10

Sources of Finance

A financial market is a market for creating and exchanging

financial assets such as shares, debentures, treasury bills.
commercial paper, etc. It serves as a critical link between
savings and investment by bringing together providers and
users of funds. Financial markets are
of twomain types
capital market and money market. Market for trading long
term financial instruments such as shares and debentures is
known as capital market. On the other hand, in money market
short term securities such as treasury bills and commercial
paper are traded.
LEARNING OBJECTIVES
After studying this chapter, you should be 10.1 MEANING OF CAPITAL MARKET
able to understand: Capital market consists of all organisations, institutions
and instruments that
10.1 Meaning of Capital Market provide long- term funds. Business firms
utilise this market to procure funds for
10.2 Functions of Capital Market their long-term invest-
ments. A wide variety of instruments
are used to raise funds in
10.3 Sources of Raising Capital the capital market. These instruments
(equity shares and preference shares),ownership
are securities
10.4 Equity (Ordinary) Shares
and creditorship
10.5 Preference Shares securities (debentures and bonds).
10.6 Retained Earnings
Capital market has two major components
10.7 Global Depository Receipts (GDRs) (i) Primary or New Issues Market, and
10.8 American Depository Receipts (ADRs)
10.9 Indian Depository Receipts (1DRSs) (ii) Secondary Market or Stock Exchange.
10.10 Debentures/Bonds The
capital market is an organised market
10.11 Public Deposits suppliers and users of funds and the agencies consisting of the
and institutions
10.12 Loans from Commercial Banks which assist in the flow of funds.
banks, financial institutions (e.g. Suppliers
of funds include
10.13 Loans from Financial Institutions IFCI, IDBI, ICICI, UTI, etc.).
10.14 Trade Credit investing public, provident funds, insurance
funds, etc. Users of funds consist of companies, mutual
10.15 Intercorporate Deposits (ICDs) business
government and semi government agencies, enterprises,
sharebrokers, stock exchanges, merchant
etc. Underwriters,
agencies and institutions that assist the bankers, etc. are the
funds. suppliers and users of
 Capital market is thus an institutional arrangement by 10.2. FUNCTIONS OF CAPITAL MARKET
which savings generated in the country are channelised Capital market performs the following functions.
into avenues of long-term investment. In the capital 1. Promotion of Thrift: A capital market inspires
market, equity and debt are marketed in the form of people to save money. It offers incentives for saving
shares, stocks, bonds, mortgages, government securities,
etc. Suppliers of funds constitute the supply side whereas money in the form of attractive rates of interest and
dividend. It also provides scope for appreciation in the
users of funds form the demand side of the capital market.
capital value of investment.
The main characteristics of capital market are as 2. Investment Avenue: A capital market provides
follows. profitable avenues to investors. It helps investors in
return on their funds.
Features of Capital Market carning maximum available
3. Liquidity : Securities used in a capital market
are negotiable. The investors can sell
them at any time.
Flowof Capital can convert their securities into cash as and when
They
Demand and Supply necessary.
4. Availability of Capital : A capital market enables
Financial Intermediaries borrowers to obtain needed funds at a reasonable cost. It
keeps the wheels of industry and commerce moving by
( Financial Instruments providing funds easily and quickly. It also enables the
government to raise funds through bonds and other types
Liquidity of securities.

Functions of Capital Market

Trading in Securities

Fig.: 10.1: Features of Capital Market Promotion of Thrift

1. Flow of Capital: Capital market is a forum which Investment Avenue

facilitates the flow of capital from investors to borrowers.
Investors with the hope of earning best return
supply funds (Liquidity
on their investment. Borrowers seek funds at reasonable
cost to meet their financial needs. Availabilityof Capital
2. Demand and Supply: Conditions in the capital
market are the result of interaction between demand for
Ready Market
capitaland of capital. Demand for capital arises
supply
from borrowers and the supply is made available by
Transfer of Funds

investors. ( Balance between Demand and Supply

3. Financial Intermediaries: In addition to borrowers
and investors, capital market comprises financial middlemen
such as banks, merchant bankers, brokers and so on. They Stability
serve as a link between borrowers and investors.
Capital Formation
4. Financial Instruments : Several types of financial
instruments are used in a capital market to facilitate flow
Fig. 10.2: Functions of Capital Market
of capital. Equity shares, preference shares, debentures, 5. Ready Market: Borrowers get a ready market for
bonds, commercial certificates, promissory notes are their shares, debentures, bonds and other instruments in a

examples of these instruments. These instruments are

popularly known as securities. Therefore, a capital market
capital market. can sell these securities
They to
investors. Capital market serves as a link between those
directly
is also called a securities market.
who save money and who need money.
5. Liquidity : A capital market provides liquidity to
investment in securities. Securities issued by borrowers to 6. Transfer of Funds: A capital market provides a

raise finance are negotiable. Therefore, investors can sell mechanism for transfer of claims on capital funds.

them whenever they need cash. 7. Balance between Demand and Supply: A capital
6. Trading in Securities: A capital market serves as market brings about a balance between demand and supply

a market where securities can be bought and sold. of capital at reasonable levels.
of capital. It maintains cost

123
 Distinction between Primary Market and Secondary Market
Secondary Market
S.No. Basis of Distinction Primary Market
only are purcnased
1. Nature of securities New securities are issued by new and Existing securities
traded and sold
existing companies
Investors exchange ownership of
2. Involvement of the A Company sells securities to investors
securities. The company
is not involved
directly or through an intermediary
companyY at all

here is flow of funds from savers to Liquidity of securities is enhanced.

formation
It
3. Capital formation nvestors. It directly promotes capital indirectly promotes capital
formation
Both buying and selling of securities
4. Buying and selling Only buying of securities takes place
takes place
supply of securities
5. Price determinationne company determines the price of Demand and
securities to be issued determine the price

6. There is no fixed, geographical location The market is located at specified

Location
of the market places.
8. Stability: Capital markets consist Owned funds refer to funds provided by the owners. In a
of financial
intemediaries. These experts can promote stability in the sole proprietorship, the proprietor himself provides funds
values of securities which represent capital funds. from his own savings, family, relatives and friends. In a
9. Capital Formation: Capital markets facilitate partnership firm, partners contribute the capital. In case
the movement of of a joint stock company, funds raised through issue of
public savings into most productive
channels. It helps to divert funds to those who can use shares and reinvestment of earnings are the owned funds.
them most profitably. Such movement of funds leads to Borrowed funds refer to the funds raised through
capital fornmation and economic growth of the country. debentures and loans from banks, financial institutions;
A well-developed capital market brings about rational and public deposits.
allocation of funds and thereby helps to avoid wastage of A business enterprise requires capital for long term to
the country's financial resources. invest in fixed assets such as land and buildings, plant and
machinery, furniture, vehicles, etc. Such capital is called
10.3 50URCES OF RAISING CAPITAL fixed capital. Funds needed for short term are invested in
A business firm can raise funds from two main current assets such as stock, debtors, bills receivables cash,
sources-(a) owned funds and (b) borrowed funds. etc. Such capital is known as
working capital.

CAPITAL

LongTerm Short Term

Equity Shares Commercial Banks
Preference shares
Public Deposits
Retained Earnings
Debentures TradeCredit
Financial Institutions Inter corporate Deposits

Fig. 10.3: Sources of Raising Capital

124
 The various methods of raising hnance may be divided as shown in Fig. 10.4

BUSINESS FINANCE
Owned Funds Borrowed Funds

Equity Shares Debenturesand Bonds

Preference shares HFinancial Institutions
Retained Earnings HPublic Deposits
GDRS Commercial Banks

ADRS TradeCredit
IDRs Intercorporate Deposits
Fig. 10.4:Sources of Finance

Equity shares, preference shares, ploughing back of dividend or repayment of capital. The rate of dividend
profits and debentures are generally used for long-term on such shares is not fixed. Dividend on equity shares is
finance. Public deposits, commercial banks and financial paid out of the residual profits left after paying interest on
institutions are the main sources of medium-term and debentures and dividend on preference shares. Similarly,
short-term finance. equity shareholders are paid at the time of winding up of
the company after all debts and preference shareholders
10.4-EQUITY (ORDINARY) SHARES have been paid in full. They are entitled to receive what
Issue of shares is the most important source of raising is left after all prior claims have been satisfied. Therefore,
long-term finance. The amount of capital to be raised from quity shareholders are the real risk-bearers. But they
members of the public is divided into units of equal value. share in the increasing profits of the company. They
These units are known as shares and the aggregate value enjoy voting rights in the management and control of the
of shares is known as share capital of the company. Those company. The amount raised by the issue of equity shares
who subscribe to the share capital are called shareholders. is known as equity share capital.
According to Justice Farewell, "A share is the interest Thus, the distinctive characteristics of equity shares
of the shareholder in the company measured by a sum
are as follows:
of money for the purpose of liability and of interest
) The holders of equity shares are the main risk
(dividend). It also consists of other rights given by the bearers. They provide risk capital because
Articles of Association." A share is, thus, one of the equal
divided. The
when the company fails and is closed, equity
parts into which the capital of a company is shareholders may lose their entire investment.
following are the features of a share: (ii) Equity shareholders are likely to enjoy higher
1. It is an indivisible part of the capital of a
return and considerable increase in the value of
company. their shares.
2. It confers certain rights on its holder, e.g.
(ii) Equity shareholders have a residual claim in
capital, etc.
dividend, yoting power, return of the company. The income left after payment of
3. It creates certain liabilities on its holder.
interest to creditors and dividend to preference
4. Each share has a distinct number.
shareholders belongs to equity shareholders.
5. Each share has a nominal or face value.
(iv) Equity share capital improves the credit
6. The holderof a share is issued a share certificate worthiness of the company and confidence of the
under the seal of the company. creditors. It is the basis on which loans can be
7. It is a movable property and can be transferred
of the raised.
in the manner laid down in the Articles
shareholders have the right to elect
(v) Equity
Company. collectively ensure that the
Equity shares those shares which do not carry any
are
directors. They can

special or preferential rights in the payment of annual company is managed in their best interests.
125
 the management
Advantages addition, full voting power
they enjoy
in

the pre emptive right to

As a source of finance, equity shares offer the of the company. They also have
has to first offer its new
following advantages: buy new shares. The company
in proportion to their
1. Permanent Shares to the existing shareholders
Capital Equity shareholders provide
the permanent funds of a company. There is no obligation existing holdings.
to returm the money except at the time of
winding up the Disadvantages
company.
following disadvantages:
2. No Equity shares suffer from the
Obligation as to Dividend : Equity shares issues
only
do not inmpose 'an obligation to pay a fixed dividend. 1. No Trading on Equity : If a company
the benefits of trading on
Dividends are payable only if the obtain
company has adequate equity shates, it cannot
profits. Equity shareholders stand by the company through equity.The costof equity shares is high.
thick and thin. Equity share
2. Danger of Overcapitalisation:lifetime of a company.
3. No Charge on Assets: For
issuing equity shares, capital is not refundable during the
the company is not required to A mistake in estimating financial requirements may,
mortgage or pledge its when the
assets. The assets remain free of
charge
for borrowing therefore, result in overcapitalisation, particularly
money in future. company's earning capacity declines. Equity capital may
4. Source of Prestige : A remain idle and under-utilised.
company with substantial
equity capital has a high credit-standing. Creditors readily 3. Perpetuation of Control: Any new issue of equity
lend money to it because they regard shares must be offered first to the existing shareholders. As
equity capital
as a
a result, there is concentration of control in a few hands.
safety shield.
5. Small Denomination The 4. Take-over Bids: Equity shares have proportionate
nominal or face value
of equity share is
an
generally quite low, such as Rs. 10. voting rights. Persons who seek to gain control over a
Therefore, equity shares have a wide appeal. The company company may indulge in undesirable practice,
such as
can mobilise
huge funds from investors belonging to cornering of votes, formation of groups and abuse of
different income groups. proxy rights.
6. Suitable for Adventurous Investors: 5. Speculation : During boom periods, profits of a
Equity
shares are the ideal investment for bold and
enterprising company and dividends on equity shares tend to increase.
investors. They get hand some dividends and the value This leads to excessive speculation in the prices of equity
of their holdings appreciates during boon periods. In shares.

Equity Shares

Advantages Disadvantages
Permanent Capital No Trading on Equity
-No Obligation as to Dividend Danger of Overcapitalisation

No Charge on Assets Perpetuation of Control

Source of Prestige Take-over Bids
Small Denomination Speculation
Suitable of Adventurous Investors Unsound Dividend Policy
Dividend Controlled by Directors
High Risk
Time Consuming
Fig. 10.5: Advantages and Disadvantages of Equity Shares

126
 6. Unsound Dividend Policy : During boom periods
10.5. PREFERENCE SHARES
Drofits tend to increase. The directors may decide to
distribute higher dividends to win the cooperation of Preference shares are those shares which carry certain
equity shareholders. They may overlook reserves for preferential or priority rights. Firstly, dividend at a fixed
contingencies, replacements, etc. rate is payable on these shares before any dividend is paid
on equity shares. Secondly, at the time of winding up the
7.Dividend Controlled by Directors The rate
company, capital is repaid to preference shareholders prior
of dividend is decided by the Board of Directors.
to the return of equity capital. Preference shares do not
Shareholders cannot demand higher dividends than those
recommended by the Board. Therefore, investors may carry voting rights. However, holders of preference shares
consider the equity shares unsafe and non-remunerative. may claim voting rights if the dividends are not paid for
two years or more on cumulative preference shares and
8. High Risk: Equity shareholders sink and swim three years or more on non-cumulative preference shares.
with the company. During depression, they get no dividend Preference shares have the characteristics of both
and the market value of their holdings falls drastically.
The collateral and resale value also declines. Equity equity sharesand debentures. Like equity shares, dividend
on preference shares is payable only when there are profits
shareholders lose heavily if the company fails and goes
and according to the terms of issue. Preference shares are
into liquidation. Therefore, equity shares do not appeal to similar to debentures in the sense that the rate of dividend
the investors who want safety of their investment and a
is fixed and preference shareholders do not generally enjoy
regular and fixed return. voting rights. Therefore, preference shares are a hybrid
9.Time Consuming: Several procedural formalities
form of financing.
are involved in making a public issue of shares. Moreover,
the issue cannot be made at any time the company wants. Types of Preference Shares
It depends on market conditions.

Preference Shares

Cumulative Non-Cumulative

Participating Non-Participating

Redeemable Non-Redeemable

Convertible Non-convertible

Fig. 10.6: Types of Preference Shares

forward or do not accumulate. If the company is unable
1. Cumulative Preference Shares: When dividends
to pay dividend in a partiçular year, the shareholders' right
go on accumulating if they are not paid, preference
to dividend in respect of that year is lost for ever
shares aresaid to be cumulative. If due to some reason
dividends in a particular year are not paid, they will be 3. Participating Preference Shares: These shares

carried forward to the next year. Such unpaid dividends carry a right to share in the surplus profits
left after a fixed
dividend is paid on both equity and preference shares. In
80 on
accumulating and become payable out of profits
in subsequent yeárs. Any dividend can be paid to equity addition to a fixed rate of dividend, the holders of such
shareholders only after the payment of such accumulated shares get a part of residual profits.
shares. Preference shares are 4. Non-participating Preference Shares: Such
dividends op preference rate of
always cumulative unless otherwise stated. preference shares carry a right of only a fixed
dividend and do not give their holders a right to share
in
2. Non-cumulative Preference Shares On this type
are not carried
the residual profits of the company.
of preference shares, dividends if unpaid
127
 is not
5. Redeemable Preference Shares These Dividends : A company
shares can be refunded either on the preference 2. No Obligation for
shares if its profits
expiry of the specified to pay dividend on preference
period or at the
bound insufficient. It
can postpone the
option of the company. The Companies in a particular year
are
shares also. No
Act has laid down that prcference
preference shares must be repayable dividend in case of
cumulative
within 20 years from the date of issue. fixed burden is created finances.
on its
6. Irredeemable Preference Shares: shares do
Such shares are 3. No Interference: Generally, preference
refunded only at the time of can raise
winding up of the company. Therefore, a company
not carry voting rights. shareholders
They are not paid up during the lifetime of the company. capital without dilution of
control. Equity
7. Convertible Preference Shares: retain exclusive control over the company.
Holders of these
shares are given the option to convert their shares into rate of dividend on
4. Trading on Equity: The
equity shares after a fixed period. with the rise in its
preference shares is fixed. Therefore,
8. the benefits of trading
Non-convertible Preference
Shares: Such shares carnings, the company can provide
cannot be converted into equity shares. on equity to the equity shareholders.
Preference shares do
Advantages 5. No Charge on Assets :

charge on the assets

of the
1. Appeal to Cautious Investors Preference not createany mortgage or
: shares keep its fixed assets free for
can be easily sold to investors who company. The company can
prefer reasonable raising loans in future.
safety of their capital and want a regular and fixed return
A company can issue redeemable
on it. These shares carry a
preferential right of 6. Flexibility:
repayment The capital can be
in the event of preference shares for a fixed period.
liquidation of the company.

Preference Shares

Advantages Disadvantages
Appeal to Cautious Investors Fixed Obligation
No Obligation for Dividends Limited Appeal
No Interference
Trading on Equity Low Return
No Charge on Assets
NoNo Voting Rights
Fear of Redemption
Flexibility
LVariety No Tax saving
Fig. 10.7: Advantages and Disadvantages of Preference Shares

repaid when it is no longer required in business. There is is paid on equity shares. The burden is greater in case
no danger of over-capitalisation and the capital structure of cumulative preference shares on which accumulated
remains elastic. arrears of dividend have to be paid.
7. Variety : Different types of preference shares can be 2. Limited Appeal : Bold investors do not like
issued depending on the needs of investors. Participating preference shares. Cautious and conservative investors
preference shares or convertible preference shares may be prefer debentures and government securities. In order to
issued to attract bold and enterprising investors. attract sufficient investors, a company may have to offer
Preference shares can be made more popular by giving a higher rate of dividend on preference shares.
special rights and privileges such as voting rights, right
of conversion into equity shares, right of shares in profits 3. Low Return: When the earnings of the company
and redemption at a premium.
are high, fixed dividend on
preference shares becomes
unattractive. Preference shareholders generally do not have
Disadvantages the right to participate in the prosperity of the company.
Dividend preference shares
1. Fixed Obligation : on
4. No
and before any dividend Voting Rights Preference shares generally do
has to be paid at a fixed rate

128
 not carry voting rights. As a result, preference shareholders is favourable. Despite the fact that
are helpless and have no say in the management and
they stood by the
company in its hour of need, they are shown the door
control of the company. unceremoniously.
5. Fear of Redemption: The holders of redeemable 6. No Tax Saving : Dividend paid on
preference
preference shares might have contributed finance when the shares is not deductible from profits for computing taxable
company was badly in need of funds. But the company
income.
may refund their money whenever the money market
Distinction between Equity and Preference Shares

S.No. Points of Distinction Equity Shares Preference Shares

1. Nominal value Generally low Generally high
Right to dividend After
2. preference dividend is paid Priority over equity shares
3. Refund of capital After preference shares are paid Priority over equity shares
4. Rate of dividend Fluctuates with profits Generally regular and fixed

Full voting rights No voting rights except when dividends

5. Voting rights are unpaid for two or three years

Degree of risk Sink and swim with the company Relatively less risk
Not repayable during the life time of May be redeemed after a fixed period
7. Redemption the company or at the option of the company

Attractive to bold and adventurous Appeals to conservative and orthodox

Appeal investors investors

10.6. RETAINED EARNINGS for modernisation, expansion etc. of business. Retained

Reinvestment of undistributed profts is a very good profits are also known as ploughing back of profits, self-
source of business finance. Retained profits refer to the financing or internal financing. As the retained profits
dividends but
belong to the shareholders, they are considered ownership
profits which have not been distributed as

have been kept for use in business. Profits are usually

funds.
retained in the form of general reserves. A part of the Advantages
profits is transferred to the reserves every year. After a few 1. Convenience : Retained profits are the most
years, it becomes a large amount which is then employed economical and convenient source of finance. No

Retained Earnings

Advantages Disadvantages
Convenience LowDividends
No Charge on Assets Misuse and Speculation

NoObligations Unbalanced Growth

NoInterference Overcapitalisation
Goodwill Uncertain
Dependable
Growth and Expansion
and Disadvantages of Retained Earnings
Fig. 10.8: Advantages
129
 bonus shares.
to issue
advertisement or prospectus has to be issued. No floatation profits may prompt management result in over-
expenses or legal formalities are involved. reserves may
Frequent capitalisation of
2. No Charge on Assets No
charge or mortgage is capitalisation.
uncertain source
created on the company's assets. The company is free to 5. Uncertain: Retained profits are an
use its assets for raising loans in future. of funds when the profits of the company
fluctuate widely.
3. No Obligations : There is no fixed burden of 10.7. GLOBAL DEPÓSITORY RECEIPTS (GDRs)
dividend and no obligation of
repayment. Retained profits
are the
company's own money. These involve no explicit Meaning markets, depository
cost in the form of interest or dividend. With the globalisation of capital
US markets. Global
4. No Interference : Retained receipts expanded outside the
profits involve no risk
of control being diluted as there is no Depository Receipts were
introduced in 1990 at the
increase in the Citíbank. A GDR is an instrument which a
initiative of
number of shareholders. Management remains
independent order to collect foreign
as no restrictions are company issues in US dollar in
put on the management. There is stock exchanges
operational freedom and flexibility of operations. capital. It is traded on all those foreign
where it is listed. For example, the GDRs issued by
Goodwill Retained profits add to the financial
5. Reliance Industries (an Indian Company) are listed on
strength, credibility and earning capacity of the busi the New York Stock Exchange. Therefore these can be
ness. The
company's borrowing capacity is increased. It purchased and sold only on this stock exchange. The term
can safely face business
cycles and other crisis. Retained global' means the GDRs can be issued in any foreign
profits provide a cushion of security during adverse country. Companies with a good track record issue GDRs.
conditions and unforseen
contingencies. These may lead
to increase in the market
price of the company's equity Features
shares. The main features of GDRs are as under:
6.
Dependable : As
an internal source of
finance (i) GDRs are denominated in US dollar.
retained profits are more dependable than external sources. (i) GDRs can be listed on any American or European
The amount of funds is not
dependent on investors stock exchange.
preference and market conditions. Retained eanings are
permanent funds. ii) One GDR can represent more than one share.
7. Growth and For example, one GDR may
Expansion : Retained profits are represent ten equity
very useful for financing new projects and expansion shares. Though a GDR is quoted and traded in
of business. These are also dollar terms, the equity shares
necessary for innovátions are denominated in or other
represented by it
and development of new products which are essential in currency.
industries like pharmaceuticals. (iv) The holder of GDRs can get them converted into
shares.
Disadvantages (v)The holder of GDRs has no voting
1. Low Dividends rights in the
Ploughing back of prøfts reduces company. But the shareholders do have
the current rate of dividends. This
may result in dissatis- rights. voting
faction among the shareholders as
they do not get the (vi) Though GDRs represent the
expected rate of dividend.
shares these have issuing company's
2. Misuse and Speculation:
separate entity.
Excessive reserves Issue Procedure of GDRs
may make the management wasteful /and extravagant.
) First of all the
Management may misuse them by inve_ting in unprofitable company
or undesirable channels. A
Reliance Industries) deliversissuing GDRs (e.g.
its shares to some
company having large reserves
may prompt its directors to indulge/in speculation in the Domestic Custodian Bank (DCB)
prices of its shares.
Bank of India). (e.g. State
(ii) The DCB requests
3. Unbalanced Growth :
Retained
an Overseas
profits may
interfcre in the balanced industrial growth of the (ODB) (e.g. Standard CharteredDepository Bank
country. in a foreign Bank) located
The profits which might hav been invested in other country (e.g. London) to issue the
shares as GDRs.
industries are reinvested in thé same industry.
(ii) The ODB converts
the shares
4. Overcapitalisation :/Too much ploughing back of
rupees into GDRs denonminated in
denominated in US dollar.
130
 (iv) Lastly. the ODB issues the GDRs to investors
The procedure of issuing GDRs is shown in the following diagram.

Domestic Custodian Overseas Depository

Issuing Co Foreign
Bank (ODB) Bank (ODB) Investors
Fig. 10.9: Procedure of Issuing GDRs
Advantages of GDRs Disadvantages of GDRs
The main advantages of GDRs are as follows. () A GDR issue dilutes earnings.
For Issuing Company (i) Pricing of GDRs are expected to be at a discount
(i) Indian companies with good profit record can get to the local market price.
attractive prices for their equity shares through (i) In India, GDR issues have an uneven track record
GDRs. This results in significant reduction in the for intermational investors.
cost of capital to the company. The Goverument of India has guidelines for issuing
(i) Investors in GDRs become shareholders. GDRs and ADRs. These guidelines are titled "Issue of
Therefore, a depreciation in the value of the Foreign Curréncy Convertible Bonds and Ordinary Shares
Indian Rupee does not lead to any extra outflow (Through Depository Receipt Mechanism) Scheme 1993"
for the company. It affects the profits of the dated 12.11.1993.
foreign investor.
(ii) GDR issues enhance the image of the issuing 10.8. AMERICAN DEPOSITORY RECEIPT
company in international markets. This also (ADRS)
provides a mechanism for raising capital or as a An ADR is a negotiable instrument issued by an
vehicle for an acquisition. American Depository Bank certifying that shares of a
(iv) GDR enables the issuing company to raise capital non-US issuing company are held by the depository's
in two or more countries simultaneously and custodian bank.
enlarge its shareholder base. The shares are issued by, say an Indian company,
to an US intermediary called the depository in whose
(v) Sale proceeds of GDR are received in foreign
name the shares are registered. It is the depository which
currency. This enables the issuing company to subsequently issues the ADRs. The physical possession
pay off its foreign exchange liabilities in respect
of the equity shares is with another intermediary, the
of project cost, foreign currency loans, etc.
custodian, who is an agent of the depository.
For Investors An American Depository Receipt (ADR) is an
American dollar-denominated instrument representing
) GDRs provide an opportunity to foreign investors
equity ownership in any non-American company. It
to diversify their investment portfolio. They can
represents the shares of any non-US company held on
participate in Indian capital market. deposit by a custodian bank outside USA. Any American
(i) Global custodians/safe keeping charges are bank functioning as a depository can issue ADR which
eliminated, saving investors 30 to 61 basis points represents a specific number of shares of the issuing
annually. company outside USA. An ADR can be listed on New
York Stock Exchange or on NASDAQ, both of which are
ii) GDRs overcome obstacles that mutual funds,
share markets in USA.
pension funds and other instittions may have in
purchasing and holding secfrities outside their Features
domestic markets. i) ADRs are denominated in US dollar.
(ii) These are issued only to American investors.
(iv) GDRs are negotiable and fiquid. An investor can
any time sell his GDR ahd raise money. (ii) ADRs can be listed on any stock exchange in

(v) GDRs overcome foreign investment restrictions, USA.

and is free from cumbersome paper based
(iv) A single ADR can represent more than one share
settlement system. e.g. one ADR = ten shares.

(vi) GDRs are easily sold at the stock exchange (v)The holders of ADRs have no voting rights.
131
 American Depository
Bank
an
(vi) The holders of ADRs can get them converted into (11) The DCB requests to issue ADRs.
Bank of America)
shares. (ADB) («.g.
into ADRs.
the shares
Issue Procedure of ADRS (11) The ADB converts
to the intending
the ADRs
() First of all, the company hands over its shares (iv) The ADB issues of issuing
The procedure
to a Domestic Custodian Bank (DCB) e.g. State investors in USA.
Bank of India. ADRs is shown in
the following diagram:
Investors
Domestic Custodian American Depository
Issuing Co inUSA
Bank (DCB) Bank(ADB)
Fig. 10.10 : Procedure of Issuing ADRS
INDIAN DEPOSITORY
RECEIPTS (IDRs)
Advantages of ADRs 10.9.
denominated instrument that
(i) ADR allows Indian companies to raise capital An IDR is a rupee
foreign company. It is issued
from equity markets in USA and thereby enlarge represents the shares of a
the investor base. by a foreign company to
Indian investors for raising
funds from the Indian market. The
shares represented by
(i) Funds from ADR are available in US dollars IDRs are held by an Overseas Custodian Bank (OCB)
which the issuing company can use to import
machinery and equipment from USA which is a foreign bank having branches in India. This
bank authorizes the Indian Depository which is a SEBI
ii) ADR provides US citizens a hassle free route to
invest in shares of non US companies. registered body such as National Security Depository Ltd
(NSDL). This body issues IDRs through a public offer
The investor gets the same benefits allowed to to investors in India. IDRs can be listed on any stock
domestic shareholders of the company outside in India. Standard Chartered Bank is the first
exchange
USA. foreign company that issued IDRs.
(iv) Marketing of ADR creates investors' interest in
the company and inspires them to invest their Features of IDRs
money. ) IDRs are denominated in Indian rupee.
(v) Companies in USA can use ADR to acquire i) These are issued by a foreign company in India.
controlling interest in any company abroad and (i) IDRs can be listed on any stock exchange in
improve their financial position. India.
(vi) Purchase and sale of ADR is inexpensive and A
(iv) single IDR can represent more than one share,
quick. No broker is needed and sale proceeds are e.g. one IDR = 10 shares.
realised in dollars.
(v) Holders of IDRs have no voting rights.
(vii) The US investor has the option to reinvest the
dividend received in dollars back into ADR. (vi) Holders of IDRs can get them converted into
shares after one year from the date of issue.
(vii) Because of the low level of stock pricesin
most developing countries now relative to other (vii) The Indian
Depository will distribute the dividend
markets, a well designed depository receipt issue to the holders of IDRs.
could attract a considerably high price per share SEBI has laid down rules for
than a similar issue sold in the domestic market, IDRs, some of these
rules are as follows.
although in the case of India when stock prices
are very high, depository receipts have been ) Issuer Company must be a listed company in the
issued at a discount. home country.
(ix) Having the company's name in the intemational (ii) It has not been
prohibited to issue securities by
market would make future financings easier as any Authority.
the company would then have a knøwn track (ii) NRIs and Flls cannot
record and a broad range of mnarkets to tap.
permitted by RBI.
acquire IDRs unlesS
132
 (iv) Automatic fungibility of IDRs is not allowed. (viii) The proceeds of IDR shall be
repatriated from
(v) Minimum investment amount in an IDR India as per the foreign exchange laws.
Application is 2,00,000. (ix)The IDRs shall be denominated in Indian
Rupees.
(a) The pre-issue paid-up capital and free (x) IDR issued in any financial year shall not exceed
reserves of the company must be at least 15% of the paid up capital and free reserves of
US $100 million and average turnover of US the issuing company.
S500 million in last 3 years.
Issue Procedure of IDRs
(b) The company must be declaring dividend of ) First of all, a foreign company delivers its shares
not less than 10% during these 3 years. to an Overseas Custodian Bank (OCB) which
(c) The company's pre-issue debt-equity ratio is must be approved by SEBI.
not more than 2:1 (i) The OCB requests the Indian Depository (ID) to
issue IDRs.
(vi) The issue of IDR must be approved by SEBI (ii) The ID converts the shares in foreign currency
(vii) The IDR shall not be converted into underlying into rupee denominated IDRs.
shares before the expiry of one year from the date iv) The ID finally issues IDRs to Indian investors.
of issue of IDR. The issue procedure of IDRs is shown in the following
diagram:
Issuing Overseas Custodian Indian Depository Indian
foreign Co Bank (OCB) (ID) Investors
Fig. 10.11 : Procedure of Issuing IDRs

Advantages of IDRs 1. Debentures represent borrowed funds.

2. Interest on debentures is paid at a fixed rate.
(i) Indian investors get an additional opportunity for
3. Interest is payable every year irrespective of
investment in foreign companies.
whether there are profits or not.
ii) Indian stock markets receive a new financial 4. Debentures generally carry no voting rights.
instrument for trading purpose. 5. Debentures may involve a charge on the assets
(il) Indian investors face less risk as only sound of the company.
foreign companies are allowed to issue IDRs. 6. If interest and borrowed sum is not paid to
from India debentureholders in time, they can take legal
(iv) Foreign companies can raise capital action (including winding up) against the
through IDRs.
company.
(v) IDRs provide an opportunity to foreign companies 7. Debentures are generally repayable after a
to get listing on Indian stock exchanges. specified period of time.
(vi) The issuing company gains popularity.
Types of Debentures
10.10, DEBENTURES/BONDS Debentures can be of the following kinds (Fig. 10.12):
Debentures constitute the borrowed funds of a Debentures
company. They are known as creditorship securities
because debentureholders are the creditors of a company.
Debenture capital may, therefore, be called debt capital. Secured Unsecured
A debenture is a document or certificate issued by
Redeemable Irredeemable
a company under its seal as an acknowledgement of its
debt. It is also an undertaking to repay the specified sum
with interest to its holder. Holders of debentures are called Convertible Non-convertible
debentureholders.

Characteristics Registered Bearer

The main features of debentures are as follows. Fig. 10.12: Types of Debentures
133
 1. Naked or Unsecured Debentures : Such debentures during the lifetime
repayable after a predetermined period
are unsecured and do not carry a be repaid on
the specified date
the
charge on the assets of of the company. These can
company. They are mere promises to pay without demand by the debentureholders
or on a notice of

security. No property is mortgaged or pledged with any

on

the redemption by the company.

holders of such debentures. In case of
default in These debentures are
by the company, they can only file a suit for payment 4. Irredeemable Debentures:
recovery of not repayable during the lifetime of
the company. They are
money. Holders of these debentures are treated as
creditors. ordinary repaid only at time of winding up of
the
the company or

when interest is not regularly on

paid the due date. These
2. Secured
or Mortgage Debentures: Such are also known as perpetual debentures.
debentures carry a fixed or
of the
floating charge on the assets 5. Convertible Debentures Such debentures carry an
company. A mortgage deed is executed
by the option to their holders to convert their holdings into equity
company describing the terms and conditions of
In case of default issue. shares after a specified period. The debentureholders can
by the company, the debentureholders
can recover become shareholders. These debentures are more attractive
money from the mortgaged
charge is created on some definite andproperty. fixed
A
for investors.
of the existing assets
company. The company cannot use these assets 6. Non-convertible Debentures : The holders of such
without the consent of the
debentureholders.
On the other debentures have no right to get them converted into shares.
hand, a
floating charge
be created on both
can They always remain creditors of the company.
and future assets. The existing
company can deal in such assets in 7. Registered Debentures The names ofthe holders
the usual course of business.
The
from asset to asset and becomes charge goes on shifting of such debentures are recorded in the company's books.
fixed when the company Interest and principal sum is paid only to the registered
goes into liquidation or
stops business or makes default holders. Such debentures can be transferred
in repayment. Any
charge created by a company in favour only by a
of debentureholders must be transfer deed and not by delivery alone.
of Companies within 30
registered with the Registrar 8. Bearer Debentures: No record
days of its creation. is kept by the company.
of such debentures
3. Redeemable Debentures :
These debentures are They can be transferred by simple
delivery without any formal notice to the company.
Distinction between Shares and Debentures
S.No. Point of Distinction
Shares
1. Debentures
Nature Part of capital, owned funds
2.
-

Debt or loan, borrowed funds

Status
of holders Owners
3. Right to return Dividends cannot be claimed
Creditors
as a Interest
matter of right can be claimed
4.
of right
as a
matter
Security No charge on assets
5. Voting rights Full voting rights
Generally a charge on assets
Not
Novoting rights
repayable during lifetimeof
6.
Redemption a
company (except redeemable Generally
period
repayable after a
specified
preference shares)
7. Order of repayment After all claims of
creditors are settled Prior to all types of
8. Frequency of return Uncertain and fluctuating shareholders
on profits depending Absolutely
of profits
certain or fixed irrespectivve
Risk to holders Complete risk borne by holders
Minimum risk in case of
debentures secured
Advantages of Debentures 1. Appeal to
Cautious Investors
Debentures are an
important source of raising long- finance can be raised
by issue of
: Large amount ot
term finance. The main advantages of debentures are as and orthodox investors debentures from cautious
who prefer
follows: and a fixed return. In
tight money
safety investment
of
are the best source of
finance. conditions, debentures
134
 Debentures

Advantages Disadvantages
Appeal to Cautious Investors PermanentBurden of Interest
RegularReturn Reduction in Credit Standing
Safety of Investment Charge on Assets
Economical Source Reduction in Dividend
Freedom of Management LNo Voting Rights
-
Trading on Equity
- Flexibility
Tax Relief
Fig. 10.13: Advantages and Disadvantages of Debentures

2. Regular Return: Debentureholders are

paid interest 8. Tax Relief: Interest paid on debentures is allowed
at a fixed rate and at periodical intervals, irrespective of a deduction while calculating taxable income. It results in
profits. Therefore, debentureholders are free from risk of saving in income tax liability.
fuctuations in the company's earnings.
3. Safety of Investment : Debentures are usually Disadvantages of Debentures
secured by a charge on the company's assets. Therefore,
Debentures suffer from the following disadvantages:
their repayment is assured.
1. Permanent Burden of
4. Economical Source : A company can raise funds Interest: Interest on
debentures has to be paid every year irrespective of
through debentures at a relatively low cost. This is profits.
because investors consider debentures a safe investment.
During periods of depression, it becomes a heavy burden
on the company's earnings.
Debentures can be sold more easily than shares.
Underwriting commission, brokerage and other expenses 2. Reduction in Credit Standing: The credit-
of issue are lesser. worthiness of a company which has issued a large amount
5. Freedom of Management : Debentures do not of debentures is low. Borrowing from banks and financial
cary voting rights. Therefore, a company can raise funds institutions becomes difficult.
without diluting or weakening the control of the existing 3. Charge on Assets : Debentures
usually involve
members. The management retains its independence as mortgage of fixed assets. A company cannot raise funds
there is no interference from easily through debentures unless it has enough fixed assets.
debentureholders
6. Trading on Equity : Interest on debentures is paid During periods of depression, the company may not be
at a fixed rate. After able to repay the amount. Debentureholders
payment of interest, the remaining may attach
profits are available to shareholders. When the earnings of the pledged assets which may paralyze business.
the company increase, the rate of dividend on equity shares 4. Reduction in Dividend During times of low
can be increased. This is known as
trading on equity. earnings, very little profit might be left after payment of
7. Flexibility: A company can repay the funds raised interest on debentures. The company may not be able to
through debentures when it does not require the funds pay enough dividends and the market value of its shares
any more. The facility of redemption avoids the danger may go down.
of overcapitalisation and keeps the financial structure
5. No Voting Rights: Debenturehoders have no
flexible. Funds are available for a fairly long period and voting rights in the management of a company. Therefore,
can be repaid out of earnings. they remain at the mercy of the shareholders.

135
 Comparison among Sources of Long-term Finance
Businesses that
Types of Cost/Dividends
Financing Repayment Repayment
Period Interest
may use it

Equity All corporations

that sell stock to
Hgh initial cost; low ongoing
Common No None Costs because dividends not investors
stock required
DIvidends not but
required Large corporations
that have an
Preference established investors base of
Preferred No None must be paid before common
common stockholders
stock stockholders receive any
dividends
Interest rates between 4% and AlI firms that can meet the
Debt 12% depending on economic lender's repayment and collateral
Long-term Yes Usually conditions and the financial| requirements
loan 3-7 years
stability of the company
requesting the loan
that
Interest rates between 46
10%, depending on economic| trust
Large and corporations investors
Corporate Usually
bond Yes 10-30 years conditions and the financial
stability of the company issuing
the bonds

10.11. PUBLIC DEPOSITS on public deposits is higher than on bank deposits. Now
Public
deposits refer to the unsecured public sector companies also invite public deposits. Public
deposits invited
by companies from the public mainly finance working
to deposits have become a popular source of industrial
capital needs. A company wishing to invite public deposits finance in India.
makes an advertisement in the newspapers. Any member
of the public can fill up the prescribed form and Advantages of Public Deposits
deposit the 1.
money with the company. The company in return issues Simplicity : Public deposits
are a very convenient
a deposit receipt. This receipt is an acknowledgement of source of business finance. No cumbersome
legal
debt by the company. The terms and conditions of the formalities are involved. The company
has to simply give an advertisement and
raising deposits
deposit are printed on the back of the receipt. The rate issue a receipt
to each depositor.
of intereston public deposits
depends on the period of
deposit and reputation of the company. 2. Economy: Interest paid on public deposits is lower
A company can invite public deposits for than that paid on debentures and bank loans. Moreover,
a period
of six months to three years. Therefore, public deposits
no
underwriting commission, brokerage, etc. has to be
are primarily a source of short term finance. However, paid. Interest paid on public deposits is tax deductible
the deposits can be renewed from time to time. Renewal which reduces tax liability.
a cheaper source of
Therefore, public deposits are
facility enables companies to use publie deposits as finance.
medium term finance. Public deposits of a company cannot 3. No Charge on Assets :
Public
exceed 25 per cent of its share capital and free reserves. As unsecured and, therefore, do not create deposits are
any charge or
these deposits are unsecured, the company having public mortgage on the company's assets. The
deposits is required to set aside 10 per cent of deposits loans in future against the company can raise
security of its assets.
maturing by the end of the year. The amount so set aside 4. Flexibility : Public
can be used only for paying such deposits. the season
deposits can
during be raised
buy raw materials in bulk
to
and for other
Thus, public deposits refer to the deposits received by short-term needs. They can be
a company from the public as unsecured debt. Companies over. Therefore, public
returned when the need is
deposits introduce flexibility in the
prefer public deposits because these deposits are cheaper company's financial structure.
than bank loans. The public prefers to deposit money with 5. Trading on
Equity : Interest on
well-established companies because the rate of interest paid at a fixed rate. This enables public deposits is
a
company to declare
136
higher rates of dividend to equity shareholders during 5. Hindrance to Growth of Capital Market: Public
periods of good earnings. deposits hamper the growth of a healthy capital market in
6. No Dilution of Control : There is no dilution the country. Widespread use of public deposits creates a
of shareholders' control because the depositors have no shortage of industrial securities.
voting rights. 6. Limited Appeal: Public deposits do not appeal as
7. Wide Contacts: Public deposits enable a company a mode of investment to bold investors who want
capital
to build up contacts with a wider public. These contacts gains. Conservative investors may also not like these
prove helpful in the sale of shares and debentures in future. deposits in the absence of proper security.
7. Unsuitable for New Concerns : New companies
Public Deposits lacking in sound credit-standing cannot depend upon
public deposits. Investors do not like to deposit money
with such companies.

Advantages Disadvantages 10.12. LOANS FROM COMMERCIAL BANKS

Business firms can raise finance from commercial
Simplicity Uncertainty banks in the following ways:
Economy Limited Funds
Term Loan
No Charge on Assets Temporary Finance

Flexibility Speculation
Trading on Equity Hindrance to Growth

No Dilution of Control
Limited Appeal Methods
Unsuitable for of Raising9 Cash
Wide Contacts New customers Overdraft Funds from Credit
commercial
Fig. 10.14: Advantages and Disadvantages banks
of Public Deposits

Disadvantages of Public Deposits

1. Uncertainty : Public deposits are an uncertain
and unreliable source of finance. The depositors may Discounting
not respond when the company needs funds. Moreover, of Bills of
they may withdraw their deposits when ever they feel Exchanges
shaky about the financial health of the company. If a
Fig. 10.15: Methods of Raising Finance from
large number of depositors simultaneously withdraw their
Commercial Banks
deposits, the company may find it difficult to repay a huge
sum at once. Therefore, public deposits are described as A. Term Loans : Banks now offer loans to business
'fair weather friends'. firms for medium term. Loans are generally secured by
assets or guarantees. The borrower may be asked to repay
2. Limited Funds: A limited amount of funds can
in lump sum or in instalments.
be raised through public deposits due to legal restrictions
and procedural difficulties.
2.Cash Credit : It is a formal and revolving credit
agreement under which the borrower is allowed to borrow
3. Temporary Finance: The maturity period of public upto the specified limit. The amount may be withdrawn
deposits is short. The company cannot depend upon public in instalments. Interest is charged on the amount actually
deposits for meeting long-term financial needs. withdrawn. The borrower is required to offer security in
4. Speculation : As public deposits can be raised the form of tangible assets or guarantees.
easily and quickly, a company may be tempted to raise 3Discounting of Bills of Exchange: This implies
more funds than it can profitably use. It may keep idle procuring cash from a bank in exchange for credit
money to meet future contingencies. The management of instruments. Commercial banks provide short-term
the company may indulge in over-trading and speculation finance to business concerns by discounting their bills of
which exercise harmful effects on the business. exchange, promissory notes and hundies. Banks charge

137