SOURCES OF LONG TERM FINANCE

Need for long term Finance

Long term vs. short term(working capital) funds requirements For modernisation, expansion, diversification; huge quantities reqd., irreversible decision Asset-liability mismatch, interest rate risk, liquidity risk, if LT reqts.met by ST funds

Equity Capital

Authorised, Issued, Subscribed and Paid up capital Par/face value, Issue Price, Book value and Market Value Rights of equity shareholders -Right to Income :PAT less preferred dividends -Right to Control: voting rights -Pre-emptive Right: for additional issues, rights issue in the same proportion -Right in liquidation: residual claim over assets

Pros and cons of equity Capital

Advantages

No fixed maturity, no obligation to redeem No compulsion to pay dividends Provides leverage capacity Dividends tax exempt for investors

Dilution of control of existing owners High Cost: rate of return expected by equityholders higher than debtholders Dividends are not tax deductible: hence cost is higher Issue costs higher: underwriting, brokerage, other issue expenses Higher servicing costs: hold AGMs, post annual reports etc.

Disadvantages

Internal Accruals
Consists of retained earnings and depreciation charges

Pros Readily available, no talking to outsiders Effectively additional equity capital, however no issue costs of loss due to underpricing No dilution of control No expansion in equity base, hence no dilution of EPS, BV per share etc.

Cons Quantum very limited High Opportunity costs: dividends forgone by equity holders Requires careful attention to NPV of projects

Preference Capital
Is a hybrid form of financing, payment after debt but before equity Equity features: -out of distributable profits -not an obligatory payment -dividends not tax deductible Debt features: -dividend rate is fixed -capital is redeemable -normally no right to vote Can have other features like cumulative, convertible, participating..

Preference Capital

Pros No obligation to pay dividend, no bankruptcy or legal action for non payment Financial distress of redemption obligation not very high Part of net worth, hence increases its creditworthiness/ leverage capacity No dilution of control No pledging of assets required

Cons Expensive source since dividends not tax deductible Though no legal consequences, liability to pay dividends stands, can spoil companys image Can acquire voting rights in some cases Have claim prior to equity holders

Term Loans

Provided by FIs/banks Can be in domestic/foreign currency, liability on FC loans translated to rupees for payment Are typically secured against fixed assets/ hypothecation of movable properties, prime security/ collateral security Definite obligations on interest and principal repayment; interest paid periodically; based on credit risk and pegged to a floor rate Carry restrictive covenants for future financial and operational decisions of the company, its management, future fund raising, projects, periodic reports called for

Term Loans

Pros Interest on debt is tax deductible Does not result in dilution of control Do not partake in value created by the firm Issue costs of debt is lower Interest cost is normally fixed, protection against high unexpected inflation Has a disciplining effect on management

Cons Entails fixed obligation for interest and principal, non payment can even lead to bankruptcy/ legal action Debt contracts impose restrictions on firms financial and operational flexibility Increases financial leverage, excess raises cost of equity to the firm If inflation rate dips, cost of debt higher than expected

Debentures

Like promissory notes, are instruments for raising LT debt More flexible compared to term loans as they offer variety of choices as regards maturity, interest rate, security, repayment and other special features Interest rate can be fixed/floating/deep discount Convertibility : Can be FCDs, NCDs, PCDs Warrants : Can have warrants attached, detachable or non detachable, detachable traded separately Option : Can be with call or put option Redemption: Bullet payment or redeemed in instalments Security: Secured or unsecured Credit rating: Need to have a credit rating by a credit rating agency Trustee: Need to appoint a trustee to ensure fulfilment of contractual obligations by company DRR: Company needs to create a DRR if maturity more than 18 months

Other forms of Finance

Leasing: asset leased out in lieu of lease rentals, title not transferred, only economic use of assets given; can be financial lease or operating (service) lease Hire Purchase: ownership transferred to the buyer after all the installments paid up Securitisation: assets involving financial claims pooled and financial instruments created, thus creating cash out of receivables Government Subsidies: central and state govts offer cash subsidies to units in backward areas, classified in three categories Sales tax deferments and exemptions: payment deferred for a fixed period, like interest free loan; or exemptions given for certain no. of years Suppliers credit: available from suppliers of machinery, other fixed assets, terms devised to defer payment, or pay in installments over a period of time

Leasing vs. Hire Purchase

Ownership not transferred to lessee Depreciation benefit to lessor Magnitude of funds high, for big ticket items No margin money/down payment required Maintenance of asset by lessor in operating lease Tax benefits of depreciation taken by lessor; lessee gets tax shield on lease rentals Considered off balance sheet mode of financing, as no asset or liability figures in balance sheet

Leasing

Ownership transferred to hirer on payment of all instalments Depreciation shield available to hirer Maybe for smaller value capital goods Some down payment reqd Maintenance cost borne by hirer Hirer allowed depreciation claim and finance charge for taxation; seller may claim interest on amount borrowed to acquire asset Asset figures in balance sheet on complete of purchase

Hire-Purchase

Raising Long Term Finance

Initial Public Offer (IPO) Secondary Public offer Rights Issue Bought out deals Euro Issues Private Placement Preferential allotment Venture Capital/ Private Equity transactions Obtaining a term loan

Initial Public Offer

Pros Access to larger amount of funds Further growth limited companies not using this route Listing: provides exit route to promoters; ensures marketability of existing shares Encash on value created in the firm Recognition in market Stock prices provide useful indicators to management Sometimes stipulated by private investors in the company

Cons Pricing may have to be attractive to lure investors Loss of flexibility Higher accountability More disclosure requirements to be met Visibility in market Cost of making a public issue quite high

Steps in an IPO

Approval of BOD Shareholders approval Appointment of lead manager(s) Due diligence by LM Appointment of intermediaries like registrars, printers, bankers, advertisers Prepare draft prospectus Filing with SEBI Listing applications filed alongwith draft prospectus Agreement with registrars and depositories Appoint underwriters (if reqd.) Make changes in draft prospectus as per SEBI observations, SE suggestions File prospectus with ROC Issue marketing exercise commences Application forms dispatched Issue opened Basis of allotment finalised Allotments made, refunds posted, shares listed on SEs

Other aspects of a public issue

Eligibility criteria defined: net worth, track record of profitability, issue in same year; secondary issues have no such restrictions Book Building process: process of tendering quantities at prices within a band Issue expenses: underwriting, brokerage commissions, fees to managers to the issue, registrars, printers, advertisers, listing fees, stamp duty Issue pricing: free pricing, disclose basis for issue price Public issue of debt: appointment of debenture trustee, creation of DRR, credit rating reqd., security to be created

Rights Issue
Issue of capital to existing shareholders Offer made on a pro rata basis Offer document called Letter of Offer Option given to apply for additional shares Rights renunciation: are tradeable, may be sold off in the market Value of a share after rights: (NP0+S)/(N+1); N=no. of existing shares required for rights; P0 =cum rights MP per share; S= subscription price of rights issue Value of a right= (P0 S)/(N+1) Comparison with Public issue: with familiar investors, hence likely to be more successful; less floatation costs since no underwriting; but lower pricing to benefit shareholders

Private Placement

Sale of securities directly to wholesale investors like FIs, banks, MFs, FIIs,PE funds etc. Called private placement in equity/equity related instruments, in unlisted companies and in all cases of debt Called preferential allotment in case of unlisted companies for equity/equity related instruments Different from reservations made for such QIBs out of a public issue Subject to SEBI regulations on pricing, lock in period, open offer to be made to public QIB placement guidelines recently issued by SEBI for compliance and disclosures

Private Placement

Pros Less expensive mode Lesser SEBI and other regulations Easier to market the issue to a few investors Entry of wholesale financially sophisticated investors in companys profile May use this route until IPO decision taken Less administrative maintenance

Cons Does not qualify for listing in an unlisted company Restrictive covenants may be imposed by the investors May call for management participation Issue pricing more tight

Venture Capital/Private Equity

Equity finance to potentially high growth companies Reasonably long to medium term commitment Hands on management approach, active participation in management Considered value add investor VC: primarily high risk high return investment esp. in technology oriented/ knowledge intensive businesses with long development cycles, greenfield ventures Can be in unlisted or listed (PIPES) Companies Exit route to be defined at the time of investment Restrictive clauses on promoters holding sell off and other financial/operational issues Detailed memorandum/business plan on company, its financials to be prepared Shareholders agreement to be signed by both parties Valuation of Company key issue Leads to dilution of control by existing promoters

Obtaining a Term Loan

Submission of loan application: a project report containing complete

details of the project given to the FI/Bank

Initial processing of loan application: prepare flash report to decide if

project worth an appraisal or not Project Appraisal: Detailed appraisal done to decide if project taken or not, in terms of market, technical, financial, managerial appraisal Issue of Letter of Sanction: to the borrower containing amount sanctioned and terms and conditions thereto Acceptance of terms and conditions by the borrowing unit: thru a board meeting and conveyed to the FI/Bank Execution of loan agreement: signed by both parties Disbursement of loan: in tranches based on progress of the project, tie up of means of finance Creation of security: formalities to be completed within a timeframe Monitoring: at implementation and operational stage thru periodic progress reports, site visits etc.