Icfai Sources_of_capital_finance

Sources of capital finance

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Objective To support its long term investment ,a firm must find the means to finance them. Equity & Debt represent the two broad sources of finance . Equity referred as share holders funds on balance sheet in India, consists of equity capital, retained earning & preference capital. Debt. referred to as loan funds on balance sheet consists of term loan, debentures & short term borrowing. (working capital) 2

Equity capital It represents ownership capital , as equity shareholders collectively own the company. They enjoy the rewards & bear the risk of ownership. However their liabilities are limited to their capital contribution . Authorized capital: Amount of capital that a company can potentially issue as per its memorandum represents the authorized capital. Issued capital: The amount offered by the company to the investors is called issued capital. Subscribed capital: The part of issued capital which is subscribed by investors represents the subscribed capital. 3

Equity capital -Advantages No compulsion to pay dividends, so firm can skip equity dividends without suffering any legal consequences. Equity has no maturity date hence firm has no obligation to redeem. It provides cushion to lenders, it enhances the creditworthiness of the company. 4

Equity capital -disadvantages Sale of equity shares to outsiders dilutes the control of existing owners. The cost of equity capital is highest.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, where interest payments are tax deductible expenses.This makes relative cost of equity more. 5

Internal accruals It consists of depreciation charges and retained earnings. Depreciation represents the allocation of capital expenditure to various periods over which the capital expenditure is expected to benefit the firm. Retained earnings are that portion of equity earnings (profit after tax less preference dividends) which are ploughed back in the firm.It is sacrifice made by equity shareholders, they are referred to as internal equity.

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Internal accruals-advantages It is readily available funds internally.They do not require talking to outsiders. It eliminates issue costs & losses on account of under-pricing as compared to externally equity. There is no dilution of control when a firm relies on retained earning. Stock market normally views an equity issue with skepticism where retained earnings do not carry any negative connotation. 7

Internal accruals-disadvantages The amount that can be raised by way of retained earnings may be limited. The opportunity cost of retained earnings is quite high.

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Preference capital It is a hybrid form of financing. It resembles equity in one way & debentures in several ways. Preference dividends is not an obligatory payment. It is payable only out of distributable profits. Is not a Tax deductible payments. 9

Preference capital-advantages No legal obligation to pay It is part of net worth so it enhances creditworthiness to firm. In normal circumstances there is no voting power to preference capital, so no dilution of control.

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Preference capital-disadvantages Compared to debt capital, it is very expensive source of financing because dividends paid to pref.capital is not tax deductible expenses. Skipping of payment of dividends adversely affect the image of the firm in capital market. They acquire voting rights, if the company skips preference dividend for a certain period. 11

Term loans Firms normally obtain long term debt mainly by raising term loans or issuing debentures. It is a primary source of finance for private as well as public firm. It is normally repayable in less than 10 years. Features are: (1) It is given in rupee loans as well as foreign currency term loans. (2) It is secured borrowing . (3) It has definite obligations that are payable irrespective of financial condition of the firm. 12

Debt financing-advantages Interest on debt is a tax deductible expense It does not result in dilution of control because they are not entitled to vote. Issue cost is lower than equity The burden of servicing debt is generally fixed in nominal terms.It provides protection against high unanticipated inflation. 13

Debt financing-disadvantages Debt financing entails fixed interest and principal repayment obligation. Failure may result in financial embarrassment & even lead to bankruptcy. It increases financial leverage which in turn increase cost of equity. Debt contracts impose restrictions which lead firms to put limits on financial & operating flexibility. 14

Debentures It Is a viable alternative to term loans. Debenture holders are creditors of company. Debentures provides more flexibility than term loans as they offer greater variety of choices with respect to maturity, interest rate, security & repayment. 15

Comparison cost

Dilution of risk control

Restraint on mgt freedom

Equity

High

Yes

Nil

No

Retained earning

High

No

Nil

No

Pref. Capital

High

No

Negligible

No

Term Loans

Low

No

High

Moderate

Debt.

Low

No

High

Some 16

 Miscellaneous Sources: • Deferred Credit • Lease and Hire Purchase Finance • Unsecured Loans and Deposits • Special Schemes of Institutions • Subsidies and Sales Tax Deferments and Exemptions • Short-Term Loans from Financial Institutions • Commercial Papers • Factoring • Securitization  Deferred Credit: The suppliers of machinery provide deferred credit facility under which payment for the purchase of machinery is made over a period of time. The interest rate on deferred credit 17

and the period of payment vary rather widely. The supplier insists that a bank guarantee should be furnished by the buyer.  Lease Finance and Hire Purchase: A lease finance represents a contractual arrangement whereby the lessor grants the lessee the right to use an asset in return for periodic lease rental payments. There are two broad types of lease: finance lease and operating lease. • A finance lease or capital lease is essentially a form of borrowing . The lease is more or less fully amortized during the primary period. The lessee is responsible for maintenance, insurance and taxes. • An operating Lease can be defined as any lease other than a finance lease. 18

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The lease term is significantly less than the economic life of the equipment. • The lessee enjoys the right to terminate the lease at a short notice without any significant penalty. • The lessor usually provide the operating know-how and the related services and undertake the responsibility of insuring and maintaining the equipment. Such an operating lease is called a ‘wet lease’. If this is done by the lessee, it is called ‘dry lease’. Hire Purchase: Finance companies offer the facility of hirepurchase to their clients. • The hiree purchases the asset and gives and gives it on hire to the hirer (counter part of lessee) 19

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The hirer pays regular hire-purchase installments over a specified period of time. • The hiree charges interest on a flat basis. A certain rate of interest is charged on the initial investment. • The hirer is entitled to claim depreciation and enjoys the salvage value of the asset.  Unsecured Loans and Deposits: • Unsecured loans are provided by the promoters to fill the gap between the contribution stipulated by FIs and the equity capital subscribed to by the promoters. This is also known as quasi-equity. • Deposits from the public represent unsecured borrowing of one to three years.  Special Schemes of Institutions: FIs have designed schemes to serve the 20 varied needs of industry.

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Bill Rediscounting Scheme: Operated by IDBI, the bill rediscounting scheme is meant to promote the sale of indigenous machinery on deferred payment basis. Under this scheme the seller realizes the sale proceeds by the discounting the bills or promissory notes accepted by the buyer with a commercial bank which in turn rediscounts them with the IDBI. • Suppliers’ Line of Credit : Administered by the ICICI, under the suppliers’ line of credit, the ICICI directly pays to the machinery manufacturer against usance bills duly accepted or guaranteed by the bank of the purchaser.  Subsidies and Sales Tax Deferments and Exemptions: 21 These facilities are provided by government.

 Short-term Loans from Financial Institutions: • FIs provide short-term loans to companies with a good track record. To be eligible for such a loan, a company must satisfy certain conditions relating to dividend track record, debt-equity ratio, current ratio, and interest coverage ratio. • They are totally unsecured and are given on the strength of a demand promissory note. • The loan is given for a period of one year and can be renewed for two consecutive years, provided the original eligibility criteria are satisfied.  Commercial Paper: • A C.P. represents a short-term unsecured promissory note issued by firms which enjoys a fairly high credit rating. 22

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The maturity period of CP ranges from 90 to 180 days. • CP is sold at a discount rate from its face value and redeemed at its face value. Interest is a function of the size of the discount and the period of maturity. • There is no well developed secondary market for commercial paper.  Factoring: • A factor is a financial institution which offers services relating to management and financing of debts arising from credit sales. • The factor selects the accounts of the client that would be handled by it and establishes along with the client, the credit limits applicable to the selected accounts. • The factor assumes responsibility for 23 collecting the debts of accounts handled by it.

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For each account, the factors pays to the client at the end of the credit period or when the amount is collected, whichever comes earlier. The factor advances money to the client against not-yet-collected and not-yet- due debts. The amount advanced is 70 to 80 percent of the face value of the debt and carries an interest rate which may be equal to or marginally higher than the lending rate of commercial banks. Factoring may be on a recourse basis or on a non-recourse basis. Besides the interest on advances against debt, the factor charges a commission of 1 to 2 percent of the face value of the debt factored. 24

 Securitization: • It involves packaging a designated pool of assets and issuing securities which are collateralized by the underlying assets and their associated cash flow stream. • Securitization is originated by a firm that seeks to liquefy its pool of assets. o Mortgage backed securities o Asset based securities • Key steps in securitization: o Seasoning o Credit enhancement o Transfer to a special purpose vehicle o Issuance of securities • The SPV issues securities backed buy the pool of assets held by it. These securities are called Pass Through Certificates (PTCs)25