Sources and Raising

of Long Term Finance

FINANCIAL MANAGEMENT
SESSION 5-8

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Objective
At the end of this session you should be able to understand
◦ Introduction to Equity Capital and Preference Capital
◦ Debenture Capital
◦ Initial Public Offerings, Public Issue by Listed Companies, Rights Issue,
Preferential Allotment, Private Placement, Term Loans, Venture Capital,
Deferred Credit
◦ Government Subsidies
◦ Leasing and Hire-Purchase
◦ Emerging Sources of Finance – Private Equity, FDI, FCCB

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Sources of Long Term Finance
•To support its investments, a firm must find the means to
finance them
•Equity and debt represent the two broad sources of finance for
a business firm
•Equity (shareholders’ funds) consists of equity capital, retained
earnings, and preference capital.
•Debt (loan funds) consists of term loans, debentures, and
short-term borrowings

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Equity
Equity capital represents ownership capital, as equity shareholders
collectively own the company
The amount of capital that a company can potentially issue, as per its
memorandum, represents authorised capital
The amount offered by the company to the investors is called the
issued capital
That part of issued capital which has been subscribed to by the
investors represents subscribed capital.
The actual amount paid up by the investors is called the paid-up
capital
NSE Equity
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Equity
The par value of an equity share is the value stated in the
memorandum and written on the share scrip.
The issue price is the price at which the equity share is issued
The book value of an equity share is equal to:

The market value of an equity share is the price at which it is

traded in the market

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Equity
Equity shareholders have a residual claim to the income of the firm
Equity shareholders, in theory, exercise an indirect control over the
operations of the firm
As per Section 152(2) of the Companies Act, 2013 directors have to
be appointed by the shareholders in a general meeting
The pre-emptive right enables the existing equity shareholders to
maintain their proportional ownership by purchasing the additional
equity shares issued by the firm
Equity shareholders have a residual claim over the assets of the
firm in the event of liquidation

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Equity
Advantages
◦ No compulsion to pay dividends. Dividends are tax-exempt
◦ No maturity date, hence, no obligation to redeem
◦ Enhances the creditworthiness of the company

Disadvantages
◦ Sale of equity shares to outsiders dilutes the control of existing owners
◦ Cost of equity is high, usually the highest
◦ Dividends are paid out of Profit after Tax, while interest payments are
tax deductible expenses
◦ Cost of issuing equity shares is generally higher than the cost of issuing
other types of securities
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Internal Accruals
The internal accruals of a firm consist of depreciation charges
and retained earnings
Depreciation represents a periodic writeoff of a capital cost
incurred in the beginning
It is non-cash charge, hence, it is considered an internal
source of finance
Retained earnings are that portion of equity earnings which are
ploughed back in the firm

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Internal Accruals
Advantages
◦ Readily available internally
◦ Effectively represent infusion of additional equity
◦ No dilution of control

Disadvantages
◦ Amount that can be raised may be limited
◦ Opportunity cost of retained earnings is quite high
◦ Many firms do not fully appreciate their opportunity cost

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Preference Capital
Represents hybrid form of financing – some characteristics of
equity and some of debentures
Like Equity
◦ Preference dividend is payable out of distributable profits
◦ Not an obligatory payment
◦ Not a tax deductible payment

Like Debt
◦ Dividend rate of Preference shares is fixed
◦ Claim of preference shareholders is prior to claim of equity owners
◦ Preference shareholders do not normally enjoy the right to vote
◦ Preference capital is typically repayable
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Preference Capital
Advantages
◦ No legal obligation to pay preference dividend, normally no voting right
◦ Financial distress on account of redemption obligation is not high
◦ Generally regarded as part of net worth

Disadvantages
◦ Very expensive source of financing compared to debt, since it not tax-
deductible
◦ Typically payable with arrears
◦ Prior claim on assets, compared to equity owners
◦ Preference shareholders acquire voting rights if dividend is skipped for
a certain period
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Term Loans
Term loans, or term finance, represent a source of debt finance
which is generally repayable in less than 10 years
Mainly employed to finance acquisition of fixed assets and
working capital margin
Term loans differ from short-term bank loans which are
employed to finance short-term working capital need and tend
to be self-liquidating over a period of time, usually less than
one year

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Term Loans
Financial institutions (and banks) give rupee loans as well as
foreign currency term loans
Term loans typically represent secured borrowings
The interest and principal repayment on term loans are definite
obligations that are payable irrespective of the financial
situation of the firm
In order to protect their interest, financial institutions generally
impose restrictive conditions on the borrowers

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Term Loans
Advantages
◦ Interest on debt is a tax-deductible expense
◦ Does not result in dilution of control
◦ Debtholders do not partake in the value created by the firm
◦ Maturity of the debt instrument can be tailored to synchronize with the
funds requirement
Disadvantages
◦ Entails fixed interest and principal repayment obligation
◦ Increases financial leverage
◦ Debt contracts impose restrictions
◦ If inflation is low, real cost of debt will be high

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Debentures
Akin to promissory notes, debentures are instruments for
raising long term debt
Debenture holders are the creditors of a company
Debentures often provide more flexibility than term loans as
they offer greater variety of choices with respect to maturity,
interest rate, security, repayment, and special features
Debt Market

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Debentures
When a debenture issue is sold to the investing public, a trustee is
appointed through a trust deed
Most debenture issues in India are secured by mortgages/ charges
on the immovable properties of the company and a floating charge
on its other assets
May carry a fixed or floating or zero interest rate
May be short-term, medium term, or long term
May carry a ‘call’ or a ‘put’ feature
A company may issue debentures which are convertible into equity
shares at the option of the debenture holders
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Comparison of Various Sources of
Long-Term Financing
Cost Dilution of Risk Restraint on
Control Managerial Freedom
Equity Capital High Yes Nil No
Retained Earnings High No Nil No
Preference Capital High No Negligible No
Term Loans Low No High Moderate
Debentures Low No High Some

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Initial Public Offer
The first public offering of equity shares of a company, which is
followed by a listing of its shares on the stock market, is called
the initial public offer (IPO).
An IPO is often considered as an important milestone in a
company’s lifecycle marking its transition from a small closely-
held company to a listed entity
NSE IPO Link

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Initial Public Offer
Decision to Go Public
◦ Benefits of Going Public
◦ Access to Capital
◦ Respectability
◦ Investor Recognition
◦ Window of Opportunity
◦ Liquidity
◦ Benefit of Diversification
◦ Signals from the Market

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Initial Public Offer
Costs of Going Public
◦ Adverse Selection
◦ Dilution
◦ Loss of Flexibility
◦ Disclosures
◦ Accountability
◦ Public Pressure
◦ Costs

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Initial Public Offer
Eligibility for An IPO
◦ Track Record
◦ QIB Participation

Issue Pricing
◦ Adjusted EPS
◦ P/E Ratio in relation to issue price
◦ Return on Net Worth
◦ Minimum return on the total net worth
◦ Net asset value

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Initial Public Offer
Fixed Price Mechanism – The price at which the shares are
to be issued to the public is fixed before the issue opens for
subscription
Book Building Mechanism – The company announces a
price band within which potential investors are required to bid
for the shares
French Auction – Retail investors are free to bid at the floor
price but institutional investors have to bid at a higher price.

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Initial Public Offer
•Principal Steps in an IPO
•Role of the Lead Manager of the Issue
•Cost of Public Issue
• Underwriting Expenses
• Brokerage
• Fees to the Managers to the Issue
• Fees for Registrars to the Issue
• Printing Expenses
• Postage Expenses
• Advertising and Publicity Expenses
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Initial Public Offer
Underpricing of Initial Public Offerings (IPOs)
◦ Winner’s Curse
◦ Bait for Future Offerings
◦ Informational Asymmetry
◦ Regulatory Constraints
◦ Political Goals

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Follow On Public Offer
For most companies, their IPO is seldom their last public issue.
As companies grow, they are likely to make further trips to the
capital market with issues of debt and equity
These issues may be public issues offered to investors at large
or rights issues offered to existing shareholders
The procedure for an FPO of equity is similar to that of an IPO
Offer for Sale

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Rights Issue
A rights issue is an issue of capital to the existing shareholders
of the company through a ‘Letter of Offer’ made in the first
instance to the existing shareholders on a pro rata basis.
This is required under the Companies Act.
The shareholders, however, may by a special resolution forfeit
this right, partially or fully, to enable the company to issue
additional capital to public.
Rights Issue

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Rights Issue
•The issuing firm decides on the number of rights shares to be
issued
•Based on the number of rights shares proposed to be issued,
the rights entitlement of the existing shareholders is determined
•The price per share for additional equity, called the subscription
price, is left to the discretion of the company
•Rights are negotiable
•Rights can be exercised only during a fixed period which is
usually about 30 days

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Rights Issue
Value of a Share

where ‘N’ is the number of existing shares required for a rights

share, ‘’ is the cum-rights market price per share, and ‘’ is the
subscription price at which the rights share are issued.
The rationale is: for every ‘N’ shares before the rights issue, there
would be ‘N+1’ shares after the rights issue. The market value of
these ‘N+1’ shares is expected to be the market value of ‘N’ cum-
rights shares plus ‘S’, the subscription price.

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Rights Issue
Value of a Right

The difference between the market price of a share after the

rights issue and the subscription price is the benefit derived
from a right, which is required along with the subscription price
to obtain one rights share. Thus the Value of a Right is:

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Illustration
Paid-up Equity Capital (1,000,000 shares of ₹10 each) ₹10,000,000
Retained Earnings 20,000,000
Earnings Before Interest and Taxes 12,000,000
Interest 2,000,000
Profit Before Tax 10,000,000
Taxes (50 Percent) 5,000,000
Profit After Taxes 5,000,000
Earnings Per Share ₹5
Market Price Per Share (Price-Earnings ratio of 8 is Assumed) ₹40
Number of Additional Equity Shares proposed to be issued as Rights Shares 200,000
Proposed Subscription Price ₹20
No. of Existing Shares Required for a Rights Issue (1,000,000/200,000) 5

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Private Placement
A Private Placement is an issue of securities to a select group
of persons not exceeding 200.
Private Placement of shares and convertible debentures by a
listed company can be of two types:
◦ Preferential Allotment
◦ Qualified Institutional Placement

NSE Institutional Placement

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Preferential Allotment
•When a listed company issues shares or debentures to a
select group of persons in terms of the provisions of Chapter
VII of SEBI (ICDR) Regulations, it is referred to as a
preferential allotment.
•Special Resolution
•Pricing
•Open Offer
•Lock-In Period

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Qualified Institutional Placement
(QIP)
•A QIP is an issue of equity shares or convertible securities to
Qualified Institutional Buyers (QIBs) in terms of the provisions of
Chapter VII of the SEBI (ICDR) Regulations 2009.
•It represents a private placement with QIBs.
•QIPs are placed with institutional investors who are well informed
•QIPs require less preparatory work, compared to a public issue
•Can be timed opportunistically
•Normally completed in a few hours

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Private Placement of Bonds
•Corporate Bonds in India are largely privately placed
•Private placement of corporate bonds is mostly done through a
book-built issue to institutional investors
•Details of the issuer and the bond are provided in the
placement document
•When the book building mechanism is used, the issue
manager collates investor interest in the issue
•NSE Private Placement of Bonds

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Deferred Credit
A deferred credit could mean money received in advance of it
being earned, such as deferred revenue, unearned revenue, or
customer advances. A deferred credit could also result from
complicated transactions where a credit amount arises, but the
amount is not revenue.
A deferred credit is reported as a liability on the balance sheet.
Depending on the specifics, the deferred credit might be a
current liability or a noncurrent liability. In the past, it was
common to see a noncurrent liability section with the heading
Deferred Credits.

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Government Subsidies
Money paid by a government to help an organization or industry reduce its
costs, so that it can provide products or services at lower prices.
WTO says a subsidy is any financial benefit provided by a government
which gives an unfair advantage to a specific industry, business, or even
individual. Types:
•Cash subsidies, such as the grants mentioned above.
•Tax concessions, such as exemptions, credits or deferrals.
•Assumption of risk, such as loan guarantees.
•Government procurement policies that pay more than the free-market price.
•Stock purchases that keep a company's stock price higher than market
levels.

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Leasing
A lease represents a contractual arrangement whereby the
lessor grants the lessee the right to use an asset in return for
periodical lease rental payments.
While leasing of land, buildings, and animals has been known
from times immemorial, the leasing of industrial equipments is
a relatively recent phenomenon, particularly on the Indian
scene

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Types of Leases
An equipment lease transaction can vary along the following
dimensions: extent to which the risks and rewards of ownership are
transferred, number of parties to the transaction, domiciles of the
equipment manufacturer, the lessor, and the lessee, etc. Based on
these variations, the following classifications have evolved:
•Finance lease vs operating lease
•Sale and leaseback vs direct lease
•Single investor lease vs leverage lease
•Domestic vs international lease

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Rationale of Leasing
•Convenience
•Benefits of Standardisation
•Better Utilisation of Tax Shields
•Fewer Restrictive Covenants
•Lower Cost of Obsolescence Risk
•Expeditious Implementation
•Matching of Lease Rentals to Cash Flow Capabilities

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Hire Purchase Arrangement
•The hiree purchases the asset and gives it on hire to the hirer
•The hirer pays regular hire-purchase instalments over a
specified period of time. These instalments cover interest as well
as principal repayment. When the hirer pays the last instalment,
the title of the asset is transferred from the hiree to the hirer
•The hiree charges interest on a flat basis
•The total interest collected by the hiree is allocated over various
years

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Project Finance
Project finance involves raising funds for a capital investment
project that can be economically separated from its sponsor.
The suppliers of funds depend primarily on the cash flows of
the project to service their loans and provide return on their
equity investment in the project
The project is set up as a separate company which is granted
a concession by the government

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Venture Capital
A young private company that is not yet ready or willing to tap the
public financial market may seek venture capital (VC).
Such capital is provided by venture capital funds which are
prepared to finance an untried concept that appears to have
promising prospects.
Venture capital funds seek to support growing firms during their
initial stages, before they are ready to make a public offering of
securities.
VC is provided mainly in the form of equity capital
SEBI Regulations
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Venture Capital
•The Venture Capitalist (VC) is inclined to assume a high degree of risk
in the expectation of earning a high rate of return
•The VC typically subscribes to equity or quasi-equity financing
instruments, which enable it to share the risks and rewards of the
investee firm
•The VC, in addition to providing funds, takes an active interest in
guiding the assisted firm
•The financial burden for the assisted firm tends to be negligible in the
first few years
•The VC normally plans to liquidate its investment in the assisted firm
after 3 to 7 years
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VC and Private Equity
•They invest in companies that are not able or ready to raise
capital from the public
•They are set up as independent pools of capital contributed by
institutions or HNIs
•Armed with tightly written investment agreements, they actively
oversee the investee companies
•Their activities are subject to few regulations
•SEBI Venture Capital

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VC and Private Equity
•In contrast to VC, PE investors invest mostly in later stage
operations with a substantial operating history
•PE investment may be used for financial or operational
restructuring of the investee company
•PE investment package may include debt, which is rare in a VC
investment package
•The PE investor puts more emphasis on corporate governance,
whereas the VC investor focuses more on management
capability

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Foreign Direct Investment - FDI
The FDI policy provides the extent to which foreign investment
is allowed in each sector and the terms for such investments
Under the extant foreign investment policy, FDI is permitted in
almost every sector, except those of strategic concern such as
defence and railways which continues to be state owned in
India.
FDI is allowed under two broad policy routes:
◦ The automatic route
◦ The government approval route

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Foreign Direct Investment - FDI
The former envisages free flow of inbound FDI into permitted
sectors which does not require any prior approval either from
GOI or the RBI
Such FDI is only monitored by the RBI through a reporting
mechanism.
The second route is meant for FDI not covered under
automatic route and it needs to seek prior government
approval.

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Foreign Direct Investment - FDI
There are three primary institutions in India that can handle
FDI-related issues:
•The Foreign Investment Promotion Board (FIPB)
•The Secretariat for Industrial Assistance (SIA) in the
Department of Industrial Policy and Promotion (DIPP) in the
Ministry of Commerce and Industry and Foreign Investment
Implementation Authority (FIIA)

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Foreign Currency Convertible Bond -
FCCB
•Under the Indian regulations, convertible bonds are known as
Foreign Currency Convertible Bonds or FCCBs
•When such bonds are issued in the euro market they are
known as euro convertibles
•FCCBs are converted into depository receipts when investors
do not have familiarity with the domestic market of the issuer
company

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Foreign Currency Convertible Bond -
FCCB
•The FCCBs are initially listed and the depository receipts
arising therefrom are also listed in the overseas market
•FCCBs can also be issued for conversion into Indian shares
directly if such shares are listed in India and are allowed for
such direct holding in India by the respective foreign investors
•Such type of FCCBs are preferred when the investors are
familiar with the domestic capital market and are allowed not
only to hold but also to trade in domestic shares

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Foreign Currency Convertible Bond -
FCCB
Most FCCBs are structured as low yield bonds or zero coupon
bonds to provide a motivation to the bondholder to convert
them into equity
They may also be structured with a redemption premium to
protect the yield if it is anticipated that conversion option may
not be exercised by many of the bondholders

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Conclusion
In this session we learnt about
◦ Introduction to Equity Capital and Preference Capital
◦ Debenture Capital, Initial Public Offerings, Public Issue by Listed
Companies,
◦ Rights Issue, Preferential Allotment, Private Placement,
◦ Term Loans, Venture Capital, Deferred Credit
◦ Government Subsidies
◦ Leasing and Hire-Purchase
◦ Emerging Sources of Finance – Private Equity, FDI, FCCB

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