Classification of Sources of Finance

Long term sources

a. Equity share capital

b. Redeemable Preference shares
c. Debentures / Bonds
d. Retained profits
e. Factoring

Medium term sources

Short term sources

a. Medium term loans

b. Deferred Credit
c. Public Fixed Deposit
d. Medium term loans from banks
e. Leasing and Hire Purchase

a. Cash credit
b. Overdraft
c. Bill Discounting
d. Commercial Paper
e. Trade Credit
f. Advances from customers
g. Credit cards

Distinction between Short-term,

Medium term and long term
Finance

On the basis of
Period of finance required
Sources of finance
Uses of funds
Volume of funds
Security

SHORT TERM

MEDIUM TERM

LONG TERM

Minimum requirement
of one day to a
maximum of on year

One to five years

Five to twenty five

years

--------same-------

---------same-------

----------same--------

Financing seasonal
fluctuations and
working capital

Financing purchase of
stock and debtors of
the company

Financing long term

assets

Volume of funds is
small

Higher than short term

funds

Is high

Security through
debtors and stocks and
reputation of the
company in the market

Security in the form of

property and other
assets

In the form of property

and high value assets

Security financing: Equity, preference

shares and debentures/bonds
Equity shares
bonus issues
Rights issues
Sweat equity shares
Preference shares
Redeemable and irredeemable
Cumulative and non cumulative
Participating and non participating
Convertible and non convertible

 Debentures / Bonds
Redeemable and irredeemable
Secured and unsecured
Warrants
Tax free bonds
Zero coupon bonds
Deep discount bonds
Convertible bonds / debentures
Inflation bonds
Floating rate bonds

Equity shares
Ownership and voting rights.
Are high risk securities
Dividend is declared only when there is a profit
Have the benefit of being traded in the stock market if its
shares are listed on the stock exchange
In case of liquidation the equity shareholders would have
the last rights after satisfying the claims of the debenture
holders and the preference share holders
New equity shares are issued in the New Issue Market
1. Bonus shares
Issued by a company cost free to its existing shareholders
Issued out of reserves or retained profits or share premium
Bonus shares do not have the effect on the volume of
shareholders funds and are issued on pro rata basis and
do not effect their voting rights

2. Rights Issue
It gives a prior advantage to existing
shareholders to subscribe to mew equity
shares of the company
The price is usually lower than the market
value
It increases confidence of the shareholders
3. Sweat equity shares
Are equity shares issued by a company to
its employees or directors at a discount for
consideration other than cash for providing
services or adding value to the companies
work.

Rights of equity share holder

Right to share the profits
Right to control the management
Voting rights at the AGM of the company
Right to receive a copy of annual accounts
and report of the company
Right to claim the residual amount after
repaying the creditors of thee company
Right to call an extraordinary general meeting
if require by thee company
Right to trade and sell thee shares in the
stock market
Right to limited liability to the extent of the
value of their shares

Evaluation of equity shares as a source of financing

Advantages:
1. It is a permanent source of funds
2. Does not have any repayment liability
3. Thee company does not have to pay any
dividends if it is not making a profit
Disadvantages:
4. Costs of funds is high because the expected
return of shareholders has to be satisfied for the
compensation of high risk
5. There are no tax deductible advantages for the
company
Floatation cost of issuing equity capital is
high(merchant bankers fees, brokerage, advertising
costs etc. )

Preference shares
Have ownership rights in the company. They have thee
preferential right to rreceive dividends before the equity
shareholders.
They do not have voting rights and have fixed dividends
Types:
1. Cumulative and Non cumulative
Cumulative preference share have the right to receive
dividends even if a company does not make a profit. When
the company is at a loss they do not receive the dividends
but in the year of making profits the dividend is calculated
and they receive the dividends eve for the year of loss
2. Redeemable and Irredeemable
Irredeemable preference shares are not popular.

3. Participating and Non Participating

Participating shares have the right to receive an extra
dividend after payment of equity share dues and are
also entitled to receive an amount in the residual
assets of the company at the time of liquidation
4. Convertible and Non Convertible
Convertible shares can at the time of maturity be
issued into equity shares or debentures of the company
Evaluation of Preference shares as a source of finance
Advantages:
Irredeemable preference shares do not have a date of
maturity therefore can be used by the company
continuously as a source and they do not have to pay
dividend in the year of loss

 They do not create any charge on the assets of

the company
Do not have an effect on the control pattern of
the company as they do not have voting rights
Are cheaper than equity shares
Disadvantages:
Are not tax deductible hence affects the profits
of the company
Are expensive than issuing debentures
Have a claim over the equity shares on the
assets of the company so their control is diluted.
CONCLUSION:
Preference share is a hybrid security. It resembles
both equity shares and debentures.

Debentures/ Bonds
Are debt securities and have the same features
Fixed rate of interest
Date of maturity
Sourcing for long term purposes
The main features are:
Form
Interest
Redemption
Debenture/ Bond Indenture(trust deed between
company and the trustees that represent the
security holders)
Call and Put option
Credit rating

Types of Bonds/ Debentures

1. Redeemable and Irredeemable
2. Secured and Unsecured
3. Convertible bonds/ debentures(have
lower rate of interest because of this
additional feature)
4. Inflation bonds(adjusting the rate of
inflation)
5. Deep discount bonds

Evaluation
Advantages:
Are a source of long term funds with stable rate of
return.
Cost of debentures is low due to the feature of tax
savings.
Do not create any dilution of control
Disadvantages:
Create an obligation for the company to give interest
continuously to the holders creating a financial
burden on the company
Debenture suit only those companies which have a
stable return
If a company fails and goes into liquidation the
debenture holders have a right to a charge on the
property and assets of the company

Loan financing
Long term loans are taken by industrial
organizations at the time of starting a new
business for expanding their business activities
The loans are of periods between 5 and 10 yrs.
The major financial institutions are which are
set up to provide financial support and facility
to industry for development are :
IDBI, ICICI, IFCI
After NER 1991, commercial banks have
emerged into institutions to provide long term
loans

The special features of loans are:

Security: term loans are fully secured
Interest rate: long term loans have fixed rate of
interest. In India it is low as the loans were given by
government financial institutions
Repayment of loans/ amortization: the borrowers
have to return the loan in installments. The
installment is calculated according to the equated
periodical payments which means that installments
are higher initially and increase in later years
Restrictive provisions/covenants: covenants are
clauses or provisions which are restrictions placed
on the borrower. The borrower has to furnish
periodical financial statements, maintain a
minimum working capital, create sinking fund for
redemption of debts and maintain its net worth.

Evaluation of loan finance as a source of finance

Advantages:
Term loans are attractive because they have a
low rate of interest and have a low financial
burden on the resources of the company
It has the advantage of a moratorium period. This
helps the organization to set up its organization
and develop it
Interest charges are tax deductible
Disadvantages:
these have restrictions on the working of the
company
Some covenants are negative and the functioning
of the company becomes difficult
Flexibility in the company is reduced

Project Financing
It refers to managing and financing the economic activities of
large infrastructural projects.
In project financing, the project, its assets, contracts, cash
flows are separated from their promoters or sponsors in order
to permit credit appraisal and loan to the project, independent
of the sponsors
The project assets are served as a collateral for the loan, and
all loan repayments are made out of the cash flows of the
project.
In the past project financing was mostly used in oil exploration
and other mineral extraction through joint ventures with
foreign firms. Now it is mostly used in infrastructural projects,
particularly in power and telecommunication projects.

Therefore, it is a method of risk sharing by the owners or

sponsors and lenders of thee company. In this manner
developing countries can develop many projects
It involves 3 major concepts:
1. Cash generating assets: a new special purpose
company is formed in which all cash generating
assets are transferred.
2. Special project account
3. Recourse: this means that the sponsors and other
guarantors support the project through contracts or
commitment of additional funds or guarantees of
revenues. It can be full recourse or limited recourse
from the lenders. Projects have full recourse in the
beginning at the start of the stage because of high
risk once they are operational they shift to limited or
no recourse.