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Debentures Preference Shares Methods of issuing securities Term-Loans Internal Accruals Deferred Credit Leasing and hire purchase Government Subsidies Sales tax departments and exemptions
Shares: Ordinary shares represent the ownership position in a company. The capital representing ordinary shares is called equity capital or share capital. Ordinary shares are the source of permanent capital since they do not have a maturity date and the capital contributed by ordinary shares is called equity capital or share capital. The holders of ordinary shares are the legal owners of the company. The shareholders are entitled for dividends for the capital contributed by them. But the amount of dividend or rate of dividend is not fixed and is decided by the company’s board of directors. Features of ordinary shares: The special features of ordinary shares that distinguish them from other securities are:
Residual claim on income: Ordinary shareholders have a residual ownership claim. They have a claim to the residual income, after expenses, interest charges and taxes and preference dividend have been paid. The residual income may be retained back or paid to the shareholders as dividends. A company is not under legal obligation to distribute dividends out of the available earnings. Residual claim on assets: When liquidation occurs on account of business failure or sale of business, the amount left out of the realized value of assets, after paying debt-holders and preference shareholders, is paid to ordinary shareholders. Right to control: Ordinary shareholders have the legal powers to elect directors on the board. They can control the management of the company through their voting rights. They are required to vote on a number of important matters like election of directors, alteration of the memorandum of association etc. Each ordinary share carries one vote. Pre-emptive right: The pre-emptive right entitles the shareholder to maintain his proportionate share of ownership in the company. The law grants shareholders the right to purchase new shares in the same proportion as their current ownership.
5.Limited liability: Ordinary shareholders are the true owners of the company, but their liability is limited to the amount of their investment in shares.
Preference shares provide some flexibility to the company since they can postpone the payment of dividends 2. a. 2. Disadvantages of equity: 1. 3. ADVANTAGES OF PREFERENCE SHARES 1. This makes equity capital the costliest source of finance. ii. it has the option of reducing or suspending payment of dividends in case of financial difficulties. a company increases its financial capability. Riskier source of finance: Due to uncertainty associated with dividend and capital gains.Advantages of raising finance through equity: 1. Payment of dividends is not a legal obligation: Preference shareholders do not have the power to force the company to pay dividends. Permanent capital: Equity capital is a permanent capital and is available for use as long as the company exists. 3. By issuing ordinary shares. Borrowing base: Equity capital increases a firm’s financial base. most of the preference shares carry a cumulative dividend feature. Payment of dividends: Since a company is not obliged to pay dividends. Higher cost of capital: Shares have a higher cost of capital compared to other sources of long-term finance because: Dividends paid to shareholders are not tax-deductible. Preference Shares: Preference share is a hybrid security as it has the features of both ordinary shares and debentures. Redemption: Irredeemable preference shares don’t have a maturity date just like the equity shares. However. in India. Dilution of ownership: The issuance of ordinary shares leads to dilution of control. Preference shareholders do not have voting rights except in case any dividend arrears exist. according to which all the unpaid preference dividend must be paid before any ordinary dividends are paid. Features of Preference Shareholders Features similar to equity shares: 2. i. . Fixed dividend payments: The preference dividend payments are restricted to the stated amount and the preference shareholders do not participate in the excess profits unlike the ordinary shareholders. 3. b. ordinary shares require a higher rate of return. Floatation costs on ordinary shares are higher than those involved in case of debt. Dividends are not tax-deductible: The preference dividends are not deductible for tax purposes. iii.
Although payment of dividends can be postponed in the case of cumulative preference shares. Debenture holders are the creditors of the firm.DISADVANTAGES OF PREFERENCE SHARES 1. Security: Debentures are classified into two categories: Secured Debentures: A secured debenture is secured by a lien on the company’s specific assets. 4. In case of liquidation also. Hence. Maturity: Debentures are issued for a fixed period of time. Features of a debenture: 1. Debenture is tax deductible for computing the company’s corporate tax. Fixed income security: The interest payments are made to the debenture holders at a fixed interest rate also known as the contractual rate of interest. 2. The maturity of a debenture indicates the duration at which the company will redeem the par value to debenture holders. Payment of interest is legally binding on a company. Yield: The current yield on a debenture is the ratio of the annual interest payment to the debenture’s market price. The YTM is the discount rate that equates the present value of the interest and principal payments made over the life of the debenture with the current market price of the debentures. it might adversely affect the image of the firm. Dividends paid to the preference shareholders are not tax-deductible. 3. The secured debenture holders have a priority over the unsecured debenture holders . Generally a financial institution. Indenture: An indenture or debenture trust deed is a legal agreement between the company issuing the debentures and the debenture trustee who represents the debenture holders. the trustee can seize the security on behalf of the debenture holders. 2. Unsecured Debentures: Debentures that are not protected by any security are called unsecured or naked debentures. Claim on assets and income: Debenture holders have a claim on the company’s earnings and priority over the shareholders. 5. If the company defaults. or a bank or an insurance company is appointed as a trustee to protect the interest of the debenture holders. Debentures: A debenture is a long-term promissory note for raising loan capital. debenture interest has to be paid before paying any dividends to preference and ordinary shares. the debenture holders have a claim on assets and priority over the shareholders.
Obligatory Payments: The payment of interest and repayment of principal are a legal obligation for the company and the company might be forced even into liquidation if it does not pay dividends. b. so investors consider them to be less risky and therefore. which involves substantial cash outflows. 3. 4. Interest payments are tax-deductible. b. Dividend rate is fixed: The preference dividend rate is fixed and is expressed as a percentage of the par value. They are not entitled to any voting rights. a. Restrictive covenants: Debenture indenture may contain restrictive covenants which may limit the company’s operating flexibility in future. Fully Convertible Debentures (FCDs): These debentures are converted into shares as per the terms of issue with regard to price and time of conversion. Similarities between preference shares and debentures: i. They are payable on maturity. A convertible debenture is one which can be converted partly or fully into shares at a specified period of time. c. Cash outflows: Debentures should be redeemed at maturity. Reduced real obligation: In periods of inflation. Dilution of ownership: Debenture-holders are creditors and not owners. Advantages of debentures as a long-term source of finance: 1. debenture issue benefits the firm as the obligation of paying interest and principal are fixed and they decline in real terms Disadvantages of debentures as a long-term source of finance 1. Fixed payment of interest: Debenture-holders do not participate in the extraordinary earnings of the firm and payment in their case is limited to the interest payment. Non-Convertible Debentures (NCDs): These are debentures which do not have the feature of conversion. financing debentures involves less cost because: They involve fixed interest payments. Debentures can be converted into the following categories: a. the interest rate on FCDs is less than that on NCDs as they have the additional feature of convertibility to equity shares attached to them. The amount of preference . 2. Financial risk: Debentures result in increase in financial leverage and this might be disadvantageous to firms having fluctuating sales and earnings. 2. Partly Convertible Debentures (PCDs): These debentures have a convertible part and a non-convertible part with the advantages of both being blended into one. require a lower rate of return. 3.CLASSIFICATION OF DEBENTURES A debenture can be convertible or non-convertible. Generally. Less expensive: Compared to equity.
preparation of prospectus that contains information about the company. etc. promoters and the details required by the Company Law. i. A convertible preference shareholder can convert his/her preference shares either partly or fully into ordinary shares at a specified price during a given period of time. interactions with other intermediaries and statutory bodies like Registrar of Companies (ROC). Those shareholders who renounce their rights are not entitled for additional shares. Underwriting of issue. preference shares might have participation feature which entitles them to participate in extraordinary profits and in certain cases. 1. preference shares may be convertible and nonconvertible.e. Private Placement: Private placement involves sale of shares (or other securities) by a company to a few selected investors. companies can issue preference shares with voting rights. SEBI etc. However. Any balance of shares left after issuing the additional shares can be sold in the open market. 3. iii. the company has to pay the preference dividend before paying the dividend on ordinary shares. 1956. As per Section-81 of the Companies Act. obtaining statutory clearances. Unit Trust of India (UTI). The firm should appoint a SEBI registered Category-I merchant banker (also known as lead manager). particularly the institutional investors like. It also has a prior claim. as compared to ordinary shares. call) the preference shares. Life Insurance Corporation (LIC). Shares becoming available on account of non-exercise of rights are allotted to shareholders who have applied for additional shares on a pro-rata basis. Preference shareholders don’t have a share in the residual earnings: Preference shareholders do not have voting rights and they cannot participate in extraordinary profits earned by the firm. Rights Issue: It involves selling of ordinary shares to the existing shareholders of the company.dividend will thus be equal to the dividend rate multiplied by the par value. a sinking fund provision may be created to redeem preference shares. The fund set aside for this purpose may be used either to purchase preference shares in the market to buyback (i. on the assets of the company in the event of liquidation. A merchant banker is appointed by the company to . Shareholders through a special resolution can forfeit this preemptive right. a company should offer additional equity capital to the existing shareholders on a pro-rata basis. Public Issue: Public issue of equity implies raising share capital directly from the public. Sinking fund: Just as in the case of debentures. 2. METHODS OF ISSUING SECURITIES: Following are some ways in which a company can issue securities to raise capital: iv. ii. The merchant banker will be responsible for all pre and post-issue activities.e. Claims on income and assets: Preference shares have a prior claim on the company’s income. final allotment of the shares are certain other activities involved in the public issue of shares. promotion of issue. Convertibility: Just like debentures.
Commercial banks advance term loans for a period of 3 to 5 years. who will later offload these shares to the public through the OTCEI (Over the Counter Exchange of India) or through a public issue. it is less expensive and takes less time to raise funds. a number of companies. TERM-LOANS A company’s debt-capital may comprise either debentures (or bonds) or term loans. For example. The method of financing through term-loans is also referred to as project financing. security is provided specifically by the assets that have been acquired using the term-loan. . b. This method is particularly useful when small amount of funds are issued. the term loans are secured by the firm’s current and future assets. Secondary or collateral security: In this case. This is because term-loans do not involve any underwriting commission and other floatation costs. the company initially places the equity shares with a sponsor. Features of term-loans: 5. In comparison to public issue. Euro-issues: Companies can now float their stocks in the global capital markets for meeting their requirements for funds at lesser costs and with reduced procedural formalities. modernization or diversification projects. Also. Maturity Period: Generally financial institutions provide term-loans for a period of 6 to 10 years.e. and a grace period (i. Depository receipts issued in the US are called American Depository Receipts (ADRs). Companies can raise funds by issuing instruments like Global Depository Receipt (GDR). They can be secured in two ways: Primary security: In this case. 4. companies which do not satisfy the conditions laid down by SEBI for premium issues may issue their shares at a premium through the BOD method. Term loans are sources of long-term debt with a maturity of more than one year.establish network with the institutional investors and negotiate the issue price. 3. moratorium period) of 1 to 2 years may also be granted in certain cases. raise funds through global depository receipts. Depository receipts represent the claims on the shares of a company and are issued by a depository (usually an international finance firm) to investors in developed countries. Security: Term loans are always secured. These instruments are issued abroad and are traded on a foreign stock exchange. Depository is an intermediary between the company and depository receipt holders. 2. a. obtained directly from the banks and financial institutions. They are generally obtained for financing large expansion. He receives the dividends from the company and then converts the same into receipt holders’ currency and distributes it to them. Bought-out Deals (BOD): In this case. Lower costs of financing: Raising term-loans involves lesser costs as compared to those involved in issuing equity or debentures. Faster access to funds and lower issue costs are the advantages of this method. particularly in developing countries. 1. Euro Convertible Bonds (ECB) etc.
a required level of current ratio and prior approval of the lender for selling fixed assets might also be included.4. The amount of installment can be computed by using the capital recovery factor Advantages of term-loans to the firm: The post-tax cost of term loans is less than that for equity and preference shares. equal loan installments (including interest and principal payments) are made. in this case the interest payment will decline over years and the total loan payment (interest + principal payment) will not be equal in each period. Thus. The restrictive covenants included in the term-loan contract might hinder the firm’s operating flexibility and might hinder its future plans. Restrictive Covenants: Term-loans are protected further by adding a number of restrictive covenants. Asset-related covenants: By introducing such a covenant. the financial institution may appoint a nominee director in the board of directors of the firm. Payment by equal installments: In this case. capital expenditures. The duty of the nominee director is to safeguard the interest of the financial institution. . c. without his prior approval. There are two ways by which loan repayment can be made in installments: i. Control-related covenants: In certain cases. where substantial financial help is provided by way of term-loans. the lender expects the firm to maintain a prescribed level of asset base. are examples of cash-flow related covenants. 2. The interest charges are tax-deductible in the hands of the borrowing firm. Repayment schedule: The loan amortization schedule or the repayment schedule specifies the time for paying interest and principal. But in situations where the firm has low earnings. 1. Cash-flow related covenants: Restrictions related to payment of cash dividends. Liability related covenants: The lender may restrict the firm from raising any additional debt or repay any existing loan. Restrictions related to reduction of debt-equity ratio and limiting the freedom of promoters to dispose off their holdings in the company also come under this category of covenants. 1. 5. Payment by unequal installments: Principal is repaid in equal installments and the interest is paid on the outstanding loan amount. b. Restrictions relating to maintenance of a minimum working capital. these obligatory payments may threaten the solvency of the firm. These covenants can be categorized as: a. These covenants are applied specially in the case of financially weak firms.Term-loans do not lead to any dilution in the existing ownership of the firm Disadvantages of term-loans to the firm: Firm is legally obliged to make the interest payments and repayment of the principal. This is because the interest paid on term-loans is taxdeductible. salaries and perks of managerial staff etc.
packing and processing materials which are used for manufacturing purposes. the payment of sales tax on the sale of finished goods may be deferred for a period ranging between 5-12 years. It is less expensive compared to other sources of finance because of absence of issue expenses.INTERNAL ACCRUALS: Internal accruals in the form of depreciation charges and retained earnings are also treated as a source of long-term financing. 2. The Bill rediscounting scheme. with the maximum limit varying from Rs. 5 lakh to Rs. Retention of earnings implies that the earnings are not paid to the shareholders in the form of dividends and this might lead to a higher opportunity costs GOVERNMENT SUBSIDIES In order to encourage industries in backward areas. the project gets an interest free loan. Category B districts get a subsidy of 15% of the fixed capital investment subject to a maximum limit of Rs. represented by the quantum of sales tax deferment period. Seed capital assistance are some examples of deferred credit schemes. Under the sales tax exemption schemes. Advantages of using internal accruals as a source of finance: 1. No dilution of control is involved. In other words. Under the sales tax deferment scheme. The districts entitled for the state subsidy schemes are different from those covered under central subsidy schemes. B and C. DEFERRED CREDIT: Under this method. 3. the supplier of the machinery provides credit facility to the buyer by allowing him to purchase the asset by paying in installments that are spread over a period of time. the central and state governments provide subsidies to them. with a maximum limit of Rs. internal accruals will not be of much use as it offers only limited funds.15 lakh.25 lakh. The central government has classified the backward areas into three districts A. Category A districts get a subsidy of 25% of the fixed capital investment subject to a ceiling of Rs. The state subsidies vary from 5% to 25% of the fixed capital investment in the project. SALES TAX DEFERMENTS AND EXEMPTIONS: Sales tax deferments and exemptions are incentives provided by the state to attract industries. A subsidy of 10% of the fixed capital investment is applicable to the category C districts. 1. Disadvantages of using internal accruals as a source of finance: In case of projects involving large investments. The exemption is provided . Depreciation charges can be used for replacement of old machinery whereas retained earnings can be used to fund profitable investment opportunities.10 lakh. some states exempt the payment of sales tax applicable on the purchase of raw materials. 25 lakh. 2. Supplier’s line of credit. The central subsidy applicable to the industrial projects in these states is as follows: 1.
And high rates of inflation make long-term debt an expensive source of finance. A hire purchase agreement between the hirer and the hiree involves the following three conditions: i. although he does not own the asset until the full payment has been made. Although the lessor is the legal owner of the asset. The hiree may be a manufacturer or a finance company. The ownership of the asset will transfer to the hirer on the payment of all the installments. the user of the asset. LEASING AND HIRE PURCHASE: Traditional financing methods are related to the liability side of the balance sheet. there are three parties: the manufacturer. iii. or a year. the lessee bears the risk and enjoys the returns. The hirer. The hirer will have the option of terminating the agreement any time before the transfer of ownership of the asset. Lease is a contract between a lessor. Alternatives related to the asset side of the balance sheet may lower the cost and redistribute the risk. the amount and timing of payment of lease rentals can be tailored to the lessee’s profit or cash flows. the hiree and the hirer. The payment made by the hirer can be classified into two parts: interest charges and repayment of principal. The lessee pays the rental to the lessor as regular fixed payments over a period of time at the beginning or end of a month or quarter. ii. Traditional financing methods like equity and debt are quite expensive. the owner gives the user the right to use the asset over an agreed period of time for a consideration called the lease rental. The owner of the asset (hiree or manufacturer) gives the possession of the asset to the hirer with an understanding that the latter will pay the agreed installments over a specified period of time. The hirer is required to show the hired asset on his balance sheet and is entitled to claim depreciation. and facilitates asset use without ownership. use assets as direct security. half-year. In hire-purchase financing. thus gets a tax relief on interest paid and not on the entire payment.for a period of 3-9 years depending on the state and the specific location of the project. Thus for the hirer. As per this contract. Sometimes. the owner of the asset and a lessee. . Leasing separates ownership and use as two different economic activities. Equity becomes an expensive method of financing because of decreasing corporate earnings and low price-earning ratios. the hire purchase agreement is like a cancelable lease with a right to buy the asset. Asset-based financing like leasing and hire purchase. The manufacturer sells the asset to the hiree who sells it to the hirer in exchange for the payment to be made over a specified period of time.
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