MES - Pillai Business School (PBS),

New Panvel

PGDM (AIMA) (Regular course)

(Batch : 2022 – 2024)

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 PGDM (AIMA), Semester–II
Core Subject : Financial Management

Unit-III : Financial Issue Management

Lesson-5 : Long-term Financial Issues
(theory only)

Lecture date: 24.2.2023

by
Dr. K.G.S. MANI

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Lecture date : 24.2.2023
Chapter-5 : Long-term Financial Issues (theory only)
(1) Introduction :
Finance is the life blood of each and every business
organisation. For establishment of any of business unit either
for trading or manufacturing, adequate finance is required.
Without sufficient finance, no organisation can run its business
activities efficiently.

(2) Funds Requirements for business :

Financial requirement for establishing a business enterprise and
ensuring its smooth operational activities can be classified as
follows :
(i) Fixed capital requirements - for investment in fixed assets
(ii) Working capital requirements – for investment in current
assets

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(3) Sources of Finance :
The sources of finance for a company may be classified as
under:
(a) Internal Source of Finance :
This consists of (i) Retained earnings/ ploughing back of profits,
(ii) Depreciation charges.

(b) External Sources of Finance :

This consists of (i) Equity Shares, (ii) Preference Shares,
(iii) Debenture, (iv) Bond, (v) Public Deposits, (vi) Long Term
Loans (banks) (more than one year), (vii) Short Tern Loans
(bank borrowings) (less than one year), (viii) Global market
instruments, (ix) External Commercial Borrowings (USD, EURO)
from Foreign Banks

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(4) Classification of Securities :
The securities issued by a Company can be classified as:
(i) Ownership Securities :
These are the securities held by the actual owners of the
company. (examples : Equity Shares, Preference Shares
(quasi-equity instrument).

(ii) Creditorship Securities :

These securities are issued by the company for raising funds
from external souces to finance its long term funds
requirements. The subscrbers to these securities are known as
‘Creditors’ of the company. (examples: Debt instruments
(Debentures, Bonds, Public Deposits, Global market securities
(American Depository Rece. ipts, Global Depository Receipts)

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(5) Concept of Funds : (Students should recall from their memory the
concepts of Cash Flow and Funds Flow Statements)

(i) Long Term Sources of Funds :

(a) Long Term Sources of funds: (available for > 1 year) (It is also
known as “cash inflow” or inflow of funds ) :
Equity share capital, Preference share capital, Reserve and
Surplus (general reserve, retained profit), Debentures, Bonds,
Public Depsits, Long term loans from banks and financial
institutions, Deferred Payment Guarantees given by banks.

(b) Long Term Uses (or Application) of funds: (> 1 year)

(It is also known as “Cash outflow” or outflow of funds) :
Purchase of Fixed Assets, Long term investment in securities,
Payment for Intangible Assets (Trade marks, Brands, Licences,
Royalties (for mining rights), Patent Rights (Pharmaceutical
companies), Intellectual Properties (new innovations of ideas or
products, eg. Electric cars), Purchase of Computer Software.
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(ii) Short Sources of Funds :
The following are the short term sources funds available for the
company.
(1) Short Term Bank Borrowings repayable within ONE year,
(2) Cash Credit facility from banks (for working capital funds),
(3) Bills Financing by Banks (Bills Discounting, Bills Purchase, Bills
Negotiation under Letter of Credit facility),
(4) Bank Overdraft (temporary funds accommodation),
(5) Pre-shipment and Post-shipment finance by banks (against Letter
of Credit)
(6) Trade Credit (Credit from suppliers of raw-material, consumable
stores) (Sundry Creditors, Bills payable),
(7) Advances from Customers’ against orders (Car mfg Companies),
(8) Inter-Corporate Deposits(ICDs)
(9) Public Deposits (less than one year)
Note : These will be explained in detail under Lesson-8 Working Capital
Management.
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(10) Commercial Paper (CP) (issued by the Listed companies),
(11) Factoring (Inland Bills for domestic trade) from Financial Services
Company (example: SBI Factoring and Commercial Services Ltd),
(12) Forfeiting (Overseas Bills for exports) from Financial Services
Company (example: SBI Factoring and Commercial Services Ltd),

(6) Classification of finance :

(i) According to period :
(a) Long term sources ( > 1 year): Shares (Equity shares and
Preference shares), debentures, long term loans from Banks and
Financial Institutions, and Reserves and surpluses (Retained
Profit).
(b) Short-term sources ( < 1 year): Short term working loans
(Bank borrowings) and overdraft from commercial banks, public
deposits, commercial papers, and trade creditors.
(ii) According to ownership :
(a) Owned capital: Share capital (Equity shares, Preference
shares), Reserves and Surplus (retained earnings).
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 (b) Borrowed capital: Debentures, Bonds, Public Deposits(more
than 1 year), Long Term Loans, Bank Borrowings.
(iii) According to source of generation :
(a) Internal sources: Retained earnings, General Reserve.
(b) External sources: Securities such as shares and debentures,
Long Term Loans, Short term borrowings from Banks and Financial
Institutions (FIs).
(iv) According to purpose :
(a) Fixed Capital: This is used for investing in fixed assets
(production assets) and also to meet promotional expenses of the
organisation/corporate.
(b) Working Capital: Regular working capital, Special working
capital (Working Capital Term Loan, Funded Interest Term Loan),
Seasonal working Capital loans (adhoc credit facility) (for seasonal
crops – tobacco for cigarette manufacturing companies, sugar
cane for sugar manufacturing companies, Orange/Mango pulp
mfg. companies, Cotton for Cotton Spinning and Processing Co.

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(7) Another method of classification :
(i) Loan financing :
It includes long term loans (more than 1 year) and bank
borrowings (or) short term loans (upto 1 year).

(ii) Security financing:

It includes Equity shares, Preference shares, Public Deposits, and
Debentures issued by the Company.

(iii) Internal financing:

It includes Retained Earnings (Profit & Loss credit balance,
Reserve & Surplus (General Reserve). (Specific reserves shall not
be used for financing assets).

Question: What is difference between depreciation and amortisation?

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(8) Security Financing : Instruments of Domestic Market :
Security financing are those which has been followed by the Company
for raising their financial requirements through issue of shares and
debentures. This method of financing includes (i) Equity shares, (ii)
Preference shares, (iii) Debt instruments (like debentures, bonds,
etc).

(i) Equity Shares (Stocks) :

(a) Meaning : This is the most common method of raising long term
funds. Equity shareholders are the owners of the company and
equity shares are known as ‘ownership securities’ . They get dividend
on their investments in equity shares. They control the company and
are entitled to voting rights. The investment made in equity shares
are perpetual in nature and the amount of investments in equity
shares are not repayable during the lifetime of the Company.
Financing through equity shares also provides the company with
sufficient flexibility in the utilisation of its profits and funds, since
neither the payment of dividend is compulsory nor any provision is to
be made for repayment of capital amount.
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(b) Features of Equity Shares :
(i) Permanent Capital,
(ii) Residual Claim to Income (Profit),
(iii) Residual Claim to Assets,
(iv) Voting Rights/ Right to control,
(v) Pre-emptive Rights,
(vi) Limited Liability.

(ii) Preference Shares :

Preference shares are another type of financing the Company.
They have preferential rights for payment of dividend and return
of capital (ahead of equity shareholders in the event of liquidation
of the Company). Preference shares may be cumulative or non-
cumulative, convertible or non-convertible, participating or non-
participating, redeemable. Irredeemable Preference shares cannot
be issued with effect from 1.3.1997 as per amendments to Co. Act
1956).

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(iii) Debentures:
Debentures are ‘Debt’ instruments also known as ‘Creditorship
Securities’. Debenture is a document evidencing a debt or
acknowledging it and any document which fulfills conditions is a
debenture as per Companies Act. This is a long term source of
funds for the Company. There are various types of debentures
viz. fully convertible, partly convertible and non-convertible
debentures. (Features : certificate issued, payment of principle
and interest on specified date, creates charge on assets of
company or otherwise). Debentures can be issued by the
company with ‘call option’ and ‘put option’.

Different Types of Debentures :

(i) Fully Convertible Debentures,
(ii) Partly Convertible Debenures

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(iv) Bond:
A bond is known as a fixed-income security because it pays its
holder a fixed sum on a regular schedule for a fixed term. Bond is
a debt instrument issued by the Governments, Corporations
(Public Sector Undertakings, such as ONGC, HPCL, BHEL, HAL),
and Municipalities. Bonds are also issued by Banks now, to raise
money for funding their capital requirements under BASEL
guidelines (RBI guidelines). Bond issues are regulated by
Securities & Exhange Board of India (SEBI).

Types of Bonds :
(v) Convertible Bonds,
(vi) Non-convertible Bonds,
(vii) Deep Discount Bonds,
(viii)Municipal Bonds.

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(9) Hybrid instruments:
(i) Warrants :
A ‘Warrant’ entitles its holders (investors) to subscribe to the
equity capital of a company during specified period at a particular
price. The holder/investor acquires only the right (option) but he
has no obligation to acquire the equity shares. Warrants are
generally issued in conjunction with or tied to other instruments.
(examples : (i) attached to equity share, (ii) debentures, (iii)
secured premium notes). They can also be issued independently.
(ii) Zero Coupon Bond (ZCB) :
ZCBs do not pay any interest prior to maturity (meaning interest is
paid only at the time of maturity along with principal amount). The
ZCBs are sold at a discount as compared to the maturity value.
These bonds are sold at a discount because the total value
amount of the bonds occurs and payable only at maturity.
(example : ZCB issued at Rs 90,000 with Face Value (maturity
value) of Rs 1,00,000, the difference is interest amount payable
on maturity). (example : Deep Discount Bond issued by IDBI Ltd
was ZCB).
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(iii) Floating Rate Bonds (FRBs) :
Floating Rate Bonds are issued at market related interest rate. It
means (instead of fixed coupon interest rate), that the interest
rate for FRNs is reset periodically based on the ‘benchmark rate’.
Some FRBs also have ‘caps and floors’ meaning the upper and
lower limit within which the floating rates can vary (move).
(example : MIBOR meaning Mumbai Inter-bank Offered Rate.
State Bank of India, was the first institution to introduce such
bonds by linking the interest rate of bonds with the maximum
bank term deposit rate.

(iv) Secured Premium Bonds (SPNs) :

SPN is a type of secured debenture redeemable at a premium
over the face value. SPN holders have the option to sell back the
Debentures/Notes to the issuing Company at face-value (before
maturity) after the lock-in period. SPNs are traceable instruments
in the capital market. (example : TISCO issued this type of
instruments in 1992).

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(10) Internal Financing :
(i) Retained Earnings : Companies set aside a part of their profits
every year, to meet future requirements of funds. Companies keep
these savings in various accounts such as General Reserve,
Debenture Redemption Reserve and Dividend Equalisation
Reserve, etc. These reserves can be used to meet long-term
financial requirements. The portion of the profits, which is not
distributed among the shareholders but is retained in business.
This accumulated profits is used by the Company to finance its
developmental activities or repay loans. It is known as “Internal
Financing” or “Ploughing back of Profits”. Companies Act also
prescribes a certain percentage of net profits after tax (PAT of not
exceeding 10%) should be compulsorily transferred to reserves
by a company before declaring dividends for the year. Following
are the benefits of retained earnings : (a) Cheap source of
capital, (b) Provides financial stability during the period of
difficulties in business, such as economic depression, (c ) Benefits
to the share-holders as they get dividend during the period of less
profit.
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(ii) Depreciation as a source of finance :
Depreciation means permanent decrease in the value of the fixed
assets, due to wear and tear, use and passage of time. In reality,
depreciation is an operating cost and a non-cash item.
Depreciation does not represent any cash outflow. A part of the
profits adjusted for depreciation can be used by management to
increase any of the current assets or pay taxes, dividend, etc.
Depreciation may, therefore, can be taken as an indirect source of
funds.

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(11) Banking Norms for financing Working Capital :
Banks extend finance to companies for their working capital
requirements. This is short term finance (known as Bank
Borrowings by companies). RBI has issued guidelines to banks
with regard to method if financing working capital requirements to
the companies. They are known (i) Tandon Committee Norms, (ii)
Chore Committee Norms. These are outdated methods now.
Presently Banks follow the methods prescribed by RBI. They are :
(i) Cash Budget method,
(ii) Maximum Permissible Bank Finance (MPBF) system.

Note : To explain these methods to students.

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Case study-1 : Chapter-4 (Sources of Finance)
(Marks -20 for internal assessment for Case Study)

Your friend approaches you with a proposal to set up a

manufacturing unit and having gestation period of 50 to 55 months
and total fund requirements of around Rs 15 crores. He seeks your
advise. Answer the following points in A4 size paper and submit to
me.
(i) Explain to him various sources of raising funds
(ii) How the Optimum capital structure can be designed?
(iii)Write the merits and demerits of various types of finance (both
equity and debt types)
(iv) Advise him the best sources of funds at least cost.
(v) Write detailed explanation for all your points.

Note : Write answer in A4 paper and submit to me on 9.3.2023

positively

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THANK YOU

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