sources of finance

Sources of finance

Introduction:

Decision making

Decide which assets to buy

Determining what is total investment required for buying assets.

How much working capital required.

To decide sources to tap the total

investment.

Parameter for choosing sources of fund

• Cost of source of fund.• Tenure.• Leverage planned by the company.• Financial condition prevalent in the economy.• Risk profile of both the company as well as the

industry in which the company operates.

Types of finance

Negotiated

Spontaneous

Classification according to term finance

• Short term finance.• Medium term finance.• Long term finance.

Short Terms Finance

• Short term finance are required primarily to meet working capital requirements.

• The focus is on maintaining liquidity at a reasonable cost.

Short Term Finance

Working Capital finance

Trade Credit

Inter-Corporate DepositsFactoring

Commercial Paper

Working Capital Finance By Commercial Banks

• Commercial banks grants short terms finance to business firms which is known as “Bank Credit”.

• Bank Credit may be granted in the following ways:-

LoansPurchase/ Discounting of bills.Cash Credit Over draft

Trade Credit

• Trade credit represents credit granted by the suppliers of goods, etc. as an incident of sale.

Merits DemeritsCredit for the purpose of raw material or finished goods.

Less flexible

No securityNo interest payable

Inter Corporate deposits

• A deposit made by one company to another iscalled as inter-corporate deposit.• It is generally for working capital funding & isfor period not exceeding six months.

FactoringFactoring is an agreement in which receivablearising out of sale are sold by a firm (client) tothe factor (a financial intermediary).

Advantages

• Establish a strong foundation.• Maximize profitability.• Capture growth opportunities.

Disadvantages• Cost.• Possible harm to customer relation.• Company image distortion.

Commercial Paper (CP)

Commercial paper is an unsecured moneymarket instrument issued in the form of apromissory note.

Advantages

• High credit ratings• Flexibility. • Provides exit options.

Disadvantages• Limited applicability.• Low bank credit limits. • A high degree of control.

Medium Term Finance

Medium term finance is defined as money raised for a period for 1 to 5 years.

The medium term funds are required by a business mostly for the repaired and modernizing of machinery.

Medium Term Finance

Commercial Banks &

State Financial

Institutions

Lease Financing

Hire Purchase

External Commercial Borrowings

Euro & Foreign Bonds

Lease financing

• It is a contract In which the assets is purchased initially by the lessor(leasing company) and thereafter leased to the user(leasee company) who pays a specified rent at periodical intervals.

Advantages & Disadvantage The holder only pays

for use.

Better liquidity.

Fixed rate.

Minimal sales risk.

Commitment to contract for entire valid period.

Higher fixed cost per month.

More expensive than purchase.

Hire Purchasing

• Hire purchase transaction, the goods are delivered by the owner to another person the agreement that such person pays the agreed amount in the periodical installment.

Advantage• Cheaper than a

(‘unsecured’) personal loan.

• relatively quick.• Deposits are lower than

with personal loans.

Disadvantages • Higher monthly

payment;• hidden fees

EXTERNAL COMMERCIAL BORROWING::--

1. ECB’s refer to commercial loan in the form of bank loans, buyers credit, suppliers credit, securitized instruments.(E.g. Floating rates notes and Fixed

rates bonds) availed from non-resident lenders with minimum average maturity years.

2. ECBs mean foreign currency loan raised by residents from recognized lenders. Financial leases and Foreign Currency Convertible Bonds are also covered by ECB

guidelines.

Euro bonds::--

• Definition of Euro Bond::-- “A bond issued in a

currency other than the currency of the country or market in which it is issued.”

• Eurobonds are attractive to investors as they have small par values and high liquidity.

Advantages

• Increased liquidity of European bond markets.

• Protection from large market shocks and erratic market.

• Discipline, guaranteed funding for all EMU countries.

Disadvantages

The main disadvantages are :

• Possible free-riding problems.

• Tensions with the no-bailout clause. • Credibility and political viability.

Foreign Bonds::--

Definition::--Foreign bonds are the debt instruments issued by foreign corporation or foreign government.

Types::--

Long Term Finance

• Long term finance refer to those requirements of funds which are for a period exceeding 5-10 years.

Long term finance

Share

Debentures

New Debt Instruments

Retained EarningsDepository Schemes

Venture Capital

Securitization

SHARESA shares indicates a smaller unit into which the overall requirement of a company is subdivided.

TYPES OF SHARES

THERE ARE TWO TYPES:

Equity sharesPreference shares

DEBENTURES• It means a document containing

acknowledgement of indebtedness issued by a company and giving an undertaking to repay the debt at a specified date.

NEW DEBT INSTRUMENT• Zero interest bond (ZIB)• Deep discount bonds (DDB)• Junk bonds• Convertible debenture

Retained Earnings

• Retained earnings means that part of trading profits which is not distributed in the form of dividends but retained by directors for future expansion of the company.

Merits & Demerits Of Retained Earnings

Merits :-Ready AvailabilityCheaper than External EquityNo Ownership DilutionPositive ConnotationDemerits :-Limited FinanceHigh Opportunity Cost

Global/ American/ IndianDepository Receipts

• GDRs :- A negotiable certificate held in the bank of one country

representing no. of shares traded on the exchange of another country.

• ADRs :- It allows US investors to buy shares of ADS companies

without the cost of investing directly in Foreign Stock Exchange.

• IDRs :- It allows foreign companies to raise the funds from Indian

markets.

Venture Capital

• The venture capital financing refers to financing & funding of the small scale enterprises, high technology & risky volumes.

Securitization

• Securitization is a process in which illiquid assets are pooled into marketable securities that can be sold to investors.

Advantages DisadvantagesReduces assets liability mismatch

Cost

Locking in profits Size limitation

Liquidity Risk

Some Important Sources Of Finance

• Seed capital assistance.• Certificate of deposit.• Internal cash accrual

Seed capital assistance

• Designed by IDBI.• 1% service charge for 5 years.

Certificate of deposit

• CD is a document of title similar to a time deposit receipt issued by a bank exepct that there is no prescribe interest rate on such funds.

• The main advantage of cd is the baker is not required to encash the deposit before maturity period and the investor is assured of liquidity because he can sell the cd in secondary market.

Internal cash Accruals

• Existing profit making companies which undertake an expansion programe may be permitted to invest a part of their accumulated reserves or cash profit for creation of capital assets.

Example Of Long Term & Short Term Finance

Standard Chartered Bank Mahindra Finance

Equity capital = 58% Equity capital = 42%

Internal accrual (reserve & surplus) =24% Internal accrual (reserve & surplus) =12%

Debentures (bonds) = 20% Debentures (bonds) = 33%

Term (long term) = 8% Term (long & short term) = 13%

Comparison Between both the companies

More hold on the companies proceedings & company is having high goodwill in the market.

Less hold as compare to SCB but have a good hold and goodwill in the market.

Company can skip dividends on equity shares more than Mahindra finance.

Company can skip dividends on equity shares but less as compared to SCB.

The company is having low tax deductible income.

More debentures means more tax deductible income.

Low debt contract means less restrictions on the company.

High debt contract can lead to impose restrictions.

Low percentage of term loans means company is having less dependence on the outside sources of finance.

High percentage of term loans means company is having high dependence on the outside sources of finance.