Sources of Long Term Finance

Sources of long term finance

• Equity Capital
• Preference Capital
• Debenture Capital
• Term Loans
• Retained Earnings
 Retained Earnings

• Retained earnings are profit after tax and

dividend.

• Internal Source of Finance

 From Company’s point of view
Advantages
• Readily available
• No additional expenses to raise
• No dilution of control

Disadvantages
• Limited Fund
• Opportunity cost is high. Because, it represents the
dividends foregone by the shareholders.
 Shareholder’s Point of view
Advantages
• Capital appreciation is subject to lower rate of tax.
• Convenient as no hassle of reinvesting.

Disadvantages
• Lower dividend
• Appreciation may not commensurate the dividend
forgone.
 Equity Capital
• Represents ownership capital
• Enjoys the rewards and bear the risks

Some Terms
• Authorized capital is the amount of capital that a
company can potentially issue, as per its memorandum.
• The amount offered by the company to the investors is
called the Issued Capital.
• The part of issued capital which has been subscribed to
by the investors represents the Subscribed Capital.
• The actual amount paid up by the investors is called the
Paid-up Capital.
 Equity Capital
Authorised Capital Say: 10,00,000 Equity
Shares of Rs.10 each

Issued capital Say :5,00,000 Equity

Shares of Rs.10 each

Subscribed Capital Say :4,00,000 Equity

Shares of Rs.10 each

Paid up Capital Say :4,00,000 Equity

Shares of Rs.5 each
Par Value
Face value of the share
The stated value on a stock certificate is called the par
value.
The par of equity shares is generally Rs. 10, or Rs. 100.

Issue Price
The issue price is the price at which the equity share is
issued.
–Generally par and issue price are same for new companies
When issue price exceeds the par value, the difference is
referred as share premium
• Contributed Surplus Usually refers to
amounts of directly contributed equity capital in
excess of the par value

– For example, suppose 1,000 shares of common stock

having a par value of Rs.1 each are sold to investors for
Rs. 8 per share. The contributed surplus would be
(8 – 1) × 1,000 = Rs. 7,000
• Book Value-
Paid up capital+Reserves and Surplus
No of Equity Shares

• Market Price is the price at which the share

is traded in the stock market
 Rights and position of equity
Shareholders
• Right to Control
– Elect the board
– Lack effective control
• Right to Income = Profit After Tax
– Income of the shareholder is called Dividend
– as recommended by the Board
– unchallengeable
• Pre-emptive right on pro rata basis
• Right in liquidation
– Residual claim over assets of the firm
• Pre-emptive Right • No Pre-emptive Right

• Value of initial • Value of initial

holding( 20 * 100) = 2000 holding( 20 * 100) = 2000

• Additional Subscription • Additional Subscription = 0

(12 * 50) = 600

• Value of equity holding • Value of equity holding

after the additional after the additional
Issue (17.33 * 150) = 2600 Issue (17.33 * 100) =1733

Expected Price = 100*20 + 50*12 = 17.33

150
 Evaluation Company’s point of view
• Positives

• Permanent Capital- no liability for repayment

• Dividend Non obligatory
• Enhances Creditworthiness

Negatives

• Pay dividend Tax @ 12.5%

• Expect High rate of return/ high cost of capital
• Paid out of Profit After Tax
– not tax deductible payments
• Issue cost quite high
– Underwriting commission, brokerage costs, publicity cost etc
• Dilution of control
 Shareholder’s point of view
Positives

• Limited liability
• High rewards
• Equity dividend exempted from tax

Negatives

• No say in Dividend matters

• Residual claim to income & assets
• Risky investment- wide fluctuations in price
 Dividend Taxation
Old New
system system

Dividend declared 1,000 1,000

Tax on dividend by company
@ 10% 100
______
______
Total outflow 1,000 1,100
To conserve funds, the company
may declare dividend of only-say 900
Tax on dividend @ 10% 90
______
______
Total outflow 990
Shareholder Dividend received 1,000 900
 Preference Capital
• A hybrid form of financing
Equity + Loan

• Preference dividend is paid out distributable profit

– Not a Tax-deductible payment
• Dividend rate is fixed
Not an obligatory payment
• Preference over equity shareholders
• No voting power
 Features of Preference Shares
• Cumulation of dividends
• Callability
– company may buyback whole/part at a certain price
• Convertible into equity
• Redeemability
• No voting power
– Exception:
– Dividend in arrear for 2/more years incase of
cumulative preference shares
– Dividend not paid for an aggregate period of 3/more
years in preceding 6 years
 Evaluation
Company’s point of view

Upside
• No legal obligation to pay dividend
• No dilution of control
• Enhances creditworthiness
• No collateral security

Downside
• Pay dividend Tax @ 12.5%
• No tax advantage
• Skipping of dividend adversely affects corporate image
 Shareholder’s point of view

Upside
• Stable dividend
• Dividend exempted from income tax

Downside
• Can not enforce payment of dividend
• Modest returns
 Debenture Capital
• Debentures are instruments for raising long term debt
capital
• Characteristics
 Trustee – Bank , Institution, Insurance Company-
 Appointed through a Deed
 Security – Secured by a charge on assets present and future
assets
 Debenture Redemption Reserve
- For all issues beyond a maturity period of 18 months
- Minimum balance – 50% of the issue amount before
beginning redemption
 Coupon Rate / Interest Rate - Fixed or floating

 Maturity Period – No limit

 Call and Put Option

 Issuing company can call/redeem before maturity at a certain
price
 The holder has the right to put/redeem before maturity at a
certain price

 Convertible into equity shares

 Partly Convertible
 Fully Convertible
 Evaluation
Company’s point of view
Upside
• Post tax cost of debentures is lower than shares
• No dilution of control

Downsides
• Obligatory payment
• The protective covenants may be restrictive
– Composition of the Board
– Bring additional funds in the form of Unsecured Loan
– No expansion without approval
– Repay existing loans with the concurrence of the
Institutions
 Example
Debentures Preference
PBIT 100 100
Interest 20 --
PBT 80 100
Tax @30% 24 30
PAT 56 70
Preference Dividend -- 20
PAT for Equity Shareholders 56 50
Investor’s point of view

Upside
• Stable earnings
• Secured Investment

Downside
• Fully taxable
• No right to vote
 Term Loans
• A source of Debt Finance –
– for a period more than a year
– For financing Fixed Assets and Working Capital

Security for the term loan, Commitment Charges

Interest and Expenses
• The assets financed with the loan are termed as Prime
Security
• Other securities are known as Collateral securities
 Evaluation
Company’s point of view
Upside
• Tax rebate
• No dilution of control
Down sides
• Obligatory payments
• Restrictive covenants

• Lender’s point of view

• Fixed Income
• Secured loans
• No right to vote