Long Term Sources of Finance

FORMS OF BUSINESS OWNERSHIP

Sole proprietorship

Decision-making is simple Can be set up easily & inexpensivelyThe owner receives all income from business. Income is taxed at only one level (that of the owner).Subject to few regulationsUnlimited liability. Limited life of the proprietorship The business has limited access to additional funds.

The general partners are decision-makers.

The owners (the partners) divide income according to partnership agreement. Income is taxed once.

Set up with easeFew government regulations

Unlimited liability for each partner. A limited life of partnership. Limited access to additional funds.

The separation of ownership and decision-making. Distinct legal entityLimited liabilityThe business enterprise has a life in perpetuity Access to additional funds through the sale of new share of stock. Income is distributed according to proportionate ownership.

Double taxation on incomeRegulated by Companies Act

Partnership Corporation

Corporation

Private Company Public Company

Minimum 2 personsMaximum Shareholders 50Public subscription not allowedRestricted rights to transfer sharesPromoters enjoy unchallengedcontrol over the firmFirms ability to raise capital is limited

Minimum 7 personsUnlimited ShareholdersPublic subscription allowedFree transfer of shares

Firm can raise substantial fundsCumbersome procedure forFormation

• Public Company is the most appropriate form of organisation as– Limited liability– Enormous growth potential– Free and easy transferability of shares

Limited Liability Partnership

• Limited Liability Partnership form of business has been introduced in India in Dec 2008

• Limited liability of partners.

• This form is suitable for small and medium enterprises, service providers, doctors, CAs, lawyers etc. to limit liability and yet have the flexibility of a partnership structure.

Features-• Liability of the partners would be limited to the agreed contribution of

partners.

• Partners would not be liable for independent and unauthorized actions of other partners.

• Name of an LLP must end with the words ‘LLP’

• LLPs can have individual, body corporates, including other LLPs, foreign LLPs and Indian as well as foreign companies as partners

• No upper limit on maximum number of partners.

• The mutual rights and duties of partners shall be governed by an agreement between the partners.

Limited Liability Partnership

• LLP will have perpetual succession.• The rights of a partner to share the profits

and losses are transferable.• LLP will maintain annual accounts• LLP will not be subject to Company Law• Other entities such as firms, companies etc.

can convert to LLP.

Limited Liability Partnership

Sources of long term finance

• Retained Earnings• Equity Capital• Debenture Capital• Preference Capital• Term Loans

Retained Earnings

• Retained earnings are profit after tax and dividend.

• Internal Source of Finance

From Company’s point of view

Advantages• Readily available• No additional expenses to raise• No dilution of control

Disadvantages• Limited Fund• Opportunity cost is high. Because, it represents the

dividends foregone by the shareholders.

Shareholder’s Point of view

Advantages• Convenient as no hassle of reinvesting.

Disadvantages• Lower dividend

Debenture Capital• Debentures are instruments for raising long term debt

capital• Characteristics

Trustee – Bank , Institution, Insurance CompanyAppointed through a Deed

Security – Secured by a charge on assets present and future assets

Debenture Redemption ReserveCoupon Rate / Interest Rate - Fixed or floating Maturity Period – fixed maturity periodConvertible and Non convertible

EvaluationCompany’s point of view

Upside• Post tax cost of debentures is lower than shares• No dilution of control

Downsides• Obligatory payment

Investor’s point of view

Upside • Stable earnings• Secured Investment

Downside• Interest is Fully taxable in the hands of investors• No right to vote

Equity Capital• Represents ownership capital• Enjoys the rewards and bear the risks

Some Terms• Authorized capital is the amount of capital that a

company can potentially issue, as per its memorandum.• The amount offered by the company to the investors is

called the Issued Capital.• The part of issued capital which has been subscribed to

by the investors represents the Subscribed Capital.• The actual amount paid up by the investors is called the

Paid-up Capital.

Equity Capital Authorised Capital Say: 10,00,000 Equity

Shares of Rs.10 each

Issued capital Say :5,00,000 Equity Shares of Rs.10

each

Subscribed Capital Say :4,00,000 Equity Shares of Rs.10 each

Paid up Capital Say :4,00,000 Equity Shares of Rs.5

each

Par ValueFace value of the shareThe stated value on a stock certificate is called the par value.The par of equity shares is generally Rs. 10, or Rs. 100.Issue PriceThe issue price is the price at which the equity share is issued.

–Generally par and issue price are same for new companiesWhen issue price exceeds the par value, the difference is referred as share premium

Market Price is the price at which the share is traded in the stock market

• Contributed Surplus Usually refers to amounts of directly contributed equity capital in excess of the par value

– For example, suppose 1,000 shares of common stock having a par value of Rs.1 each are sold to investors for Rs. 8 per share. The contributed surplus would be

(8 – 1) × 1,000 = Rs. 7,000

Rights and position of equity Shareholders

• Right to Control – Elect the board– Lack effective control

• Right to Income = Profit After Tax – Income of the shareholder is called Dividend– as recommended by the Board– unchallengeable

• Pre-emptive right on pro rata basis• Right in liquidation

– Residual claim over assets of the firm

• Pradhan enterprises has 1,000,000 outstanding equity shares with a par value of Rs.10 and a market value of Rs.20 .The firm plans to issue 500,000 additional equity shares at a price of Rs.12 per share .The market value per share after this issue is expected to drop to Rs.17.33. Now if a shareholder has 100 shares, his financial situation with respect to Pradhan’s equity when he exercises the preemptive rights and when he does not exercise the preemptive rights would be as shown below:

Takes Pre-emptive Rights

Value of initial holding( 20 * 100) = 2000

Additional Subscription(12 * 50) = 600

Value of equity holding after the additional Issue (17.33 * 150) = 2600

No Pre-emptive Rights

Value of initial holding( 20 * 100 = 2000

Additional Subscription = 0

Value of equity holding after the additional Issue (17.33 * 100) =1733

Expected Price = 100*20 + 50*12 = 17.33 150

Evaluation Company’s point of view• Positives

• Permanent Capital- no liability for repayment• Dividend Non obligatory• Enhances Creditworthiness

Negatives

• Investors expect High rate of return/ high cost of capital

• Issue cost quite high– Underwriting commission, brokerage costs, publicity cost

etc• Dilution of control

Shareholder’s point of viewPositives

• Limited liability• High rewards• Equity dividend exempted from tax

Negatives

• No say in Dividend matters• Residual claim to income & assets• Risky investment- wide fluctuations in price

Preference Capital• A hybrid form of financing- It has some features of Equity

and some features of Debentures• Dividend rate is fixed -Not an obligatory payment but

dividends get accumulated• Preference dividend is paid out of profit after tax

– Not a Tax-deductible payment• Preference over equity shareholders• No voting power• Convertible into equity• Redeemability

EvaluationCompany’s point of viewUpside• No legal obligation to pay dividend• No dilution of control• Enhances creditworthiness • No collateral security

Downside• Pay dividend Tax• No tax advantage• Skipping of dividend adversely affects corporate image

Shareholder’s point of view

Upside• Stable dividend• Dividend exempted from income tax

Downside• Can not enforce payment of dividend• Modest returns

Term Loans• A source of Debt Finance –

– for a period more than a year– For financing Fixed Assets and Working Capital

Features-Security- The borrowing is secured. The assets financed

with the loan are termed as Prime Security and other assets of the firm may serve as Collateral securities.

Interest- Interest is a fixed obligation. Rate is fixed or floating.

EvaluationCompany’s point of view

Upside• Interest is tax deductible• No dilution of control

Down sides• Obligatory payments

Lender’s point of view• Fixed Income• Secured loans• No right to vote