dilution: In case if the company raises additional

capital by issue of shares, the controlling position of existing
shareholders is not affected, as the debenture holders do not enjoy
any voting rights.
2) Less Costly:

It is relatively less costly source of raising capital.

As it involves payment of fixed amount of interest to the suppliers of the funds

i.e. to debenture holders.

This return is in the form of interest and it is less than the return which is paid to
shareholders i.e. Dividend. Dividend is portion of the profit.

The interest paid on debenture provides tax benefit to the company, hence it is
less costly source of raising finance and thus beneficial to the company.
Merits:

To the Investors:

1) Debentures are good investment avenue for the investors. This is

because of two reasons:

✔ Debenture holders are entitled to get fixed amount of interest on their

investment, and

✔ Security is available for their investment.

Demerits of Debentures:

1) Obligatory Payment: It is legal obligation on the company to pay the interest and principle
amount. The debenture holders can take legal action against the company in case of nonpayment of
interest and principle amount.

2) Risky Source:

Raising capital through debentures is relatively risky.

If the company has fluctuations in its sales and hence if earnings are not stable it may be difficult
for the company to make arrangement of funds to pay the interest and principal amount.