SOURCES OF LONG TERM

FINANCE
Need for long term Finance
 Long term vs. short term (working
capital) funds requirements
 For modernization, expansion,
diversification; huge quantities of funds
reqd., irreversible decision
 Asset-liability mismatch, interest rate
risk, liquidity risk, if LT reqts. met by ST
funds
Sources of LT Finance
Debt
 Contractual set of cash
flows: interest, principal
 Interest: out of PBIT
 Interest: tax deductible
 Has fixed maturity
 No participation in
management
 Low risk, low return
Equity
 Have claim on residual
profits of Company
 Dividends: out of PAT
 Dividends: not tax
deductible
 Has infinite life
 Have voting rights
 High risk, high return
Equity Capital
 Authorized, 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 Disadvantages
 Dilution of control of existing
 No fixed maturity, no owners
obligation to redeem  High Cost: rate of return
 No compulsion to pay expected by equityholders
higher than debtholders
dividends  No tax shield on dividends
 Provides debt raising  Issue costs higher:
capacity underwriting, brokerage,
other issue expenses
 Dividends: tax exempt  Higher servicing costs: hold
for investors AGMs, post annual reports
etc.
 Internal Accruals
Pros Cons
 Readily available, no  Quantum very limited
talking to outsiders  High Opportunity costs:
 Effectively additional dividends forgone by
equity capital, however equity holders
no issue costs, and no  Requires careful attention
loss due to underpricing to NPV of projects
 No dilution of control
 No expansion in equity
base, hence no dilution of
EPS, BV per share etc.
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
 Part of net worth, hence
increases company’s
creditworthiness/ debt
raising 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, non
payment can spoil
company’s 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
 Are typically secured against fixed assets/
hypothecation of movable properties
 Definite obligations on interest and principal
repayment
 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 Cons
 Interest on debt is tax  Entails fixed obligation for
deductible interest and principal, non
 Does not result in dilution of payment can even lead to
control bankruptcy/ legal action
 Issue costs of debt is lower  Debt contracts impose
restrictions on firm’s financial
 Has a disciplining effect on
and operational flexibility
management
 Increases financial leverage,
excess debt raises cost of
equity to the firm
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 installments
 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 fulfillment 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
 Hire Purchase: ownership transferred to the buyer after all the
installments are 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
 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
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 for
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
 Lengthy process, administrative
hassles
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 finalized
 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 tradable, 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
Bought Out Deal
 On OTCEI
 Shares offered to sponsor who would offload
to public at a later stage
 Agreement with OTCEI
 Market makers appointed
 Faster mode, at low cost, need not wait for
opportune timing
 Only route for companies with low equity
base/ networth
Private Placement
 Sale of securities directly to wholesale investors like
FIs, banks, MFs, FIIs,PE funds etc.
 Preferential allotment also allowed with pricing
stipulations
 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 by SEBI to be complied
with
Private Placement
Pros Cons
 Less expensive mode  Does not qualify for listing in
 Lesser SEBI and other an unlisted company
regulations  Restrictive covenants may be
 Easier to market the issue to imposed by the investors
a few investors  May call for management
 Entry of wholesale financially participation
sophisticated investors in  Issue pricing more tight
company’s profile
 May use this route until IPO
decision taken
 Less administrative
maintenance
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 is the 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