Financial Management: Chapter 6 Financing Decision

CHAPTER SIX

FINANCING DECISION

6.1. The concept of capital structure

Capital structure refers to the makeup of the firm’s capitalization. It represents the mix of different

sources of long-term funds in the capitalization of the company. The term capital structure differs from

financial structure. Financial structure refers to the way the firm’s assets are financed. It includes both

long-term as well as short-term sources of funds. Capital structure is the permanent finance of the

company represented primarily by long-term debt and shareholder’s funds but excluding all short-term

sources. It is evident from this, that capital structure is only a part of its financial structure.

Financial structure Capital structure

It includes both long-term and short-term It includes only the long-term sources of funds.
sources of funds.
It means the entire left side of the balance sheet. It means only the long-term liabilities of the
company.
Financial structures consist of all sources of It consists of equity, preference and retained earning
capital. capital.
It will not be more important while determining It is one of the major determinations of the value of
the value of the firm. the firm.

Capital structure of a firm may be one of any of the following patterns:

 Capital structure with issue on only common share.

 Capital structure with common shares and preference shares.

 Capital structure with common shares and debt capital.

 Capital structure with equity shares, preference shares and debt capital.

The choice of an appropriate capital structure depends on a number of factors like regularity of

earnings, nature of the firm’s business conditions, capital markets, investor’s perceptions and so on. Firm

interested in mobilizing funds should always keep the following points in bringing additional

funds for its investment needs.

Issue of common shares is considered as the variable yield bearing securities, as the dividend payment

on these shares varies from year to year.

 Financial Management: Chapter 6 Financing Decision

Issue of preference shares or debt capital (bonds/debenture) is called as the fixed yield securities, as

the interest payment or dividend payment on these remains constant thought out the life period of

security.

CAPITAL
STRUCTURE

VARIABLE YIELD FIXED YIELD BEARING

BEARING SECURITIES
SECURITUES

 Preference shares
 Bonds or
Common Shares
Debentures

6.1.2. Optimum Capital Structure

Optimum capital structure is the state of capital structure every firm desires to maintain so as to attain

financial stability. Financial stability is obtained when the market value of the common share is high.

Optimum capital structure is defined as the relationship of debt and equity, which maximize the value of

share. The value of equity share is high while the average cost of capital is minimum at the

optimum capital structure.

Features of optimum capital structure:

Profitability: The capital structure should be devised so as to maximize the profits of the firm.

The most profitable capital structure is that minimizes cost of financing and maximizes earnings

per share.

Solvency: Capital structure is said to be optimum, when the firm is free of becoming insolvent.

Use of debt in excess capacity may result as insolvency situation for a firm in long run.

Flexibility: Capital structure of the firm should be flexible, so as to mobilize additional funds

whenever required by the firm.

Conservatism: Capital structure should be such that it should generate future cash flows desirable
 Financial Management: Chapter 6 Financing Decision

by the firm.

Control: Capital structure should be devised in such a way that it minimizes risk of loss of control

over the firm financial operations.

6.2. Leverage

Every business requires additional capital for its operational performance, which is financed

through issue of common shares or by increase the debt by the creditors. Issue of additional

common shares will extend the owner’s equity base, while issue of debt increases the claims by the

creditors. Capital structure decision is the decisions determining the composition of the debt-equity mix

in the firm’s capital sources. Employment of additional funds from outsiders increases the earnings of

equity shareholders on one hand, and also increases the risk of shareholders on the other hand.

Leverage is defined as “the process of employment of an asset or funds for which the firm pays a fixed cost

or fixed return”. According to the above definition leverage results from the employment of

additional funds, which carry fixed cost (called as interest charges). It is to be noted that, fixed cost

or return or debt capital is incurred irrespective of size, volume, and output of the firm. Financial

charges bear considerable effect on the firm’s shareholders interest in profits contribution.

Leverage helps finance manager in knowing the effect of change in sales over profits and earnings

per share. It is also defined as the relative change in profits due to change is sales. A high degree of

leverage implies that there will be a large change in profits due to a small change in sales and vice

versa.

Leverage is classified into three components and they are:

(1) Operating leverage,

(2) Financial leverage, and

(3) Composite (or combined) leverage.

6.2.1. Operating leverage

It is always observed that changes in sales volume or value bear direct effect on the operating

profits of the firm.

 Financial Management: Chapter 6 Financing Decision

 Operating leverage is defined as “the process of operating profits varying proportionately with

change in the sales”.

An increase in sales will bring more operating profits, and a decrease in sales volume reduces the

operating profits. A firm is said to have a high degree of operating leverage, if it employs greater amount

of fixed cost than variable costs. Therefore, it is essential to know that operating leverage is dependent

on the employment of proportion of fixed cost by the given firm. Operating leverage can be

calculated by the following formula:

Contribution C
Operating leverage = Operating profits = EBIT

Alternatively, operating leverage can be calculated using the following formula:

Percentage change∈ profits

Degree of operating leverage = Percentage change∈ Sales or

%Δ in EBIT
DOL=
%Δ in Sales
The operating leverage indicates the impact of changes in sales on operating income.

Decision rule: Operating leverage may be favorable or unfavorable.

 A favorable leverage arises due to higher contribution over fixed cost and

 Unfavorable leverage arises due to lower contribution over fixed cost.

The operating leverage indicates the impact of changes in sales on operating income. A high degree

of operating leverage indicates a small change in sales will have drastic effect on the operating profits of the

firm. Higher operating leverage is a risky situation for firm, as the small drop in sales volume or

value; there can be excessive damage to profits of the firm.

6.2.3. Financial Leverage

Financial leverage is defined as “the tendency of the residual net income to vary disproportionately with

operating profits”.
 Financial Management: Chapter 6 Financing Decision

Financial leverage explains the changes in the taxable income with the changes in operating

profits.

Employment of debt capital involves interest charges, which are paid before taxes. The use of fixed

charge bearing securities like, debt capital and preferred capital along with the owner’s equity in

the capital structure of the company is described as the financial leverage. A firm is said to lever

largely when larger portion of debt is employed, and weakly levered when fewer debt capital is

employed. The higher the financial leverage, the higher the financial risk, and the higher the cost of

capital.

 Debt causes financial risk because it imposes a fixed cost in the form of interest payments.

 The use of debt financing is referred to as financial leverage.

 Financial leverage increases risk by increasing the variability of a firm’s return on equity or

the variability of its earnings per share.

Financial leverage is calculated using the following formula:

Operating profits EBIT
Financial leverage = Profits before taxes = EBT

Alternatively, financial leverage can be calculated using the following formula:

Percentage change∈earnings per share
Degree of financial leverage = Percentage change∈operating profits =

%Δ in EPS
DFL=
%Δ in EBIT
Decision rule: Financial leverage may be favorable as well as unfavorable depending upon the
earnings made by the fixed returns bearing securities.
 A favorable leverage is resultant factor when a firm earns more than the fixed cost bearing
securities. It is also termed as “trading on equity’.
 Unfavorable or negative leverage occurs when the firm does not earn as much as the fixed
cost bearing securities.
 Financial Management: Chapter 6 Financing Decision

Leverage and the Income Statement

Sales

- Fixed costs Operating leverage

- Variable costs

EBIT Operating leverage

- Interest

EBT

- Taxes Financial leverage

EAT

Note: EPS = EAT/ (no of shares) [assuming no pfd. stock]

Leverage Analysis: An Example Webb’s Incorporated Income Statement Year Ended December

31, 2007)

Sales (30,000 units @ Br. 25) ………………………… 750,000

- Variable costs (Br. 7 per unit).…………………….... (210,000)

Contribution margin………………………………… 540,000

- Fixed costs ……………………………………………. (270,000)

EBIT………………………………………………….... 270,000

- Interest expenses……………………………………... (170,000)

EBT……………………………………………………. 100,000

-Taxes ……………………………………………………. (34,000)

EAT……………………………………………………. 66,000

Given 20,000 shares outstanding: EPS = Br. 66,000/20,000 = $3.30

Required: Calculate operating, financial and combined leverage of Webb’s incorporated

Webb’s DOL When Q = 30,000 Units

%Δ in EBIT
DOL=
%Δ in Sales
Q( P−V ) S−VC
= =
Q( P−V )−F S−VC−F
S−VC
=
EBIT
 Financial Management: Chapter 6 Financing Decision

Note:
Note: If F = 0, DOL = 1 (i.e., without any F, the % change in EBIT would be equal to the % change
in sales). By employing F, the firm’s % change in EBIT will be greater than the % change in

sales.
30 , 000( $ 25−$ 7 )
DOL= =540 ,000 ¿ , 000=2. 0
30 , 000( $ 25−$ 7 )−$ 270 , 000
For every 1% change in sales, EBIT will change 2%.

Operating Leverage is Risky: If sales increase 5%, a DOL of 2.0 indicates that EBIT would increase

10%. On the other hand, if sales decline 7%, a DOL of 2.0 indicates that EBIT would decline 14%.

Webb’s DFL When Q = 30,000 Units

%Δ in EPS
DFL=
%Δ in EBIT
EBIT
=
EBT
Note: If interest expense = 0, DFL = 1.0 (i.e., without any debt financing, the % change in EPS

would be equal to the % change in EBIT).

By incurring interest expense (debt financing) the firm’s % change in EPS will be greater than the

% change in EBIT.

Br.270 ,000
DFL= =2.7
Br . 270 ,000−Br .170 ,000
For every 1% change in EBIT, EPS will change 2.7%

Financial Leverage is Risky: If EBIT increases by 2%, a DFL of 2.7 indicates that EPS would

increase by 5.4%. On the other hand, if EBIT declines by 4%, a DFL of 2.7 indicates that EPS would

decline 10.8%.

Combined leverage

When the company uses both financial and operating leverage the magnification of any change in

sales into a larger relative change in earning per share. Combined leverage expresses the

relationship between the revenue in the account of sales and the taxable income.

 DCL is the % change in a firm’s earning per share (EPS) results from one percent change in

sales.
 Financial Management: Chapter 6 Financing Decision

 This is also equal to the firm’s degree of operating leverage (DOL) times its degree of

financial leverage (DFL) at a particular level of sales.

%Δ in EPS
DCL=
%Δ in Sales
Q ( P−V )
=
Q ( P−V )− F−I
S−VC S−VC
= =
S−VC−F− I EBT
= ( )(
%Δ in EBIT %Δ in EPS
%Δ in Sales %Δ in EBIT )
= ( DOL)( DFL )
Note: If F = 0, and I = 0, DCL = 1.0 (i.e., without F or I the % change in EPS would be equal to the %

change in sales).

By employing F or I (or both), the firm’s % change in EPS will be greater than the % change in

sales.
30 ,000 (25−7 )
DCL=
30 ,000 (25−7 )−270 , 000−170 , 000
= (DOL )(DFL )
= (2)(2.7 )
= 5. 4
For every 1% change in sales, EPS will change by 5.4%

Comparing Operating leverage

Operating Leverage Financial Leverage

Operating leverage is associated with Financial leverage is associated with
investment activities of the company. financing activities of the company.
A percentage change in the profits resulting A percentage change in taxable profit is
from a percentage change in the sales the result of percentage change in EBIT.
Operating leverage depends upon fixed cost Financial leverage depends upon the
and variable cost. operating profits
Tax rate and interest rate will not affect the Financial leverage will change due to tax
operating leverage rate and interest rate
6.3. Long- term Financing Instruments
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Long Term Finance – Its meaning and purpose

A business requires funds to purchase fixed assets like land and building, plant and machinery,

furniture etc. These assets may be regarded as the foundation of a business. The capital required

for these assets is called fixed capital. A part of the working capital is also of a permanent nature.

A fund required for this part of the working capital and for fixed capital is called long-term

finance.

6.2.1 Purpose of long term finance:

Long term finance is required for the following purposes:

1. To Finance fixed assets:

Business requires fixed assets like machines, Building, furniture etc. Finance required to buy these

assets is for a long period, because such assets can be used for a long period and are not for resale.

2. To finance the permanent part of working capital:

Business is a continuing activity. It must have a certain amount of working capital which would be

needed again and again. This part of working capital is of a fixed or permanent nature. This

requirement is also met from long term funds.

3. To finance growth and expansion of business:

Expansion of business requires investment of a huge amount of capital permanently or for a long

period.

3.2.2Factors determining long-term financial requirements:

The amount required to meet the long-term capital needs of a company depend upon many

factors. These are:

(a) Nature of Business:

The nature and character of a business determines the amount of fixed capital. A manufacturing

company requires land, building, machines etc. So, it has to invest a large amount of capital for a

long period. But a trading concern dealing in, say, washing machines will require a smaller

amount of long term fund because it does not have to buy building or machines.

(b) Nature of goods produced:

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If a business is engaged in manufacturing small and simple articles it will require a smaller

amount of fixed capital as compared to one manufacturing heavy machines or heavy consumer

items like cars, refrigerators etc. which will require more fixed capital.

(c) Technology used:

In heavy industries like steel the fixed capital investment is larger than in the case of a business

producing plastic jars using simple technology or producing goods using labor intensive

technique.

6.2.3 Long- term Financing Instruments

Long- term Financing Instruments

Debt security Equity security

 Bond  Common share
 Lease  Preference share

1. Bond markets

The word “bond” means contract, agreement, or guarantee. All these terms are applicable to the

securities known as bonds. An investor who purchases a bond is lending money to the issuer, and

the bond represents the issuer’s contractual promise to pay interest and repay principal according

to specified terms.

Why issue bonds?

Bonds are never an issuer’s only source of credit. All the businesses and government entities that

choose to sell bonds have already borrowed from banks, and many have received financing from

customers, suppliers or specialized finance companies.

 The principal reason for issuing bonds is to diversify sources of funding. The amount any

bank will lend to a single borrower is limited. By tapping the vastly larger base of bond

market investors, the issuer can raise far more money without exhausting its traditional

credit lines with direct lenders.

Bonds also help issuers carry out specific financial-management strategies. These include the following:
 Financial Management: Chapter 6 Financing Decision

I. Minimizing financing costs. Leverage, the use of borrowed money, enables profit-making

businesses to expand and earn more profit than they could using only the funds invested by

their shareholders.

 Firms generally prefer bonds to other forms of leverage, such as bank loans, because the

cost is lower and the funds can be repaid over a longer period. A bond issue may or may

not increase the issuer’s leverage, depending upon whether the bonds increase the total

amount of borrowing or merely replace other forms of borrowing.

II. Promoting inter-generational equity. Governments often undertake projects, such as building

roads or buying park land, that create long-lasting benefits. Bonds offer a means of requiring

future taxpayers to pay for the benefits they enjoy, rather than putting the burden on current

taxpayers.

III. Controlling risk. The obligation to repay a bond can be tied to a specific project or a particular

government agency. This can insulate the parent corporation or government from

responsibility if the bond payments are not made as required.

IV. Avoiding short-term financial constraints. Governments and firms may turn to the bond

markets to avoid painful steps, such as tax increases, redundancies or wage reductions, that

might otherwise be necessary owing to a lack of cash.

Bond issuers

Three basic types of entities issue bonds.

National governments

Bonds backed by the full faith and credit of national governments are called sovereigns. These are

generally considered the most secure type of bond. A national government has strong incentives to

pay on time in order to retain access to credit markets, and it has extraordinary powers, including

the ability to print money and to take control of foreign currency reserves, that can be employed to

make payments.

Lower levels of government

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Bonds issued by a government at the sub national level, such as a city, a province or a state, is

called semi-sovereigns. Semi-sovereigns are generally riskier than sovereigns because a city, unlike

a national government, has no power to print money or to take control of foreign exchange.

Corporations

Corporate bonds are issued by a business enterprise, whether owned by private investors or by a

government. Large firms may have many debt issues outstanding at a given time. In issuing a

secured obligation, the firm must pledge specific assets to bondholders. In the case of an electric

utility that sells secured bonds to finance a generating plant, for example, the bondholders might

be entitled to take possession of and sell the plant if the company defaults on its bonds, but they

would have no claim on other generating plants or the revenue they earn.

Types of bonds

An increasing variety of bonds is available in the marketplace. In some cases, an issuer agrees to

design a bond with the specific characteristics required by a particular institutional investor. Such

a bond is then privately placed and is not traded in the bond markets. Bonds that are issued in the

public markets generally fit into one or more of the following categories.

Straight bonds

Also known as debentures, straight bonds are the basic fixed-income investment. The owner

receives interest payments of a predetermined amount on specified dates, usually every six

months or every year following the date of issue. The issuer must redeem the bond from the owner

at its face value, known as the par value, on a specific date.

Callable bonds

The issuer may reserve the right to call the bonds at particular dates. A call obliges the owner to

sell the bonds to the issuer for a price, specified when the bond was issued, that usually exceeds

the current market price. The difference between the call price and the current market price is the

call premium. A bond that is callable is worth less than an identical bond that is non-callable, to

compensate the investor for the risk that it will not receive all of the anticipated interest payments.

Non-refundable bonds
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These may be called only if the issuer is able to generate the funds internally, from sales or taxes.

This prohibits an issuer from selling new bonds at a lower interest rate and using the proceeds to

call bonds that bear a higher interest rate.

Putable bonds

Putable bonds give the investor the right to sell the bonds back to the issuer at par value on

designated dates. This benefits the investor if interest rates rise, so a putable bond is worth more

than an identical bond that is not putable.

Perpetual debentures

Also known as irredeemable debentures, perpetual debentures are bonds that will last forever

unless the holder agrees to sell them back to the issuer.

Zero-coupon bonds

Zero-coupon bonds do not pay periodic interest. Instead, they are issued at less than par value and

are redeemed at par value, with the difference serving as an interest payment. Zeros are designed

to eliminate reinvestment risk, the loss an investor suffers if future income or principal payments

from a bond must be invested at lower rates than those available today. The owner of a zero-

coupon bond has no payments to reinvest until the bond matures, and therefore has greater

certainty about the return on the investment.

2. Lease

Lease transactions involve two parties: the lessor, who owns the property, and the lessee, who

obtains use of the property in exchange for one or more lease, or rental, payments.

Parties to a lease

 The lessee, who uses the asset and pay rental, payments,

 The lessor, who owns the asset and receives the rental payments,

Note that the lease decision is a financing decision for the lessee and an investment decision for the

lessor.

Types of lease
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Leasing takes several different forms, the five most important being (1) operating leases, (2)

financial, or capital, leases, (3) sale-and-leaseback arrangements, and (4) combination leases.

A. Operating Leases

Operating leases generally provide for both financing and maintenance. Ordinarily, operating leases

require the lessor to maintain and service the leased equipment, and the cost of the maintenance is

built into the lease payments. Another important characteristic of operating leases is the fact that

they are not fully amortized.

 In other words, the rental payments required under the lease contract are not sufficient for

the lessor to recover the full cost of the asset. However, the lease contract is written for a

period considerably shorter than the expected economic life of the asset, so the lessor can

expect to recover all costs either by subsequent renewal payments, by releasing the asset to

another lessee, or by selling the asset.

 A final feature of operating leases is that they often contain a cancellation clause that gives the

lessee the right to cancel the lease and return the asset before the expiration of the basic

lease agreement. This is an important consideration to the lessee, for it means that the asset

can be returned if it is rendered obsolete by technological developments or is no longer

needed because of a change in then lessee’s business.

B. Financial, or Capital, Leases

Financial leases, sometimes called capital leases, are differentiated from operating leases in that

they (1) do not provide for maintenance service, (2) are not cancellable, and (3) are fully amortized

(that is, the lessor receives rental payments equal to the full price of the leased equipment plus a

return on invested capital).

In a typical arrangement, the firm that will use the equipment (the lessee) selects the specific items

it requires and negotiates the price with the manufacturer. The user firm then arranges to have a

leasing company (the lessor) buy the equipment from the manufacturer and simultaneously

executes a lease contract.

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The terms of the lease generally call for full amortization of the lessor’s investment, plus a rate of

return on the unamortized balance that is close to the percentage rate the lessee would have paid

on a secured loan. For example, if the lessee would have to pay 10 percent for a loan, then a rate of

about 10 percent would be built into the lease contract. The lessee is generally given an option to

renew the lease at a reduced rate upon expiration of the basic lease. However, the basic lease

usually cannot be cancelled unless the lessor is paid in full. Also, the lessee generally pays the

property taxes and insurance on the leased property. Since the lessor receives a return after, or net

of, these payments, this type of lease is often called a “net, net” lease.

C. Sale-and-Leaseback Arrangements

Under a sale-and-leaseback arrangement, a firm that owns land, buildings, or equipment sells the

property to another firm and simultaneously executes an agreement to lease the property back for

a stated period under specific terms. The capital supplier could be an insurance company, a

commercial bank, a specialized leasing company, the finance arm of an industrial firm, a limited

partnership, or an individual investor. The sale-and-leaseback plan is an alternative to a mortgage.

Note that the seller immediately receives the purchase price put up by the buyer. At the same time,

the seller-lessee retains the use of the property. The parallel to borrowing is carried over to the

lease payment schedule.

Sale-and-leaseback arrangements are almost the same as financial leases, the major difference

being that the leased equipment is used, not new, and the lessor buys it from the user-lessee

instead of a manufacturer or a distributor. A sale-and leaseback is thus a special type of financial

lease.

D. Combination Leases

Many lessors now offer leases under a wide variety of terms. Therefore, in practice leases often do

not fit exactly into the operating lease or financial lease category but combine some features of

each. Such leases are called combination leases.

 To illustrate, cancellation clauses are normally associated with operating leases, but many of

today’s financial leases also contain cancellation clauses.

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 However, in financial leases these clauses generally include prepayment provisions

whereby the lessee must make penalty payments sufficient to enable the lessor to recover

the unamortized cost of the leased property.

3. Equity Shares/common shares

Equity Shares also known as ordinary shares, which means, other than preference shares. Equity

shareholders are the real owners of the company. They have a control over the management of the

company. Equity shareholders are eligible to get dividend if the company earns profit. Equity

share capital cannot be redeemed during the lifetime of the company. The liability of the equity

shareholders is the value of unpaid value of shares.

Features of Equity Shares

Equity shares consist of the following important features:

1. Maturity of the shares: Equity shares have permanent nature of capital, which has no maturity

period. It cannot be redeemed during the lifetime of the company.

2. Residual claim on income: Equity shareholders have the right to get income left after paying

fixed rate of dividend to preference shareholder. The earnings or the income available to the

shareholders is equal to the profit after tax minus preference dividend.

3. Residual claims on assets: If the company wound up, the ordinary or equity shareholders have

the right to get the claims on assets. These rights are only available to the equity shareholders.

4. Right to control: Equity shareholders are the real owners of the company. Hence, they have

power to control the management of the company and they have power to take any decision

regarding the business operation.

5. Voting rights: Equity shareholders have voting rights in the meeting of the company with the

help of voting right power; they can change or remove any decision of the business concern.

Equity shareholders only have voting rights in the company meeting and also they can

nominate proxy to participate and vote in the meeting instead of the shareholder.

6. Pre-emptive right: Equity shareholder pre-emptive rights. The pre-emptive right is the legal

right of the existing shareholders. It is attested by the company in the first opportunity to
 Financial Management: Chapter 6 Financing Decision

purchase additional equity shares in proportion to their current holding capacity.

7. Limited liability: Equity shareholders are having only limited liability to the value of shares

they have purchased. If the shareholders are having fully paid up shares, they have no liability.

Advantages of Equity Shares

Equity shares are the most common and universally used shares to mobilize finance for the

company. It consists of the following advantages.

1. Permanent sources of finance: Equity share capital is belonging to long-term permanent nature

of sources of finance, hence, it can be used for long-term or fixed capital requirement of the

business concern.

2. Voting rights: Equity shareholders are the real owners of the company who have voting rights.

This type of advantage is available only to the equity shareholders.

3. No fixed dividend: Equity shares do not create any obligation to pay a fixed rate of dividend. If

the company earns profit, equity shareholders are eligible for profit, they are eligible to get

dividend otherwise, and they cannot claim any dividend from the company.

4. Less cost of capital: Cost of capital is the major factor, which affects the value of the company. If

the company wants to increase the value of the company, they have to use more share capital

because, it consists of less cost of capital (Ke) while compared to other sources of finance.

5. Retained earnings: When the company have more share capital, it will be suitable for retained

earnings which are the less cost sources of finance while compared to other sources of finance.

Disadvantages of Equity Shares

1. Irredeemable: Equity shares cannot be redeemed during the lifetime of the business concern. It

is the most dangerous thing of over capitalization.

2. Obstacles in management: Equity shareholder can put obstacles in management by

manipulation and organizing themselves. Because, they have power to contrast any decision

which are against the wealth of the shareholders.

3. Leads to speculation: Equity shares dealings in share market lead to secularism during

prosperous periods.
 Financial Management: Chapter 6 Financing Decision

4. Limited income to investor: The Investors who desire to invest in safe securities with a fixed

income have no attraction for equity shares.

5. No trading on equity: When the company raises capital only with the help of equity, the

company cannot take the advantage of trading on equity.

4. Preference Shares

The parts of corporate securities are called as preference shares. It is the shares, which have

preferential right to get dividend and get back the initial investment at the time of winding up of

the company. Preference shareholders are eligible to get fixed rate of dividend and they do not

have voting rights.

Preference shares may be classified into the following major types:

1. Cumulative preference shares: Cumulative preference shares have right to claim dividends for

those years which have no profits. If the company is unable to earn profit in any one or more

years, C.P. Shares are unable to get any dividend but they have right to get the comparative

dividend for the previous years if the company earned profit.

2. Non-cumulative preference shares: Non-cumulative preference shares have no right to enjoy

the above benefits. They are eligible to get only dividend if the company earns profit during the

years. Otherwise, they cannot claim any dividend.

3. Redeemable preference shares: When, the preference shares have a fixed maturity period it

becomes redeemable preference shares. It can be redeemable during the lifetime of the

company. The Company Act has provided certain restrictions on the return of the redeemable

preference shares.

4. Irredeemable Preference Shares

Irredeemable preference shares can be redeemed only when the company goes for liquidation.

There is no fixed maturity period for such kind of preference shares.

5. Participating Preference Shares

Participating preference shareholders have right to participate extra profits after distributing the
 Financial Management: Chapter 6 Financing Decision

equity shareholders.

6. Non-Participating Preference Shares

Non-participating preference shares holders are not having any right to participate extra profits

after distributing to the equity shareholders. Fixed rate of dividend is payable to the type of

shareholders.

7. Convertible Preference Shares

Convertible preference shares holders have right to convert their holding into equity shares after a

specific period. The articles of association must authorize the right of conversion.

8. Non-convertible Preference Shares

There shares, cannot be converted into equity shares from preference shares.

Features of Preference Shares

The following are the important features of the preference shares:

1. Maturity period: Normally preference shares have no fixed maturity period except in the case of

redeemable preference shares. Preference shares can be redeemable only at the time of the

company liquidation.

2. Residual claims on income: Preferential shares holders have a residual claim on income. Fixed

rate of dividend is payable to the preference shareholders.

3. Residual claims on assets: The first preference is given to the preference shareholders at the

time of liquidation. If any extra Assets are available that should be distributed to equity

shareholder.

4. Control of Management: Preference shareholder does not have any voting rights. Hence, they

cannot have control over the management of the company.

Advantages of Preference Shares

Preference shares have the following important advantages.

 Financial Management: Chapter 6 Financing Decision

1. Fixed dividend: The dividend rate is fixed in the case of preference shares. It is called as fixed

income security because it provides a constant rate of income to the investors.

2. Cumulative dividends: Preference shares have another advantage which is called cumulative

dividends. If the company does not earn any profit in any previous years, it can be cumulative

with future period dividend.

3. Redemption: Preference Shares can be redeemable after a specific period except in the case of

irredeemable preference shares. There is a fixed maturity period for repayment of the initial

investment.

4. Participation: Participative preference shareholders can participate in the surplus profit after

distribution to the equity shareholders.

5. Convertibility: Convertibility preference shares can be converted into equity shares when the

articles of association provide such conversion.

Disadvantages of Preference Shares

1. Expensive sources of finance: Preference shares have high expensive source of finance while

compared to equity shares.

2. No voting right: Generally, preference shareholders do not have any voting rights. Hence, they

cannot have the control over the management of the company.

3. Fixed dividend only: Preference shares can get only fixed rate of dividend. They may not enjoy

more profits of the company.

4. Permanent burden: Cumulative preference shares become a permanent burden so far as the

payment of dividend is concerned. Because the company must pay the dividend for the

unprofitable periods also.

5. Taxation: In the taxation point of view, preference shares dividend is not a deductible expense

while calculating tax. But, interest is a deductible expense. Hence, it has disadvantage on the tax

deduction point of view.