Sources of capital finance

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Objective
To support its long term investment ,a firm
must find the means to finance them.
Equity & Debt represent the two broad
sources of finance .
Equity referred as share holders funds on
balance sheet in India, consists of equity
capital, retained earning & preference
capital.
Debt. referred to as loan funds on balance
sheet consists of term loan, debentures &
short term borrowing. (working capital)
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Equity capital
It represents ownership capital , as equity
shareholders collectively own the company.
They enjoy the rewards & bear the risk of
ownership.However their liabilities are limited
to their capital contribution .
Authorized capital: Amount of capital that a
company can potentially issue as per its
memorandum represents the authorized
capital.
Issued capital: The amount offered by the
company to the investors is called issued
capital.
Subscribed capital: The part of issued capital
which is subscribed by investors represents
the subscribed capital.
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Equity capital -Advantages

No compulsion to pay dividends, so

firm can skip equity dividends without
suffering any legal consequences.
Equity has no maturity date hence
firm has no obligation to redeem.
It provides cushion to lenders, it
enhances the creditworthiness of the
company.
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Equity capital -disadvantages
Sale of equity shares to outsiders dilutes
the control of existing owners.
The cost of equity capital is highest.The
rate of return required by equity
shareholders is generally higher than the
rate of return required by other investors.
Equity dividends are paid out of profit after
tax, where interest payments are tax
deductible expenses.This makes relative
cost of equity more.

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Internal accruals
It consists of depreciation charges and
retained earnings.
Depreciation represents the allocation of
capital expenditure to various periods over
which the capital expenditure is expected
to benefit the firm.
Retained earnings are that portion of equity
earnings (profit after tax less preference
dividends) which are ploughed back in the
firm.It is sacrifice made by equity
shareholders, they are referred to as
internal equity. 6
Internal accruals-advantages
It is readily available funds internally.They
do not require talking to outsiders.
It eliminates issue costs & losses on
account of under-pricing as compared to
externally equity.
There is no dilution of control when a firm
relies on retained earning.
Stock market normally views an equity
issue with skepticism where retained
earnings do not carry any negative
connotation.
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Internal accruals-disadvantages

The amount that can be raised by

way of retained earnings may be
limited.
The opportunity cost of retained
earnings is quite high.

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Preference capital

It is a hybrid form of financing.

It resembles equity in one way &
debentures in several ways.
Preference dividends is not an
obligatory payment.
It is payable only out of distributable
profits.
Is not a Tax deductible payments.
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Preference capital-advantages

No legal obligation to pay

It is part of net worth so it enhances
creditworthiness to firm.
In normal circumstances there is no
voting power to preference capital, so
no dilution of control.

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Preference capital-disadvantages

Compared to debt capital, it is very

expensive source of financing because
dividends paid to pref.capital is not tax
deductible expenses.
Skipping of payment of dividends adversely
affect the image of the firm in capital
market.
They acquire voting rights, if the company
skips preference dividend for a certain
period.

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Term loans
Firms normally obtain long term debt mainly
by raising term loans or issuing debentures. It
is a primary source of finance for private as
well as public firm.
It is normally repayable in less than 10 years.
Features are:
(1) It is given in rupee loans as well as foreign
currency term loans.
(2) It is secured borrowing .
(3) It has definite obligations that are payable
irrespective of financial condition of the
firm.
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Debt financing-advantages
Interest on debt is a tax deductible
expense
It does not result in dilution of control
because they are not entitled to vote.
Issue cost is lower than equity
The burden of servicing debt is generally
fixed in nominal terms.It provides
protection against high unanticipated
inflation.

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Debt financing-disadvantages
Debt financing entails fixed interest and
principal repayment obligation. Failure may
result in financial embarrassment & even
lead to bankruptcy.
It increases financial leverage which in turn
increase cost of equity.
Debt contracts impose restrictions which
lead firms to put limits on financial &
operating flexibility.

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Debentures

It Is a viable alternative to term loans.

Debenture holders are creditors of
company.
Debentures provides more flexibility
than term loans as they offer greater
variety of choices with respect to
maturity, interest rate, security &
repayment.
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Comparison
cost Dilution of risk Restraint
control on mgt
freedom

Equity High Yes Nil No

Retained High No Nil No

earning
Pref. Capital High No Negligible No

Term Loans Low No High Moderate

Debt. Low No High Some

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