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Business Financing

What should be the capital structure of the firm ? What methods of finance should the firm use ?

Which markets should the firm tap ? Which Financing instruments should the firm employ ?

When and what price should the issue be made ? What should be the dividend policy of the firm ? How should a firm communicate with its investors ?
How can a firm improve the standard of corporate governance ?

Capital Structure

Shareholders Funds
Equity Capital Retained Earnings Preference Capital

Loan Funds
Debenture Capital Term Loans Fixed Deposits Working Capital Advance

Capital Structure

EQUITY Have residual claim on income & wealth of the firm Dividend paid not a tax deductible expense

DEBT Have fixed claim in the form of interest & final payment Interest paid to creditors is a tax deductible expense

Capital Structure Key Considerations


Earnings Risk

per share

Control
Flexibility Nature

of Assets

Earnings Per Share


Equity Earnings/ No of outstanding shares The need to understand how sensitive EPS is to changes in PBIT

EPS = (PBIT Int)(1-Tax rate) Preference Dividend No of equity shares

Risk

Business Risk :Variability of PBIT & is influenced by,


Demand Variability Variability of input prices Price variability Proportion of fixed costs

Financial Risk : Risk from financial leverage (high proportion of debt)

Control

DEBT CAPITAL ???

Control

Rights Issue of Equity Capital


Debt Capital

Pros No dilution of control No financial risk No dilution of control Lower costs No financial risk

Cons Severe limits on financing High cost Financial Risk Dilution of control Higher Cost

Public Issue of Equity Capital

Flexibilty

Ability of firm to raise capital from any source it wishes Some financial institutions restrict the debt equity ratio.

Firms do not usually exhaust their full debt capacity

Nature of Assets

Tangible

-----

Debt Equity

Intangible -----

Lenders more willing to lend against tangible assets.

Use more Equity When :

Use more debt when :


Corporate tax rate is negligible

Corporate tax rate is high Business risk exposure is low Dilution of control is an important issue Assets of firm are mostly tangible Firm has few growth options

Business risk exposure is high


Dilution of control is not an important issue Assets of firms are mostly intangible Firm has many valuable growth options

Which instruments / sources should the firm employ ?


Equity Capital
Preference Capital Debenture Capital

Term Loans
Working Capital Advance

Equity Capital

Represents ownership capital

Enjoy reward & risk of ownership


Liability is limited to their capital contribution
Authorized Capital Subscribed Capital Issued Capital Paidup Capital Issue Price Market Value

Issued = Subscribed = Paid-up


Par Value Book Value

Rights of Equity Shareholders

Residual claim in the firm


(Manner in which earnings split into dividends & retained earnings is prerogative of board of directors)

Elect board of directors & right to vote on every resolution placed. Enjoy Pre-emptive rights enables them to maintain proportional ownership. Have residual claim over assets in case of liquidation.

Equity Capital

Advantages : Permanent Capital. No liability for immediate repayment No fixed obligation for dividend payment Enhances credit worthiness of the company Disadvantages : Cost is high Equity dividends are paid from post tax earnings Cost of issuing equity capital is high (underwriting costs, brokerage costs etc.)

Preference Capital
Hybrid form of financing Resembles equity :

Pref div is paid only out of PAT Pymt of Pref Div discretion of directors

Resembles Debt :
Div rate on Pref Capital is fixed Claim on Pref shareholders prior to equity shareholders Pref shareholders do not enjoy right to vote

Debenture Capital
Instruments for raising long term debt Obligation is interest & capital repayment Appointment of trustee

Protects the interest of the debenture holders Ensures that borrowing firm fulfills contractual obligation

Secured by a charge on immovable properties by way of equitable mortgage

Debentures - Features
Redeemable debentures - debenture redeemable reserve Convertible debentures - convert into equity shares Call Feature - issuing company has option to redeem before maturity Put Feature - Holder has right to seek redemption at specified times

Debentures - Evaluation

Advantages :
Cost is lower Interest tax deductible No dilution of control Fixed rate in spite of change in price level

Disadvantages:
Interest & capital repayment obligatory Enhances financial risk of the firm

Term Loans
Source of debt finance Period of loan >1 year to <10 years Used to finance acquisition of fixed assets Secured borrowings (prime security/ collateral security) Interest on loans is a fixed obligation Total debt service burden decreases over time. Restrictive Covenants

Evaluation

Advantages :
Cost of term loans is lower than cost of equity No dilution of control

Disadvantages
Obligatory Interest & Principal payments Restrictive Covenants Increase Financial risk of the firm

Working Capital Advance

Three types :
Cash

Credit / Overdrafts Discount of Bills

Loans
Purchase/

Cash Credit/ Overdrafts


Predetermined limit for borrowing


Can draw as often as required provided outstanding does not exceed limit Payback as/ when desired Interest is charged on running balance not on limit sanctioned

Loans

Advances of fixed Amounts


Credited to the current a/c of the borrower Interest is charged on the entire loan

Purchase/ Discount of Bills

Bill Trade transactions

Seller of goods draws bill on purchaser


On acceptance of bill by purchaser, the seller offers it to the bank for discount /purchase When the bank discounts/ purchases the bill it releases the funds to the seller Bank presents the bill to the purchaser on due date and gets its payment.

Instrument

Issuer
risk, income & control

Investor
Wants to share risk, income & control

Equity shares Wants to share Preference Shares Debentures

Wants tax Has exhausted sheltered debt capacity & unwilling to dividend with issue equity low risk Seeks to contain costs in bad times Seeks down side protection.

Long term loans

Wants fixed Wants fixed nominal cost & nominal cost & maturity maturity

Instrument

Issuer
risk, income & control

Investor
Wants to share risk, income & control

Equity shares Wants to share

Preference Shares Debentures Long term loans

Wants tax sheltered Has exhausted dividend with low debt capacity & risk unwilling to issue equity Seeks to contain costs in bad times Wants fixed nominal cost & maturity Seeks down side protection. Wants fixed nominal cost & maturity