Long term sources of Finance

The capital of any company can be raised from shares, debentures and term loans.
Total share capital of the company is divided into units of small denomination. One
of the units into which the capital of the company is divided is called a share.

Classes of shares: Companies usually issue two classes of shares, namely equity
shares, preference shares.

Equity Share capital: Equity share 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.

Features:

1. Equity share capital is the ownership capital.

2. It is the permanent capital. No repayment.

3. The portion of profits distributed to the shareholders is called dividends.

Dividend on equity shares is not fixed.

4. Dividend is not an obligatory payment for the company. If the company earns
profits then dividends are paid otherwise not.

5. Equity shareholders are having voting rights. They are having the right to
vote the board of directors of the company.

6. The Pre-emptive right enables existing equity shareholders to maintain their

proportional ownership by purchasing additional equity shares issued by the
shareholders the first opportunity to purchase equity shares issued by the
firm. This issue is termed as ‘Rights Issue’

7. the companies issuing equity shares can list their shares in the stock
exchange. So the equity shareholder when he wants to sell his shares/buy the
shares he can sell/buy in the stock exchange by giving the order to the broker
of the stock exchange.

Rights of Equity Shareholders:

 Right to income: if the company earns profits then equity shareholder
can get dividend. Dividend is the portion of profit distributed to the
equity share holders.

 Right to control: equity shareholders as owners of the firm elect the

board of directors and have the right to vote on every resolution
placed before the company. The board of directors in turn selects the
management, which controls the operations of the firm. Hence,
equity shareholders, in theory, exercised an indirect control over the
operations of the firm.

 Pre-emptive right: the Pre-emptive right enables existing equity

shareholders to maintain their proportional ownership by purchasing
additional equity shares issued by the shareholders the first
opportunity to purchase equity shares issued by the firm. This issue is
termed as ‘Rights Issue’. However the shareholders are at liberty to
reject such ‘rights offer’.

 Right in liquidation: like in the case of income, equity shareholders

have a residual claim(last priority) over the assets of the firm in the
event of liquidation,. Claims of all others- debenture holders; secured
lenders, unsecured lenders, other creditors and preferred
shareholders are prior to the claims of equity shareholders.

 Permanent capital: Equity share capital is the permanent capital. The

company will never repay the capital to the share holders. (except buy
back of shares)

Firm’s point of view:

Advantages:

 It represents permanent capital. Hence there is no liability for

repayment.

 It does not involve any fixed obligation for payment of dividend.

 It enhances the credit worthiness of the company. In general,

other things being equal, the larger the equity base, the higher the
ability of the company to obtain credit.

Disadvantages:
  The cost of the equity capital is high, usually the highest, the rate of return
required by equity shareholders is generally higher than the rate of return
required by other investors.

 Equity dividends are payable from post-tax earnings. Dividends are taxable..

 The cost of issuing equity shares is generally higher than the cost of issuing
other types of securities. Underwriting commission, brokerage costs and
other expenses are high for equity capital.

 Sale of equity stock to outsiders may result in dilution of the control of

existing shareholders.

Shareholder’s point of view:

Advantages:

 Equity share holders enjoy controlling power over the firm

 The liability of equity shareholder is limited to the extent of their capital

contribution.

 The rewards of equity capital, representing the ownership capital is very high.
The equity shareholder can get two types of returns. They are dividends and
capital gain. Capital gain is the difference between purchase price and sale
price of the equity share. If sale price is more than the purchase price then it
is called as capital gain. If the sale price is less than the purchase price then it
is termed as capital loss.

Disadvantages:

 Though equity shareholders enjoy controlling power over the firm in theory, the
real control exercised by them is often weak because they are usually scattered
and ill organized.

 Equity shareholders cannot contest the dividend decision of the board of

directors.

 Equity shareholders have a residual claim(last priority) to income as well as

assets-they enjoys the lowest priority.

 Equity stock prices tend to fluctuate rather widely, making equity investments
risky.
2. Preference share capital:

Preference shares are those shares, which enjoy preferential rights as to

payment of dividend and repayment of capital in the event of winding up of the
company over the equity shares.

Features of Preference shares

1. Preference dividend is fixed.

2. Dividend is paid only out of distributable profits only.

3. Preference shares carry preferential rights over equity shares for payment of
dividend and repayment of capital in the event of winding up of the
company.

4. Preference dividend is not an obligatory payment.

5. Preference dividend is not a tax-deductible payment. Or preference dividend is

taxable.

6. Preference shareholders do not normally enjoy the voting right. A preference

shareholder is entitled to vote on every resolution placed before the company if
cumulative preference dividends is in arrears for two years or more in the case of
cumulative preference shares or the preference dividend has not been paid for a
period of three or more years in the preceding six years ending with the expiry of
the immediately preceding financial year.

Similarities between preference shares and equity shares

Preference share capital contains some characteristics of equity and some

attributes of debentures. It resembles equity in the following ways:

 Preference dividends is payable only out of distributable profits.

 Preference dividend is not an obligatory payment

 Preference dividend is not a tax-deductible payment. (taxable).

Preference capital is similar to debentures in several ways:

 The dividend rate on preference capital is usually fixed.

  The claim of preference shareholder is prior to the claims of equity
shareholders; and

 Preference shareholders do not normally enjoy the voting right. A

preference shareholder is entitled to vote on every resolution placed
before the company if cumulative preference dividends is in arrears for
two years or more in the case of cumulative preference shares or the
preference dividend has not been paid for a period of three or more years
in the preceding six years ending with the expiry of the immediately
preceding financial year.

Distinction between equity share and preference share:

Sl.No. Equity share Preference share

1. Equity shares the Dividend is not Fixed percentage of dividend to

fixed. preference shares

2. Equity share holders are having In normal situation no voting rights

voting rights. to preference share holders.

3. Dividend arrears can not be In case of cumulative preference

accumulate. shares dividends are accumulate.

4. Equity share capital is the In case of Redeemable preference

permanent capital. shares there is some repayment
period.

5. While distributing the income and While distributing the income and at
at the time of liquidation last the time of liquidation preference is
preference is given to the equity given to the preference share holders
shares holders. over equity shares holders

Types of Preference Shares:

1. Cumulative and Non-cumulative Preference Shares: Regarding dividend

payment, there are two types of preference shares, viz, cumulative
preference shares and non-cumulative preference shares. Cumulative
preference shares will have the right of obtaining dividend on its holding.
Even if the dividend is skipped in any year, it accumulates and is payable in
 subsequent years. Eg., A company has issued 9% preference shares and has
not paid dividend for two years. In the third year, even the profits are made,
the cumulative preference shareholders get 27% dividend including the
dividend of 18% for the past two years. However, the law provides that
preference shareholders should be given the dividend (including arrears)
even before the equity dividend is declared. But in case of non-cumulative
preference shares, the dividend will not accumulate. The holders will be
treated on par with the equity holders as far as dividend is concerned.

2. Redeemable and Irredeemable Preference Shares: Redeemable preference

shares are repayable to the holders after the completion of the stipulated
period (Redemption period). Where as Irredeemable (Perpetual) Preference
share has no maturity period.

3. Convertible and Non-convertible Preference shares: The holders of the

convertible preference shares are enjoy the option of converting preference
shares into equity shares at a certain ratio during a specified period.

4. Participating Preference Shares: The shareholders enjoy the right to

participate in surplus profits and assets. Surplus profits here refer to the
profit left after preference dividend and equity dividend are paid at certain
rates. Surplus assets refer to the assets left over on liquidation after meeting
all debts and obligation including the repayment to preference shareholders
according to an accepted norm and is totally available for distribution of
equity holders. The non-participating preference shares on which only a
fixed rate of dividend is paid are known as non-participating preference
shares. These shares do not carry the additional shares. The right of
conversion must be authorized by the Articles of Association.

5. Cumulative Convertible Preference Shares: In 1985, a new share called

‘Cumulative Convertible Preference share’ was introduced.. This was
introduced with the basic object of capital appreciating. These shares are to
be listed on one or more recognized stock exchanges of the country. The
preference shares are converted into equity shares and the dividend is
cumulative.

Company’s Point of View:

Advantages:

1. There is no legal obligation to pay preference dividend.

2. There is no redemption liability in case of perpetual preference shares.

3. Preference capital is generally regarded as a part of net worth,. Hence, it
enhances the credit worthiness of the firm.

4. Preference shares do not, under normal circumstances, carry voting right.

Hence there is no dilution of control.

5. No collateral is pledged in favour of preference shareholders. This helps the

company in conserving the assets.

Disadvantages:

1. Issuing preference share capital is an expensive one as the dividend payable

is not a tax deductible expense.(dividends are taxable)

2. Though there is no legal obligation to pay the preference dividends, skipping

them can adversely affect the image of the firm in the capital market.

Share holder’s point of view:

Advantages:

1. It brings the investors definite earnings because dividend is fixed.

2. The risk is less in comparison to equity shares.

Disadvantages:

1. Legal protection is not given to the preference holders regarding dividend

and capital repayment. The company can skip the dividend and also can
postpone the capital repayment.

2. The rate of dividend on preference shares is comparatively less. And the

shareholder can not have voting rights.

Debenture capital: Debenture is a debt instrument indicating that a company

has borrowed certain sum of money, and promises to repay it in future under
clearly defined terms. .

Definition: Debenture is an instrument in writing acknowledging the debt given

under the seal of the company and containing a contract for the repayment of
the principal amount after expiry of a certain period and for the payment of
interest at fixed rate of interest will the debt amount is repaid. It may or may not
be assigned a charge on the assets to the company as collateral security.
 Characteristics:

1. Debenture capital is termed as lenders capital.

2. Debentures the interest rate is fixed.

3. Debenture holders does not have voting rights.

4. There is some fixed maturity period for debentures. The company has to
repay the money to debenture holder at the time maturity.

5. When debentures are issued to the investing public, a trustee is appointed

through a deed. The trustee is usually a bank or an insurance company or a
financial institution, which play the role of protecting the interests of
debenture holders.

6. Debentures issued by the companies are secured debentures. Debentures

without security are called ‘Naked Debentures’. The secured debentures will
have a charge on the fixed assets of the issuing company.

7. It is a statutory obligation to pay interest to the debenture holders at

periodical intervals of one year or six months.

8. Interest paid on debenture capital is tax deductible expense.

Types of Debentures:

1. Naked /unsecured debentures: Debentures that do not carry any charge on

the assets of the company are known as naked or unsecured debentures. The
holders of these debentures do not have any security as to repayment of
principal or interest there on.

2. Secured Debentures: debentures those are secured by a mortgage of the

whole or part of the assets of the company are known as mortgage
debentures or secured debentures. The assets so mortgaged shall be utilized
for repayment of debentures if the company fails to redeem them.

3. Redeemable Debentures: Debentures, which are redeemable at the expiry of

a certain period, are known as redeemable debentures.

4. Perpetual/irredeemable debentures: these debentures are not redeemable

during the lifetime of the company. These are due for payment only at the
time of liquidation of the company.

5. Bearer Debentures: These debentures are payable to a bearer and are

transferred by mere delivery without endorsement and no stamp duty is
payable on the transfer. The debenture holder is not registered in the books
 of the company but is entitled to claim interest and repayment of principal.
They are just like bearer cheques.

6. Registered debentures: Registered debentures are those debentures, which

are issued in the name of a particular person. The name of whom is
registered by the company. These are transferred just like shares.

7. Non-convertible debentures: the debentures which are not convertible to

equity or preference shares are known as non-convertible debentures.

Evaluation:

Company’s point of view:

Advantages:

1. The cost of issue of debentures to the issuing company is less compared to

the equity and preference capital. As the debenture interest is tax-
deductible, the effective interest payable to debenture holders will be less.

2. As the debenture holders do not carry voting rights, debenture financing

does not result in dilution of control.

Disadvantages:

1. Payment of interest and capital repayment are obligatory payments. If the

interest is not paid in time, the debenture holders may sue the company.

2. Debenture capital increases the financial risk of the firm.

Investor’s point of view:

Advantages:

1. Debenture holders earn a stable rate of return because their interest is

fixed.

2. The interest of debenture holders will be looked after by the Debenture

trustees.

3. Debenture holders will be given first preference at the time of payment of

interest and at the time of liquidation also.

Disadvantages:
 1. The interest on debentures is the income for the investors. They have to
pay income tax according to their tax bracket.

2. Debentures do not have the voting powers. They are only the lenders of the
company.

Bank Loan (Term Loans): Debt capital of a company may consist of either
debentures or bonds, which are issued to public for subscription or term loans,
which are obtained, directly from the banks and financial institutions. Term loans are
sources of long-term debt. In India, they are generally obtained for financing large
expansion, modernization or diversification projects. Therefore, this method of
financing is also called project financing.

Features of term loans

1. Maturity: banks and specially created financial institutions (FI) are the
main sources of term loans in India. FIS provide term loans generally
for a period of 6 to 10 years.

2. Direct negotiation: a firm negotiates term loans for project fiancé

directly with a bank or FI.

3. Security: term loans generally are secured. The companies taking

term loans should provide some fixed asset as security for the loan.

4. Restrictive Covenants: In addition to the asset security, lender would

like to protect itself further; therefore, FIs add a number of restrictive
covenants. A Financially weak firm attracts stringent terms of loan
from lenders. The borrowing firm has generally to keep the lender
informed by furnishing financial statements and other information
periodically.

5. Convertibility: FIs in India provide huge amount of loan assistance to

the companies. because of substantial financial stake of these
institutions, in the past they had the option to convert a part of the
rupee loan into equity. FIs would state the terms and conditions of
the conversion. FIS in India insist on the option of converting loans
into equity.

6. Repayment Schedule: The payment schedule or loan amortization

specifies the time schedule for paying interest and principal. Payment
of loan is a legal obligation. Interest charges are tax deductible in the
hands of the borrowing firm.
Advantages: 1. The interest is tax deductible for the borrower.

2. No voting rights to the lenders. So company point of view there is no dilution

of control Of the existing shareholders.

Disadvantages: 1. The lenders do not have voting rights.

3. It increases the financial risk of the company.

4. Interest is fixed and obligatory payment.

Retained Earnings (Internal funds)_

The internal accruals of a firm consist of depreciation charges and

retained earnings. Depreciation represents the allocation of capital
expenditure to various periods over which the capital expenditure is
expected to benefit the firm. Retained earnings are that portion of
equity earnings (Profit after tax less preference dividends), which are
ploughed back in the firm. Because retained earnings are the sacrifice
made by equity shareholder, they are referred to as internal equity.
Companies normally retain 30percent to 80 percent of profits after tax
for financing growth.

Advantages of Internal Funds:

Internal accruals (Funds) are viewed very favorably by most corporate managements for the
following reasons:

 Retained earnings are readily available internally.

 There is no dilution of control when a firm relies on retained earnings.

 Retained earnings effectively represent infusion of additional equity in the firm . Use
of retained earnings, in contrast to external equity, eliminates issue costs and losses
on account of under pricing.

Disadvantages of Internal Funds:

 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 because companies
typically pursue a stable dividend policy. As a result, the variability of profit after tax
is substantially transmitted to retained earnings.
  The opportunity cost of capital of retained earnings is quite high. Remember that
retained earnings, in essence, represent dividends foregone by equity shareholder.

 Many firms do not fully appreciate the opportunity cost of retained earnings they
impute a low cost to it. As a result, they may, comp0forted by the easy availability of
retained earnings, invest in sub-marginal projects that have a negative NPV.
Obviously, such a sub-optional investment policy hurts the shareholder.

Some important terms

Sweat Equity: The term ‘Sweat Equity’ means equity shares issued by a company to its
employees or directors at a discount or for consideration other than cash for providing
know-how or making available rights in the nature of intellectual property rights (say,
patents or copyright) or value additions, by whatever name called. The idea behind the issue
of sweat equity is that an employee or directors works best when he has sense of
belongingness’ and is amply rewarded. One of the ways of rewarding him is by ‘offering him
shares of the company at low prices, where he is working. It is terms as ‘Sweat equity’; as it s
earned by hard work of employees and it is also referred to as ‘sweet equity’ as employees
become happy on the issue of such shares.

Deferred Shares: These shares were earlier issued to promoters or founders for services
rendered to the company. These shares were known as founders’ shares because they were
normally issued to founders. These shares rank last so far as payment of dividend and return
of capital is concerned. Preference shares and equity shares have priority as to payment of
dividend. These shares were generally of a small denomination and the management of the
company remained in the hands by virtue of their voting rights. These shareholders tried to
manage the company with efficiency and economy because they got dividend only at last.
Now, of course these cannot be issued and theses are only of historical importance.
According to Companies Act, 1956 no public limited company or which is a subsidiary of a
public company can issued deferred shares.