SOURCES OF LONG-TERM FINANCE

Introduction
The long-term investment decisions of a firm involve the acquisition of long-term /fixed assets. They have to be financed with long-term sources of finance. The mean sources of long-term finance fall into two broad groups: (i) Internal and (ii) External.
The internal sources of long-term funds are normally used to replace the concerned assets. In a way, therefore, the only internal source of financing expansion / growth / diversification for such companies are retained earnings.

Internal Source: Retained Earnings

As a source of long-term finance, retained earnings have some commendable features. They are readily available to the firm. Flotation / issue costs and losses on account of under pricing associated with external equity are avoided / eliminated. There is no dilution of control of the firm by the existing shareholders. However, the magnitude of financing through retained earnings may by limited and variable / unstable / fluctuating primarily as a result of the quantum and variability of profits after taxes. It has, moreover, high opportunity cost in terms of dividends foregone by the shareholders.
Thus, retained earnings have both positive and negative attributes from the viewpoint of the firm as well as the shareholders / investors and should be employed with caution.

External Sources of Finance

The external sources of long-term funds comprise of equity capital, term loans, debentures / notes / bonds including innovative debt instruments, hybrid sources such as preference capital, convertibles, warrants and options, leasing and hire-purchase finance and Venture capital financing.

A. Equity Shares
Equity /ordinary share capital represents ownership capital and its owners equity-holders / ordinary shareholder share the reward and risk associated with the ownership of corporate enterprises. The ordinary shares have some special features in terms of the rights and claims of their holders: (i) residual claim to income, (ii) residual claim on assets, (iii) right to control, (iv) pre-emptive rights and (v) limited liability. A shareholder can (1) exercise, (2) sell in the market and (3) renounce / forfeit his pre-emptive right partially / completely. He does not gain / lose from right issues. However, he would suffer dilution of financial interest if he dose not exercise his pre-emptive right. Ordinary share capital is a high-risk reward source of finance for corporate. The shareholders share the risk, return and control associated with ownership of companies.

B. Term Loan
Term loans / project finance are negotiated loans between the borrower and the lenders with a maturity of up to 10 years. They are employed to finance acquisition of fixed assets and working capital margin. All term loans are secured. The asset security stipulations are reinforced by a number of positive / affirmative and negative covenants. While negative covenants are (i) assets-related, (ii) liabilityrelated, (iii) cash flow-related and (iv) control-related, the positive covenants relate to maintenance of (i) net worth, (ii) level of working capital, (iii) creation of redemption funds and so on. The term loans to be amortized according to the predetermined schedule. They carry low cost and involve high risk. They have no adverse effect on control but there is moderate restraint on managerial freedom.

C. Debentures / notes / bonds including innovative debt instruments

Debentures represent creditor ship securities and debenture-holders are term creditors of the company. As long-term source of finance, debentures have some contrasting features compared to equity shares. When they are sold to public, a trustee is appointed through a trust deed / in denture to ensure that the borrower fulfills all contractual obligations. The coupon rate of interest is legally enforceable as well as tax-deductible. A typical non-convertible debenture (NCD) has a maturity of 7-10 years.

C. Debentures / notes / bonds including innovative debt instruments

The redemption of debentures can be accomplished in either of the two ways:
(ii) call and put (buy back) provision.
(i) debenture redemption reserves (sinking fund) and

They are generally secured by way of an equitable mortgage. The convertible debentures can be partly / fully converted into equity shares. All debentures must be rated by a rating agency. As long-term source of funds, debentures (i) have low cost, (ii) do not dilute control, (iii) involve high risk and (iv) put some restraint on managerial freedom. To improve the attractiveness of debentures, a wide range of innovative instruments have emerged such as deep discount bonds, secured premium notes and floating rate bonds.

D. Hybrid sources such as preference capital, convertibles, warrants and options

A hybrid source of financing takes some features of equity shares and some features of debt instruments. The important hybrid instruments are preference shares, convertible debentures / bonds, warrants and options. The issue procedure for these instruments is similar to the raising of equity shares.

1. Preference Share
The main attributes of preference shares- (i) prior claim on income / assets, (ii) cumulative dividends, (iii) redeem ability, (iv) voting rights when preference dividend is in arrears, (v) participation in surplus profits / excess assets and so on. Preference capital involves high cost, does not dilute owners control of the company, has negligible risk and puts no restraint on managerial freedom. The shareholders receive modest return and are vulnerable to arbitrary managerial actions. It is not a popular source of long-term finance in India. .

2. Convertible Debentures
Convertible debentures (CDs) confer on their holders the right / option to convert them partly (PCDs) / fully (FCDs) into equity at a later date on specified terms / conditions. Their operational features, namely, conversion ratio, conversion premium and conversion timing are specified in advance. The call option gives the issuer the right to redeem the debentures prematurely. The investor has also the right to prematurely sell them back. The value of optionally CDs depends upon three factors: (i) straight debenture value, (ii) conversion value and (iii) option value. The reasons for the popularity of CDs are (1) cash flow matching of firms, (2) financial synergy and (3) mitigation of agency problem.

3. Warrants
A warrant entitles its holders to subscribe to the equity capital of a company during a specified period at a stated / particular / striking price. It differs from a CD in that while debentures can be offered independently also. The important features of warrants are (1) exercise price, (2) exercise ratio and (3) expiry date. The implied price of an attached warrant is the price effectively paid for each warrant. It is equal to price of bond with attached warrants less straight debenture / warrant value. A warrant has a market value and a theoretical value. The difference between them is the warrant premium. A warrant premium results from a combination of (1) positive investor expectation and (ii) the ability of the investor to obtain larger potential return by trading in warrants instead of underlying shares.

4. Options
Options are not a source of financing like shares, debentures, CDs and warrants. But they do stabilize prices of shares by increasing trading activity in them. An option is an instrument that provides to its holders an opportunity to purchase (call option) / sell (put option) specified security / assets at a stated striking price on / before a specified expiration date.

E. Lease Financing and Hire Purchase

The financing of credit transactions has been a growth industry in recent years. Such transactions take various forms; the principal ones are as follows: Hire purchase transactions are entered into where the title to the goods or assets remains with the seller, until a specified number of instalments are paid. Leasing agreements are made where the goods are leased to the hirer. The title of the goods remains with the finance company. Hire purchase system refers to that system where the buyer undertakes to pay the price of the goods but by instalments including interest for the delayed payment to acquire the possession immediately, but the title passes to the buyer only on the payment of the last instalment.

E. Lease Financing and Hire Purchase

There are two parties involved in the hire purchase agreement- one the Purchaser and the other the Hire purchase Vendor. In order to sale the goods or assets under hire purchase system, the hire purchase vendor prepares an agreement with some stipulated terms and conditions of selling the goods or assets on hire purchase basis to the interested purchaser and if the intended purchaser agrees to the terms and conditions of the agreement, he will sign it and the hire purchase vendor delivers him the goods or assets.

E. Lease Financing and Hire Purchase

Usually in the hire purchase agreement, an option to purchase the goods or assets is given to the purchaser and the agreement generally includes the following Possession of goods or assets is delivered by the hire purchase vendor to the purchaser on condition that such person pays the agreed amount in periodical instalments; The property in the goods or assets is to pass to the purchaser on the payment of the last instalment and The purchaser has a right to terminate the agreement at any time before the property so passes.

E. Lease Financing and Hire Purchase

Lease can be of two types: operating lease and finance lease. An operating lease is a simple arrangement, where in return of rent, the lessor allows the lessee to use the asset for a certain period. On the other hand, in a finance lease, a party acquires the right to use an asset for an agreed period of time in consideration of payment of rent to another party. In this type of lease, the legal ownership of the asset remains with the lessor (the leasing company), but in substance, all the risks and rewards of ownership of the asset are transferred to the lessee.

Venture Capital Financing

The term venture capital refers to capital investment made in a business or industrial enterprise, which carries elements of risks and insecurity and the probability of business hazards. Capital investment may assume the form of either equity or debt or both as a derivative instrument. The risk associated with the enterprise could be so high as to entail total loss or be so insignificant as to lead to high gains. The European Venture Capital Association describes venture capital as risk finance for entrepreneurial growth oriented companies. It is an investment for the medium or long term seeking to maximize the return.

Venture Capital Financing

Venture Capital, thus, implies an investment in the form of equity for high-risk projects with the expectation of higher profits. The investments are made through private placement with the expectation of risk of total loss or huge returns. High technology industry is more attractive to venture capital financing due to the high profit potential. The main object of investing equity is to get high capital profit at saturation stage. In broad sense under venture capital financing venture capitalist makes investment to purchase debt or equity from inexperienced entrepreneurs who undertake highly risky ventures with potential of success.

International Sources of Finance

Global Depository Receipts (GDRs) It is a negotiable certificate denominated in US dollars with represents a Non-US companys publicly traded local currency equity shares. GDRs are created when the local currency shares of an Indian company are depository receipts in US dollars. The GDRs may be traded freely in the overseas market the counter market or among qualified institutional buyers. By issue of GDRs Indian companies are able to tap global equity market to raise foreign currency funds by way of equity. It has distinct advantage over as there is no repayment of the principal and service costs are lower.

International Sources of Finance

Euro Convertible Bond Euro Convertible bonds are quasi-debt securities (unsecured) which can be converted into depository receipts or local shares. ECBs offer the investor an option to convert the bond into at a fixed price after the minimum lock in period. The price of equity shares at the time of conversion will have a premium element. The bonds carry a fixed rate of interest. These are bearer securities and generally the issue of such bonds may carry two options viz, call option and put option. A call option allows the company to force conversion if the market price of the share exceeds a particular percentage of the conversion price. A put option allows the investors to get his money back before maturity. In the case of ECBs, the payment of interest and the redemption of the bonds will be made by the issuer company in US dollars. ECBs issues are listed at London or Luxemburg stock exchanges.

International Sources of Finance

Euro Convertible Bond An issuing company desirous of raising the ECBs is required to obtain prior permission of the Department of Economic Affairs, Ministry of Finance, Government of India; Companies having 3years of good track record will only be permitted to raise funds. The condition is not applicable in the case of projects in infrastructure sector. The proceeds of ECBs would be permitted only for following purposes: import of capital goods Retiring foreign currency debts Capitalising Indian joint venture abroad 25% of total proceeding can be used for working capital and general corporate restructuring. The impact of such issues has been to procure for the issuing companies finances at very competitive rates of interest. For the country a higher debt means a forex outgo in terms of interest.

International Sources of Finance

American Depository Receipts (ADRs) These are depository receipts issued by a company in USA and are governed by the provisions of Securities and Exchange Commission of USA. As the regulations are severe, Indian companies tap the American market through private debt placement of GDRs listed in London and Luxemburg stock exchanges. Apart from legal impediments, ADRs are costlier than Global Depository Receipts (GDRs). Legal fees are considerably high for US listing Registration fee in USA is also substantial. Hence ADRs are less popular than GDRs.

SOURCES OF WORKING CAPITAL FINANCE Introduction Typically, working capital requirements / current assets are financed by a combination of long-term and short-term sources. The important traditional shortterm sources of current assets financing are trade credit and bank credit. Two newly emerging sources of working capital finance are factoring and commercial papers.

A. Trade Credit
Trade credit represents credit extended by suppliers of goods and services in the normal course of transactions of the firm. As cash is not paid immediately for purchase but after an agreed period of time, the deferral of payment (trade credit) represents a source of finance for credit purchases (current assets). It does not involve nay explicit interest charge / cost. The implicit cost or trade credit depends on the terms offered by the supplier of goods. When the terms include cash discount for prompt payment, the cost of trade credit is generally very high beyond the discount period. Trade credit and accruals as source of working capital refers to credit facility given by suppliers of goods during the normal course of trade. It is a short term source of finance. SSI firms in particular are heavily dependent on this source for financing their working capital needs. The major advantages of trade credit are easy availability, flexibility and informality.

A. Trade Credit
There can be an argument that trade credit is a cost free source of finance. But it is not, it involves implicit cost. The supplier extending trade credit incurs cost in the form of opportunity cost of funds invested in trade receivables. Generally, the supplier passes on these costs to the buyer by increasing the price of the goods or alternatively by not extending cash discount facility.

B. Bank Credit
Bank credit is the single most important institutional source of working capital finance. It is provided mainly in three forms (i) cash credit / overdraft, (ii) loans, and (iii) purchase / discount of bills. Of these, loans contribute the most important component. The security for working capital advances by banks is in the form of hypothecation or pledge.

C. Commercial Papers
Commercial papers which are unsecured promissory notes issued by firms which enjoy high credit rating are emerging as an innovative short-term source of current assets financing. Eligibility criteria for issuer of commercial paper The companies satisfying the following conditions are eligible to issue commercial paper. The tangible net worth of the company is Rs. 5 crores or more as per audited balance sheet of the company. The fund base working capital limit is not less than Rs. 5 crores. The company is required to obtain the necessary credit rating from the rating agencies such as CRISIL, ICRA etc. The issuers should ensure that the credit rating at the time of applying to RBI should not be more than two months old. The minimum current ratio should be 1.33:1 based on classification of current assets and liabilities. For public sector companies there are no listing requirement but for companies other than public sector, the same should be listed on one or more stock exchanges. All issue expenses shall be borne by the company issuing commercial paper.

D. Factoring
Factoring involves sale of accounts receivables to a factor who charges a commission, bears the credit risk associated with the accounts receivable purchased by it and provides funds in advance of collection and thus, finances receivables.
Factoring provides resources to finance receivables as well as facilitates the collection of receivables. Although such services constitute a critical segment of the financial services scenario in the developed countries, they appeared in the Indian financial scene only in the early nineties as a result of RBI initiatives.

D. Factoring
Factoring can broadly be defined as an agreement in which receivables arising out of sale of goods / services are sold by a firm (client) to the factor (a financial intermediary) as a result of which the title of the goods / services represented by the said receivables passes on to the factor. Henceforth, the factor becomes responsible for all credit control, sales accounting and debt collection from the buyers. In a full service factoring concept, if ant of the debtors fails to pay the dues as a result of his financial inability / insolvency / bankruptcy, the factor has to absorb the losses. Depending on the type / form of factoring, the main functions of a factor, in general terms, can be classified into five categories: Financing facility / trade debts; Maintenance / administration of sales ledger; Collection facility / of accounts receivable; Assumption of credit risk / credit control and credit restriction; and Provision of advisory services.