Chapter 17

SOURCES OF LONG-TERM FINANCE

Centre for Financial Management , Bangalore

OUTLINE Equity Capital Internal Accruals Preference Capital

Term Loans
Debentures Comparative Picture
Centre for Financial Management , Bangalore

EQUITY CAPITAL
Equity capital represents ownership capital as equity shareholders collectively own the company. They enjoy the rewards and bear the risks of ownership Authorised capital
Issued capital Subscribed capital

Paid-up capital
Par value Issue price Book value Market value
Centre for Financial Management , Bangalore

RIGHTS OF EQUITY SHAREHOLDERS Right to Income

Right to Control
Pre-emptive Right Right in Liquidation

Centre for Financial Management , Bangalore

PROS AND CONS OF EQUITY CAPITAL Pros

No compulsion to pay dividends

No maturity date Enhances creditworthiness Cons Dilution of control

High cost
Centre for Financial Management , Bangalore

INTERNAL ACCRUALS Internal accruals of a firm consist of depreciation amortisation, and retained earnings.

Pros
Readily available

No dilution of control
Cons Opportunity cost is high
Centre for Financial Management , Bangalore

PREFERENCE CAPITAL

Preference capital represents a hybrid form of financing. It

partakes some characteristics of equity and some attributes of debt.
Equity Dividend not an obligatory payment Dividend not a tax-deductible No voting right Debt Dividend rate is fixed

payment
Centre for Financial Management , Bangalore

PREFERENCE CAPITAL Pros No legal obligation to pay dividends

Enhances creditworthiness
No dilution of control

Cons
Costly source Skipping preference dividends adversely affects image Voting rights under certain conditions
Centre for Financial Management , Bangalore

TERM LOANS

Term loans, given by financial institutions and banks,

represent a source of debt finance which is generally

repayable in less than 10 years. They are employed to finance fixed assets and working capital margin

Centre for Financial Management , Bangalore

FEATURES OF TERM LOANS

Currency Financial institutions give rupee term loans as well as foreign currency term loans
Security Term loans typically represent secured borrowing. Usually, assets which are financed with the term loan provide the prime security. Other assets serve as collateral security. Interest Financial institutions charge an interest rate that is related to the credit risk of proposal. Principal Repayment Generally, the principal amount is repayable in equal semi-annual or quarterly instalments over a period of 4-8 years after an initial grace period of 1 to 2 years. Restrictive Covenants To protect their interest financial institutions impose restrictive conditions on the borrower.
Centre for Financial Management , Bangalore

FEATURES OF DEBENTURES Trustee Security Interest Rate Call and Put Feature Convertibility

Centre for Financial Management , Bangalore

PROS AND CONS OF DEBT FINANCING Pros Lower post-tax cost

No dilution of control
Disciplining effect

Cons
Fixed debt servicing burden Raises the cost of equity Imposes restrictions
Centre for Financial Management , Bangalore

COMPARATIVE PICTURE

Cost

Dilution of control Yes No No No No

Risk

Restraint on managerial freedom No No No Moderate Some

Equity capital Retained earnings Preference capital Term loans Debentures

High High High Low Low

Nil Nil Negligible High High

Centre for Financial Management , Bangalore

SUMMING UP Equity capital represents ownership capital Internal accruals consist of depreciation, amortisation, and retained earnings Preference capital represents a hybrid form of financing

Term loans and debentures are the most important sources of long-term debt finance
Cost, dilution of control, risk, and restraint on managerial freedom are the key criteria used for evaluating the various sources of long-term finance
Centre for Financial Management , Bangalore