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Sources of finance

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  1. Sources of finance

  2. Needs of finance • In our present day economy finance is defined as the provision of money at the time when it is required. every enterprise whether big, small or medium needs finance to carry on its operation. • In fact, finance is so indispensable today that is rightly said that it is the life blood of an enterprise.

  3. Capital required for a business can be classified under two main categories:- • Fixed capital • Working capital

  4. Long term funds are required to create production facilities through purchase of fixed assets such as plant ,machinery, land and furniture etc. Funds are also needed for short term purposes for the purchase of raw material, payment of wages and other day to day expenses.

  5. SOURCES OF FINANACE According to period short- term medium –term long- term 1.Bank credit 1.issue of debentures 1.issue of shares 2.Cutomer advances 2.issue of preference shares 2.issue of deb. 3.Trade credit 3.bank loans 3.retained earning 4.Factoring 4.public deposits 4.loans from 5.Commercial credit5.loansfinancialinstitutions

  6. According to ownership • Owned capital - shares capital, retained earnings , profits and surpluses etc. • Borrowed capital -debentures ,bonds ,publics deposits , loans etc.

  7. According to sources of finances • Internals sources such as retained earnings, profits, depreciations funds etc. • Externals sources- shares, debentures, public deposits and loans etc

  8. According To mode of financing • Externals financing- Financing through raising of corporate securities such as shares. • Internals financing- Financing through earnings , capitalization of profits. • Loans financing through raising of long term and short term loans.

  9. Internal sources of Finance • Owners’ funds • When business persons invest some of their own money (cash in hand ) in their business. Even they can obtain the funds after selling their personal belongings - e.g. a car. • Reinvested profits • once the business is up and running, any profits it makes can be used to finance its activities

  10. External Sources • Ordinary Shares (Equities): • Ordinary shareholders have voting rights • Dividend can vary • Last to be paid back in event of collapse • Share price varies with trade on stock exchange • Preference Shares: • Paid before ordinary shareholders • Fixed rate of return • Cumulative preference shareholders – have right to dividend carried over to next year in event of non-payment

  11. New Share Issues – arranged by merchant or investment banks • Rights Issue– existing shareholders given right to buy new shares at discounted rate • Bonus or Scrip Issue – change to the share structure – increases number of shares and reduces value but market capitalisation stays the same. • Venture Capital • Foreign Direct Investment (FDI) • Foreign Institution Investors (FIIs) • Disinvestment

  12. Loans (Represent creditors to the company – not owners) • Debentures – fixed rate of return, first to be paid • Bank loans and mortgages – suitable for small to medium sized firms where property or some other asset acts as security for the loan • Merchant or Investment Banks – act on behalf of clients to organise and underwrite raising finance • Government – may offer loans in certain circumstances • Grants

  13. SECURITY FINANCING OWNERSHIP SECURITIES OR CAPITAL STOCK. • Equity shares. • Preference shares. • No par stock, • deferred shares. CREDITORSHIP SECURITIES OR DEBT CAPITAL. • Debentures.

  14. OWNERSHIP SECURITIES • The term ownership securities also known as capital stock represent share .shares are the most universal form of raising long term funds from the market .every company ,except a company limited by guarantee ,has a statutory right to issue shares. • According to Farewel : A shares is the interest of a shareholders in the company measured by a sum of money ,for the purpose of liability in the first place and of interest in the second.

  15. Long term sources • Issue of shares • Issue of debentures • Retain earning • Loan from specialized financial institutions.

  16. Types of Equity Shares • Authorized share capital • Issued share capital • Subscribed share capital • Paid up share capital

  17. Issue price of shares: The price at which share is issued in the market. • Paid up share capital = issue price * no. of ordinary shares. • Issue price has two components • Par value • Share premium Par value is the price per ordinary share stated in the memorandum of association. Generally they are in the denomination of 10 or 100. Any amount in excess of par value is called the share premium. Shareholders equity = paid up share capital + share premium + reserves and surplus = Net worth Book value per share = Net worth / no. of ordinary shares Market value of a share is the price at which it trades in the market. It is generally based upon the expectations about the performance of the economy in general and company in particular.

  18. Equity share • It is known as ordinary share or common share, represents the owners’ capital in a company. The holder of these shares are the real owner of the company. Equity share holder are paid dividend after paying it to the preference share holders. Equity share capital can not be redeemed during the lifetime of the company.

  19. Features of Equity Shares • Residual claim to income • Residual claim on assets • Right to control • Voting system • Pre-emptive right • Limited liability

  20. Characteristics of equity shares • Also known as ordinary shares. • Represents the owner’s capital of the company. • Can not be redeemed during the life time of the company. • Are paid dividend after payment to preference shareholders • More risky as compared to preference shares.

  21. Advantages of equity shares. • Equity shares do not create any obligations to pay a fixed rate of dividend. • Equity shares can be issued without creating any charge over the assets of the company. • Equity shareholders are the real owners of the company who have the voting rights . • It is a permanent sources of capital and the company has not to repay it except under liquidation.

  22. Disadvantages • Asequity capital cannot be redeemable ,there is a danger of over capitalization. • Investors who desires to invest in safe securities with a fixed income have no attraction for such shares. • A company cannot take the advantage of trading on equity.

  23. Net Shell-Equity • It is a permanent source of fund without any repayment liability • It does not involve any obligatory dividend payment • high cost of fund reflecting the high required rate of return of investors as a compensation for higher risk • High floatation cost in terms of underwriting, brokerage and other issue expenditure • Dilution of control

  24. Method of Raising Capital • By issue of prospectus • Rights issue of equity shares. • Private placement of shares

  25. Initial Public Offer Benefits of going public • Access to capital • Respectability • Investors recognition • Liquidity • Signals from the market Costs of going public • Adverse selection • Dilution • Disclosures • Accountability • Public pressure

  26. Cost of Public Issue • Underwriting Expenses • Brokerage • Fees to the managers to the issue • Fees for registrars to the issue • Printing expenses • Postage expenses • Advertising and publicity expenses • Listing fees • Stamp duty

  27. Rights Issue of Equity Share • It involves selling of ordinary shares to the existing shareholders. • Law in India requires that the new ordinary shares must be first issued to the existing shareholders on a prorata basis • No. of rights = existing share/ new share

  28. Private placement of shares • It involves sale of shares (or other securities) by a company to few selected investors, particularly the Institutional Investors like the Unit Trust of India (UTI), the Life Insurance Corporation of India (LIC), IDBI etc. • Private placement has the following advantages • It is helpful to raise small amount of fund • It is less expensive • It is a much faster way of raising fund.

  29. Shareholder • A shareholder (or stockholder) is an individual or company (including a corporation) that legally owns one or more shares of stock in a joint stock company. • Shareholders are granted special privileges depending on the class of stock, including • the right to vote (usually one vote per share owned) on matters such as elections to the board of directors, • the right to share in distributions of the company's income, • the right to purchase new shares issued by the company, • and the right to a company's assets during a liquidation of the company. • However, shareholder's rights to a company's assets are subordinate to the rights of the company's creditors.

  30. Preferential Allotment • An issue of equity or equity related instruments by a listed company to pre-identified investors who may or may not be the existing shareholders of the company at a pre-determined price is referred to as a preferential allotment. • Made to promoters, strategic investors, venture capitalist, financial institutions and suppliers • Rationale- to secure equity participation of those that the company considers desirable, but who may otherwise find it very costly or impractical to buy large chunk of shares in the market.

  31. Preference shares • Preference shares capital: Preference share is the one which satisfies the following criteria • With respect to dividend it carries a preferential right to be paid which may be a fixed amount or a fixed rate • On winding up or on repayment of capital a preferential right to be repaid the amount • As the name suggests, these shares have certain preferences as compare to other types of share. These shares are given to preferences. • There is a preference for the payment of dividend. • The second preference for these shares is the repayment of capital at the time of liquidation of company.

  32. Features of Preference Share • Claims on income and assets • Fixed Dividend • Cumulative dividend • Redemption • Sinking fund • Participation feature • Hybrid form of security (mixture of equity + deb)

  33. FEATURES • A fixed rate of dividend is payable on preference shares . • Preferences shares have a preference in the payment of capital at the time of liquidation of company. • Preferences shareholders do not have any voting rights ; so they do not have any say in the management or control of the company . • Generally , preference shares resemble shares in respect of maturity. These are perpetual and the company is not required to repay the amount during its life time.

  34. Hybrid Security • Ordinary share • Non payment of dividend does not force the company to insolvency • Dividends are not deductible for tax purpose • In some cases there is no fixed maturity date. • Debenture • Dividend rate is fixed like interest as in case of debts. • Pref shareholders do not share in • the residual earnings • They have claim on income and • assets prior to ordinary shareholders

  35. TYPES • Cumulative Preference Shares: these shares have a right to claim dividend for those years also for witch there have no profits .whenever there are divisible profits ,cumulative pref. shares are paid dividend for all the previous Years in which dividend could not be declared. • Non cumulative pref. shares :the holders of these shares have no claim for the arrears of dividend. • Redeemable Preference Shares : if articles of association allow such an issue . The company has right to return redeemable pref. share capital after certain period.

  36. Irredeemable Pref. Shares: those shares which cannot be redeemed unless the company is liquidated are known As irredeemable pref. shares. • Convertible pref. shares: the holders of these shares may be given a right to convert their holdings into equity shares after specific period. • Non-convertible pref. share :the shares which cannot be converted into equity shares are known as non –convertible pref. shares.

  37. Voting rights for preference shareholders • Every member of a company holding any preference shares has a right to vote only on resolutions placed before the company which directly affect attached to his preference shares • Apart from this preference shareholders are entitled to vote if dividend has remain unpaid in case of cumulative as well as non cumulative for two years.

  38. Pros • Risk less leverage advantage • Dividend post pondability • Fixed dividend • Limited voting right • Cons • Non tax deductibility of dividend • Commitment to pay dividend

  39. ADVANTAGE • There is no legal obligation to pay dividend on pref.share pref. dividend is payable only out of distributable profits at the discretion of the management. • Pref. share provide a long term capital for the company . • There is no liability of the company to redeem pref .share during the life time of the company. • As no specific assets are pledged against preferred stock. • Pref. shares do not carry voting rights under normal circumstances and hence there is no dilution of control.

  40. DISADVANTAGES • Cumulative pref. shares become a permanent burden so far as the payment of dividend in concerned. • In same cases ,pref. shares carry even the voting right and hence the control and management of the company may be diluted. • The market prices of preference shares much more than that of debentures. • It is an expensive sources of finance as compare to debt because generally investor expect a higher rate of dividend on preference shares . • The rate of dividend on preference share is usually lower as comported to the equity shares.

  41. MEANING OF DEBENTURES A company may raise long term finance through public borrowings. A debenture holder is a creditor of the company. A fixed rate of interest is paid on debentures. The interest on debenture is a charge on the profit and loss account of the company. The debentures are generally given a floating charge over the assets of the company. Debenture/bond is a debt instrument indicating that a company has borrowed certain sum of money and promises to repay it in future under clearly defined terms.

  42. Features • Maturity • Claims on income • Claims on assets • Control • Call feature (redemption of debts on certain price before maturity)

  43. Attributes • Trust indenture: it is a complex and lengthy legal document stating the conditions under which a bond has been issued. • It provides the specific terms of agreement such as description of debenture, rights of debenture holder, rights of the issuing company and responsibilities of the trustees. • Trustees is a bank or financial institution that acts as a third party to the bond to ensure that the issue does not default on its contractual responsibilities to the bond holders. • Interest: the debenture carries a fixed rate of interest, payment of which is legally binding • Maturity: It indicates the length of time for redemption

  44. Debenture redemption reserve: It is a requirement in the debenture indenture to provide for systematic retirement of debenture on maturity. • Call and put provision: the call/buyback provides an option to the issuing company to redeem the debenture at a specified price before maturity. The put option is the right to the debenture holder to seek redemption at a specified time at a predetermined price. • Security • Convertibility • Credit rating • Claim on income and assets

  45. Types of debentures • Simple or Unsecured debentures- These debentures are not given any security on assets. They have no priority as compared to other creditors. • Secured debentures- These debentures are given security on assets of the company. In case of default in the payment of interest amount debenture holder can sell the assets in order to satisfy their claims.

  46. Bearer debentures- These debentures are easily transferable. They are just like negotiable instruments. • Registered debentures- As compared to bearer debentures which are transferred by mere delivery registered debentures require a procedure to be followed for their transfer.

  47. Redeemable debentures- These debentures are to be redeemed on the expiry of a certain period. • Irredeemable debentures- These are payable either on the winding up of the company or at the time of any default on the part of the company

  48. Distinction between shares and debentures SHARES DEBENTURES A debenture is an acknowledgement of a debt. Debenture holders are paid interest on debentures. Interest on debenture is a charge against profit and loss account • A share is a part of owned capital. • Shareholders are paid dividend on the shares held by them. • Dividend on share is a charge against profit and loss appropriation account.

  49. Shareholders have voting right. • Shares are not redeemable during the life of the company. • At the time of liquidation of the company share capital is payable after meeting all outside liabilities. • Debenture holder are only creditors of the company. • Debenture can be redeemed after a certain period. • Debentures are payable in priority over share capital.