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Long term finance refers to finance of permanent nature or that which is payable over a long
period of time. The most common sources of long term capital are issue of shared, long term
debt and leasing.

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‘rdinary shares represent the ownership position in a company. The owners of ordinary shares
are called shareholders and are the legal owners of the company. ‘rdinary shares are the source
of permanent capital since they do not have a maturity date. For the capital contributed by
shareholders by purchasing ordinary shares, they are entitled to dividends. The amount of rate of
divided is not fixed; the company¶s board of directors decides on it.

Being the owners of the company, the shareholders bear the risk of ownership; they are entitled
to dividends after the income claims of others have been satisfied. Similarly, when the company
is wound up, they can exercise their claims on assets after the claims of other suppliers of capital
have been met.

Pubic issue is the issue of shares to the public. Here the shares are usually underwritten, that is, a
financial institution guarantees, at a fee, to buy the shares if the issue is not fully subscribed.

Private placement is where the shares of the company are sold to few selected investors.

Features of ordinary shares

1. Claim on income ± ‘rdinary shareholders have a claim to the residual income, which, is,
earnings available for ordinary shareholders, after paying expenses, interest charges,
taxes and preference dividend, if any. This income may be split into dividends and
retained earnings. Dividends are immediate cash flows to shareholders while retained
earnings are reinvested n the business.
2. Claim on assets ± ‘rdinary shareholders have a residual claim on the company¶s assets in
the case of liquidation. ‘ur of the realised value of assets, first the claims of debt-holders
and then preference shareholders are satisfied, and the remaining balance, if any, is paid
to ordinary shareholders.
3. Right to control ± ‘rdinary shareholders have the legal power to elect directors and are
able to control the management of the company through their voting rights and right to
maintain proportionate ownership.
4. Voting rights ± ‘rdinary shareholders are required to vote on a number of issues such as
elections directors. The votes are equal to the number of shares held by him. Shareholders
may vote in person or by proxy.
5. Pre-emptive rights ± The pre-emptive right entitles a 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. The
shareholders¶ option to purchase a stated number of new shares at a specified price during
a given period is called rights. These rights can be exercised at a subscription price,
which is generally much below the share¶s current market price, or they can be allowed to
expire, or they can be sold in the stock market.
6. Limited liability ± ‘rdinary shareholders are the true owners of the company, but their
liability is limited to the amount of their investment in shares. If a shareholder has already
fully paid the issue price of shares purchased, he has nothing more to contribute in the
event of a financial distress or liquidation.

Advantages of Equity Capital

1. Permanent capital ± Since ordinary shares are not redeemable the company has no liability
for cash outflow associated with its redemption. It is a permanent capital, and is available
for use as long as the company exists.
2. Borrowing base ± The equity capital increases the company¶s financial base, and thus its
borrowing limit. Lenders generally led in proportion to the company¶s equity capital. By
issuing ordinary share, the company increases its financial capability.
3. Company is not legally obliged to pay dividend. In times of financial difficulties, it can
reduce or spend payment of dividend. Thus, it can avoid cash outflow associated with
ordinary shares.
Disadvantages of Equity capital

1. Flotation costs ± Share have higher costs since dividends are not tax deductible as are
interest payments. Also, flotation costs on ordinary shares are higher than those on debt.
2. Risk ±‘rdinary shares are riskier form an investor¶s point of view as there is uncertainty
regarding dividend and capital gains. Therefore, they require a relatively higher cost
source of finance.
3. Earnings dilution ± The issue of new ordinary shares dilutes the existing shareholders¶
earnings per share if the profits do not increase immediately in proportion to the increase
in the number of ordinary shares.
4. ‘wnership dilution ± The issuance of new ordinary shares many dilute the ownership and
control of the existing shareholders. While the shareholder has a pre-emptive right to
retain their proportionate ownership, they may not have funds to invest in additional
shares. Dilution of ownership assumes great significance in the case of closely held
companies.

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Preference shares have the following features:

1. Claims on income and assets ± Preference shareholders have a prior claim on the
company¶s income in the sense that the company must first pay preference dividends
before paying ordinary dividend. They also have prior claim on the company¶s assets in
the event of liquidation. Preference share is less risky than ordinary shares. Preference
shareholders generally do not have voting rights and they cannot participate in
extraordinary profits earned by the company.
2. Fixed dividend ± The dividend rate is fixed and is not tax deductible. The preference
dividend rate is expressed as the percentage of the par value.
3. Cumulative dividends ± All past unpaid preference dividend are to be paid before any
ordinary dividends are paid. Preference shareholders do not have power to force company
to pay dividends, thus the cumulative feature is necessary to protect their rights.
4. Redemption ± Redeemable preferential shares are redeemable at the maturity date.
5. Sinking fund ± A sinking fund provision may be created to redeem preference shares.
The money set aside for this purpose may be used either to purchase preference share in
the open market or to buy back the preference share.
6. Call feature ± The call feature permits the company to buy back preference shares at a
stipulated buy-back or call price. The call price may be higher than the par value. The
difference between the call price and par value of the preference share is called call
premium.
7. Participation feature ± Preferential shares may in some cases be entitled to participate in
extra-ordinary profit earned by the company.
8. Voting rights ± Preference shareholders ordinarily do not have any voting rights. They
may be entitled to contingent or conditional voting rights.
9. Convertibility ± Preference shares may be convertible or non-convertible. A convertible
preference share allows preference shareholders to convert their preference shares, fully
or partly into ordinary shares or debentures at a specified price during a given period of
time.

Advantages of Preference Shares

1. Riskless leverage advantage ± Preference share provides financial leverage advantages


since preference dividend is a fixed obligation. This advantage occurs without a serious
risk of default. The non-payment of preference dividends does not force the company into
insolvency.
2. Dividend postponability ± Preference share provides some financial flexibility to the
company since it can postpone payment of dividend.
3. Fixed dividend ± The preference dividend payments are restricted to the stated amount.
Thus preference shareholder does not participate in excess profits as do the ordinary
shareholders.
4. Limited voting rights ± Preference shareholders do not have voting rights except in case
dividend arrears exist. Thus the control of ordinary shareholders is preserved.

Disadvantages of Preference Shares


5. Non-deductibility of dividends ± Preference dividend is not tax deductible. Thus it is
costlier than debenture.
6. Commitment to pay dividend ± Non-payment of preference dividends can adversely
affect the image of a company, since equity holders cannot be paid any dividends unless
preference shareholders are paid dividends.

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A debenture is a long-term promissory note for raising loan capital. The firm promises to pay
interest and principal as stipulated. Debentures can be convertible or non- convertible.
Convertible debenture is one which can be converted, fully or partly, into shares after a specified
period of time.

Debentures are usually issued to a large number of investors, who hold debenture certificates
entitling them to claim of annual fixed interest and return of capital on maturity.

Features of debentures

1. Interest rate ± The interest rate on a debenture is fixed and known. Payment of interest is
legally binding on a company. Debenture interest is tax deductible.
2. Maturity ± Debentures are issued for a specific period of time. The maturity of the
debenture indicates the length of time until the company redeems the par value to
debenture-holders and terminates the debentures.
3. Redemption ± Debentures are generally redeemed on maturity, and this can be
accomplished either through a sinking fund or buy-back (call) provision. The call price
may be more than the par value of the debenture.
4. Indenture ± An indenture or debenture trust deed is a legal agreement between the
company issuing debentures and the debenture trustee (usually a bank or insurance
company) who represents the debenture holders. It is the responsibility of the trustee to
protect the interests of debenture holders by ensuring that the company fulfils the
contractual obligations.
5. Security ± Debentures are either secured or unsecured. A secured debenture is secured
by a lien on the company¶s specific assets. If the company defaults, the trustee can seize
the security on behalf of the debenture holders.
6. Yield ± The yield on a debenture is related to its market price. The current yield on a
debenture is the ratio of the annual interest payment to the debenture¶s market price. The
yield to maturity takes into account the payment of interest and principal over the life of
the debenture. This is the internal rate of return of the debenture.
7. Claims on assets and income ± Debenture holders have a claim on the company¶s
earnings prior to that of the shareholders. Debentures interest has to be paid before
paying any dividends to preference and ordinary shareholders. Defaulting on interest
payment may lead to bankruptcy.

Advantages of Debentures

1. Less costly ± It involves less cost to the firm than the equity financing because investors
consider debentures as a relatively less risky investment alternative and therefore, require
a lower rate of return. Also, interest payments are tax deductible.
2. No ownership dilution ± Debenture holders do not have voting rights, therefore,
debenture issue does not cause dilution of ownership.
3. Fixed payment of interest - Debenture holders do not participate in extra-ordinary profits
of the company. Thus the payments are limited to interest.
4. Reduced real obligation ± During periods of high inflation, debenture issue benefits the
company. Its obligation of paying interest and principal which are fixed decline in real
terms.

Disadvantages of debentures

1. ‘bligatory payments ± Debenture results in legal obligations of paying interest and


principal, which, if not paid, can force the company into liquidation.
2. Financial risk - It increases the firm¶s financial leverage which may be particularly
= =  to those firms which have fluctuating sales and earnings.
3. Cash outflows ± Debentures must be paid on maturity and therefore, at some point, it
involves substantial cash outflows.
4. Restricted covenant ± Debenture indenture may contain restrictive covenants which may
limit the company¶s operating flexibility in future.

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Term loans are obtained directly from banks and are mostly used to finance projects.

Features of term loans

1. Maturity ± Term loans have a maturity for a period of 6 to 10 years. In some cases a
grace period of 1 to 2 years is granted, during with the company does not make any
payment.
2. Direct negotiation ± A firm negotiates for the loan directly with the bank. Thus the costs
are lower than a public issue of debentures, where there are underwriting and flotation
costs.
3. Security ± Term loans are secured by the company¶s current and future assets. Also, the
lender may create wither fixed or floating charge against the firm¶s assets.
4. Restrictive covenants ± A financially weak fir attracts stringent terms of loan from
lenders. The borrowing firm has generally to keep the lender informed by furnishing
financial statements and other information periodically.
5. Convertibility ± Term loans may have the option of being converted into equity.

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This is where the funds for the business are retained. This happens under the following
conditions:
1. When the external capital is difficult to obtain and/or carries high cost of capital. External
capital may be scarce due to general credit restraint in the money market or because the
business financial position does not allow more room for employing external funds.
2. Where the rate of income tax on shareholder dividends is very high.
3. When a company can earn a relatively higher return on its investments than the rate
shareholders can obtain from any other investment elsewhere.
4. When a firm¶s share prices are temporarily depressed and/or high inflation rates have
increased interest rates in the debt market.

Advantages of Retained Earnings

1. No issue costs and hence it allows the firm use of a cheaper source of finance
2. Retention preserves the funds of the business and does not give rise to a drain on cash
funds of the business as not dividends will be declared.
3. Increases financing (capital structure) flexibility by providing a larger equity base which
can be used to raise more debt capital i.e. increases a firm¶s borrowing capacity.

Disadvantages of Retained Earnings

1. Too much retention may lead to depressed share prices where low dividend payout is
understood by shareholders to convey unfavourable information.
2. It may hurt income flow to investors or shareholder whose primary objective of
investment is the realisation of income through dividends.

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Depreciation is merely an allocation of cost of fixed assets to each accounting year; no funds are
necessarily set aside for the replacement of fixed asset. In this sense it is part of retained profits
in the same way that retained profits is. Furthermore, where the accounting depreciation is an
allowed expense for tax purposes, it reduces the amount of taxable profit and reduces tax payable
by the firm.
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Equipment leasing is a term used to denote a contract that enables a user (the lessee) to secure
the use of a tangible asset over a specified period of time by making periodic payment to the
owner (the lessor). Usually, the contract specifies the details of the payment, the disposition of
income, tax benefits. There a provisions for maintenance, renewal options and other clauses.
Leases can be broadly categorized into two types:

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These are short term; usually the period involved is only a fraction of the economic life of the
asset. The asset is not fully amortized over the term of the lease. They usually contain a
provision for service and maintenance i.e. the lessor provides maintenance services. They also
contain a cancellation clause that permits the lessee or the lessor to break the lease.

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These are ³full pay out net leases´ i.e. The cost of the asset and the return to the lessor are
amortised over the term of the lease. The lessee is responsible of maintenance, service, taxes,
insurance, and other expense that arise in connection with the use of the asset. It is similar to a
bond in that it represents a non-cancellable financial obligation. The lessee may have the option
to purchase the asset at the end of the lease period.

Sale and lease back is a special type of financial lease where the firm sells its own equipment to
an investor and simultaneously enters into a lease agreement to use that property. The proceeds
from the sale provide working capital and the firm still has the use of the asset.

Leveraged lease is a type of financial lease it involves three parties: a lessee, a lessor (equity
participant) and a long term lender (debt participant). The equity participant may provide only
10% of the funds. The remaining 90% is provided by the debt participant on a non-recourse basis
to the equity participant. Thus, the repayment to the lender comes solely from the lease payment
and from the security of their lien on the leased asset. The equity participant has no financial
obligation to the debt participant if the lessee defaults on the lease agreement.

The equity participant receives 100% of the tax benefit which included an investment tax credit
and depreciation of the asset. The equity participant is frequently willing to charge the lessee a
lower effective interest rate than would have been the case in a direct lease. If the lessee is in a
negative income position (i.e. making losses) and cannot take advantage of tax, he would benefit
by trading the tax benefits that he would lose any way for a lower interest rate on the lease (i.e.
lower lease payments.

Advantages of Leasing

1. Convenience and flexibility ± It is financially convenient to lease an asset that will be


needed for a short period of time. Also, companies that cannot raise funds from banks can
obtain assets. Also financial leases are less restrictive and can be negotiated faster. The
lease payments can be tailored to the lessee¶s cash flows.
2. Shifting of risk of obsolescence ± Where an asset is susceptible to unpredictable
technological changes e.g. computers, a lessee can, through short-term cancellable lease,
shift the risk of obsolescence to the lessor.
3. Maintenance and specialized services ± With a full-service lease, a lessee can look for
advantages in maintenance and specialized services.

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In hire purchase financing, there are three parties: the manufacturer, the hiree and the hirer. The
hiree may be a manufacturer for a finance company. 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.

A hire purchase agreement between the hirer and the hiree involves the following three
conditions:
-The owner of the asset (the hiree or the manufacturer) gives the possession of the asset to the
hire with an understanding that the hirer will pay agreed instalments over a specified period of
time.

-The ownership of the asset will transfer to the hirer on the payment of all instalments.

-The hirer will have the option of terminating the agreement any time before the transfer of
ownership of the asset.

Thus, for the hirer, the hire purchase agreement is like a cancellable lease with a right to buy the
asset. The hirer is required to show the hired asset on his balance sheet and is entitled to claim
depreciation, although he does not own the asset until full payment has been made. The payment
is both the interest charges and repayment of principle. The hirer, thus, gets tax relief in interest
paid and not the entire payment.

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These are funds available for a period of one year or less. They mostly finance working capital.

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Trade credit refers to the credit that a customer gets form suppliers of goods in the normal course
of business. It is mostly an informal arrangement and is granted on an open account basis (as
sundry creditors), since the buyer agrees to pay the amount due as per sales terms in the invoice,
but does not formally acknowledge it as a debt. The buyer is required to repay the credit on
credit terms or conditions such as the due date, and cash discount in case of prompt payment

Trade credit may also take the form of bills payable. When the buyer signs a bill ± a negotiable
instrument ± to obtain trade credit, it appears on the buyer¶s balance sheet as bills payable. The
bill has a specified future date. A promissory note is a formal acknowledgement of an obligation
with a promise to pay on a specified date and they appear as notes payable in the buyer¶s
balance.

Advantages of trade credit


1. Easy availability ± Trade credit is relatively easily to obtain. This availability is
particularly important to small firms which generally face difficulty in raising funds from
the capital markets.
2. Flexibility ± Trade credit grows with the growth of the firm.
3. Informality ± Trade credit is an informal, spontaneous source of finance. It does not
require any negotiations and formal agreement. It does not have restrictions

Disadvantages of trade credit

1. The cost of credit may be transferred to the buyer via the increased price of goods
supplied.
2. The supplier incurs costs in the form of the opportunity cost of funds invested in accounts
receivable and cost of any cash discount taken by the buyer. These costs are hidden to
unknowing businessmen.
3. Impairment of a firm¶s credit standing as the liquidity ratio is lowered by use of too much
credit. When payments on creditors are not made within credit periods, it may affect
business relations with the suppliers¶ thereby hurting the smooth operations of the
business.

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Accrued expenses represent a liability that a firm has to pay for the services which it has already
received. They represent an interest-free source of financing.

Deferred income represents funds received by the firm for goods and services which it has
agreed to supply in future.

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A firm can draw funds from its bank within the maximum credit limit sanctioned. It can draw
funds in the following forms:
a) ‘verdraft ± Here the borrower is allowed to withdraw funds in excess of the balance in
his current account up to certain specified limit during a stipulated period. Though the
overdrawn amount is repayable on demand, they generally continue for a long period by
annual renewals for the limits.
b) Cash credit ± This is similar to the overdraft arrangement. The borrower is allowed to
withdraw fund from the bank up to the sanctioned limit. Cash credit limits are sanctioned
against the security of current assets.
c) Discounting of bills ± Here a borrower can obtain credit from a bank against its bills.
d) Letters of credit ± Here, a bank opens a letter of credit in favour of a customer to
facilitate the purchase of goods. If the customer does not pay to the supplier with the
credit period, the bank makes the payment under the letter of credit arrangement. This
arrangement passes the risk of the supplier to the bank.

Banks generally require security for finance in form of hypothecation, mortgage or lien

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This is a money market instrument used by blue-chip companies which are financially sound.
The buyers of commercial papers included banks, insurance companies, unit trust and firms with
surplus funds to invest for a short period with minimum of risk.

Advantages of commercial paper

1. It is an alternative source of raising short-term finance, and proves to be handy during


periods of tight bank credit.
2. It is cheaper source of finance in comparison to the bank credit. Usually, interest yield on
commercial paper is less than the prime rate of interest.

Disadvantages of commercial paper

1. It is an impersonal method of financing. If a firm is unable to redeem its paper due to


financial difficulties, it may not be possible for it to get the maturity of paper extended.
2. It is always available to the financial sound and highest rated companies. A firm facing
temporary liquidity problems may not be able to raise funds by issuing new paper.
3. The amount of loanable funds available in the commercial paper market is limited to the
amount of excess liquidity of the various purchasers of commercial paper.
4. It cannot be redeemed until maturity. Thus if a firm doesn¶t need the funds any more, it
cannot repay it until maturity and will have to incur interest costs.