Classification of Sources of Finance

Long – term sources

a. Equity share capitalb. Redeemable Preference shares

c. Debentures / Bondsd. Retained profits

e. Factoring

Medium – term sources

a. Medium – term loansb. Deferred Credit

c. Public Fixed Depositd. Medium term loans from banks

e. Leasing and Hire Purchase

Short – term sources

a. Cash creditb. Overdraft

c. Bill Discountingd. Commercial Paper

e. Trade Creditf. Advances from customers

g. Credit cards

Distinction between Short-term, Medium – term and long – term Finance

On the basis of• Period of finance required• Sources of finance• Uses of funds• Volume of funds• Security

SHORT TERM MEDIUM TERM LONG TERM

Minimum requirement of one day to a maximum of on year One to five years Five to twenty five years

--------same------- ---------same------- ----------same--------

Financing seasonal fluctuations and working capital

Financing purchase of stock and debtors of the company Financing long term assets

Volume of funds is small Higher than short term funds Is high

Security through debtors and stocks and reputation of the company in the market

Security in the form of property and other assets

In the form of property and high value assets

Security financing: Equity, preference shares and debentures/bonds

• Equity sharesbonus issuesRights issuesSweat equity shares• Preference sharesRedeemable and irredeemableCumulative and non – cumulativeParticipating and non – participatingConvertible and non – convertible

• Debentures / BondsRedeemable and irredeemableSecured and unsecuredWarrantsTax – free bondsZero coupon bondsDeep discount bondsConvertible bonds / debenturesInflation bondsFloating rate bonds

Equity sharesOwnership and voting rights. Are high risk securitiesDividend is declared only when there is a profitHave the benefit of being traded in the stock market if its shares are listed on the stock exchangeIn case of liquidation the equity shareholders would have the last rights after satisfying the claims of the debenture holders and the preference share holdersNew equity shares are issued in the New Issue Market1. Bonus sharesIssued by a company cost free to its existing shareholdersIssued out of reserves or retained profits or share premiumBonus shares do not have the effect on the volume of shareholders funds and are issued on pro – rata basis and do not effect their voting rights

2. Rights IssueIt gives a prior advantage to existing shareholders to subscribe to mew equity shares of the companyThe price is usually lower than the market valueIt increases confidence of the shareholders3. Sweat equity sharesAre equity shares issued by a company to its employees or directors at a discount for consideration other than cash for providing services or adding value to the companies work.They are authorized when a special resolution is passed in the AGM of the company

Rights of equity share holder• Right to share the profits• Right to control the management• Voting rights at the AGM of the company• Right to receive a copy of annual accounts and report

of the company• Right to claim the residual amount after repaying the

creditors of thee company• Right to call an extraordinary general meeting if

require by thee company• Right to trade and sell thee shares in the stock market• Right to limited liability to the extent of the value of

their shares

Evaluation of equity shares as a source of financingAdvantages:1. It is a permanent source of funds2. Does not have any repayment liability3. Thee company does not have to pay any dividends if it

is not making a profitDisadvantages:4. Costs of funds is high because the expected return of

shareholders has to be satisfied for the compensation of high risk

5. There are no tax deductible advantages for the company

Floatation cost of issuing equity capital is high(merchant banker’s fees, brokerage, advertising costs etc. )

Preference sharesHave ownership rights in the company. They have thee preferential right to rreceive dividends before the equity shareholders.They do not have voting rights and have fixed dividendsTypes:1. Cumulative and Non – cumulativeCumulative preference share have the right to receive dividends even if a company does not make a profit. When the company is at a loss they do not receive the dividends but in the year of making profits the dividend is calculated and they receive the dividends eve for the year of loss

2. Redeemable and IrredeemableIrredeemable preference shares are not popular.

3. Participating and Non – ParticipatingParticipating shares have the right to receive an extra dividend after payment of equity share dues and are also entitled to receive an amount in the residual assets of the company at the time of liquidation4. Convertible and Non – ConvertibleConvertible shares can at the time of maturity be issued into equity shares or debentures of the company

Evaluation of Preference shares as a source of financeAdvantages:• Irredeemable preference shares do not have a date of

maturity therefore can be used by the company continuously as a source and they do not have to pay dividend in the year of loss

• They do not create any charge on the assets of the company

• Do not have an effect on the control pattern of the company as they do not have voting rights

• Are cheaper than equity sharesDisadvantages:• Are not tax – deductible hence affects the profits of the

company• Are expensive than issuing debentures• Have a claim over the equity shares on the assets of the

company so their control is diluted.CONCLUSION:Preference share is a hybrid security. It resembles both equity shares and debentures.

Debentures/ Bonds• Are debt securities and have the same features• Fixed rate of interest• Date of maturity• Sourcing for long – term purposesThe main features are: Form Interest Redemption Debenture/ Bond Indenture(trust deed between

company and the trustees that represent the security holders)

Call and Put option Credit rating

Types of Bonds/ Debentures1. Redeemable and Irredeemable 2. Secured and Unsecured3. Convertible bonds/ debentures(have lower rate of

interest because of this additional feature)4. Inflation bonds(adjusting the rate of inflation)5. Deep discount bonds

EvaluationAdvantages:• Are a source of long term funds with stable rate of return.• Cost of debentures is low due to the feature of tax savings.• Do not create any dilution of controlDisadvantages:• Create an obligation for the company to give interest

continuously to the holders creating a financial burden on the company

• Debenture suit only those companies which have a stable return

• If a company fails and goes into liquidation the debenture holders have a right to a charge on the property and assets of the company

Loan financing

Long term loans are taken by industrial organizations at the time of starting a new business for expanding their business activitiesThe loans are of periods between 5 and 10 yrs.The major financial institutions are which are set up to provide financial support and facility to industry for development are :IDBI, ICICI, IFCIAfter NER 1991, commercial banks have emerged into institutions to provide long term loans

The special features of loans are:Security: term loans are fully secured Interest rate: long term loans have fixed rate of interest. In

India it is low as the loans were given by government financial institutions

Repayment of loans/ amortization: the borrowers have to return the loan in installments. The installment is calculated according to the equated periodical payments which means that installments are higher initially and increase in later years

Restrictive provisions/covenants: covenants are clauses or provisions which are restrictions placed on the borrower. The borrower has to furnish periodical financial statements, maintain a minimum working capital, create sinking fund for redemption of debts and maintain its net worth.

Evaluation of loan finance as a source of financeAdvantages:• Term loans are attractive because they have a low rate

of interest and have a low financial burden on the resources of the company

• It has the advantage of a moratorium period. This helps the organization to set up its organization and develop it

• Interest charges are tax deductibleDisadvantages:• these have restrictions on the working of the company• Some covenants are negative and the functioning of the

company becomes difficult• Flexibility in the company is reduced

Project Financing

It refers to managing and financing the economic activities of large infrastructural projects.In project financing, the project, its assets, contracts, cash flows are separated from their promoters or sponsors in order to permit credit appraisal and loan to the project, independent of the sponsorsThe project assets are served as a collateral for the loan, and all loan repayments are made out of the cash flows of the project.In the past project financing was mostly used in oil exploration and other mineral extraction through joint ventures with foreign firms. Now it is mostly used in infrastructural projects, particularly in power and telecommunication projects.

Therefore, it is a method of risk sharing by the owners or sponsors and lenders of thee company. In this manner developing countries can develop many projectsIt involves 3 major concepts:1. Cash generating assets: a new special purpose company

is formed in which all cash generating assets are transferred.

2. Special project account3. Recourse: this means that the sponsors and other

guarantors support the project through contracts or commitment of additional funds or guarantees of revenues. It can be full recourse or limited recourse from the lenders. Projects have full recourse in the beginning at the start of the stage because of high risk once they are operational they shift to limited or no recourse.