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Sources of Finance

An Overview

Prepared by:


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Subject Index
 General Classification
 Equity Capital
 Debentures
 Preference Share Capital
 Banks
 Capital Financing
 Venture Capital Financing
 Debt Securitisation
 Lease Financing
 Negotiable Instruments
 Factoring
 Short term sources
 Foreign Investments
 Derivative & New Instruments
 Ideal Capital Structure
Corporate Financing

Internal Sources External Sources
• Retained earnings
• Promoter’s Long Term Medium Short Term
Contribution Term

• Bank Loans
• Security Financing
• Financial Instruments
• Leasing
• Other Sources
Equity Share Capital
 Permanent Source of Finance
 Raised from common public or internal sources as per the goodwill of concern
 Signifies part ownership & prime risk element in an enterprise
 A basic investment in business providing security to other investors and
suppliers of money
 Low risk element:
- Redemption only on the liquidation of the business entity
- Payment of dividend when sufficient profits are generated

 Flexibility:
- Options of bonus and right issue
- Non- voting equity shares can also be issued
- Company can buyback its own shares from the market
 Security to the Shareholders of maintaining control over company
 More aggressive market dealings and high market price
Equity Share Capital…
 More cost to the payer company:
- Dividends are paid out of the post tax profits
- A Dividend distribution tax of 12.5% is additionally payable
 Administrative and procedural compliances for serving the equity is
 Risk of dilution of Control of Management in the company

- Cost: High
- Repayment terms: Flexible
- Control: High risk of dilution

An Inevitable Source of Finance
 Derived from the latin word “Debre” meaning to owe
 Serves as an acknowledgement of debt to the investor
 Fixed rate of interest paid and redemption as per commitments
 Enjoys priority in Dissolution of the Company
 Generally secured against assets. Can be convertible into equity
 No dilution of control since Debenture holders are never given voting rights
 Cost Effective:
- Tax Shield on the interest paid on debentures
 Flexibility:
- Scheme of Debt can be framed as per the company’s needs
* Due consideration to the Paari Passu clause
- No complicated compliances serving the debt
- Own Debentures
 Convertible Debentures:
- Effective substitute when the equity market is not very effective

 Very High Risk:
- Interest payments at fixed rates
- Redemption as per the commitments
 Effect on Equity Capital:
- With increase in the financial risk, expected rate of return rises and resultantly, the
cost of equity
- Capitalization rate rises reducing the market price of the Equity share capital
 Effect on Company’s Assets:
- Debentures are generally secured against the company’s assets, hence, the
borrowing capacity is substantially affected

- Cost: Moderate
- Repayments Terms: Rigid
- Control: Not Affected
Preference Share Capital
 Special type of shares enjoying priority over payment of dividends and
 Should be redeemed in a period of maximum 20 years
 A fixed rate of dividends paid before equity shareholders
 A hybrid of both debt and equity mix
 A part of share capital of the company, hence a favorable debt equity ratio
can be maintained
 Preference Capital carries no voting rights
 Payment of dividend only if sufficient profits are generated
 An attractive investment scheme for the investors:
- A more secured investment
- A fixed rate of dividends is paid on priority basis
- Speculation tends to be generally less
Preference Share Capital…
 High cost of serving the capital:
- Administrative and legal compliances
- Fixed rate of dividends payable at priority basis
- No tax shield on dividends. Further, a dividend distribution tax of 12.5%.
 Can acquire voting rights if dividends not paid for over certain years
 The unpaid dividends accumulate over the years of lower profits and a
consolidated liability is discharged when sufficient profits are generated

- Cost: High
- Repayments Terms: Negotiable
- Control: Moderate risk

An emerging source of finance
Banks Financing

Loans Cash Credits Overdrafts Secured
•A single advance •Bank credits a •Customers
disbursed entirely fixed sum to loan allowed to draw •Advances given
at one time account in excess of their on security of
bank account confirmed orders,
•Interest charged •Withdrawal as government
on the amount per needs tenders etc.
sanctioned •Interest charged
•Secured against •Letter of credit
on Daily balance
•Recovery of loan stock can also be given
at specified time •Secured by
•Interest charged •Interest &
Fixed Deposit
•Can be secured or on the sum Repayment terms
receipts, stock
unsecured withdrawn as per standards
•Not a running •Government
•Can be
account agencies also
unsecured (Clean
OD) provide such loans
Capital Financing
Seed Capital Assistance
 Provided by all recognized banks
 By means of loans and grants
 Terms of loans sanction and repayments etc. are specified
 Mainly for small and medium scale projects costing up to 1-2 Crores. A minimum
10% of promoter’s contribution is generally kept
 A nominal interest along with a service charge varying with the volume of business
Capital Incentives
 An economy promotion tool employed by the Government
 Mainly for the promotion of the backward areas
 Assistance is provided to the new undertakings either by way of a lumpsum subsidy
or exemption from taxes
 Mechanism is governed through State Finance Corporations and the provisions of the
applicable tax laws
 Normally takes 1-2 years for the release of revenue. So, bridge finances can be
availed up to 85% of the sanction
Venture Capital Financing
 Started in 1987-88 by creation of Technology Development Fund and
guidelines for venture capital companies
 To finance the upcoming modern and risky projects in sunrise sectors
 Mainly in the fields of IT, Energy conservation, Quality up gradation
 Main financing agencies are Asset Management Companies, FII, State
Finance Corporations, banks and private companies
 Common Methods of Financing:
- Equity Financing: Generally up to 49% of the total capital
- Conditional loans: Repayable as royalty ranging between 2-15%
- Income Note: Both Interest and Royalties are charged at lower rates
- Participating Debentures: Varying interest as per the operations
 Venture Capital companies can claim income tax exemption under section
10(23FB) of the Income Tax Act, 1961
 RB I and SEBI guidelines for registration and operations of venture capital
companies to be observed
Debt Securitisation
 Mainly a function of Non banking finance corporations (NBFC)
 Recycling of funds by issue of securities against the pools of assets generating
steady cash flow
 Securitisation Process
- Locating the borrower as per credit worthiness and efficiency
- Pooling Function:
* Clubbing the receivables & advances into pools
* Structuring the pools with specific terms and conditions
* Transferring the pools to Special purpose vehicle (SPV)
- SPV to issue securities based on the Asset pool
 Generally SPVs are Merchant bankers and Investors in such scheme are
mutual funds, insurance companies etc.
 Transfer of ownership of Assets( Receivables) to SPV and the risk of non
payment to the investors of such schemes
 An arrangement with the leasing company wherein particular assets are provided
against periodic rent
 Can be an effective alternative to purchasing the asset out of owned or borrowed
 Tax benefits on depreciation and lease rentals can be claimed by the respective
parties to agreement
 Provisions of Hire Purchase Act, 1972 to be observed

 A method of expanding business on less capital than would otherwise be needed
 Under a franchising agreement, a franchisee pays a franchisor for the right to operate
a local business, under the franchisor’s trade name
 The Franchisor bears all initial establishment costs
 The franchisee makes regular payments to the franchisor based on the turnover &
after the agreed number of years, the ownership of business is transferred to
Negotiable Instruments
Discounting of Bills
 Trade bills acknowledging the dues can be obtained from the customers
 Credit worthiness of the parties can be exploited effectively
 Banks discount the trade bills so obtained for a nominal charge
 The payment due after 2-3 months can be obtained instantly
 Drafting an operation of the promissory notes or bills receivable to be governed
by Indian Negotiable Instrument Act, 1881
Commercial Papers
 An unsecured promissory note issued as per provisions of Indian Negotiable
Instruments Act,1881
 Can be issued to any extent but in the multiples of Rs. 5 Lakhs. An individual
investor cannot invest more than 25 Lakhs
 Issued for a period of 30-180 days
 No RBI restrictions or section 58Aof the Companies Act shall apply
 Only for the companies having stock exchange lisitng and a tangible net worth of
5 crores or more
 Issuer to bear all the preliminary charges
 Provision of specialized services of credit investigation, sales management, credit
collection etc. by factor to the client under an agreement
 In the agreement, the receivable accounts are sold to the factors who charges
commission & bear all the risks associated with it
 For every account, factor assumes all the responsibilities and pays to the client at the
end of credit period or when the account is settled
 Generally on recourse basis

Asset Reconstruction Companies (ARC)
 Asset Reconstruction Companies acquires bad loans/NPAs from Banks at a steep
discount and sell them eventually to the bidders
 Banks and Financial Institutions sell their NPAs to take them out of their loan books &
improve their balance sheets
 This move is different from the Corporate Debt Restructuring
 The borrower cannot oppose the sell of by the Banks and Finance Institutions
 Generally the ARC issues security receipts as pass through certificates of certain rights
& entitlements to the investors in the assets held by the ARC
 Arcil is the only functional Asset Reconstruction Company in the country
Short Term Sources
Trade credit Inter-corporate Public Short term
deposits unsecured
• Credit period for
•Flow of funds Debentures
between entities Deposits •For less than 18
• Granted by
•Not Public Deposits •Unsecured months
supplier of goods
u/s 58A Deposits •A higher rate of
• By Customers
•Interest as per terms •From 6 months interest charged
before placing the
agreed to 3 years •No credit rating
•Can be secured by •Renewable on is required
• 15-90 days
personal guarantee maturity •Terms should be
• No cost of debt
•Generally up to 6 •Covered under as per acceptable
• Varies with months section 58A standards
business volume
• Restrictions under •Maximum limit
• Regional & section 372A of the of borrowing,
Industry Standard Co. Act Interest etc. is
Foreign Investments
 Foreign Direct and Institutional Investment is allowed subject to the sectoral caps
 Investment through Portfolio investment, foreign technology agreements, External
commercial borrowings
 Active Involvement of FIPB, RBI and SEBI
 Investor can take automatic route for simplified procedures
 ADRs are traded in American Markets and GDRs worldwide
Mechanism of ADR/GDR:
 Indian Co. issues shares to an overseas depository bank having office in India
 Physical shares remain in India with custodian who acts as agent of the depository
 Against the underlying shares, depository issues receipts to foreign investors
 Depository receives dividends from Indian co. in rupees and pass on to the investors
in Dollars
 Foreign investor can sell the depository receipts in foreign stock exchange or can sent
back to depository & get the shares of underlying Rupee denomination
 Depository receipts are convertible into equity not vice-versa
 Investors in ADR/GDR are entitled to benefits of dividends, right and bonus issue
 Voting rights remain with the depository who can exercise it on behalf of investors
Derivative Market
 Derivative: A financial instrument whose pay off depend on another financial instrument or
 Derivatives can be used effectively for Hedging the payment risk and also for the speculation
purpose. Derivatives are of various types.
 Forwards: It involves a contract initiated at one time and its performance in accordance with
the terms of contract at a subsequent time
 Futures: A highly standardized & closely specified contract. They are traded on the stock
exchanges with an active involvement of the clearing houses
 Options: Trading of the right to buy or not to buy the underlying goods. Call option &
currency options are its types.
 Swaps: An agreement between two or more parties to exchange sequence of cash flow over a
period of time in the future.
 Spot Contracts: To cover the exposure on the date of receipt/payment. Premium / discount
is already included in exchange rate & risk of currency fluctuations is to the company’s accounts
 Roll Over Contracts: To cover the long term foreign exchange liabilities/ assets.
Premium/discount is a function of interest rate differentials between US Dollar and other currency
 Arbitrage: The process of buying a financial instrument in one market & selling the same in
another market. A method of making profits in an unstable market that brings the market to
New Instruments
Secured Premium Notes
 Issued with a Detachable warrant
 Redeemable after 4-7 years. Can be convertible into equity

Option Bonds
 For Principal or Interest sum or both
 Redemption premium is offered
 Investor has the option to sell the bonds as per market situations

Junk Bonds
 For organizations with lower credit ratings and high risk projects
 3-5% more than the normal market interest is charged
 Wide usage in takeovers & buyouts

Deep Discount Bonds
 Issued by IDBI in 1992
 Zero interest bonds sold at a nominal sum
 Redeemable after 25 years at Rs. 1 lakh with the exit option to investor in 5 th, 10th, 15th
& 20th year
Inflation and floating rate bonds
 Prior agreement for interest payment subject to inflation or market conditions
Miscellaneous sources
Bridge Financing:
 Short term loans provided on the basis of loans pending disbursements
 Repaid after the sanction of original loan
 Generally provided against the Hypothecation of Current Assets, personal guarantee
& promissory notes
 Generally a higher rate of interest is charged
 Provided by both Banks and NBFC
 An agreement with the parties known as “underwriters” to secure the realization of
minimum subscription of the public issue of shares
 Underwriters can help finding the potential investors for the issuing company
 The underwriters charge a nominal commission to arrange the requisite funds
 Generally Banks & Pvt. Cos. Are active as underwriters in the market
 With their market contacts, underwriters can also help in proper allotment of units and
arranging other sources of finance as well
Ideal Debt Equity Mix
 Cost of Finance: With a lower arrangement cost and being a tax deductible item, is
usually cheaper than equity finance
 Capital Gearing of Business: Though debt is a cheaper source of finance, it
carries a fixed repayment obligation for interest & principal amounts
 Security available: Money lenders require certain assets to be pledged against the
borrowings. In the absence of good asset security, further borrowings may not be an option
 Voting control: Shareholders often deny those sources which tends to dilute their
 Business risk: Companies with highly volatile profits should avoid heavy
borrowings. High risk ventures are normally financed by the equity as there is no legal
obligation of repayment
 Operating Gearing: It refers to the proportion of a company’s fixed operating
costs against its variable costs. Higher operating gearing signify a higher fixed cost element
& a more volatile operating profits.
 Market State: Bearish run in the market often results in lesser returns to the entity
 Currency of Borrowing: Currency fluctuations may add to the cost of the loan
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