. '~ .. :; .. : .

. .., ,~

-~ ; ....•

. . .

When a fum wants to invest In long-term assets,-'it 'ni.uS{fl~iilie:1l!~~~s.td }fua~ce'tli~~it~Thlli firm can rely to some extent on funds generated Internally, Howe?er,in,mo~t cases' it)ternaLi~sourc::s are not enough-to support investment plans, When that happens the firm mayhave.to c~,r.taUits investmentplan orseek.external funding. Most firms choose the latter course .of actloh::T4ey

. s.u.pplement internal fundingwithexternalfunding raised from a varietyof sources, ",/.",;,<

" . This chapter looks at tile following sources of long-term finall:c~c0~monlyep1pJ9ye,.q .. ~k, business firms:, ' ' . . .... . .," .;

:! i-R'etaitiea iearnings' -i • .: Equity'capital

" .; . ; Preference capital

• Debenture capital

• Term loans '." .

, ........

. "' ..

, .... ,

It:d~sctibesthe features of these sources of finance and evaluates theni iiddhhe' '~6i#t'Jf ~ie~ af the firm as well as .the investors .

. ~~:.:.' ... ,.' ~ '. ~.~ ... : :

Depreciation charges and retainedearnings represent the internal sources of finance available to the company. If depreciation charges are used for replacing worn-out equipment, retam~dc~eamings represent the only internal source for financing expansion and growth. Companies normally retain 3Qp~r~ent to 80 per cent of prQfit after tax for fmanc::it1g··growth.:Hetrce. retained earnings can be

an lmpqrtanJ"source .9fJ9ng-:~~.rtl\·fmancing.,· .' . ..

Company's Point of View Retained earnings are Viewed very favourably by most!cotPorate managements for the following reasons:

.. .• . Retained earnings, are readily available internally. They do llQt reqpir~ t;alk148 to oJ,ltllIders

(lenders or shani;h6Jders).· .. , .... .... . '. ,,,,,,,.:.;.,, .. .'):, ' ',.\

• Retained earnings ~ffectively represent Infuston ()f a?ditionalequity"in the firm. Use of . retainel1f' eathings, in' lieu , oh~xi:~mai' equitY, ' elimiftate$: 'issuecb'sfsana losses' on account

.'. 6f urtderpiicing.· . ..' ... . ,

~ ~': fhere is" no dilution of' control w~en ~ finn relies'on !-emih~~:earnfrigs.

"::.-."-::.-

The disadvantages of retained earnings are: ' '.. •... ....•.••.•• ..•••.... •.... ......>:j);..d"

• The amount ti\at can be ~ised by way of re~ih:~·.~Jf~rikLh~~ ~b~'iimited:~:~~rih~l,' th~

. ':·;:'";z:. ·;:- ..• ·quarit11ilY of . retained:earfliil.gstendstobe>highlyv~Htable:J.·;::,:."""" ~",.

=: •. ,. TheopPbrtunitye0sr~f retatnedearnings is'quite'high'~7Remerubemhat retained earnings, in essence, fepresent dividends foregone by equity shareholders.

Shareholders' Point of View The advantages of 'retained earnings from the shareholders' point . ',ofvieW:ll'e:

• Compared to dividend income, the capital appreciation that arises as a sequel to retained

earningsis subject to a lower rate of tax, ' .' ." ." .. ' -..", '. .. ". :"

•. Reinvestment of profits 'may be .convenient'for mariy'shareholders ak. itrdieve~ them tb

sdmeexte~t of the problem of '~vesting (lIt their own; _, "'",

··'.·Prdmthe point of vie~'of ~hareholders.·.tbe'disadvantage-s of retalned.earntngsere.Shareholaeis. ~howanta . curreritintoriie ]high~r 'thah the diviabha'ihcOIlie:ma}r~e' highly 'a-ve1:seto,or may find it Inconvenientto.iconvert a portion dfcapital.apprechltion: (which results from retention of earnings) Into current income, as it calls for selling some shares:

• Many firms do not fully appreciate the opportunity cost of retained.earnings-They impute a.-low cost to it. As a result, they may, comforted by the easy availabtltty.of. retained ea(pings, invest in sub-marginal projects that have a negative NPV. Obviously.such a sub-

optimal investment policy hurts the shareholders.' . - ."

.~ ,-".'

. ''''~1f2 .EQUn:V_CAPITAL, ' '. . _ , .' . , .'

'V Equity capital represents ownership capital as equity ShafehQldt:r~ c~ii~ctively ~~~1 tilt:\O;~l~~ii~~ 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' cbrl.terri/iS'lrmited fo'-th2ii-

. capital contributions. '

~. _: • 'c.

~ ,-, ., ~.

;,-,_-:

Cf.'-'_';"'\

Authorised, Issued,· Subscribed, aildPaid~up-'Capit~i . Theaniddrit·bfcapltal tfui(a company~ah potentially issue, as per its memorandum, represents the clutlio.'rlSed,cap'iftil. The'alllounto'ffeteti 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 the subscribed capital. The actual amourit'pWitllip

by the investors is called the Paid-up capttaJ--typicaliy the issued, subscribed, and paid- up 'capital

~·ttle·saJD,e. ". " . ., .. _. '"~'.''' \.;. 'L:";"" {~ "'<'.' .; ,;;:<'"

--;;- .•

J __ ". !_~- '. '

. ,ParrValue,·/ssueJPi'ice/'Bo'ok :Va/ue,and Market:'Valuec:Tlre'par·oalturdf!tln equity"$h:are value-statedin·the:memoratidu~lFandwfitten' on-the: share. scrip;' The par -vali16bfeq*ity sh'are(# generally Rs-.··I0 (the-most-popular denominattonror Rs.·lOO.:Tnftequently,· onecomes aticiss par values-likeRe. 1~;RS.-2; Rs.:5, Rs; OSO,' and Rs.l;OOO. . . .' ., , ... .: :., _ .: The· issue price 1S the priceat which the equity shareistssued. Generallythe issue price. arid par value-are one and the same for new companies. A:n existing Cbmpa'n:ymaYSbfuetlmessel: ltSissue price-higher than theparvalue, 'E.Meick(India)Lin1ited,~for·example',:setitS Issuepriceat RS:';t3 per-share as against the par value ofRs. '10 'per share~Wheh theIssue price exceeds the- par valbe:; the difference-is referred to as the sharepremfum. Note that the-issue price cannotbe, as pet law;

lowerthan-the par-value;.', . . . - ,... .

The: .booi: value of an equity .share.ls equal to:

• ! _.

-» " . '. ~';'. "'.' ~ .

Paid-up equity capital+ Reserves and surplus

. . .. ' _" ~.;; ", .,' ',' _" .! . - ",_ '_ •. '. " '_,' -, ~-'- .• ~ .' ,''', i', ."

Nu¢belof outsta~di~g eq~Jty; s~r~~, . '.'

Quite"naWrally;lhe book;vatue' dt'~ri ·gqultY' ~h~re't~ndS' ib'iri'cr6hse a~'the"citi~'"&ff~S'~ry;;;~'-~ii~

surplus to "paid-up' equity ·capltaJincreases. '.. ...". .. .. ....:.: ·.···.':~,:'! .. ·'.·'t:'

~··iIT~matket' vatueof an:~'qultyshaie: ;is·the price' it whiCh it·is·tiaae'd:lri':ili~rna'rk~,(1.hi5p;ii:e can be easily established for a company ~hich is listed' ort the' stotit' ma~ket- aii~·:~c't~velYif~de'd:. For a .company whiCh is listed on thestockmarket buttradecfverYirureqtierii:iy~ itl{~lfff~ulf~9. obtain a-reliable market quotation. Por such a cbmpany;thefl;1tlrkerqu'btatioqhla:yi-~tt'~~~jp;~,pre of a few shares in a past period' and hence may not' reflecnhe cutientmarketva,llle'bf'thenmt. For a company which is not listed onthe stockmarICet,6n:ec'an meretYcdnjectutt:"a'sJo"wlX# its market price would he 'if it were traded. The market price is detenniried by a va'riety-OffiCtors"j~e

earnings potential, dividend poHcy,'risk,'andEompa~y size.' . '.' .

. )98htsand Position of Equity Shareholders, ..

V R~ght to Inc~ine T~e equity i~vestors have a Tes~d1.lalciaim to the income' ofthe'fiim:The'i~~~rrie left after satisfying the claims of all other investorsbelongs to the equity shareholders.This income is simply equal to profit after tax minus preferred' dividend. . . . '..... , .

The income of equity.shareholders may be retained by the firm or paid out as dividends; Equity earnings which are ploughed' back in the 'firm tend to increase the market value of equity shares and equity . earnings .. distributed as dlvidendprovidecurrerit . iricgme 'tc'-:equlty sh~iehpldeis~.For example;' if a firm earns Rs.15 million during the year and'pays di~idend of RS.S·ntlliion, thiv~lue of equity shares may riseby.aboufRs~7inlllion, the.amount tetained.,PY,the .firrh::rh~·e.quity shareholders thus receivebetientS in two ways: dividend income of Rs.· 8 millionand capital

ap~i=~~tJ; ~t~ci ~ef~~V#~:~;qthty'Sharehbiders' are erititledcl6 -'divideha thai i~'a~;~lared :.b~~'~~e

. board of directors; The dividend decision is,,theprerogative of the board of direct()rsand e.,q~ity shareholders cannot challenge this decision' ina courtof law. In this respect the position of equity

. shareholders differs markedly from that of suppliers of debt capital. Debenture holders, for example, can take legal action against the company for its failure to meet contractual interest payment ahg principal repayment, irrespective of the financial circumstances ofthe c(impa:hy~ EqujtY'shiiieho1Ciiffs, on the other hand, cannot challenge thedividend decision of the board of directors ina-court of

law, . however impressive the. flnancia! pelfor:il1ance- bf'the' companymay be: . ;;-f.: ': .

.. '.""_; ' ..

I'

~, '

r

1

, ; " ' .. to~<ontrol " Equity.shareholdersasowners-of thefirmelecrthe~b6ard'of:tlireet6rs,':a:hd?ha:ve

~ ~~;_ ~~htt0vpte~.on every r~solutieh placedbefor:' the' compa~y: The board' .of·direCtors, 'intur~, selects the management-which controls the' operations-of the ffrm-Hence, equtty shareholders, m the Dry, exercise an, indirect control' over the operations of the firm. Hew effective Issuch 'indirect control? 9ft¢fisuchinc;lirect,corttrol is-weak: and ineffective because .of the apathyand-indifference

of,tnCSfofth~,shareh.oiderswho rarelybother-to cast their votes, by posr.or.througha.proxyr-let alone attend .the .annual general meetings. Scattered.andfll-organisedjequity shareholdersfail to exercise their collective power effectively:Usually,the·tnanagementof,tlw firm,' with .thesupport ofa wellorganised but' not a very substantial group-of sharehclders.fs able 'to .hold.the reins of control. The proxy.system helps the management further. If the shareholders are satisfied/they may

'sign the proxy Infavour of management, authorising' management to vote .on: their 'behalf; 'This SYstem may confer a distinct advantage to the management in the votingprocess,

,,~' mptiveRight Th~ p~~~~fuPtive,righ~'e~~bl~{exi~~i'h~'~qut~'~h~rehelders to maintain their roportional ownership by purchasing 'the additional equity' shares issued by the fum. The law

l:~qu~re$ ¢o.q:iPflrii~~ to', giv,e existingequity. shareholdersthe first. eppprtunity, to purchase,' ell, pre rata basis, addittoria] issues of equity capital. Fer example, if the.company has 1,000,000 outstanding shar~s QfeqHityste~k; andp(opeses to-issue ~90,OOO a~c1it~orial,equity shares.an equity shareholder q#0g'lOdshares hastheright.to purchase'ZQ Dfthe'ZpO,OOOnew shares before those are offered toanyol1e:els~. the equltyshareholdersrnay, however, forefeitthis right, partially or totally, as per managt:!ment'~ request 'if thisright creates problems or hindrancesin, issuing additionalshares. '.,' ~t kitldof p~otecrion is. 6fferedbyth~ pre-emptive right? 1:'his fight ensures that. the management ~rissut:: additiQnal shares te persons .or ,greups who are faveurably dispcsed tewards it and

therebystrellsthen its centrel ever .the flfm. ¥ere impertant., the~re-empti:I7€l right pOO:te-€tS-theeXis~ sAarebrilde'rs frem the...dihltj6Q of their financial ,interest ,as a resplt .of additional. equity

. ,iSsUe. ThisjXlfUt may be illustrated ,by a numerical example. Pradhan Enterprises 'has 1,000,000 outstandirtgequity shares with a par value of Rs. 10 and a market value-of Rs.. 2Q, The' firm plans

, to issue 500,000 additional equity shares at a price of Rs. 12per share. The market value per share artefthis issue '~~xpected to drop to Rs. 17.33.1 Now, if a shareholder has 100 shares in, ,the outstanding equity capital; his financial situation with respect to Pradhan's equity when he enjoys the • pre~mpfive right and when he does not e,nJ9Y die pre-emptive right would be as shown below ..

'":, . ,:,

" 'Vah.i~()( initial '

h6I~inif(Rs. ,'2Q x,'t Q(») 'Add,itiOnal' su.t~$criptien'

'Valui{oriniti~l ;:hc)ldJrtg(ru:;2d;X100) ..

r- AHditiollal 'sUDSCflpti6ri "'(Rs; 12>< 50} "

Value of equity holding after the' additlQriai issue (Rs.17.33 x 150)

',;',' .'

'=,~:""'600

.. Rs » ~,600

• ~ ., ~ _.,:i;' .',

, ,,~,,-.f:~:!:~< ;-.~_~ _ .. (.-

-Value cCeq!Jity,pplding"

after 'the' additional issue <Rs'.17.33,X 100) .

.'-,. ~ . "

" 1 ;000 pOGo xR,:(. 20''+'" 500',000,')( Ri.i2';"

;. , ' ""it ,sOO,OOO' "

Sources ofil!ijnf-t~rrif'Fii\an'Ce\ t~f'i~~~~'"

.c.' ,

Prom this exariliHe fns dear :thafthe shareh61tledmffecs'oiIution 'offifuiiicfitl interest When;the;pr~. emptiVe;fight is not eh;oyed~the market valueof''his' holding falls froin'ru.. 2';OOO''_to:~. 1;733. When the pre-emptive right is exercised, such dilution, however, does riot occ\.ir~the'hllirket value of his shareholdirigafter the pre-etnptivelssue is equal to ' the market value othis holding before thepre-emptive issue plus the amount of additional subscription he makes in the exercise of his pre-emptive right. , 'un<:;~.) t L~!i

ght.inLiquidatioli As inthe case of income, equity' shareholders havea,r~sic::iuar.claiin.qver:th~" assets of the firm in the-event of Ilquidatton. Claims of. aU .cthers=-debenture .: ho~4ers.: secu:r~4: lenders,' unsecured lenders, other creditors, and preferred shareholders-c-are priorto the claim. of equityshareholders, More often $a~ not equity shareholders do not get~pyth~hg~inthe e:v~p.t9f liquidation because the liqu~dation value of assets is not adequate to ,m,eet.ftllly~he c1aimso~otb¢'~.,

" .-L·

... ' '.' ~. -:

c'. ".'-','_"_:' " ': . __ , "", . ~c,: .. ~_~ ,:,~., __ ,,~l.'.~<' :_'::;c~\::.·\:~(,:~·)-'~.\';:'.~(:.:

Company's ~Poitit ~f;View The mostimportant source of long-term funds, equity' capital offersthe

followingadvantages: ' ::< K;

.. ...,

• ' it represents permanent capital. Hence, there is no ,liability for repayrn~nt.,

; j'.: . It does net-Involve anyflxed obligation for payment ofH1Vidend's: ",:'-;;" .' "<','

•. Itenhances the 'creditworthiness of the company; In general, other things1:leln{equaI::the' ""

larger the equity base, the higher the ability of the company to obtain credif.'·'·(':, .'.

The disadvantages of raising fundsby way of equity. capitalare: ',~" , ,'-', ~>, ;)\ .. y", ">:

j. ',. . The cost of equ:ity capital' is' high, ' usually the' higHest: The' ·taie of r~furii' re<idirei;fBY'~iltiit1 shareholders is generally 'higher than the rate 'of return requiredby othefmvestbr~;·~'.' . • 'Equity' dividends are payable frompost-tax eainings:'rhey are n6tcix,<ieductible~payhibhfs:

• The cost of Issuingequlty stock is generally higher than the' cost oflssuing dther.tYpes'of securities. Underwriting commission, brokeragecosts, and other 'issue expenses arehiih

lor ~qHity capitaL. '. '. .'.. .. , ', -, ' '.' '.' . "./<'."cc,L';/"

",/,'. ' Sale of equity stock to outsiders 'may resU:ltiri dilbu6ri of the cOntroldf t!xistiiig' sh.areIiold~rs:

0'bOUgh' . theexiStm,g' e<lu"itY shareholders may 'have theifght tdilliiiiliciin 'pioporti6f1al ownership whenaddittonalequity capital is issued, they may not be able to exercise thi~ , tight for variousreasoris. FUrther, tn certain cases pre-emptive fighis- may b~ctirtiile(f'ot

foregone.) " ,

~ .. -, ; r ~ .

.... ,,<' .

Shareholders" Point : of 'VieW 'The', advantages '6£ equityinvestmenr'fnrm 'thesharehblderS'pofut

of view are: ~. . .. '. .'.. ' .

• Eq\lio/,sharehbld~rsenjC?ythe,controlling power, over. the firm, ", />;)-,; .• The liability or equity shareholders is limited to the extent of their capital' contribution..

• The rewards of equity capital! representing the .ownership interest; can be veryhigh..

• Equity dividends have been exempted from tax from the Accounting Year 1997·98.

~ : ·oTn~iaisadi~'nt~gesj·ofeqt.iitYlriveStineht ff()m;~e' ~hatefrolders:' pdineof'vlew' atJ?':'~'")\\ "

=, :, ·':·~L.:: ~>-':';~.' ,' .... ,.\:.,,':--.~,-.:~.,;,-:.:.:-/:.; .•. :--;~ .. :: - . __ -:-.'<:, -. ;. : .§.'. _.-:.-,.:-; -'-Fo..r:. '.- . ;·,-7 ,.:'-'-'<: .v.' '.:,:.~""'{~-,";.' ~o. ~~-;3~·-_].·· ,_:,"} :;-,t

;,·1J1°9~lL7fnHty~ha.rehold~.rs;:~AjoY.tAe~9:?tr9~iQ.g·.P9yv,~r.Q,'f~r;th~ f4>m:A,Q:meQry,",fu~l(~_~l

; .~ont£9t·~~5~e4.J?y,tP~w#>yften ,yv,ealfJ)tlqiu~~ th~y,3.f~ USJ.;l~lJ;y:. &~tt~{~~~:Uhozig:iu.is~d:~, .'

"···-'l· ,.. _. - , - _., c . • '. t:~F<r~;?~~5t:". . '.

~:91 lpp&~ermJi=-W~I1~ing;,,;;,~,

~G " '£quity shareholders 'cannot'-contesflhe diviqend decision of the. boardofdirectors, '

•. Equity shareholders have a.residual.clalmtoIncome, as well as;Is.s~ts~¢y.~njoy;m!=,

low~stptiority., '. " ".' ,.'" " .. ;

• Eqllity stock prices tend to fluctuate rather widely,.n'laking equityinv~~W1e.l1t risky.

"':,'-','

",.1

.J!s14.3.iPR,EFERENCJ;:CAPITAl. .: ", :. ""', .: C.'

Y@~~~a~~~?r~~~=$,~~~~7.~::~:';::~/!~~i;~~~~

(thepaynierit of preference dividend Isentlrely'wtthin' the discretion of directors), and (iii) preference

dividend is nota tax-deductible payment. . , '.'

. ';Preference capital' 'is similar to debentures iii several ways: CO the dividend' rate on p~eferepce.

~::~~~d~~~;~~~~e::;:~~~~:,:c:::or:l~;:~9r:;::,~g:~~~:;t!ity

Features .pi,-,Pt~ference'·-Shar~s' . .'" -> '",.:;:':,- :+::;-"," .. ~ ,.-.

sv-. ,',.: . .! < \.; : =. '_ '.. , ,", '.- r .~. ~~

Thefeatures attachedt6p.r~fek~ce shares m ity 'Vary along the f91~i:iw4Igd!i:nel1sions: cumulation QLWYJ\1~dSJ callability, convertibility, redeemability; participation in surplus.profits and assets, and

vp,i~),~~~n':i? ... , . "",, ' ,.,,'... " ' __.,

<(;iJ#ilIr~f!iiii';iOftJiYidends' Prefei~ride~iHires'lliay Be chfuurdttve 'bf h3hitufuul<ittVe wim' r~sp-eh tBdi¥4qep~::,1,3~rr¢g.a few exceptions, preference shares In India.carry a cumulative feature.with respectJP·4ivi,~nds. The unpaid dividends on cumulatlvepreferenceshares are.carried forward . and_p~yd~l~ when. th~,qivi,dend is resumed, For example, !f thedivide~d'pa}m~e~t on a .ljper, cent Plm,uJativepreferred share.is skipped for 4 years, a divldendarrear of 52 per cent is payable. Note

",~t·a company 'cannot declare equity dividends ~flIess preference dividends are paid with arrears.

"'<Cal/;lJ:illity . Theterms of preference share. .issue .maycontam :;t:qll.featti~~by, :Whi~h~fleiSSUing company, enjoY1?·,thepgf:lt to call the .preference shares.. wholly '. or, partly r, at a. <:ert~i~ .price,

",,-,::'.;;{'~_::'i?;"':--I'.'-:·<.-';''"'~~· -:'.:;-;_.,;.. ,;: ',:~:-_;.(: '; , '. ~_.; ;'_-.-:;_:- :-~.:.: ~.j'; ;';" , ',1.-,; :,,~."'. _,

Coi1J'~ljlpility Preferenceshares may sometimes.be ,cop.y:e.rtiblejQto~quity:s~ares.The holders of convertible preference shares enjoy the option of convertingpreference shares ir~.tp,(NU_ity shares at a certain ratio during a specified period. For example, the preference shareholders may enjoy theoption of(:opvertin& preference shares into equity shares.in the ~tidof JL5after'Z;y~~rs.Jo.r

a period of 3 months. . . . . '.. :',. .

RedeemabilitYPrefefenc~:sh~res'm~Ybe"perpetua'i6r·redeeth~bl~'~ ~A~rPetuar prefdretic~ share has no-maturity period; whereas aredeemable 'preference share has 'a nffiitbd lif~~ftef'Wiuch it is

supposed to be retired. Mostpreference . issues . are 'redeemable.' ' .

.• '~; ( 0;'

{_ L ,J.,

. :Votin!fiff!Jfer .. ,P~~f~,renc~ §l}~re~'4tP Jl,ot,plrryi\'oTip.g r~~s;"AJPre[~,r~np~,sl;~'~~J?!"~,:!!9w:~yer, ~s entt~¢$l''!o vote on e_very resolutionplaced beforethe company if 0) the preference djytdend is In:ttqe1rl's.fb.rtWOi years or mbteitfthe'dIse'bf~tiJltrul{iti\iepiHereric~ shiresf!dp'1JiX1ijiFpleference dividetldhas :llotheel'i'p~Hd: .£01"·:a :p~rlod' of:,tWO":{}i:m6recbllseeunve:1?fece(i~feiJ$~~Qr for an

", .: .;.:-.".: ... : -'.'.:: ..... "." .,~h~~~l;!·:'.~'··

Sourceso(L(lng~termFini(l;nce' 0' ~'

aggregate period of three ormore"ye~r$"in -the preceding six years-ending withtheexpkyo(the

" immediately preceding financial year. .

" ~ .".::"" :.'." ,.:~ ,.. . '" .... -;' • c • .., .••. " • :" <_

-" (.:"

.:> '"

,'";-;::

A new financial instrument labelled as 'Cumulatrve·ConveitiblePi'ef~ten.ce'(tC:p) 'sh"arewas ffifroduced in 1985; ThiS~strlimeritis issued as preference share carrying a dividendrateofW pe{tent:"The . preference shares are compulsorily convertible into equity shares between 3 years and S''years from

~~~~ . .

The salient features of Ccp· shares are: (0' Only public . limited (:,qA1P~Q:i~s:. ~re)ent~tle~ . to Js,su~ CCP shares. (ii) The CCP shares must be listed on one or more recognised stock exchanges .in the. country. (iii) The funds raised from CC:P shares should be applied. towards setting new. pt~j~cts, expansion or diversification of existing projects; normal capital expenditure for modernisation, and

working capital ~qll~~~ent. ..••. '; :' " .; ." .,iffJ,:~:·':'

The objective of introducing CCP shares was to' offer the investor an assured minimuf!i;return together with the' prospect of appreciation associated with equity. This;im,;tflJme.ntyho'i~Yerihas proved to, be unpopular so far on account of certain llmitatlons: (0 It' does not provide ahY"8enefit underthe Income Tax Act. (ii) It represents an expensive source of.fmancea

EvahJation

_ : ... : . " . ' .. .. ;if.

Company's Point of View There are some advantages in issuing preference capital from the

c0p1pany's_point ofview: _ ; .', -. .: ','

• There is no legal obligation to pay prefetenct:;CTivid~I).d:·-AcompanYd6esn6tficeh~rikriipicY

, or legal action if it skips prefere~ce dividend. .' .' .'. . .' .. ' . . ..,.. . '.' ' ., . '" '" ' .. ' ••...

..•. " There is no-redemption 'liability in' the case of 'perpe'tua1: prefhehce"~Mres; Ev·e.ril'ili tH$:9W~:~

of redeemable preference shares, financial distress may not be' much because (i): periodlc slnklng fund' payments are hot 'required, and (il) 'redemption can be delayed without

significant 'penalties; '. . '. . .

.Preferenice 'capitaltsgenerally regarded as part of net worth. Hence, it' enhances'th~'

creditworthiness of the finn. Of course, some consider it'as part Of debt.' .

• . Preference . shares do' not,under normal circumstanees, any the voting right. Hence/there

is no dilution of control. '. _'

• No collateral is pledged iii favour of preference shareholders. Hence, the mortageable

assets of the firm are' conserved. . .

Preference capital, however, suffers from some serious shortcomings:

• Compared to debt capital, it is a very expensive source of financing because the dividend paid to preferenceshareholders is not.vunlfke debt interest, a tax~deductible expense. .

• - . Though there is no legal obligation to pay .' dividends, sklpplng them can adversely

affect the image of the firm in thecapita~ . may create some control' problems .

. Shareholders' Point of View Investors mav-nne

• Itearnsa stable dividend' .

• Fora' cbrpoffl,te Investor, nr'i>f .... "'rl ... .,. _d~YiGt~iitl.ulC~Ul~. . ista:x~e~emptto·ifi.e,e~eut"pfWf:': .

t dividend~paid :6u.~ by the ','C ","', ',' _. ..

11t1'l ... ·

"0'Fhe'disad'vantages;,tJf~preferertce shares.seemtobe 'cohSid'erable: """"" ~ ..';<', ::. ~ '.,

• Preference shareholders are vulnerable to arbitrary n{a~~g~ri~l;~Ctiori~.·Th~y ~an~~toW~;~ enforce their right to diviflend i or even their rjg:pt to re,pa:yp:1eQ.tjJ:b~,~,se;()ft reA,e;emaQ1e

preference shares .

•. ".,.:,P.r:ef~r.en,f,~,div~qe4d,I"a,tes,t~ndJo;bempde~k .>: <;,: i:,:, 'L', ;';~r", '.

'~~i~~i'h~{pricefluctu~tiph,Qfprefere~}(::e shares.Is usually greater-than tpeprictrJlu(?t)Jation, of

. ;,;!'.;g~bePJll!~~: ",,'r ' ",',:;",;' , ';",'." ~\'" , Y !,.,;,.:>, ",,:.,:.:;.,: .: , .. ,.:

' ~.t O'EBENTlJREtNPlTA[ j , .: '" c"," , ",' :', " ," ,:', '

V~1t~~ib'~r6mis~orY n?~es, ~eben~r~S '~re '~st~men~s ~~r raisi'ng long-~erm debt' capit~l. ~~~be~~re holders' are the creditors of'thecompany. The obligation of the company towards Its debenture holders is similar to that of a borrower who promises to pay interest arid'dipitarat:~pedfied times;

• ,'...: '_ ;'; ', •• ,. c

, , ,'~"

• '~: 'c' "'.'. - .

Ti~stee When a defl~fif~11s'sue'is"sold'tO:the"iilV'est1hg'1:)tiblic,,'~ :tnist'e'~ i$a~p'oirited through ii , deed. The trustee is usually a bankor an insurance company or a finanicial institution. ,ElJ:'trusted with the-role of protecting the interest of debenture holders, the trustee is ,responsibletfcr;6nstire

, thatthe bortpwing firm fulfills its contractual obligations.

" ,. '0 ... "., . ','" , ';.,:" " ·,,';'~',',f \',. " , ''t

::_:.,:~::' ~'~r~,'~·.:':_ -:~~~;.~.f~,.f~; ::'-i'~"~~$~_-f::;' .:,,:., i ~ .0,-' ,;. '.Y; 's- "/;_ ~ ~;~ .~\> >';~,_: ~.:, ,." -. ~"~- , '_,'~' ,_~ ,"' ~ 'i." _:_ ~. '. r; ~,'.,. ',_ r ~ _ ... '_":,'.

;jf{Se.~qr!tyit'9{rtwdeben~res are secured by a charge on the immovable propeitid; bothpreSeritand

"f~.1J.!f~;:}~t~~~~J',cop)p:;t1),yby ,wayoraq . ~quiW'ble.fi.1Prtg~~e"... ,,'; '.~: "~:",, " ':.,i '.. ' .. ' ;." <';, '

,1l~j*~~ii~en,p'illl?Jleserve For aU <ieb~ntureiss~~~'vJi~.'~·~turity P~riQcl of ~~re ~~.la months, :eH?ebenture Redemptl.onReselVe(DRR)has,t~be created, The, company.should create a ORR e.gu.ivalent toat.least ·50 per cent of rhe.amountofissue beforeredempnencommences,

FQuf!.C!n~tf!,,;, p;rev)oll$}y the.coupon rateJori1)ter,e,stm.~)(mdebentures;was subject-to-a ceiling fixed by the Ministry of Finance, N,osu9h ceiUl1gappliesnow.A company ,iSfl;~e to .choose the coupon ~~~. Further, the rate.may.beBxed or floartng.In the latter ~a~ei~ is;p~tioQj.qitllY:4~termined '

1nrel~ti911to somebenchmarkrate, """")

',-:/\',;.~. ;·''::.;~.'i- t:',;_:p:_-'." _ ,,"_;:, :-.~'.' e _. ',~ J' I" ",':' :'~:. \-". ._ <_. ",' . _', ;,'1. ," ~. ~_, r;·c

Maturity Period Earlier the average redemption period for nQllcc()gy~rtil;:ll~ "epeI),ture.s was.supposed to be about seven years. Now there i.!) no such restriction. A company has freedom, to choose the

redemption (maturity) period, " ,",::: ~\>;"'.';"

J",;;'::":'O':' '~, : . -'. ">.: ,.;;;: :; ,.:'. .'. '.; ,'." .;:,.:' \ ,; ,"". . ';,.; '. '. :'.:. ';C;,'

,Ca.J1, 'n.4 .. e,,,,t f~at'!r.~", ,J~ebenttlr~s()ccasiona,Uycaf;IY a 'call' Jea.~re which. provides, the issuing cotn.!?any the option to-redeem thedebenturesat a certain price before the maturity date. Sometimes the debentures mayhave a 'put' featute WQ.icll gives the holder the rlghtto. seek redemption at specified times at predetermined prices.

\'-{'i-;":::' ,;-~ -:':_ :~1"9j~.,~:, .:. ,'r.'"i_:;. ,'_>;;:\'"::, . ._::;.::.- ,:'~~-.~; _":.;~{:.~ . ),'~.'~.>: .'-r _;;.f;;::\~~~\ .. _ _ -"-:.'.:';::?-.

J~OI!.Vf:rt;bi/~ty·. ~ company may Issue p~ben~rel5~li~ch a~~,~f:9~X~P;~P}~/iJ?~~,,~g~i~~~~aws ~ .. ~h~

·.,'I:~~~~r~~~~t~~lC~~t~~~:~~~~~~~~~g.~~~i~~yt:{:tt~~4~~'~~il~~~:;!~f;'

...................... "". . .... ~ .. _ . __ ~.~.~:::::U~'~·:"'_ __ ._L.

____ ~=m=-~~==== ~ '=.'- .. ='- .. ----'.= .. =======- = -=---_- ~_

.' ; .. :

•. -sourfZe~.pfilPng;-1~f~;J=~~~llte;':~ tJ:l.4i9 .

issued.200,000, 12 per cent secured convertible debentures-of ~s.·500~a'Ch 'in:l98l, ,~ese d¢peri.tt1t~s carried a conversion featureentitling the debentur~ holdersthe right to seekconversion into a

certain .number ofequit},'sfures ;during ~ spedfil::if-perlOlf' of; '.: ~... --," .'. .., .r.. .' .-

- ~.,. ' ,:". ~ , .'~ ., , .:

Variety is the'''I~e :'~ftll~.Ga~e .

" ;.. ; ~' .:. ,( .: '

-: ; ~. -". • <~' • ,.. .~

. Thanks to the latitude companies enjoy in designing debt instni~tWia; ~a ~H~iY' 6£ debt iiiSbUmen1:s have been employed, Hereis a:sampiing:'''/ \;", ... ' ' .. , ';

• III 1992, the Tata Iron and Steel Company LimitedissuedSecured Premium Notes (SPNs) of Rs. 300 each. The.principal ~m9l!-ntoftheSPN-is to berepaid in. Jour -equal annual instalments of .Rs 75 each from the end of the fourth year to -the-end of the' 7th· year, together with an equivalent additional amount of. Rs 75· with each .instalment, No' interest or repayment of principal will become due or accrue on the ~PN during the first' three-years after allotment. The additional amount as mentioned' above: 'WiU' repres~'ni 'interest:'arid/dt premium on redemptionIn such formas Illay bein:,th.e int~restofthe; SPN-h01ders"accoidirig to the then prevailing regulations ~ndth.~c9mpaf).y will: offer,;b.ef9re; the. end. of-the" third year, specific options (e.g, full interest or premium or-c6mbim..ti9!lJ:heJ:~f)tp!ili¢SPN'h(!)lders. which option would have to be exercised at the end of the third'year. EaCh SPN willhave a detachable warrant against which the holder can get one eqtlity, share for Rs, 8.Q;,;:-,;,":';;

• In 1992,. the Small Industries Development Bank ofIndia (SIDBI)'~c~fue·*"it}fin?t§~:fule~f

.\ . _ ',. _. ., . _.... . '_ ',.' . .:.:'t,:!_-,.,.~ -.-:

deep discount. bonds .. Each bond havinga face value ofRs 100,000 was issuedat#de~p

discounted price 'ofRs 2,500 with a 'matUrity peridd'ofi5 years'ft-om the 'd~\:e bf fillptthe'ut

. (i.e. February t, 1993). the investor as well as StDBfhave tne\option tdWithdra,* cirred~ein thebond respectivelyat the' end of 5th or 9th. or 12th or l'Sth-'O:r20th yearfr'oIh thedate of allotment at the deemed Vahle of Rs. 5,300; Rs, 9,6oo,.R~.; i5,300;R$"25;OQO;~~h(h~s.

50,goo respectively.' ,. ,:... ' ... ,.', ,,>i .! 'i"H'.X,~., Ie

,,'.~, , Mangalot-eRefineries and Petrochemicals Limited (MRPL) offered an interest-rate of 17.5 . per cent on its NCDs issued in 1992. (To-sweeten th.is.issue·awarrant was.attacbedto-every NCD of Rs, 200 face va lue. This warrant gives its holder the option to~ubsCr:ibe to one

equity share of MRPL at par between the 18th month and 24th month). .

• In 1993, the StateBank of India tame with. the first ever issue of floating fnterest-rate bonds.Jt issued 50 IakhGcs 1000 face value) unsecured, redeemable=subordinated, floating

; interest rate bond$,Jn the nature of pmmij)5Qry notes pl1:rying, interest at 3, pes.eeat-per

annumover, the ba~'~,rq<l:~4n\ll¥t~rindeposit.t:ate.-· p,.,' .

. Evaluation· •

_;_ ... ' ..

.-\_.\ -

;.'. <

'. ,~t.(), .; -, ~;:,-~<-- ~ i:_-:·~:·\·: : -. ,-;;""';-"- ::,'~ >~;.'~ ;--'.~' .' ~.-. ~t~'·~<,~·~

,Company's Point of View Debentures offer the following.advantages to the issuing company: .

• The specific CO$t of d~bt capit~l, ~epres~ri~~d by debeniJ~~'s,i~ lo~er than ·th~ c~st:df preference or equity capital. This is because. the-iriterest-on. debentures is taic.-deductil:lle ; and . hence .the eff~ctiv:~ post-tax cost of ciebentures.is.lower.·,

• Debenture financing does not result in dilution oIcon'trol since debenture-holdersare'not

entitled to vote. .

• . The fixed monetary burden associated With debenture financing, irrespectiY¢Q[~h?,nge~jp

price level, has appeal to many companies. . <" •.. k:'f;K~~~;)'"

"

11.10 ,-0 )~~~!1J1F~~ia:-g'" "".;,);~

2"3::Cjn~~ disa<1Varltages:6f'debe'ntu.rtf{manclhg'~te'v~;r:::" "-,, ",': ',"

• The d~beriruie iUteig~t ~~d~iMtal;~~4YnJ~t1t ~;~~biigatqo/P~Yll1~pt~. Faii.ur,elo,m~et

thes~ payments can cause a great deal of embamissment. ' ' - ,'.

• T~e protectivecovenants associated with a debenture~~~~y':~;e,~~~fjC\,~xe.:,: , ..,

• Debenture financing enhances the financial risk associated with the firm. This may increase

: ;';';'':'" ,~~Fg~l9LrHH~O/,E~Bf~~h'L:n:'" ;',;' ,:"/" " '0' ""t(.,1''-;, ,>:-?:, .: ',l ,; ",,>,

Investors!:Point-,of View Debentures look attractive tb:iri:vestOrs forthe' f6116.w.ing'reasdhs:"'/;':

(~}'\',!.j /.TR~y{eaFrt,:ft1stable:f.ate fcif'i'eturn);';:':,"';-' ",~:" ;';;~'" ,',"i

, jt;W£it~;~~yiefi;O¥}%)Jhigll''drcle{'of'Pri8titY;lh''the-evehf; of Uqtiidatioli: " ":" , ,,', "

",:.,:?-.:' '-Tht!y 'are:protetteci' byvariows'provisi6ns 'of die debenture trust :'tie~d:r , ,'/;;:', "

1!ne}t'generaHyha:ve 'a::fix'iiCimatiIrity'periodi",· ','

~''''';~';'-;' ~ fj, .• ' ~ ~:-. :-. ' ~ • i < .: - " IJ-. ,-: ~ ,,~. 'r ~ , ,. _ ~ ~. ~ f . I ~ I • I

~'~:,i,~R~Q.wn~$~ bowev~r, have the JQUOW,lng ,qisadvan14g~s; , '

_ ~ ,1'-!" ",.<, '._ n,' • • , _ , _ _J _ •• r "" h ,<' ~. <' • , • •

. . -. .." . .

,;;.~~~j: oj:-:, '~'r~ ;. \, F'~~_ ~'i-:::,;J -~ , .:: f'~',i-:,"' .; ~.~_;_~_'J ,'i :< .~" ,\ .. , ~:~:. \ _.: • ~:_ ~: '~r~,: , -: :,":',',': : :;' ~'-,-:- .s. ; ... y ~'~_": i_"\ • -..:;. ~ '/; z. ':., -:,'; :' ~ : .. ::,... ~'~ _' :: i _. .

:Xi(h.ll9tti~~:,w~P iefeii~d1to,as., ~erm#n~nc~., r:~piesent,aso\lr<:~,of debt financ~,~h.~d,l is generally , ',~~pij:Y~l?)~'tn,iji~r~ than 9i1.eyear butless Thall 1 0 ¥~ars,rh~yareempIQye4' tofinance acquisltion

pq&~d~~~~~and working capital'margUi, Term Ioans differ from.short-term bankloans which are 7,tp.p~BYe:d ~9Jinarice short-term working. capital need ~n~;ten~ to be, self-liqu~clatl?g~ver a period of tUn~;usuaUy less than one year', The following features of termlQ~~P,l3,;¥,9f,fli,~~4sse<i,

. ' ',' " .' . - . '. . . - - , . ,-'., - , .' -'" ,- . ~

:.': :')'PSeC(i:dty)" t:' , ,~' . ,

-A?;i,"c.,)-;tnterest,pa.Yhle'nta-ad·ptmcipaf repayment ' '. :';;\"".,,'Restrictivetovenants ;;", / ,,' ',"

,_ .:.\:," ," ~:-,~.',~

:f

"".- .

(fk~rmLloansi rypIcallyteptesentsecured bbooWing.'Ust1'i:l.lly·assets' 'whiCh are' "firuinced'with' the proceeds of the term loan provide the prmursectirity. Otherassets-of thefirtri; rriayserve'fJ;s'collateral

security. '.' - ,'. " ,

Ali loans provided by fittancial Institutions; along, with interest, liquidated' damages, t6hilrtitfuent

charges, expenses, etc., are secured by way of: "

.i~,t!;,\ Flfsti~q{'iltabib'rnQrl~ig~:'~tail"~~~~abl~,~~~pe;e~i6t;~~ b~;:~~~~, :b~~ present and

'ifufure~ and.: ,;::.;, ,'",;.,_":,,,0:;"" ','T". ,-:',"',; ,c",,<, , ' . ,'''' , , ... ;'"

: .',,2.' 'HyPotheca,tlqriof,allrtroWbltl'pfdt%rUesdf the borrower;- boffipreserital1d furore;', subject to 'prior charges in favour ofoommercia! banks for obtainingworking:capitatadv'aficeinthe normal

:course of business; ' , ;:-' \ -. ' '

:_".'- ... ~~;: =-: .. _:. ..... "" :-."~,. ~--. / '-"

Sourcesof;t'Orrg4ehwf.iha.nce,Cf 14' .. 11"

c ~~.

Interest Payment and Principal Repayment

The interest on termib~nsis adefinite dbiigation that is' payabletrrespectfve.of the'financial situation of the firm. To the generalcategory of borrowers, financial institutions charge an interest rate that is related to the credit risk of the proposal, subject usually to a certain floorrate;"Fiftahcial institutions impose' a penalty for defaults.' In . case of default of payment of irlstalments of principal and/or interest; the borrowerts liable topay byway of 'liquidated damages' additional' interest calculated at the rate of2 per centper annum for the periodof default on the amount of.princlpal and/or interest in default. In addition to interest, lending institutions levy a commitment fee on the unutilised loanamount .

. The' principal amount' of a term loan isgenerally repayable over a period of6 to 1 0 y~ars after an initial grace period of 1 to 2 years. Typica:Ily,term loans provided by fthariCiafinstitutionsare repayable in equal semi-annual.instalments, whereas term loans granted by. commercial banks are

repayable in equal quarterly instalments. . _ . .' .

~ote that the :interest burden . declines over time: whereas the . pt:incipal repayment remains constant, This means that. the total debt servicing burden (c;onsi,sting of interest payment and principal repayment) declines over time. This. pattern of debt servicing burden, typical in India, differs from the pattern-obtaining in.western economies where debt is typically amortised in equal

periodic instalments.' . . ". . - . , '~'_':':" ,',},

The latter pattern is relativelymore acceptable to borrowers because it does not result 'in a debt servicing burden in earlier years. It has also been recommended hy the IntematioriaI R.",ri'J..fA .. Reconstruction and Development (popularly called the World Bank). However, presently financial institutions in India' do not follow the scheme of equal periodlc'amortisatlon. Yet theytiy to ensure, by suitably modifying the debt repayment schedule; Within-limitS, 'that the debt serV~clP.g burden

,is not very otfe_r6us. .' .,

Restrictive Covenants

i.:

"

" s.: ;'",

c, ..... " ""~ r ,",

":', .

-; • .:',.:" ..... :"-.',-'_: .',' :,"""_~" _ '"';'. .'. _::;, _".-,::. ,~,~.-]' .'~':"':""." .,.,,':, .':I'~·,·,.-.- .. : ', -:(_,_-,,·: _i~-·~t': ,~-~,.'';'"-t~~?;''::'r~;,-'':~:-A'~~;:---';'_:'-''~'''' I':~_ , •

In order to protect their interest, financial instittitionsgenefaliy impose reStricti.v~· ~ondi~i9nS on the

borrowers. While the specific set of restrictive covenantsdepends on the' nature 'o{the pioject~p,d

· the financial situation of the borrower, loan contracts often requirethat the borrowing firmril'b

. . ,', , .:_.~: - '.".~,_.~,_~--, ,~. ':-'-;:'~/'~_"','-: . ":-"'-}~¢?"'~1~

• Broad-base its board'ofdirectors and finalise its management set-up in'consultation:~tIi

and to the satisfaction, of the financial.institutions, . . .... ~-,

. • . Make arrangements' to bringaddltional funds- .in the form of unsecured ~iqa,ll$!,deposits" for

meeting overruns/shortfalls; .

• Refrain from undertaking any new project and/or-expansion or make-any investment without ". the prior approvaLoLthefmanciaLinstitutionsj ... " .-'. -,,~, ··Obtain clearances and licences from vaneus-government agencies;

';;'Repay'eXisting loanswith the concurrence of financial institutions; '1

• .Refra~\. from additionalborrowings or.s~eiftHe consent of flnancial Institutions for .additional·

borrowings; _ . . .' . y:,~

• Reduce the proportion of debt in its capital structure by .issuing additional eouitwanc

preference capital, .. /~~,;;.;:..:, ., /

i .• Limit:dts dividendp~¥~ent,to:·,a"certamrate or seek the :cons¢rlt of.Ji;r~~~[if1il~~~l>l

· ~ deelarezdivldend. at:a;;;;h.ighet:rate; ".\ ~

· L,_ .. "~!_J~~f.fgmJfQ!ll..q::atfug,Ju.;ttber,,e;Iw.Ig~~ndtScas.sets.; ..... '" ."'-'.' ··-_W' .... , , ,~"."_,._.,_~.o.,,~,·-,,,-,~

• Provide periodic information about its operatlons.. ti,>,r';vr,~1~'

• Limit the freedom of the promoters to dispose of their shareholding; and

,.Effect ol"ganisgtiqnalchanges and .appointsuitable .professlooal staff -. : ,"'. . .... '

; .. -,;:: .. .'

EvaJuatiQn.,:

~o'mM/iK,~'( f.q!rt oly!~~·::"r~rh.i.ioa~~ff~r, 'th;.fq4~win~. ~d~a~t~gestQ.th~. b'~rr~~~l'; .:. • .

'" ". "1ripost~taXtei'fus;' the :cost: onernfloans:~is '16WeftharitKe c<?st 6f~qultY'capitar of piefe'rerice

-,capita.tc:, ' .. ",'... '. ..,.," ' " f. """: .. :'; i:;;·C··':··: .,,: ·";.,:\".i., :,' "")j',','O; "",:".,.

!' . Term lo~ns do not result in dilution of control, as lenders do not'fiWe~the\rl~littcvvoie.

-', ~-::1~L; ~:j-.,-t.,:j-,\r :_~'.",, __ :. _:,::- ~ .: t:>-::'~_;,·3 -~,; '._ ~ _, .::._~:. .~.,. ,.> _ :,._,' .: .<' ._.1.;.)"~. _: ,':'j{",.,_. ,'_; ~ '. ":: ~ _: r~J. :.,;:. . ;-:;_"i ~_ "':' >, ";<"_, 't:, :' f':i ;.;.~ ':: .. ;..~' ,,;' .. c

McThc;;<U~aqvaQt4g~:>: pf teriu.JqariS . from the, hprrower's, po~tof view-are as.followsx.

:::»~, .. "";," .. ' .. ~,'~,~.~., ,~ ... ,.;,:,,>:.,.~.:,.,., .•. :; '\~:, .. ']'.""",'" .: - .' '.' .,' • ". '~~":',> . ,_' "", ', .

.'. . ; 'Th~.iriteiest'a'nd'pimdpal;repaylnenf are' 6bfigatoryIjaYhlentS."FaUt!tet<:;:In'e·erthese'paynients

')riay threaten the existence of the firm, ", \ ~ ... s v> i~' ..'.";' ,":;' .. ' '> ' .. .:

"Term' loan. ;cbritracts i cat&r~stti~tive ·c6v~naritS·'Wh.ith· maY~'.H~du<:e ~nag~rla~i fre~ilOlTI~ 'PUitlier,' they ehtitle' 'ilie:leriders ~t6'put 'therr"lloriIirlee(s) on the b6atd6f the 'borrowing

·compahy.; .'·L' . . ...•.. {!<' , ". ".. . . . . '.!;.. ", '. . . .'. . .... '" ",' '". '. .'

, 'T~tnHdaris 'increase' thcl' fliianCiil risk of me firin; This; iri' tiiri1; 'terids.id:rai~e th~' c05(of

"c''''''''''.' . '. ~,.,q, .. W.:ty" .. "c.a.p,,~ta,_,J' ..... , ' .>" .';;.':, s-: ;.;, ..••.•. ; ..•. ',' ':';

-, .,,'":";~: . ;._. . .,5; : ~ . <. ,.;.~. ',:; ,,-,_J •.. ~t-~ <r;; t~ >;;_ !T:~::,·::"::t..'~, ·;~·_\t31~'t

lehder'sPointo{,View!" Term .loans.appear-attractivenoithe' lender' f6t the'f61lbwirig 'teasohs:' i .•

. ~ . - . - ,~, ~' , , ~_ \, , I' .' •. , ,~ , . ~ ~,~-. ~ -, ~ ... ; ~~, ! ~ -<.' '

'j ~:... . Term l~af1S ea~n' a, 'fIXed' ~~t~.'i-9~ int~r~"si a~4 1i.a~e, ~ defi~i~~ ma~rfty p~~i~d. ,. " ",-'

• Teim loans represent ,secured Jiw;ljpg. ' .. '. _.. ...." , . ,. " . _.'

. Terin lo~uiscarrY si:;Vera(restri~ti{re c'ovenarits to :prdiectthe iilterest o.t tb.e,Jeticl~r~

.,' ..' .' -." . ...• .- . ' ."t."./,"._ ·".e '," -_, ..

The disadvantages to .the lender ofthetermloan are as follows:

-.,", ... '-.

•. . Term loans do not carry the right to vote. • . TergIloa.n:~·!lr~. nl?t represented by negotiable .securitles .. (ofcourse; if term loanscan b,C;:

.',,,s~~~~i;tfs,~,d~:~~)frnJ~hO'i{caij'be.;?Ver,c,<>#iej.':':' "" . ;:;' ,._,<: .:«, .,,' ,"

.i· .;._)_)";

We, have looked atthe.pros and cons Qfvari&\ls'f6htis:df'16rig4~r¥tln~hhtiIg?raBte:;i~!i'provides ;~i'sumin:irY:co'tnpafis'On'of theextehlafsQurc:es' ftom' di~:pb'lnt: i?fyiew "of tlW:'-'firrtt:·' t,'o" ~'.,

;;'~_~:,~;t.J.'.·:~~.';l(.. \ ... ~r~;:.:Ti_'~_'::f-':.,

,·Trable14.1 ', COnlp.ari$'()nofLong"lel'm'SijUrtI!S;9f)Fit,~nclng: '" ."

I • .-'~i;'~ ~ .~; -, ':": " -; •• ' -'IC- ~-·~(·f· -~'n! 1

::n';,',,';.i "~~i~;~~'

. -, -J;-~.'~:_::;.: .. .. ~-J'99":!!!!J~ ;~:

:./Rf!straiflt on:, ";:'?! .Ma~4tiak· i;' (;;,l[rMf/91JJ .'

Retained Earntngs High

, 11qy,ityCapitaL ..... ·:High'

Pre/Crence Capitat High

'7 Pe!!tm'Wfr{:4pital,\[~;' ....: i'Lo:w: .. · ' ... , i,

Term Loan's Low

Nil ·L'·Nlf';,'·;· :;','-

No Negligible"); I' -:;»-'N({,('{

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,t,Ji-glt.l1) ir~':.':· 1'.; ;.i;M0der:ate

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No

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Sources of:tun"g .. teim-ifiharr~~ i!J:.' '4'~1.3'''>

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SUMMARY

• Tlieptincipal sbtm:e~6ii&:fgitekf1n~te f6rtfirniare: ;retriili~dearn.ings, equitYtapi~l,

.prefere;nce capital, debenture capital, and, term.loans, .' .":,.. ..,; .... ;

• . Retained earnings represent the profits pJoughed hack inthe business.

• From the firm's pdiIit of view~etaiheclearnings represent a very convenient . source of ftnancingt-However-thismayIead to some inefficiency in its use .:

• Equity capital represents ownership capital 'as equity shareholders collectively ownthe" firm. Equity shareholders enjoy the rewards, as well as bear the risk, of ownership.

• The rights of equity shareholders consist of (0 the right to residual income, (ii) the right of control, (iii) the pre-emptive right to purchase additional equity shares issued by the firm, and (iv)the residual claim ever assets in the event of liquidation, .

• The advantages of equity capital are that it represents a permanent source of finance, . does not, carry any fixed burden, and ,enhances the creditworthiness of the firm. The" disadvantages, on the other hand, are that its cost is very high and issue of equity to outsiders causes.dilution of control.

'. . Ptef~r~nd:: capital repres~hts a hybrid form of financing-it partakes of some characteristics of equity and' some attributes of debt capital.'

• The features attached to preference' shares may vary along the following dimensions: cumulation of dividends, participation in surplus profits, redeemability, callability, and

convertibility. .

• Preference capital carries no definite legal obligation to pay dividends and enhances the creditworthiness of the firm. It is, hewever,a costly source of flnancing.

• Cumulative convertible preference (CCP) shares, introduced in 1985, carry a dividend rate of 10 per cent and are compulsorily convertible into equity shares.

• Akin to promissory notes, debentures are instruments for raising long-termdebt capttal, The obligation 'Of a company towards its debenture holders is similar to that of a borrower' who promises to p~y interest-and principal at specified times. Whc::n a debenture issue is made a trustee is appointed to protect the interest of debenture holders.

• Thanks 'to' the 'latitude 'that companies enjby in' designing debt instruments, a variety of debt instruments have been employed. They have put and call options; they have convertibility feature; they are sweetened with warrants; they carry floating rates of interest; , so on and so forth.

• Term leans represent a source of debt finance which is generally repayable in mere than one year butIess . than ten years. The' important features of term loans are: (a)'"They .: represent secuted borrowings, (b) The interest and principal repayment burden are definite -: obligations which are payable irrespective of the financial situation of the firm. (c) Term ., loanscarry a number of restrictive covenants with them ..

QUESTIONS

...

Describe jhe fellowtngterms-authorised share capital, is~ued share capit",i.a:n,i>pa~~ups~,~ .• ;i:

Define the following terms in relation to.an equity share: par value, issue price,book value,and .market value, . ." " . . . . . '''-' .' ., What is the equity shareholders' right to income and control?

..

4:' DiscUss -the pre-emptiverlglif6fequfty shareholders.

5. Evaluate equity capita]' from the point o£:v:ie\Vof the company and the' shareholders.

6. Discuss, the features of preference capital' '.

7. . Evaluate preference capital from the point of view of tJ;WO;::Qffipany and the shareholders,

8. . Discuss the characterlsticS of debenture capital. '.. ..•. ,.........

9. Evaluate the debenturec:apit~l frrifu'the 'pdint dfvi~ - dfihe td.rtpany and the debenfui~' holders.'

10. Discuss the important features of term'loans 'in: India. ' .. . . ": " , . '. , . -.

n. ' -Bvaluate retained earnmgsas asourceof long-term finance: ,! " .' ' .. r-

12. Give examples of some:innovativedebtinstroments offered'bycomparties 'lrrIndla»

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