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Unit I

Chapter 2
Sources of finance
The sources from which a business meets its
financial requirements can be classified as
follows:

1. According to period
A. Long term sources i.e. shares, debentures, long-
term loans etc

B. Short term sources i.e. advances from
commercial banks, public deposits, advances
from customers and trade creditors etc

2. According to ownership

A. Own capital i.e. share capital, retained
earnings and surpluses etc

B. Borrowed capital i.e. debentures, public
deposits and loans etc

3. According to source of generation

A. Internal sources i.e. retained earnings and
depreciation funds etc

B. External source i.e. securities like shares and
debentures, loans, etc

Equity financing
They represent the ownership position in a
company.

The holders of the ordinary shares, called
shareholders, are the legal owners if the
company.

Ordinary shares are also called permanent
capital since they dont have a maturity period.

An ordinary share is also known as variable
income security.



Features of ordinary shares

Claim on income(last)

Claim on assets(last)

Right to control (voting rights)

Pre-emptive rights (right issues)

Limited liability

Debenture financing
A debenture is a long term promissory note
for raising loan capital.

The firm promises to pay interest and
principal.

The purchasers of debentures are called
debenture holders.

Features of debentures

Interest rates (fixed, tax deductible, legal
binding)

Maturity(fixed)

Sinking fund

Indenture (debenture trust deed between
company and the trustee)


Security(mostly secured by companys assets)

Claims on income (first position)

Claims on assets (first position)

Preference financing
Preference shares are those shares which carry
preferential rights over other shares.

It is called a hybrid security.

It is similar to ordinary share in that

No legal obligation to pay dividend.

Not tax deductible.

In some cases, it has no fixed maturity date.


It is similar to debentures in that

Dividend rate is fixed.

Do not share in the residual earnings.

Claims on income and assets prior to ordinary
shareholders.

Features of preference share

Claim on income and assets(middle position)

Fixed dividend

Cumulative dividend(pay all dividends)

Redemption

Sinking fund


Call feature(buy back of shares at call price)

Participation feature(in extraordinary profits)

Voting rights(may or may not)

Convertibility

Loan financing
A loan is the purchase of the present use of
money with the promise to repay the amount in the
future according to a pre-arranged schedule and at
a specified rate of interest.

Credit is extended under a formal loan
arrangement.

Use to finance your permanent working capital,
purchase of new equipment, construction of
buildings, business expansion, refinance existing
debt and business acquisitions.
Projected profitability and cash flow from
operations are two key factors lenders consider
when making term loans.

Debt originally scheduled for repayment in more
than 1 year, but generally in less than 10 years.

Usually payments that cover both interest and
principal are made quarterly, semiannually, or
annually.

Borrower is also required to pay legal expenses (loan
agreement)




Interest rates are either (1) fixed or (2)
variable depending on changing market
conditions -- possibly with a floor or ceiling.

The borrower can tailor a loan to their specific
needs through direct negotiation with the
lender.

Term loan financing is more readily available
over time making it a more dependable
source of financing than, say, the capital
markets.
Project financing
Project finance is the long
term financing of infrastructure and industrial
projects based upon the projected cash flows
of the project rather than the balance sheets
of the project sponsors.

Project financing is substantially more
expensive due to its non recourse nature.

There is a high debt equity ratio in financing
of projects.

Project finance is different from traditional
forms of finance because the financier
principally looks to the assets and revenue of
the project in order to secure and service the
loan.

It avoids any negative impact of the project on
the credit standing of the sponsors.


Loan syndication
A syndicated loan is one that is provided by a
group of lenders and is structured, arranged,
and administered by one or
several commercial banks or investment
banks.

Typically there is a lead bank or underwriter
of the loan, known as the "arranger", "agent",
or "lead lender".

This lender may be putting up a proportionally
bigger share of the loan, or perform duties
like dispersing cash flows amongst the other
syndicate members and administrative tasks.

The main goal of syndicated lending is to
spread the risk of a borrower default across
multiple lenders (such as banks) or
institutional investors like pensions funds and
hedge funds.



Book Building
Book Building is essentially a process used by
companies raising capital through Public
Offerings-both Initial Public Offers (IPOs) or
Follow-on Public Offers ( FPOs) to aid price
and demand discovery.

It is a mechanism where, during the period for
which the book for the offer is open, the bids
are collected from investors at various prices,
which are within the price band specified by
the issuer.

The process is directed towards both the
institutional as well as the retail investors.
The Issuer who is planning an offer nominates
lead merchant banker(s) as 'book runners'.
The Issuer specifies the number of securities
to be issued and the price band for the bids.
The Issuer also appoints syndicate members
with whom orders are to be placed by the
investors.
The syndicate members input the orders into
an 'electronic book'. This process is called
'bidding' and is similar to open auction.

The book normally remains open for a period of 5
days.
Bids have to be entered within the specified price
band.
Bids can be revised by the bidders before the book
closes.
On the close of the book building period, the book
runners evaluate the bids on the basis of the
demand at various price levels.
The book runners and the Issuer decide the final
price at which the securities shall be issued.
Allocation of securities is made to the successful
bidders. The rest get refund orders.

New financial institutions and
instruments

Some of the new financial institutions and
instruments will be discussed in the next few
slides:

Factoring
Factoring is a type of financial service whereby a
firm sells or transfers title to its account
receivable to a factoring company, which than
acts as a principal, not an agent.

Factors actually buy your receivables and rely
on their own credit and collection expertise.

Essentially, your customers become their
customers.

Payments are made directly to the factor by
your buyer.

The SBI Factors and Commercial
Services(Pvt.) Ltd. was the first factoring
company allowed by RBI in 1991.

Factoring provides short term finance to the
company.
It is employed to finance both domestic and
export businesses.
It encompasses financing, administration of
the sales ledger, assumption of credit risk,
recovery of debts and rendering consultancy
services.
The factor has to wait till the due date for
getting payments
Venture capital
One problem many new businesses face is
raising sufficient capital.
A business in its primary phase will also face a
difficult challenge getting a bank loan.
Venture capital firms offer capital in exchange for
equity in a company.
This type of financing is ideal for new
businesses since venture capital firms focus
mainly on the future prospects of a company
when banks use past performance as a primary
criteria.

VC refers to the financing of new high risk
ventures promoted by qualifies entrepreneurs
who lack the necessary experience and funds
to give shape to their ideas.

VC was started in USA and in India it was
initiated by GOI and was first administered by
IDBI.

It is a long term investment in growth
oriented small and medium firms
The VC institutes provide not only capital but
also business skills to investee firms.

VC financing involves high risk-return
spectrum.

Such institutions disinvest the holdings either
to the promoters or in the market.
Credit rating
A credit rating estimates the credit worthiness
of an individual, corporation , or even a
country.
It is an evaluation made by credit bureaus of a
borrowers overall credit history.
It is also known as an evaluation of a potential
borrower's ability to repay debt, prepared by
a credit bureau at the request of the lender.
Credit ratings are calculated from financial
history and current assets and liabilities.

Objectives
It provides guidance to investors or creditors
in determining a credit risk associated with
debt instrument or credit obligation.
Establishes a link between risk and return.
Helps investors in making investment
decisions.
Credit rating shows the exact worth of the
organization.


Credit rating and information services of
india ltd.(CRISIL). was set up in 1987 as the
first credit rating agency followed by ICRA Ltd
i.e . Investment Information and Credit Rating
Agency of India ltd in 1991 and CARE i.e.
Credit Analysis and Research ltd in 1994.

In India, SEBI regulates all the credit rating
agency
Certificate of Deposit
CDs are short-term borrowings in the form of
Promissory Notes having a maturity of not less than
15 days up to a maximum of one year.

They are like bank term deposits accounts. Unlike
traditional time deposits these are freely negotiable
instruments and are often referred to as Negotiable
Certificate of Deposits
CDs can be issued by all scheduled commercial
banks except RRBs
Minimum period 15 days
Maximum period 1 year
Minimum Amount Rs 1 lac and in multiples of Rs. 1
lac
CDs are transferable by endorsement

Commercial Paper
Commercial Paper (CP) is an unsecured money
market instrument issued in the form of a
promissory note by the high worth
corporate.

The tangible net worth of the company, as per
the latest audited balance sheet, is not less than
Rs. 4 crore.

All eligible participants should obtain the
credit rating for issuance of Commercial Paper
CP can be issued for maturities between a
minimum of 15 days and a maximum up to
one year from the date of issue.
If the maturity date is a holiday, the company
would be liable to make payment on the
immediate preceding working day.
CP is issued to and held by individuals,
banking companies, other corporate bodies
registered or incorporated in India and
unincorporated bodies, Non-Resident Indians
(NRIs) and Foreign Institutional Investors (FIIs).
Global depository receipt
Indian companies are allowed to raise equity
capital in the international market through
the issue of GDR/ADRs/FCCBs.
These are not subject to any ceilings on
investment.
An applicant company seeking Government's
approval in this regard should have a
consistent track record for good performance
(financial or otherwise) for a minimum period
of 3 years.
Indian companies are permitted to issue its
Rupee denominated shares to persons
outside India for the purpose of issuing Global
Depository Receipts (GDRs) and/ American
Depository Receipts (ADRs).
Issuer is the company that plans to tap the
foreign market through the global issue
mechanism (the Issuer).
The lead manager is the person responsible
for marketing the issue .

GDR is a bank certificate issued in more than
one country for shares in a foreign company.
The shares are held by a foreign branch of an
international bank.

The shares trade as domestic shares, but are
offered for sale globally through the various
bank branches.



Depositories
Depositories are companies registered under
the companies act ,1956 and registered with
SEBI in accordance with the provisions of SEBI
n(Depositories and Participants) Regulations,
1996.
They keep the physical custody of share
certificates leading to immobilization of shares
to be followed by book entry system of trading
in future.
The major players in the depository system
are depositories, participants, issuers and
clients.
The investor/client has to approach the
participant either to avail the depositorys
services or to get the securities
dematerialised.
Depository participants are persons dealing
directly with the depository on their own
account or for their clients.
Depository participant is an important link
between the investor and the depository.
An investor who wishes to avail the services
will have to open an account with the
depository through a depository participant.
The depository participant can be commercial
banks, financial institutions , stock exchanges
etc.