Financial Management I

Session 3, 4 & 5

Assets & Liabilities

Investment/Assets
Capital (Long term) Assets - Land, Building, Machinery, Long term lease, long term
investments, etc.
Current (Short term) Assets Inventory, Work in progress, cash, sundry debtors,
bills receivable, prepaid expenditure, short term investment, etc.

Capital/Liability
Capital Shares; theoretically available forever or till firm exists.
Internal accruals & reserves capital holders claim; kept for special needs;
available for continual investment (asset financing); at times application dependent
on purpose of reserve creation, dividend policy of the firm and/or legislative
requirement.
Long term liability Long term loan, Bonds, Debentures, Long term credit for
capital investment by manufacturers/suppliers, etc.
Current (Short term) Liability Sundry creditors, short term loan, bank overdraft,
bills payable, unpaid expenditure, etc.

Working Capital
Current assets current liabilities = working capital
What should be the standard working capital?
Ideal current ratio? (current assets/current liability)
Implications of high current ratio
Implications of low current ratio.
Is 1:1 good enough?

Sources of long term finance

Requirements
Long term requirements (Investment Capital)
setting up of firm, expansion, modernization, diversification,
replacement, etc.
Big money involved for a longer term, mostly irreversible
decisions, gestation period.

Short term (Working capital)

Frequent requirements of fund for short term,

required for smooth execution of business activities,
compliments capital investment,
creates assets of short term,
pays off for short term requirements,
not planned or budgeted very as capital investments.

Assets Liability Match

Long term assets Long term Liability

Short term assets/requirement Short term funds

Mismatch
Some Long term assets Short Term Liability
Some Short Term Assets Long term Liability
All Assets (Short term + Long term) Long term Liability
All Assets (Short term + Long Term) Short Term Liability

Problem of asset liability mismatch

Interest rate risk
Liquidity/insolvency risk
Cost of fund raising
Reduction in fund management flexibility
Lost opportunities
Reduction in return
Bad impression on stake holders especially financers

Types of capital
Equity capital

Ownership rights (voting rights)

Residual profit
Liability restricted to capital contributed (limited)
No fixed obligation to pay dividend
Permanent capital (minimum repayment liability)

High cost of issuing equity

Dividends are not tax deductible
Dilution of effective control due to voting rights

Preference capital
Some attributes of equity as well as debentures
Equity attributes
No obligation for payment
Dividends (preference) not tax deductible

Debenture attributes
Earn a fixed rate of return for dividend payment
Preference over equity shareholders in the matter of dividend
payment
Preference over equity holders in the matter of liquidation

Preference capitalcont.
Other attributes
Call feature (option that firm can redeem shared wholly or partly prior to maturity at certain price)
After Companies Act 1956 Preference shares voting rights arises
only in following cases;
Cumulative Preference share: arrears in dividends for two or more years
Due preference dividend for a period of two or more preceding
consecutive years
In preceding six years including the preceding FY, fir has not paid
dividend for 3 or more years

Types of preference capital

Two types three categories
Cumulative vs. non cumulative
Dividends paid on a cumulative basis (in case of arrears, all
previous payments has to be made in the year of payment in
future before equity dividends)

Redeemable vs. non redeemable

To be redeemed after a given maturity period; perpetual will
remain forever with company)

Convertible vs. non convertible

Convertible will be converted to other instrument (equity shares)
after a certain time.

Debenture capital

A marketable legal contract in the nature of debt where firm promises its owner to pay
a specified rate of interest for a defined period of time.

After completion of such time, the firm also promises to pay the principal amount.

Usually secured by charge on fixed assets

Interest of debenture holders is usually represented by a trustee

For debentures maturing in >18months firm has to create a debenture redemption

reserve >=50% of amount before redemption

Call option gives company right to redeem before maturity date at a certain price

Put option gives debenture holders right to surrender debenture at a certain price
before maturity.

Types of debenture

Non convertible debenture (NCD)

Cannot be converted into equity and have to be redeemed at maturity only.

Fully convertible debentures

To be converted into equity after certain period, in part or in one go.
May or may not carry interest
Capital gain possibility

Partly convertible debentures

A part of debenture will be converted to equity after specified period at a certain rate
Non convertible portion will be redeemed at maturity
Non convertible part will earn interest till maturity but converted portion will have
interest till conversion only.

Secured premium notes (SPN)

A kind of NCD with attached warrant
No interest on for some initial period
Subsequent repayment of principal, in installments, together with a certain amount as
interest (regular income) /premium (capital gain).
Warrant attached with SPN gives owner right to get equity within certain period at a
certain price.

New Financial instruments

Non voting shares

Detachable shares
Participating debentures
Participating preference shares
Convertible debentures with options
Third party convertible debentures
Mortgage-backed securities
Convertible debenture redeemable at premium
Debt equity swap
Zero coupon convertible note

Issue of securities

Public issue issued in primary market and then listed on exchange for trading
in secondary market. (cost of issue 12%-15% can go up to 20%)
Appointment of lead manager (a SEBI registered Category - I merchant banker.
Responsible for all pre and post issue activities, liaison with other intermediaries and
institutions, viz. SEBI, Exchange, Registrar of Companies, etc.
Preparation of prospectus responsibility of lead manager; to disseminate information
about firm, promoters, objective of issue, other contents specified by legislation.
Appointment of intermediaries :

Underwriters
Registrars
Bankers to the issue
Brokers
Advertising & promotion agency
Agency for printing & dispatching offer document

Obtaining legal clearances and filing initial listing application

Final allotment and refund activities

Rights Issue

Right is an option given to existing shareholders to get preference in new a

issue which is offered to them at a lower price compared to public issue.

1 share for 4 held

Value of share after right issue

Right issue@ Rs 50

Existing price Rs. 60

[(Number of shares required for a right x price per share before right) + Right subscription price]
Number of shares required for a right + 1

Theoretical value of a right

price per share before right - Right subscription price
Number of shares required for a right + 1

Private Placement

Direct selling of securities to small number of high net worth

investors.

Avoids delays, inconvenience and minimizes expenses

Has fewer procedures suitable for relatively small fund raising

Helps firms with relatively little proven history

Merchant banker searches for investors and negotiates with them

on price and terms of issue.

Bought out deals

Investors buy out a major portion of an unlisted firm for future capital gain prospects

Firm to be listed and investment to be sold to public within a given time frame.

Firm places shares for sale to public along with sponsor.

At agreed time shares would be sold to public via a public issue or using OTCEI
route.

Less expensive & faster procurement of funds, especially for startups

Offloading time and price negotiation gives flexibility for finding better value

New firms which do not fulfill SEBI condition for public issue at premium, may get
premium using this mechanism

Issue price close to intrinsic value

Euro issues

Indian companies issues in foreign markets where they are listed and traded

Usually has lower cost of capital

GDRs, ADRs, Euro Convertible bonds, Foreign Currency Convertible

bonds

If convertible, upon conversion to equity, the underlying shares are listed

and traded on the domestic exchange.

Term Loans

Normally to be repaid between 1 to 10 years

Offered by financial institutions (FI) viz. IDBI, NABARD, IFCI, ICICI, PFC, etc.

Interest rate is fixed after appraisal of project by FI (credit risk & return) and

Payment of principal and interest in equal installment

Moratorium period of 1 to 2 years are allowed

Interest and principal payment defaults attract penalties

Are normally secured by title deeds of immovable property, first mortgage, or

hypothecation of property

Restrictive covenants & placing nominee on Board

Post tax cost of this source is very low and is a cheap source for big projects.

Internal accruals

Depreciation charges

Retained earnings

Reserves

Easy availability but limited

No issue expenses

No dilution of control

Dividend payment considerations (opportunity cost for investors)

Good for growth oriented firms

Deferred credit

Offered by supplier of Capital Goods/ machinery in which buyer can pay for
the price in installments, over a long period of time.

Interest & terms of repayment are negotiable

Some deferred credit schemes offered by financial institutions are:

Bill Rediscounting Scheme
Supplier Line of credit
Seed capital assistance
Risk Capital Foundation Schemes.

Leasing

Offered by Fis, NBFCs, Banks and Manufacturers of

equipments/assets.

Leasing is a contractual agreement between a lessor and a lessee.

Here firm (lessee) can enter into a lease deal with the manufacturer
of equipment (lessor) directly or through some intermediary

Contract will give right to use assets till lease maturity date

Lessee has to pay a lease rent for the lease period

Hire Purchase

Very similar to lease

Here ownership of the assets has to be transferred to the buyer after all
installments are paid

If installment is not paid the ownership of the asset remains with the financer
and he claims the asset

Readily available

Requires good credit worthiness

Government Subsidies

The State and Central Governments provide subsidies to the industrial units
in the backward areas

Backward areas are classified into three categories

A Districts -25% of Fixed Capital (FC) (sub. to max. Rs.25 Lakhs)

B Districts 15% of FC (sub. to max. Rs.15 Lakhs)

C Districts 10% of FC (sub. to max. Rs.10 Lakhs)

State government also offers cash subsidy (normally 5% to 25% of the

capital sub. to a max. ceiling of 5 to 25 lakh rupees.

Sales Tax Deferments and

Exemptions

State has the power to tax (SST/ VAT) by which it exempts companies to
provide inventive to operate in underdeveloped areas.

Interest free deferment of sales tax is being generally allowed on sale of

goods for a period of 5 12 years

Deferment of sales tax is being allowed specifically on purchase of certain

items from within the state (normally for a period ranging between 3 years to
9 years)

Things to Dofor You

Go through the red herring prospectus of companies who have

come out with IPO, FPO.

Look for innovative sources of finance employed in the recent

mergers and acquisitions

See the financial mix in financing a project which are different in

their risk and return.

Next class, Raising Long Term Finance (read through your text)