Sources of Long Term Finance

 Debentures
 Preference Shares
 Methods of issuing securities
 Term-Loans
 Internal Accruals
 Deferred Credit
 Leasing and hire purchase
 Government Subsidies
 Sales tax departments and exemptions

Shares
Shares: Ordinary shares represent the ownership position in a company. The
capital representing ordinary shares is called equity capital or share capital.
Ordinary shares are the source of permanent capital since they do not have a
maturity date and the capital contributed by ordinary shares is called equity
capital or share capital. The holders of ordinary shares are the legal owners of the
company. The shareholders are entitled for dividends for the capital contributed
by them. But the amount of dividend or rate of dividend is not fixed and is
decided by the company’s board of directors.
Features of ordinary shares:
The special features of ordinary shares that distinguish them from other securities
are:
1. Residual claim on income: Ordinary shareholders have a residual
ownership claim. They have a claim to the residual income, after expenses,
interest charges and taxes and preference dividend have been paid. The
residual income may be retained back or paid to the shareholders as
dividends. A company is not under legal obligation to distribute dividends
out of the available earnings.
2. Residual claim on assets: When liquidation occurs on account of business
failure or sale of business, the amount left out of the realized value of
assets, after paying debt-holders and preference shareholders, is paid to
ordinary shareholders.
3. Right to control: Ordinary shareholders have the legal powers to elect
directors on the board. They can control the management of the company
through their voting rights. They are required to vote on a number of
important matters like election of directors, alteration of the memorandum
of association etc. Each ordinary share carries one vote.
4. Pre-emptive right: The pre-emptive right entitles the shareholder to
maintain his proportionate share of ownership in the company. The law
grants shareholders the right to purchase new shares in the same
proportion as their current ownership.
5.Limited liability: Ordinary shareholders are the true owners of the company, but
their liability is limited to the amount of their investment in shares.
Advantages of raising finance through equity:

1. Permanent capital: Equity capital is a permanent capital and is

available for use as long as the company exists.
2. Borrowing base: Equity capital increases a firm’s financial base. By
issuing ordinary shares, a company increases its financial capability.
3. Payment of dividends: Since a company is not obliged to pay
dividends, it has the option of reducing or suspending payment of
dividends in case of financial difficulties.
Disadvantages of equity:
1. Higher cost of capital: Shares have a higher cost of capital
compared to other sources of long-term finance because:
a. Dividends paid to shareholders are not tax-deductible;
b. Floatation costs on ordinary shares are higher than those involved in
case of debt.
2. Riskier source of finance: Due to uncertainty associated with
dividend and capital gains, ordinary shares require a higher rate of return.
This makes equity capital the costliest source of finance.
3. Dilution of ownership: The issuance of ordinary shares leads to
dilution of control.

Preference Shares:
Preference share is a hybrid security as it has the features of both ordinary shares
and debentures.
Features of Preference Shareholders

Features similar to equity shares:

i. Payment of dividends is not a legal obligation: Preference
shareholders do not have the power to force the company to pay
dividends. However, in India, most of the preference shares carry a
cumulative dividend feature, according to which all the unpaid preference
dividend must be paid before any ordinary dividends are paid.
ii. Dividends are not tax-deductible: The preference dividends are not
deductible for tax purposes.
iii. Redemption: Irredeemable preference shares don’t have a maturity
date just like the equity shares.
ADVANTAGES OF PREFERENCE SHARES
1. Fixed dividend payments: The preference dividend payments are
restricted to the stated amount and the preference shareholders do not
participate in the excess profits unlike the ordinary shareholders.
2. Preference shareholders do not have voting rights except in case any
dividend arrears exist.
3. Preference shares provide some flexibility to the company since they can
postpone the payment of dividends
DISADVANTAGES OF PREFERENCE SHARES

1. Dividends paid to the preference shareholders are not tax-deductible.

2. Although payment of dividends can be postponed in the case of cumulative
preference shares, it might adversely affect the image of the firm.

Debentures:
A debenture is a long-term promissory note for raising loan capital. Debenture
holders are the creditors of the firm.
Features of a debenture:

1. Fixed income security: The interest payments are made to the

debenture holders at a fixed interest rate also known as the contractual
rate of interest. Payment of interest is legally binding on a company.
Debenture is tax deductible for computing the company’s corporate tax.
2. Maturity: Debentures are issued for a fixed period of time. The maturity
of a debenture indicates the duration at which the company will redeem
the par value to debenture holders.
3. Indenture: An indenture or debenture trust deed is a legal agreement
between the company issuing the debentures and the debenture trustee
who represents the debenture holders. Generally a financial institution, or
a bank or an insurance company is appointed as a trustee to protect the
interest of the debenture holders.
4. Security: Debentures are classified into two categories:

Secured Debentures: A secured debenture is secured by a lien on the company’s

specific assets. If the company defaults, the trustee can seize the security on behalf
of the debenture holders.

Unsecured Debentures: Debentures that are not protected by any security are
called unsecured or naked debentures.
5. Yield: The current yield on a debenture is the ratio of the annual
interest payment to the debenture’s market price.

The YTM is the discount rate that equates the present value of the interest
and principal payments made over the life of the debenture with the current
market price of the debentures.

Claim on assets and income: Debenture holders have a claim on the company’s
earnings and priority over the shareholders. Hence, debenture interest has to be
paid before paying any dividends to preference and ordinary shares. In case of
liquidation also, the debenture holders have a claim on assets and priority over the
shareholders. The secured debenture holders have a priority over the unsecured
debenture holders
CLASSIFICATION OF DEBENTURES
A debenture can be convertible or non-convertible. A convertible debenture is one
which can be converted partly or fully into shares at a specified period of time.
Debentures can be converted into the following categories:

a. Non-Convertible Debentures (NCDs): These are debentures which do not have

the feature of conversion. They are payable on maturity.
b. Fully Convertible Debentures (FCDs): These debentures are converted into
shares as per the terms of issue with regard to price and time of conversion.
Generally, the interest rate on FCDs is less than that on NCDs as they have
the additional feature of convertibility to equity shares attached to them.
c. Partly Convertible Debentures (PCDs): These debentures have a convertible
part and a non-convertible part with the advantages of both being blended
into one.

Advantages of debentures as a long-term source of finance:

1. Less expensive: Compared to equity, financing debentures involves less cost

because:

a. They involve fixed interest payments; so investors consider them to be less

risky and therefore, require a lower rate of return;
b. Interest payments are tax-deductible.

2. Dilution of ownership: Debenture-holders are creditors and not owners. They

are not entitled to any voting rights.
3. Fixed payment of interest: Debenture-holders do not participate in the
extraordinary earnings of the firm and payment in their case is limited to the
interest payment.

Reduced real obligation: In periods of inflation, debenture issue benefits the firm as
the obligation of paying interest and principal are fixed and they decline in real
terms
Disadvantages of debentures as a long-term source of finance
1. Obligatory Payments: The payment of interest and repayment of
principal are a legal obligation for the company and the company might be
forced even into liquidation if it does not pay dividends.
2. Financial risk: Debentures result in increase in financial leverage and
this might be disadvantageous to firms having fluctuating sales and
earnings.
3. Cash outflows: Debentures should be redeemed at maturity, which
involves substantial cash outflows.
4. Restrictive covenants: Debenture indenture may contain restrictive
covenants which may limit the company’s operating flexibility in future.
Similarities between preference shares and debentures:
i. Dividend rate is fixed: The preference dividend rate is fixed and is
expressed as a percentage of the par value. The amount of preference
 dividend will thus be equal to the dividend rate multiplied by the par
value.
ii. Preference shareholders don’t have a share in the residual earnings:
Preference shareholders do not have voting rights and they cannot
participate in extraordinary profits earned by the firm. However,
preference shares might have participation feature which entitles them to
participate in extraordinary profits and in certain cases, companies can
issue preference shares with voting rights.
iii. Claims on income and assets: Preference shares have a prior claim
on the company’s income, i.e. the company has to pay the preference
dividend before paying the dividend on ordinary shares. It also has a prior
claim, as compared to ordinary shares, on the assets of the company in
the event of liquidation.
iv. Sinking fund: Just as in the case of debentures, a sinking fund
provision may be created to redeem preference shares. The fund set aside
for this purpose may be used either to purchase preference shares in the
market to buyback (i.e. call) the preference shares.
Convertibility: Just like debentures, preference shares may be convertible and non-
convertible. A convertible preference shareholder can convert his/her preference
shares either partly or fully into ordinary shares at a specified price during a given
period of time.

METHODS OF ISSUING SECURITIES:

Following are some ways in which a company can issue securities to raise capital:
1. Public Issue: Public issue of equity implies raising share capital
directly from the public. The firm should appoint a SEBI registered
Category-I merchant banker (also known as lead manager). The merchant
banker will be responsible for all pre and post-issue activities; interactions
with other intermediaries and statutory bodies like Registrar of Companies
(ROC), SEBI etc; preparation of prospectus that contains information about
the company, promoters and the details required by the Company Law.
Underwriting of issue, promotion of issue, obtaining statutory clearances,
final allotment of the shares are certain other activities involved in the
public issue of shares.
2. Rights Issue: It involves selling of ordinary shares to the existing
shareholders of the company. As per Section-81 of the Companies Act, 1956, a
company should offer additional equity capital to the existing shareholders on a
pro-rata basis. Shareholders through a special resolution can forfeit this pre-
emptive right. Those shareholders who renounce their rights are not entitled for
additional shares. Shares becoming available on account of non-exercise of rights
are allotted to shareholders who have applied for additional shares on a pro-rata
basis. Any balance of shares left after issuing the additional shares can be sold in
the open market.

3. Private Placement: Private placement involves sale of shares (or

other securities) by a company to a few selected investors, particularly the
institutional investors like, Unit Trust of India (UTI), Life Insurance
Corporation (LIC), etc. A merchant banker is appointed by the company to
 establish network with the institutional investors and negotiate the issue
price. This method is particularly useful when small amount of funds are
issued. In comparison to public issue, it is less expensive and takes less
time to raise funds.
4. Bought-out Deals (BOD): In this case, the company initially places
the equity shares with a sponsor, who will later offload these shares to the
public through the OTCEI (Over the Counter Exchange of India) or through
a public issue. Faster access to funds and lower issue costs are the
advantages of this method. Also, companies which do not satisfy the
conditions laid down by SEBI for premium issues may issue their shares at
a premium through the BOD method.
5. Euro-issues: Companies can now float their stocks in the global
capital markets for meeting their requirements for funds at lesser costs
and with reduced procedural formalities. Companies can raise funds by
issuing instruments like Global Depository Receipt (GDR), Euro Convertible
Bonds (ECB) etc. These instruments are issued abroad and are traded on a
foreign stock exchange.
For example, a number of companies, particularly in developing countries, raise
funds through global depository receipts. Depository receipts represent the claims on
the shares of a company and are issued by a depository (usually an international
finance firm) to investors in developed countries. Depository is an intermediary
between the company and depository receipt holders. He receives the dividends from
the company and then converts the same into receipt holders’ currency and
distributes it to them. Depository receipts issued in the US are called American
Depository Receipts (ADRs).
TERM-LOANS

A company’s debt-capital may comprise either debentures (or bonds) or term

loans. Term loans are sources of long-term debt with a maturity of more than one
year, obtained directly from the banks and financial institutions. They are
generally obtained for financing large expansion, modernization or diversification
projects. The method of financing through term-loans is also referred to as project
financing.
Features of term-loans:
1. Maturity Period: Generally financial institutions provide term-loans
for a period of 6 to 10 years; and a grace period (i.e. moratorium period)
of 1 to 2 years may also be granted in certain cases. Commercial banks
advance term loans for a period of 3 to 5 years.
2. Lower costs of financing: Raising term-loans involves lesser costs as
compared to those involved in issuing equity or debentures. This is
because term-loans do not involve any underwriting commission and other
floatation costs.
3. Security: Term loans are always secured. They can be secured in two
ways:
a. Primary security: In this case, security is provided specifically by the
assets that have been acquired using the term-loan.
b. Secondary or collateral security: In this case, the term loans are
secured by the firm’s current and future assets.
 4. Restrictive Covenants: Term-loans are protected further by adding a
number of restrictive covenants. These covenants are applied specially
in the case of financially weak firms. These covenants can be categorized
as:
a. Asset-related covenants: By introducing such a covenant, the lender
expects the firm to maintain a prescribed level of asset base. Restrictions
relating to maintenance of a minimum working capital, a required level of
current ratio and prior approval of the lender for selling fixed assets might
also be included.
b. Liability related covenants: The lender may restrict the firm from
raising any additional debt or repay any existing loan, without his prior
approval. Restrictions related to reduction of debt-equity ratio and limiting
the freedom of promoters to dispose off their holdings in the company also
come under this category of covenants.
c. Cash-flow related covenants: Restrictions related to payment of cash
dividends, capital expenditures, salaries and perks of managerial staff etc.
are examples of cash-flow related covenants.
Control-related covenants: In certain cases, where substantial financial help is
provided by way of term-loans, the financial institution may appoint a nominee
director in the board of directors of the firm. The duty of the nominee director is to
safeguard the interest of the financial institution.

5. Repayment schedule: The loan amortization schedule or the

repayment schedule specifies the time for paying interest and principal.
The interest charges are tax-deductible in the hands of the borrowing firm.
There are two ways by which loan repayment can be made in installments:
i. Payment by unequal installments: Principal is repaid in equal installments
and the interest is paid on the outstanding loan amount. Thus, in this case
the interest payment will decline over years and the total loan payment
(interest + principal payment) will not be equal in each period.
Payment by equal installments: In this case, equal loan installments (including
interest and principal payments) are made. The amount of installment can be
computed by using the capital recovery factor

Advantages of term-loans to the firm:

1. The post-tax cost of term loans is less than that for equity and
preference shares. This is because the interest paid on term-loans is tax-
deductible.
2.Term-loans do not lead to any dilution in the existing ownership of the firm

Disadvantages of term-loans to the firm:

1. Firm is legally obliged to make the interest payments and repayment
of the principal. But in situations where the firm has low earnings, these
obligatory payments may threaten the solvency of the firm.
The restrictive covenants included in the term-loan contract might hinder the firm’s
operating flexibility and might hinder its future plans.
INTERNAL ACCRUALS:

Internal accruals in the form of depreciation charges and retained earnings are
also treated as a source of long-term financing. Depreciation charges can be used
for replacement of old machinery whereas retained earnings can be used to fund
profitable investment opportunities.
Advantages of using internal accruals as a source of finance:
1. It is less expensive compared to other sources of finance because of
absence of issue expenses.
2. No dilution of control is involved.
Disadvantages of using internal accruals as a source of finance:
1. In case of projects involving large investments, internal accruals will
not be of much use as it offers only limited funds.
Retention of earnings implies that the earnings are not paid to the shareholders in
the form of dividends and this might lead to a higher opportunity costs

GOVERNMENT SUBSIDIES

In order to encourage industries in backward areas, the central and state

governments provide subsidies to them. The central government has classified the
backward areas into three districts A, B and C. The central subsidy applicable to
the industrial projects in these states is as follows:
1. Category A districts get a subsidy of 25% of the fixed capital investment
subject to a ceiling of Rs.25 lakh.
2. Category B districts get a subsidy of 15% of the fixed capital investment
subject to a maximum limit of Rs.15 lakh.
3. A subsidy of 10% of the fixed capital investment is applicable to the
category C districts, with a maximum limit of Rs.10 lakh.
The districts entitled for the state subsidy schemes are different from those
covered under central subsidy schemes. The state subsidies vary from 5% to 25%
of the fixed capital investment in the project, with the maximum limit varying
from Rs. 5 lakh to Rs. 25 lakh.
DEFERRED CREDIT: Under this method, the supplier of the machinery provides
credit facility to the buyer by allowing him to purchase the asset by paying in
installments that are spread over a period of time. The Bill rediscounting scheme,
Supplier’s line of credit, Seed capital assistance are some examples of deferred
credit schemes.
SALES TAX DEFERMENTS AND EXEMPTIONS: Sales tax deferments and
exemptions are incentives provided by the state to attract industries.
Under the sales tax deferment scheme, the payment of sales tax on the sale of
finished goods may be deferred for a period ranging between 5-12 years. In other
words, the project gets an interest free loan, represented by the quantum of sales
tax deferment period.
Under the sales tax exemption schemes, some states exempt the payment of
sales tax applicable on the purchase of raw materials, packing and processing
materials which are used for manufacturing purposes. The exemption is provided
 for a period of 3-9 years depending on the state and the specific location of the
project.
LEASING AND HIRE PURCHASE:
Traditional financing methods are related to the liability side of the balance sheet.
Traditional financing methods like equity and debt are quite expensive. Equity
becomes an expensive method of financing because of decreasing corporate
earnings and low price-earning ratios. And high rates of inflation make long-term
debt an expensive source of finance. Alternatives related to the asset side of the
balance sheet may lower the cost and redistribute the risk. Asset-based financing
like leasing and hire purchase, use assets as direct security.
Lease is a contract between a lessor, the owner of the asset and a lessee, the
user of the asset. As per this contract, the owner gives the user the right to use
the asset over an agreed period of time for a consideration called the lease rental.
The lessee pays the rental to the lessor as regular fixed payments over a period of
time at the beginning or end of a month or quarter, half-year, or a year.
Sometimes, the amount and timing of payment of lease rentals can be tailored to
the lessee’s profit or cash flows. Although the lessor is the legal owner of the
asset, the lessee bears the risk and enjoys the returns. Leasing separates
ownership and use as two different economic activities, and facilitates asset use
without ownership.
In hire-purchase financing, there are three parties: the manufacturer, the hiree
and the hirer. The hiree may be a manufacturer or a finance company. The
manufacturer sells the asset to the hiree who sells it to the hirer in exchange for
the payment to be made over a specified period of time. A hire purchase
agreement between the hirer and the hiree involves the following three
conditions:
i. The owner of the asset (hiree or manufacturer) gives the possession
of the asset to the hirer with an understanding that the latter will pay the
agreed installments over a specified period of time.
ii. The ownership of the asset will transfer to the hirer on the payment
of all the installments.
iii. The hirer will have the option of terminating the agreement any time
before the transfer of ownership of the asset.
Thus for the hirer, the hire purchase agreement is like a cancelable lease with a right
to buy the asset. The hirer is required to show the hired asset on his balance sheet
and is entitled to claim depreciation, although he does not own the asset until the full
payment has been made. The payment made by the hirer can be classified into two
parts: interest charges and repayment of principal. The hirer, thus gets a tax relief
on interest paid and not on the entire payment.