BMSCW Department of Commerce

UNIT- 2

CAPITAL OF A COMPANY

Meaning of Capital: According to Marshall, “Capital consists of all kinds of wealth, other than free
gifts of nature, which yield income.” Therefore, every type of wealth other than land which helps in
further production of income is called capital.

Types of capital: There are two types of capital:

Debt capital: It means the money borrowed which must be repaid before certain time period and
generates income for the lender of money in the form of interest.
Equity capital: Money given to company to take the ownership of shares of the company is known as
equity capital.

Meaning Of Share Capital: Share capital denotes the amount of capital raised by the issue of shares,
by a company. It is collected through the issue of shares and remains with the company till its
liquidation. Share capital is owned capital of the company, since it is the money of the shareholder and
the shareholder are the owners of the company.

The amount required by the company for its business activities is raised by the issue of shares. The
amount so raised is called ‘Share Capital’ (or capital) of the company.

PHASES OF SHARE CAPITAL: Share capital of a company can be divided into the following
different categories:

1. Authorized, registered, maximum or nominal capital: The maximum amount of capital, which
a company is authorized to raise from the public by the issue of shares, is known as authorized
capital. This is the amount of capital with which the company intends to get itself registered, therefore
it is also known as registered capital. Nominal capital is divided into shares of a fixed amount. It must
be set out in the memorandum of association. It can be increased or decreased by following the
prescribed procedure.
Authorized capital is known as nominal capital or registered capital. For example: A company wants
to sell 100 shares of . 10/- each, so the total amount collected by the company is . 1000/- i.e. 100
shares x 10 each = 1000.

2. Issued Capital: A company need not issue the entire authorized capital at once. It goes on raising
the capital as and when the need for additional funds is felt. So, issued capital is a part of authorized
capital, which is offered to the public for subscription, including shares offered to the vendor for
consideration other than cash.
For example: A company has issued 80 shares out of 100 authorised shares of . 10/- each so the issued
capital is . 800/-

3. Subscribed Capital: It cannot be said that the entire issued capital will be taken up or subscribed
by the public. It may be subscribed in full or in part. So, it is that part of the issued capital which is
actually subscribed by the general public or which has been actually taken up by the purchaser
of shares in the company and which has been allotted. That is company has issued 80 shares out of
which 70 shares are being bought by the general public, so the subscribed capital is . 700/-. That is 70
shares of . 10/- each. Subscribed capital cannot be more than issued capital.

4. Called Up Capital: It is that part of subscribed capital, which is called by the company to pay
on shares allotted. Called up capital is that amount of the nominal value of shares subscribed for which
1
BMSCW Department of Commerce
the company has asked its shareholders to pay by means of calls or otherwise. For instance, if a
company has asked its shareholders to pay . 5/- per share so on 70 shares, they have to pay 70 shares
x . 5 each = . 350/-. This is the called up capital.

5. Paid-up Capital: That part of the called up capital which is actually paid up by the members is
known as the paid up capital. In other words, paid up capital represents the total payments made by the
shareholders to the company in response to the calls made by the company. Therefore it is known as
real capital of the company. Paid up capital of the company is calculated by deducting the calls in
arrears from the called up capital.
Paid-up Capital = Called up capital - calls in arrears
For example, out of 70 shares which were subscribed for 60 shareholders have paid up their call money,
that is 60 x . 5 = . 300/- is called as the paid up capital of the company.

6. Reserve Capital: It is that part of uncalled capital which has been reserved by the company by
passing a special resolution to be called only in the event of its liquidation. This capital cannot be called
up during the existence of the company. It would be available only in the event of liquidation as an
additional security to the creditors of the company. The purpose of reserve capital is to meet the
interests of the creditors at the time of winding up of the company.

MEANING OF SHARES:
The capital of the company can be divided into indivisible units of fixed amount. These units are called
shares. Holders of these shares are called shareholders or members of the company.
In other words, Share capital of a company is divided into a large number of equal parts and each part
is known is a share.

DEFINITION:
As per section 2(84) of Companies act 2013, “A share means a share in the share capital of the
company and includes stock, except where a distinction between stock and share is expressed or
implied”.

TYPES OF SHARES: A company issues different kinds of shares in order to satisfy the needs of
different classes of investors and to collect more capital.
Public company can issue only two types of shares whereas a private company can issue deferred shares
also along with preference and equity shares. The types of shares are as follows:

I. Equity shares: These shares are also known as ordinary shares. They are the shares which do not
enjoy any preference regarding payment of dividend and repayment of capital. Equity shares will get
dividend and repayment of capital after meeting the claims of preference shareholders.

FEATURES OF EQUITY SHARES:

(i) Right to Income: Equity shareholders have a claim to the residual income, that is, the income left
after paying expenses, interest charges, taxes, preference dividend, if any. Usually, a part of the residual
income is distributed in the form of dividend to the shareholders and other part called retained earnings
is reinvested in the business.

(ii) Claim on Assets/Liquidation Rights: In case of liquidation of the company, equity shares are the
last ones to be paid. If a company goes bankrupt and liquidates all its assets, the ordinary shareholders
have the right to receive their share of sale proceeds. However they are the last to receive money after
the creditors, bondholders and preference shareholders are paid.

2
BMSCW Department of Commerce
(iii) Right to Control: Right to control here means the power to take decisions, frame major policies
and power to appoint directors. Equity shareholders have the legal power to elect directors on the board
and also to replace them if the board fails to protect interest of the shareholders.

(iv)Voting Rights: Each equity share carries one vote. Directors are elected in the annual general
meeting by the majority votes. Thus, every shareholder can participate in the vital affair of election of
directors and cast his vote depending on the number of shares held by him. Shareholders are entitled
to vote in person or by proxy.

(v) Limited Liability: In a company limited by shares, an equity shareholder’s liability is limited to
the amount of investment in his respective share. If his shares are fully paid up, he doesn’t have to
contribute anything in the event of financial stress or winding up of his company.

(vi) Dividend Payments: Ordinary shareholders are entitled to a share of the profits in the form of
dividend. However the amount of dividend payments is not based on a fixed percentage rate, it is
recommended and decided by the board of directors.

(vii) Pre-emptive Rights: If a company plans to issue new shares, existing shareholders have the rights
to subscribe to new shares, often at lower prices, before they are issued to the public.
(viii) Risk/ loss absorption for other investors and other creditors: the shareholders have to bear
the losses of the company as they are liable to the debt to the company and will get no dividend in case
of incurrence of loss by the company.
(ix) They are permanent in nature.
(x) Equity shareholders are the actual owners of the company and they bear the highest risk.
(xi) Equity shares are transferable, i.e. ownership of equity shares can be transferred with or without
consideration to other person.
(xii) Dividend payable to equity shareholders is an appropriation of profit.
(xiii) Uncertain returns: Equity shareholders do not get fixed rate of dividend in other words, they
are not entitled to regular dividends in case of loss. But in case of profits, the returns will be equal to
risk.

Advantages of equity shares:

Advantages to company:

Long-term and Permanent Capital: It is a good source of long-term finance. A company is not
required to pay-back the equity capital during its life-time and so, it is a permanent source of capital.
No Fixed Burden: Unlike preference shares, equity shares suppose no fixed burden on the
company’s resources, because the dividend on these shares are subject to availability of profits and
the intention of the board of directors. They may not get the dividend even when company has
profits. Thus they provide a cushion of safety against unfavourable development
Credit worthiness: Issuance of equity share capital creates no change on the assets of the company.
A company can raise further finance on the security of its fixed assets.
Risk Capital: Equity capital is said to be the risk capital. A company can trade on equity in bad
periods on the risk of equity capital.
Dividend Policy: A company may follow an elastic and rational dividend policy and may create
huge reserves for its developmental programmes.

Advantages to Investors: Investors or equity shareholders may enjoy the following advantages:
3
BMSCW Department of Commerce
More Income/ Potential for Profit: Equity shareholders are the residual claimant of the profits after
meeting all the fixed commitments. The company may add to the profits by trading on equity. Thus
equity capital may get dividend at high in boom period.
The total yield or yields to maturity may be substantial over a period of time.
Right to participate in the Control and Management: Equity shareholders have voting rights and
elect competent persons as directors to control and manage the affairs of the company.
Capital profits: The market value of equity shares fluctuates directly with the profits of the company
and their real value based on the net worth of the assets of the company. An appreciation in the net
worth of the company’s assets will increase the market value of equity shares. It brings capital
appreciation in their investments.
An Attraction of Persons having Limited Income: Equity shares are mostly of lower denomination
and persons of limited recourses can purchase these shares.
Free Transferability: The owner of shares has the right to transfer his interest to someone else. The
buyer should ensure that the issuing corporation transfers the ownership on its books so that dividends,
voting rights, and other privileges will accrue to the new owner.
Share in the Growth: The major advantage of investment in equity shares is its ability to increase in
value by sharing in the growth of company profits over the long run.
Limited Liability: In corporate form of organisation, its owners have, generally, limited liability.
Equity Share is usually fully paid. Shareholders may lose their investment, but no more, they are not
further liable for any failure on the part of the corporation to meet its obligation.

Disadvantages of equity shares::

Dilution in control: Each sale of equity shares dilutes the voting power of the existing equity
shareholders and extends the voting or controlling power to the new shareholders
Trading on equity not possible: If equity shares alone are issued, the company cannot trade on equity.
Over-capitalization: Excessive issue of equity shares may result in over-capitalization. Dividend per
share is low in that condition which adversely affects the psychology of the investors. It is difficult to
cure.
No flexibility in capital structure: Equity shares cannot be paid back during the lifetime of the
company. This characteristic creates inflexibility in capital structure of the company.
High cost: It costs more to finance with equity shares than with other securities as the selling costs and
underwriting commission are paid at a higher rate on the issue of these shares.
Speculation: Equity shares of good companies are subject to hectic speculation in the stock market.
Their prices fluctuate frequently which are not in the interest of the company.

Disadvantages to investors: Equity shares have the following disadvantages to the investors:

Uncertain and Irregular Income: The dividend on equity shares is subject to availability of profits
and intention of the Board of Directors and hence the income is quite irregular and uncertain. They
may get no dividend even three are sufficient profits.
Capital loss During Depression Period: During recession or depression periods, the profits of the
company come down and consequently the rate of dividend also comes down. Due to low rate of
dividend and certain other factors the market value of equity shares goes down resulting in a capital
loss to the investors.
Loss on Liquidation: In case, the company goes into liquidation, equity shareholders are the worst
suffers. They are paid in the last only if any surplus is available after every other claim including the
claim of preference shareholders is settled.

4
BMSCW Department of Commerce
It is evident from the advantages and disadvantages of equity share capital discussed above that the
issue of equity share capital is a must for a company, yet it should not solely depend on it. In order to
make its capital structure flexible, it should raise funds from other sources also.

Different Types of Equity Issues: The different types of equity issues have been discussed below:

1. New Issue: A company issues a prospectus inviting the general public to subscribe its shares.
Generally, in case of new issues, money is collected by the company in more than one installment—
known as allotment and calls. The prospectus contains details regarding the date of payment and
amount of money payable on such allotment and calls. A company can offer to the public up to its
authorized capital.

2. Bonus Issue: Bonus in the general sense means getting something extra in addition to normal. In
business, bonus shares are the shares issued free of cost, by a company to its existing shareholders. As
per SEBI guidelines, if a company has sufficient profits/reserves it can issue bonus shares to its existing
shareholders in proportion to the number of equity shares held out of accumulated profits/ reserves in
order to capitalize the profit/reserves. Bonus shares can be issued only if the Articles of Association of
the company permits it to do so. They are advantageous to the equity shareholders as they get additional
shares free of cost and also they earn dividend on them in future.

3. Rights Issue: According to Section 81 of The Company’s Act, 1956, rights issue is the subsequent
issue of shares by an existing company to its existing shareholders in proportion to their holding. Right
shares can be issued by a company only if the Articles of Association of the company permits. Rights
shares are generally offered to the existing shareholders at a price below the current market price, i.e.
at a concessional rate, and they have the options either to exercise the right or to sell the right to another
person. Issue of rights shares is governed by the guidelines of SEBI and the central government.

4. Sweat Issue: According to Section 79A of The Company’s Act, 1956, shares issued by a company
to its employees or directors at a discount or for consideration other than cash are known as sweat
issue. The purpose of sweat issue is to retain the intellectual property and knowhow of the company.
Sweat issue can be made if it is authorized in a general meeting by special resolution. It is also governed
by Issue of Sweet Equity Regulations, 2002, of the SEBI.

II. Preference shares: These shares are those shares which are given preference as regards to payment
of dividend and repayment of capital over the equity shareholders, as in the case of winding up of the
company.

Sec. 45 of the Companies Act 2013 defines “preference shares as those shares which carry preferential
rights as the payment of dividend at a fixed rate and as to repayment of capital in case of winding up
of the company”.

Features of preference shares:

Preference shareholders get priority over ordinary shareholders in respect of dividend and repayment
of capital
Preference shareholders are not the owners of the company and as such they do not have voting rights.
Preference shareholders cannot interfere in the management affairs of the company.
They have the preference in getting back their capital first before anything is paid to other classes of
shareholders in the event of winding up.
They generally have voting rights only on those resolutions which directly affects their interest.
It is preferred by the cautious investors who do not want to undertake much risk.

5
BMSCW Department of Commerce
DIFFERENCE BETWEEN EQUITY SHARES AND PREFERENCE SHARES :
Sl No. Equity shares Preference shares

1. They are entitled to dividend only after They are entitled to dividend as a
payment of dividend to preference preferential right before dividend is
shareholders. paid to equity shareholders.
2. They have preferential rights over the
Their capital is repaid to them only after
equity shares in the matter of
repayment of capital to preference
repayment of capital in the event of
shareholders.
liquidation.
3. The dividend is paid out of profits as
They are paid to them at a fixed rate
recommended by the board and approved by
subject to profits.
the members in the annual general meeting.
4. In case of cumulative preference
Dividends payable to equity shares are non-
shares the arrears of dividends are
cumulative only.
cumulative until it is paid.
5. They cannot be redeemed except:
They may be redeemed by the
As reduction of capital u/s 100 with court
company over a period of time u/s 80.
approval
Irredeemable preference shares are
Buy back of shares u/s 77(a)
not supposed to be issued.
On winding up of the company.
6. Their voting rights are restricted and
They are entitled to voting right on every arise only in certain specified
resolution placed before the general meeting. circumstances or matters affecting
their interests.
7.
They are entitled to right/bonus shares when They are not entitled to any
declared by the company. right/bonus shares.

8. Though equity shareholders do not enjoy

preferential rights, they are more preferred by
the investing public because the listed equity Preference shares are illiquid.
shares enjoy more liquidity in the stock
market.
9. As the rate of dividend on preference
In case of equity the market value fluctuates shares is fixed or stable, the market
as the dividend rates are not stable. value of preference shares remain
more or less stable.
10. As there is steady dividend like rent
There is a lot of risk in equity shares so it is
preference share capital is considered
considered as risk capital.
as rentier capital.
11. Preference shares appeal to the
Equity share capital to the adventurous
cautious investors who want to take
investors who are prepared to assume risk.
up less risk.
12. Preference shares except participating
The equity shareholders can participate in the preference shares cannot participate in
surplus profits and in surplus assets in case of the surplus profits and in surplus
winding up of a company. assets in case of winding up of a
company.
6
BMSCW Department of Commerce
13. Preference shareholders have no
The equity shareholders have much control
much control over the management of
over the management of the company.
the firm.
14. Equity shareholders are the real owners of the Preference shareholders are not the
company. real owners of the company.
15. Preference shares provide both long
Equity shares provide only long term capital.
and medium term capital.
16.
Equity share holders are ready to sacrifice Preference shareholders are ready to
stability but not prosperity sacrifice prosperity but not stability.
17. Equity shares can never be converted into Preference shares can be converted
preference shares into equity shares.
18. Comparatively less risk involved from
Equity shareholders are the Primary risk
the preference shareholder’s point of
bearers
view.

Different Types of Preference Shares:

Preference share may be classified under following categories:

i. According to Redeemability: Under this category preference shares is classified into following two
categories.
a. Redeemable Preference Shares: Redeemable preference shares are those shares which are
redeemed or repaid after the expiry of a stipulated period or after giving the prescribed notice as desired
by the company. As per The Companies (Amendment) Act, 1988, a company can issue redeemable
preference shares which are redeemable within 10 years from the date of issue. It must be authorized
by the articles of association to make such an issue.
b. Irredeemable Preference Shares: Irredeemable preference shares are those shares which are not
redeemed before a stipulated period. It does not have a specific maturity date. Such shares are redeemed
at the time of liquidation of the company. As per The Companies (Amendment) Act, 1988, a company
at present cannot issue irredeemable preference shares. Since there is an absence of maturity, they are
also known as perpetual preference share capital.

ii. According to Right of Receiving Dividend: As per this category, preference shares are classified
under two heads:

a. Cumulative Preference Shares: cumulative preference shares allow the preference shareholders to
claim unpaid dividends of the years in which dividend could not be paid due to insufficient profit.
When unpaid dividends on preference shares are treated as arrears and are carried forward to
subsequent years, then such preference shares are known as cumulative or simple preference shares.

b. Non-cumulative Preference Shares: The holders of non-cumulative preference shares will get
preference dividend if the company earns sufficient profit but they do not have the right to claim unpaid
dividend which could not be paid due to insufficient profit. Dividends on these shares do not get
accumulated.

iii. According to Participation: Under this category preference shares are of two types
a. Participating Preference Shares: preference shares, which have right to participate in any surplus
profit and surplus assets of the company after paying the equity shareholders, in addition to the fixed
rate of their dividend, are called participating preference shares.

7
BMSCW Department of Commerce
b. Non-participating Preference Shares: Preference shares, which have no right to participate on the
surplus profit or in any surplus on liquidation of the company, are called non-participating preference
shares.
Preference shares are presumed to be non-participating unless expressly provided in Memorandum of
Association and Articles of Association.

iv. According to Convertibility: According to convertibility, preference shares are of two types:
a. Convertible Preference Shares: The holders of convertible preference shares are given an option
to convert whole or part of their holding into equity shares after a specific period of time at some agreed
terms and conditions.
b. Non-convertible Preference Shares: The holders of non-convertible preference shares do not have
the option to convert their holding into equity shares i.e. they remain as preference share till their
redemption.

ADVANTAGES OF PREFERENCE SHARES: The advantages of Preference shares are as follows:

(A) Advantages from Company point of view: The company has the following advantages by issue
of preference shares.

I. Fixed Return: The dividend payable on preference shares is fixed that is usually lower than that
payable on equity shares. Thus they help the company in maximizing the profits available for dividend
to equity shareholders.

II. No Voting Right: Preference shareholders have no voting right on matters not directly affecting
their right hence promoters or management can retain control over the affairs of the company.

III. Flexibility in Capital Structure: The company can maintain flexibility in its capital structure by
issuing redeemable preference shares as they can be redeemed under terms of issue.

IV. No Burden on Finance: Issue of preference shares does not prove a burden on the finance of the
company because dividends are paid only if profits are available otherwise no dividend.

V. No Charge on Assets: Preference shares do not create any mortgage or charge on the assets of the
company. The company can keep its fixed assets free for raising loans in future.

VI. No Interference: Generally, preference shares do not carry voting rights. Therefore, a company
can raise capital without dilution of control. Equity shareholders retain exclusive control over the
company.

VII. Appeal to Cautious Investors: Preference shares can be easily sold to investors who prefer
reasonable safety of their capital and want a regular and fixed return on it.

VIII. No Obligation for Dividends: A company is not bound to pay dividend on preference shares if
its profits in a particular year are insufficient. It can postpone the dividend in case of cumulative
preference shares also. No fixed burden is created on its finances.

IX. Flexibility: A company can issue redeemable preference shares for a fixed period. The capital can
be repaid when it is no longer required in business. There is no danger of over-capitalisation and the
capital structure remains elastic.

8
BMSCW Department of Commerce
(B) Advantages from Investors point of view: Investors in preference shares have the following
advantages:

I. Regular Fixed Income: Investors in cumulative preference shares get a fixed rate of dividend on
preference share regularly even if there is no profit. Arrears of dividend, if any, is paid in the year's) of
profits.

II. Preferential Rights: Preference shares carry preferential right as regard to payment of dividend
and preferential as regards repayment of capital in case of winding up of company. Thus they enjoy
the minimum risk.

III. Voting Right for Safety of Interest: Preference shareholders are given voting rights in matters
directly affecting their interest. It means their interest is safeguarded.

IV. Lesser Capital Losses: As the preference shareholders enjoy the preferential right of repayment
of their capital in case of winding up of company, it saves them from capital losses.

V. Fair Security: Preference share are fair securities for the shareholders during depression periods
when the profits of the company are down.

DISADVANTAGES OF PREFERENCE SHARES: The important disadvantages of the issue of

preference shares are as below:

(A) Demerits for companies: The following disadvantages to the issuing company are associated with
the issue of preference shares.

I. Higher Rate of Dividend: Company is to pay higher dividend on these shares than the prevailing
rate of interest on debentures of bonds. Thus, it usually increases the cost of capital for the company.

II. Financial Burden: Most of the preference shares are issued cumulative which means that all the
arrears of preference dividend must be paid before anything can be paid to equity shareholders. The
company is under an obligation to pay dividend on such shares. It thus, reduces the profits for equity
shareholders.

III. Limited Appeal: Bold investors do not like preference shares. Cautious and conservative investors
prefer debentures and government securities. In order to attract sufficient investors, a company may
have to offer a higher rate of dividend on preference shares.

IV. Low Return: When the earnings of the company are high, fixed dividend on preference shares
becomes unattractive. Preference shareholders generally do not have the right to participate in the
prosperity of the company.

(B) Demerits for Investors: Main disadvantages of preference shares to investors are:

I. No Voting Right: The preference shareholders do not enjoy any voting right except in matters
directed affecting their interest.

II. Fixed Income: The dividend on preference shares other than participating preference shares is fixed
even if the company earns higher profits.

9
BMSCW Department of Commerce
III. No claim over surplus: The preferential shareholders have no claim over the surplus. They can
only ask for the return of their capital investment in the company.

IV. No Guarantee of Assets: Company provides no security to the preference capital as is made in
the case of debentures. Thus their interests are not protected by the assets of the company.

V. Fear of Redemption: The holders of redeemable preference shares might have contributed finance
when the company was badly in need of funds. But the company may refund their money whenever
the money market is favourable. Despite the fact that they stood by the company in its hour of need,
they are shown the door unceremoniously.

VI. Costly Source of Finance: Preference shares are considered a very costly source of finance which
is apparently seen when they are compared with debt as a source of finance. The interest on debt is a
tax deductible expense whereas the dividend of preference shares is paid out of the divisible profits of
the company i.e. profit after taxes and all other expenses.

III. Deferred shares: These shares are those shares which are held by the founders or beginners of the
company. They are also called as Founder shares or Management shares or promoter’s shares.
Deferred shares are shares whose right to receive dividend and their right to receive the refund of
capital in the event of the winding up of the company is deferred or postponed to the end. In other
words, these are the shares which get dividend only after the payment of dividend to preference and
equity shareholders. Companies act prohibits the issue of deferred shares by a public company.
However an independent private company which is not a subsidiary of public company can issue
deferred shares.

DEBENTURES:

Introduction: If a company needs funds for extension and development purpose without increasing
its share capital, it can borrow from the general public by issuing certificates for a fixed period of time
and at a fixed rate of interest. Such a loan certificate is called a debenture.

Meaning: Debenture is an instrument that signifies the acknowledgement of a debt, given under the
seal of the company and containing a contract for the repayment of principal sum at a specified date
and for the payment of interest (usually half yearly) at affixed rate until the principal sum is repaid and
it may or may not give a charge on the assets of the company as security for loan.

Definition: Section 2(30) of the companies act, 2013 “a debenture includes debenture stock, bonds and
any other securities of a company, whether constituting a charge on the assets of the company or not.”

Features of Debentures:

Debenture holders are the creditors of the company for the amount mentioned in the acknowledgement
carrying a fixed rate of interest to be paid periodically.
Debenture is redeemed after a fixed period of time and it is not a permanent capital.
Debentures may be either secured or unsecured. But it will be usually secured.
Interest payable on a debenture is a charge against profit and hence it is tax deductible expenditure.
Debenture holders do not enjoy any voting
Interest rate is predetermined.
Cost of raising the debentures is generally lower than the preference shares and equity shares. Thus it
is a cheap source of finance.
It is a risky capital
10
BMSCW Department of Commerce
It is a long term source of funds.
Debenture holders will not bear any risk. Debenture holders are entitled to regular interest even in case
of incurrence of loss.
Debenture certificate always bears the seal/stamp of the company. However, when it is signed by 2 or
more directors of the company but does not bear the seal is also a valid.
Debentures can be issued by a public company as well as private company. With effect from 1/1/1984,
the standard denomination or face value of a debenture should be . 100.

Advantage of Debentures: Following are some of the advantages of debentures:

1. Preferred by Investors: A company can raise large amount by issue of debentures because investors
give weightage to safety of capital on fixed rate of return.
2. Maintenance of Control/ no dilution in control: No voting rights are conferred on the debenture-
holders and as a result they cannot weaken the control of existing shareholders. Issue of debenture does
not result in dilution of interest of equity shareholders as they do not have right either to vote or take
part in the management of the company.
3. Reliable Source: The debentures can be issued for long periods as a result of which the company
can take up the projects for further expansion.
4. Trading on Equity: The company can adopt the policy of trading on equity and thereby increasing
the return of equity shareholders. In other words, company can adopt lower rate of interest than the
earnings of the company.
5. Interest charged against Profits: For the purpose of income-tax, company enjoys the benefit by
issuing debentures as the interest paid on debentures is deductible from the profits of the company.
6. Less Costly: Usually the rate of interest is lower than the rate of dividend payable on preference
shares and equity shares. So raising of capital through debentures is less costly.
7. Remedy against over capitalisation: Whenever the company is over capitalised, it can redeem
debentures
8. Interest on debenture is a tax deductible expenditure and thus it saves income tax.
9. Interest on debenture is payable even if there is a loss, so debenture holders bear no risk.

Disadvantages of Debentures: Following are the disadvantages of debentures:

1. Permanent Burden: The Company is obliged to bear a fixed burden of interest, irrespective of the
profits earned by the company.

2. Danger of Liquidation: There is the danger of liquidation if the company fails to pay interest at the
stipulated time.

3. High Denomination: Debentures are usually issued in high denominations and as such common
investors cannot afford/ purchase debentures.

4. Loss of Credit worthiness in Stock Market: Due to one or more mortgage charges on the assets
of the company (necessary to issues debentures), debentures causes the loss of credit in the stock
market.

5. Costly: Debentures are expensive source of financing due to high stamp duty. A company has to fix
. 15 stamps for bearer debenture and . 7.50 for registered debentures of . 1,000 each.

6. Debentures are issued to trade on equity but too much dependence on debentures increases the
financial risk of the company.

11
 BMSCW Department of Commerce
TYPES OF DEBENTURES: A company may issue the following types of debentures.

On the basis of convertibility:

1. Convertible debentures: Convertible debenture holders are given the option to convert their holdings
into preference shares or equity shares at a standard rate of exchange on the expiry of the stipulated
period. The option must be exercised within a fixed period.

2. Non-convertible debentures: A non-convertible debenture is a debenture where there is no option for

its conversion into equity shares. Thus the debenture holders remain debenture holders till maturity.

On the basis of security:

1. Secured/ mortgage debentures: Secured debentures are those which create fixed or floating charge
on the property of issuing company. This type of debenture is issued by mortgaging an asset and
debenture holders can recover their dues by selling that particular asset in case the company fails to
repay the claim of debenture holders. They are the secured creditors of the company. The charge
created may be fixed or floating.
Fixed charge: Debentures is said to enjoy fixed charge when the charge is created on specific or
definite immovable property of the company.
Floating charge: In case of floating charge the charge is not created on any specific asset or property
of the company. Floating charge is created on the assets of the company in general.

2. Unsecured/ ordinary debentures: On the other hand, debentures which do not create any charge or
security on the assets of the company are known as naked or unsecured debentures. The holders of
these debentures like ordinary unsecured creditors may sue the company for the recovery of the debt.

On the basis of transferability/ registration:

1. Registered debentures: Registered debentures are those debentures where names, address, serial num-
ber, etc., of the debenture holders are recorded in the register book of debenture holders of the company
and also on debenture certificate. Such debentures cannot be easily transferred to another person. It is
a non-negotiable debenture. Only those debenture-holders whose name appears in the register are
entitled to repayment of the principal amount (capital) and periodical payment of interest.
2. Bearer debentures/ Unregistered Debentures: Unregistered debentures may be referred to those
debentures where there is no registration of the holder. The name of the holder is not mentioned either
on the debenture bond or in a register of debenture holders. It can be transferred by mere delivery
without informing the company.

On the basis of redeemability:

1. Redeemable debentures: Redeemable debenture is a debenture which is redeemed/repaid on a prede-

termined date and at predetermined price. These are issued only for a specific period.
2. Irredeemable Debenture: Irredeemable or perpetual debentures are those which are not repayable
during the life time of the company. But the debt becomes due for redemption only when the company
goes into liquidation or when the interest is not regularly paid as and when accrued. It can also be
repaid at the option of the company by giving prior notice.

Share Certificate: A share certificate is a document issued under the common seal of the company
and it states the extent of the interest of its holder in the company's capital. This certificate is usually
given free of charge to every member whose name is entered in the register of members.

12
BMSCW Department of Commerce
Share warrant: A share warrant is a bearer document of title to shares and can be issued only by
public limited companies and that too against fully paid up shares only. A share warrant cannot be
issued by a private company, because the share warrant states that its bearer is entitled to a number of
shares mentioned there in.
DISTICNTION BETWEEN DEBENTURES AND SHARES:

SHARES DEBENTURES
Shares are part of the capital of a company It constitutes a loan
The shareholders are members/owners of the Debenture holders are creditors.
company
Shares do not carry any charge on the assets of Debentures generally have a charge on the
the company. assets of the company.
Shareholders are entitled to get dividend Debenture holders are entitled to get interest.
The dividend varies from year to year The rate of interest is fixed.
depending upon the profit of the company and
the Board of Directors discretion.
Shareholders enjoy voting rights. Debenture holders do not have any voting
rights.
Dividend can be paid to shareholders only out Interest is payable even if there are no profits
of the profits of the company. i.e., even out of capital.
Dividend paid cannot be claimed as allowable Interest paid on debentures is allowable as
expenditure. business expenditure for the purpose of
income tax.
Shares may be fully paid or partly paid. Debentures are always fully paid.
Share capital is not refunded or repaid during Debentures are repaid after a certain period.
the existence of the company except
preference shares.
When the company is wound up the claims of Claims of debenture holders will be
shareholders will be secondary. considered first in the order of payment.
Share certificates can be issued even before Debenture certificates can be issued only
the last call on the shares is paid. when the last instalment or call is paid.
Shares can be forfeited Debentures are not forfeited.

BOOK BUILDING PROCESS:

Definition: SEBI (disclosure and investor protection) guidelines, 2000 defines book building as “a
process by which a demand for the securities proposed to be issues by a body corporate is elicited and
built up and the price for such securities is assessed for the determination of quantum of such securities
to be issued by means of a notice, circular, advertisement, document or information memoranda or
offer documents.
Meaning: Book building is the process of determining the quantum of shares to be issued and the price
at which the shares are to be issued on a feedback from potential investors based upon their perception
about the company.

STAGES INVOLVED IN BOOK BUILDING PROCESS:

13
 BMSCW Department of Commerce
1) QUANTITY ASSESSMENT STAGE: Quantity assessment stage is concerned with the assessment
of demand shares and the determination of the quantity (i.e., the number) of shares to be issued, and
the price band of the issue.
a) Appointment of lead book runner: A lead book runner has to be appointed by the issuing
company. A lead book runner is a merchant banker who is required to act as the lead book runner
and to perform the various operations connected with issue of shares through the book building
process.
b) Preparation of information memorandum: the information memorandum is a document which
contains information about the issuing company, its promoters, financial structure, operations, etc.
c) Sending the copies of information memorandum to qualified institutional buyers: after the
information memorandum is prepared, copies of the same are sent to all the qualified institutional
buyer through the syndicate members.
d) Collection of information by syndicate members: the syndicate members collect information
about the quantities of shares and the prices at which the qualified institutional buyers are willing
to buy the shares, and supply that information to the lead book runner.
e) Determination of quantity of shares to the offered and price band: after the collection of
information from the qualified institutional buyers, through the syndicate members, the lead book
runner, in consultation with the issuing company, decides the quantity of shares to be issued, and
the price band (i.e., the range of the issue price, say, Rs 30 to 40) within which the investors can
bid.
2) ISSUE STAGE: Issue stage is concerned with all operation undertaken before the issue of shares and
also during the issue of share.
a) Entering into underwriting agreement: the lead book runner has to enter into underwriting
agreements with the syndicate members, who are eligible to be appointed as underwriters for the
underwriting of shares.
b) Appointment of other financial intermediaries: the service of other financial intermediaries like
the registrar to the issue, bankers to the issue, etc. are required. The other financial intermediaries
are appointed by the lead book runner in consultation with the issuing company.
c) Sending application to stock exchange for listing: listing of shares is mandatory for book
building. So, an application has to be sent by the issuing company to the stock exchange for the
listing of its shares, after allotment.
d) Preparation of draft red-herring prospectus: a red-herring prospectus has to be prepared, a red-
herring prospectus which contains all the details about the public issue, except the price band and
the quantum of shares to be issued.
e) Informing the registrar of companies: the registrar of companies has to be informed about the
issue of shares through book building by sending a copy of the red-herring prospectus.
f) Agreement with the depository: the issuer should enter into an agreement with a depository, either
the NSDL (National Service Depository Ltd.) or the CDSL ( Central Depository Service Ltd.) for
crediting the shares allotted in electronic from to the demat accounts of those who are allotted the
shares.
g) Appointment of an advertising agency: The advertising agency announces the issue of shares
through book building process through statutory advertising media and also through other
conventional media of advertisement like hoardings, magazines, T.V. channels, etc.
h) Despatch of application forms: The registrar to the issue must make the necessary arrangements
for sending the bid-cum application forms to the syndicate members.
i) Opening the subscription list: The issue should be kept open for a minimum of 5 days with atleast
3 working days.
j) Receipt of bid-cum application forms: The syndicate members receive bid-cum application forms
from the applicants.
k) Sending the bid forms on the closure of subscription list: On the closure of the subscription list,
the syndicate members send the bid-cum application forms received by them from the investors to
either the lead book runner or the registrar to the issue.
14
 BMSCW Department of Commerce
3) ALLOTMENT STAGE: Lead book runner makes the allotment to qualified institutional buyers, and
the registrar to the issue makes the allotment to the retail investors. The allotment of shares should be
made within 15 days. Allotment of shares involves the following operation:
a) Determination of the cut-off price or issue price: The lead book runner, in consultation with the
issuer company, decides the issue price (i.e., the price at which the shares will be allotted), based on
the bids received from the qualified institutional buyers and the retail investors.
b) Determination of the basis allotment: After the cut-off price is determined, the basis allotment
will be determined.
c) Crediting the Demat accounts: As shares are allotted in electronic form or Demat form in book
building process, the allotted shares will be credited to the Demat accounts of the allottees (i.e., the
investors), and communication about the allotment will be sent of the allottees.
d) Listing of shares: The shares should be listed immediately on the stock exchange.
e) Sending of final prospectus: The final prospectus containing the cut-off price or issue price will
be prepared, and sent to the Registrar of Companies.

SEBI GUIDELINES FOR THE ISSUE OF SHARES:

1. When shares are issued by a company to the public an advertisement in a leading newspaper is given
along with some important extracts of the prospectus, for the information of general public.
2. People who are interested in purchasing the shares on the basis of information may have the
application form and the prospectus for detailed information.
3. If a person is satisfied with thee profitability and other things, he fills up the application form and
deposits the application money with the prescribed schedules bank.
4. As per sec 69(3) of companies act 1956, sum equal to atleast 5% of nominal value of shares must
be received in cash by the company as application money, but as per SEBI guidelines minimum
application money to be paid shall not be less than 25% of issue price.
5. Minimum number of shares for which application is to be made should be fixed at 500 shares of the
face value of . 10 each, in case of public issue at par. If the issue is at premium amount payable by
each applicant shall not be less than . 5000 irrespective of the size of the premium.
6. Scheduled bank will send the application money along with a list of applicants to the company
which will ultimately record this in its application and allotment book.
7. Subscription list should be kept open for at least 3 working days and disclosed in the prospectus.
8. After receiving application director takes steps to allot the shares. Directors have discretionary
power either to reject or accept partially the application for the purchase of shares.

A public company cannot allot shares unless the following conditions are satisfied:
a) The minimum subscription stated in prospectus that is (90% of the issued amount) has been
received. If not it should refund the amount within 120 days of issue of prospectus and pay interest
at 6% per annum for delay by more than 10 days after this period of 120 days.
b) A prospectus or a statement in lieu of prospectus has been filed with registrar of companies before
first allotment.
c) Application amount which is at least 25% of the issued price has been received.

The applicants to whom shares are allotted will be sent allotment letters and those to whom shares
could not be allotted will be sent letter of regret along with refund of application money.

SEBI GUIDELINES ISSUED ON 11/06/1992:

15
BMSCW Department of Commerce
First issue of new companies: A new company is defined as one which has not completed 12 months
of commercial operations and its audited operative results are not available, and which is set by
entrepreneurs without any track record. Such company will be permitted to issue capital to public only
at par.
Where a new company is setup by existing companies with a 5 year track record of consistent profit, it
will be free to price its issue. The participation of the promoting companies in such company should
not be less than 50% of the equity and issue price must be made applicable to all investors uniformly.
No private placement of promoters of shares shall be made by solicitation of share contribution from
un-related investors through any kind of market intermediaries.
The shares of the above companies can be listed on either over the counter exchange of India or any
other stock exchange.

First issue by existing private /closely held companies:

a) The companies with 3 years of consistent profits are permitted to freely price the issue and list their
securities on stock exchange.
b) Not less than 20% equity should be offered.
c) Draft prospectus should be vetted by SEBI to ensure adequacy disclosure.
d) Pricing would be determined by the issuer and the lead manager to the issue and would be subject
to specific disclosure requirements including:
Disclosure of the net asset value of the company as per the last audited balance sheet.
Justification for the issue price.

PUBLIC ISSUE:
The eligibility criteria which have to be satisfied by the Unlisted Company to make public issue
are as follows:
1. Pre-issue net worth of company should not be less than . 1 crore and it should be maintained for
last 3 out of 5 years with minimum networth.
2. The net worth should be met for upcoming 2 years.

3. Tracking of the records of profits has to be maintained for at least 3 years out of immediately
upcoming 5 years.
4. Issue size should not be more than 5 times its pre-issue networth.
5. In case these requirements are not satisfied then the company can issue through book-building
process, it has to allot at least 60% of issue size to Qualified Institutional Buyers.

Eligibility criteria for a listed company to make public issue:

The eligibility criteria which need to be satisfied by the listed company to make a public issue are as
follows:-
1. If the issue size which is a collective combination of offer document, firm allotment, and promoters’
contribution is less than 5 times its pre-issue net worth.
2. The listed company goes through the book building process and allot 60% of the issue size to
Qualified Institutional Buyers if issue size is more than or equal to 5 times of pre-issue net worth.
Promoter’s contribution:

16
BMSCW Department of Commerce
In case of an Initial Public Offer (IPO).i., public issue by unlisted company, the promoters have to
necessarily offer at least 20% of the post issue capital.
In case of public issue by listed companies, the promoters shall participate either to the extent of 20%
of the proposed issue or ensure post-issue shareholding to the extent of 20% of the post issue capital.

GUIDELINES OF SEBI FOR THE ISSUE OF DEBENTURES

1. Issue of debentures should not exceed more than 20% of gross current assets and also loans and
advances.

2. Debt-equity ratio in issue of debentures should not exceed 2:1. But this condition will be relaxed for
capital intensive projects.

3. Any redemption of debentures will not commence before 7 years since the commencement of the
company.

4. For small investors for value such as Rs. 5,000, payments should be made in one instalment.

5. With the consent of SEBI, even non-convertible debentures can be converted into equity.

6. A premium of 5% on the face value is allowed at the time of redemption and in case of non-
convertible debentures only.

7. The face value of debenture will be Rs. 100 and it will be listed in one or more stock exchanges in
the country.
8. Issue of FCD with a conversion period of more than 36 months: If the FCDs are issued having
a conversion period of more than 36 months, it must be made optional with ‘Call’ and ‘Put’ option.

9 Purpose of Issue: Debenture issued by a company for financing or acquiring shareholding of other
companies in the same group or providing loan to any company belonging to the same is not permitted.
However, it is not applicable to the issue of FCD providing conversion is made within 18 months.

10 Credit Rating: The company must obtain credit rating from CRISIL or any other recognised credit
rating agency if conversion of FCDs is made after 18 months or maturity period of NCDs/PCDs
exceeds 18 months.

11 Debenture Trustees to be appointed: The name of the Debenture trustees must be stated in the
prospectus and the trust deed should be executed within 6 months of the closure of issue. However, the
same is not required if the debenture have maturity period of 18 months or less.

12 Predetermination of Premium on Conversion and Conversion Time: The premium of

conversion of PCDs/FCDs and time of conversion, if any, must be predetermined which should be
stated in the prospectus.

13 Rate of Interest: The rate of interest on Debentures is freely determinable.

14 Conversion Option: If the conversion of debentures is made at or after 18 months from the
allotment date but before 36 months, the same must be made optional to the debenture-holders.

15 Disclosure of: Period of Maturity, Amount of Redemption and yield: Amount of redemption,
period of maturity and the yield on redemption for NCDs/PCDs must be stated in the prospectus.

17
BMSCW Department of Commerce
16. Discounting on Non-convertible portion of PCD: If the PCDs are traded in the market the rate
of discount must be disclosed in the prospectus.

17. Creation of Debenture Redemption Reserve (DRR): It is a must (except for debentures whose
maturity period is 18 months or less).

18. Creation of Charge: If the company proposes to create a charge for the debentures which are
issued for a maturity period of 18 months or less the same must be filed with the Registrar of
Companies. If no charge is created, this compliance of the provisions of Deposit Rule should be
ensured.

19. Roll over of PCD/NCD: Where the non-convertible portions of PCD/NCD are to be rolled over
with or without change in the rate of interest, a compulsory option is to be given to such debenture-
holders who either want to withdraw or en-cash from the programme of debenture.

Letter of information relating to roll over is required to be vetted by SEBI with regard to credit rating,
resolution of the debenture-holders, option for conversion, and such other items which are prescribed
by SEBI. The letter of option, however—for roll over or conversion of debenture, value of which
exceeds Rs. 50,00,000, which are issued by a listed company—must be forwarded to SEBI for vetting
through a merchant banker/lead manager.

20 Monitoring: The lead institution is required to monitor the progress relating to debentures for
modernization, expansion, diversification, normal capital expenditure etc. The lead manager should
also monitor if the debentures are issued for working capital purposes.

21 Creation of Security: The security must be created within a period of 6 months from the date of
issue and if not created within 12 months the company is liable to pay @ 2% penal interest to debenture-
holder. If it is not created even after 18 months, the debenture-holders may call upon a meeting within
21 days to explain the reasons and the date on which these will be created.

The company is also required to file with SEBI, together with a prospectus, a certificate from the
bankers that the assets (which are secured) are free from any encumbrance, has been obtained or, if the
assets are encumbered, No Objection Certificate has to be obtained from a bank/institution for a record.

22 Certificate from the Auditor: The trustees and the institutional debenture-holders must obtain
from the auditors a certificate relating to the utilisation of funds during the period of implementation
of projects. Certificate should also be obtained at the end of each accounting year, if the debentures are
issued for the purpose of working capital.

23 Other Disclosures: Other disclosures include the existing/future equity and long-term debt ratio,
servicing patterns of the existing debentures, payments of interest on term loan, or debenture, etc.
together with a certificate from a bank or financial institution that they have no objection for a second
charge.

18