Module 4

Sources of Long term Finance

To support its investments, a firm must find the
means to finance them.
Two broad sources of finance – Equity & Debt
The discount rate used in Investment appraisal is the
weighted average cost of capital.
Equity & Debt
Equity Debt

Referred to as shareholder’s Referred to as loan funds on

funds on balance sheets. balance sheets.

Consists of equity capital, Consist of term loans,

retained earnings and debentures and short-term
preference capital borrowings
Difference between Equity & Debt
Equity
 Equity has an infinite life
 Equity investors have a claim on
the residual cash flows of the
firm, after it has satisfied all
other claims and liabilities.
 Dividend paid to equity
investors has to come out of
profit after tax.
 Equity investors enjoy the
prerogative to control the affairs
of the firm.
Debt
 Debt has a fixed maturity
 Debt investors are entitled to a
contractual set of cash flows
(interest and principal)
 Interest paid to debt investors
represents a tax-deductible
expense.
 Debt investors play a passive
role in the affairs of the firm.
1. Equity Capital
Represents ownership capital, as equity shareholders
collectively own the company.
They enjoy the rewards and risk of ownership.
Some terms
Authorized capital: the amount of capital that a
company can potentially issue, as per its
memorandum.
Issued capital: the amount offered by the
company to the investors.
Subscribed capital : the part of issued capital
which has been subscribed to by investors.
Paid-up capital: the actual amount paid up by
the investors.
The par value of an equity share is the value stated in the
memorandum and written on the share scrip.
The issue price is the price at which the equity share is
issued. When the issue price exceeds the par value, the
difference is referred to as share premium.
The book value of an equity is
( paid up equity capital + reserves and surplus) / number
of outstanding equity shares
The market value of an equity share is the price at which
it is traded in the market.
Rights and position of equity shareholders
 Right to income – have residual claim to the income of the firm.
= PAT – preferred dividend
This income may be retained by firm or paid out as dividends.
Equity earnings which are ploughed back in the firm increase the market value of
equity shares and the equity earnings distributed as dividend provide current
income to equity shareholders.

 Right to control – equity shareholders, as owners of the firm, elect the

board of directors and enjoy voting rights at the meetings of the
company. The BoDs select the management which controls the
operations of the firm. Individual investors often have negligible
influence as they have small holdings.
Pre-emptive right – this enables existing equity
shareholders to maintain their proportional
ownership by purchasing the additional equity shares
issued by the firm.

Right in liquidation – have a residual claim over the

assets of the firm in the event of liquidation
Advantages of Equity Capital
Equity capital has no maturity date and hence the firm has
no obligation to redeem.
There is no compulsion to pay dividends. If the firm has
insufficiency of cash it can skip equity dividends without
suffering any legal consequences.
Equity capital enhances the creditworthiness of the
company. The larger the equity base, the greater the
ability of the firm to raise debt finance on favorable terms.
Dividends are tax-exempt in the hands of investors. The
company paying equity dividend is required to pay a
dividend distribution tax.
Disadvantages of Equity Capital
Sale of equity shares to outsiders dilutes the control of
existing owners.
The rate of return required by equity shareholders is
generally higher than the rate of return required by other
investors.
Equity dividends are paid out of profit after tax. This
makes the cost of equity is high.
The cost of issuing equity shares is generally higher than
the cost of issuing other types of securities. Underwriting
commission, brokerage costs, and other issue expenses are
high for equity issues.
2. Internal accruals
Consist of depreciation charges and retained
earnings
Depreciation is a periodic write off of a capital
cost incurred in the beginning. It is a non-cash
charge. Hence is an internal source of finance.
Retained earnings are that portion of equity
earnings (profit after tax less preference
dividends) which are ploughed back in the firm.
Corporates normally retain 30 percent to 80
percent of profit after tax for financing growth.
Advantages of internal accruals
Retained earnings are readily available internally.
Retained earnings represent infusion of additional
equity in the firm. Use of this eliminates issue costs
and losses on account of under pricing.
There is no dilution of control
Disadvantages of internal accruals
The amount that can be raised by way of retained earnings
may be limited. Further this is highly variable because
companies typically pursue a stable dividend policy. The
variability of profit after tax is transmitted to retained
earnings.

The opportunity cost of retained earnings is quite high for

the firm. As it represents dividends forgone by equity
shareholders.

Some companies attribute a low cost to retained earnings

and invest it in sub-marginal projects that have negative
NPV. Such sub-optimal investment policy hurts
shareholders.
3. Preference Capital
 Represent a hybrid form of financing – have some characteristics of equity and
some attributes of debentures.
 Resemblance with equity
 Dividend is payable only out of distributable profits
 Preference dividend is not an obligatory payment ( the payment of preference
dividend is entirely within the discretion of directors)
 Preference dividend is not a tax-deductible payment
 Resemblance with debentures
 The dividend rate of preference capital is fixed.
 Unpaid dividends are carried forward and payable when the dividend is
restored.
 The claim of preference shareholders is prior to the claim of equity
shareholders.
 Preference shareholders do not normally enjoy the right to vote
 Preference capital is typically repayable.
Advantages of Preference capital
No legal obligation to pay preference dividend
Financial distress on account of redemption obligation is
not high because preference shares are redeemable only
out of profits or proceeds of a fresh issue of share ( equity
or preference).
Regarded as part of net worth, hence eliminates the
creditworthiness of the firm.
Do not carry voting right. Hence no dilution of control.
No assets are pledged in favour of preference shareholders.
Hence mortgageable assets of the firm are conserved.
Disadvantages of Preference capital

Compared to debt capital, it is a very expensive source of

financing because the dividend paid to preference
shareholders is not a tax deductible expense. Further there
is divided distribution tax.
Preference dividend are typically payable with arrears.
Compared to equity shareholders, preference shareholders
have a prior claim on the assets and earnings of the firm.
Preference shareholders acquire voting rights if the
company skips preference dividend for a certain period.
Sources of long term debt
Term loans

Debentures
4. Term loans or Term finance
Long term debt
Given by financial institutions and banks
Generally repayable in less than 10 years.
They are mainly employed to finance acquisition of fixed
assets and working capital margin.
Differ from short-term bank loans which are employed to
finance short-term working capital need and tend to be
self-liquidating over a period of time, less than one year.
Features of term loans
Rupee loans as well as foreign currency term loans
available.
Term loans are secured borrowing. Assets of the firm
may serve as collateral security.
Obligation to pay interest and repayment of principal
Financial institutions generally impose restrictive
covenants on borrower, to protect their interest. E.g.;
limit freedom of promoters to dispose their
shareholding., give financial institutions the right to
appoint nominee directors etc.
Advantages of Term Loans
 Interest on debt is tax deductible expense.
 Debt financing does not result in dilution of control because debt
holders are not entitled to vote.
 Debt holders do not part take in the value created by the company as
payments to them are limited to interest and principal.
 The maturity of a debt instrument can be tailored to synchronize
with the period for which the firms needs funds.
 If there is a precipitous decline in the value of the firm, shareholders
have the option of defaulting on debt obligations and turning over the
firm to debt holders.
 Issue costs of debt are significantly lower than those on equity and
preference capital.
The burden of servicing debt is generally fixed in
nominal terms. Hence, debt provides protection
agianst high unanticipated inflation.
Debt has a disciplining effect on the management
of the firm
It is generally easier for management to
communicate their propretary information about
the firm’s prospects to private lenders than to
public capital markets.
Disadvantages of Term Loans
 Debt financing entails fixed interest and principal repayment
obligation. Failure to meet these commitments can cause a great deal
of financial embarrassment and even lead to bankruptcy.

 Debt financing increases financial leverage, which raises the cost of

equity to the firm.

 Debt contracts impose restrictions that limit the borrowing firm’s

financial and operating flexibility. These restrictions may impair the
borrowing firm’s ability to resort to value-maximising behavior.

 If the rate of inflation turns out to be unexpectedly low, the real cost
of debt will be greater than expected.
5. Debentures
Debentures are instruments for raising long-term debt.
For large publicly traded firms, debentures are a viable
alternative to term loans.
Debenture holders are the creditors of a company.
The company has to pay interest and principal at specified
times.
Debenture provide more flexibility than tem loans as they
offer greater variety of choices with respect to maturity,
interest rate, security , repayment and special features.
Features of Debentures
 When a debenture issue is sold to public, a trustee ( usually a bank or
a financial institution) is appointed. The trustee is supposed to ensure
that the borrowing firm fulfills its contractual obligations.
 Most debenture issues in India are secured by mortgages. Companies
can issue unsecured debentures also.
 Debentures can carry fixed or floating or zero interest rate.
 Maturity and redemption: Corporate debt could be short term,
medium term or long term. Short term corporate debt of less than one
year is called commercial paper. This is an instrument of working
capital financing.
Medium term debentures have maturity of 1 year to 5 years.
Long term debentures have a maturity period of 5 to 15 years.
Medium term debentures are redeemed as bullet payment, whereas
long term debentures are generally redeemed in installments of 2-3
years.
Convertibility: A company may issue debentures
which are convertible into equity shares at the
option of the debenture holders.
Call and put feature: debentures may carry a “call”
feature which provides the issuing company the
option to redeem the debentures at a certain price
before the maturity date. Sometimes the
debentures may have a ‘put’ feature which gives
the holder the right to seek redemption at
specified times at predetermined prices.
Term Loan vs Debentures
 The advantage and disadvantages of term loans are more or less
applicable to debenture financing.
 In case of a debenture issue, a firm deals with numerous investors
whereas in the case of a term loan a firm deals with one or a few
institutional investors.
 Before the debenture issue, a firm enjoys greater flexibility in
designing the debenture issue. After the issue, however, the firm
hardly has any freedom in re-negotiating the terms of the issue.
 A firm has lesser flexibility in hammering out the features of a term
loan. After taking the term loan, however, the firm enjoys greater real
freedom in re-negotiating the terms of the loan contract.
Difference between Debentures
and Bonds
 Technically there is no difference between Debentures and Bonds as both
are debt instruments.
 However the difference between two is due to practice in the financial
market. They are,

 Generally, public sector organizations issue their debt instruments in the

name of bonds whereas private sector organizations issue their debt
instruments in the name of debentures.
 Generally the unit size of bonds is very high as compared to debentures
and therefore bonds are normally secured whereas debentures are
unsecured
 Generally bonds are not convertible whereas debentures are convertible.
Convertible debentures are those debentures, which convert into pre-
specified number of shares after certain time.
Comparison of various sources of long term
financing
Source of Cost Dilution of Risk Restraint on
Finance control Managerial
Freedom

Equity capital High Yes Nil No

Retained High No Nil No

earnings

Preference High No Negligible No

capital

Term Loans Low No High Moderate

Debentures Low No High Some