S Fm 3 Sources Of Finance

Sources of Long term finance & Raising Long Term Funds

1

Agenda • Meaning and purpose of long term finance • Various sources of long term finance • Raising share capital – Equity finance & Debt finance

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Types of Finance There are three types of finance which might be needed: 1. Short term: for up to one year 2. Medium term: for one to ten years 3. Long term: for more than ten years There are two main sources: 1. Internal to the business 2.External to the business There are two main reasons for raising funds: a)The purchase of fixed assets b)The need for more working capital 

4.

Meaning of Long term Finance Long term finance: Funds required for fixed capital and part of working capital is called long term finance. Purpose of long term finance i. To Finance fixed assets ii.To finance the permanent part of working capital iii.To finance growth and expansion of business 

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Factors determining longterm financial requirements i. Nature of Business ii.Nature of goods produced iii.Technology used

Funding a firm depends on? Financial Strategy Leverage Business expectations affect investment Different products require different stock levels • Large firms can regulate stocks more readily • Government grants & tax allowances will influence the asset structure of a business • • • •

Which source of funds to choose ? 1. Cost: interest rates vary, but share issues carry high administration costs 2. Size of loan: large amounts are less likely to be found from internal resources 3. Gearing: the ratio between owners’ equity & borrowed money will affect creditworthiness 4. Risk: the likely profitability of the investment will affect whether owners or lenders are willing to invest 5. Collateral: where firms have assets as guarantees against loans, institutions are more willing to lend 6. Status: reputable firms will find fund raising 

The need for each type of finance Short term: 1. To cover time lags between producing & selling 2. To cover seasonal fluctuations in cash flow 3. To buy equipment with a life of under one year Medium term: 1. For small scale expansion 2. To cover more persistent cash flow problems 3. To buy equipment & assets with lives of 1-10 yrs Long term: 1. For starting up, or large scale expansion 2. To finance takeovers or mergers 3. To buy long term assets like buildings 

Sources of Long Term Finance External: Loan from financial institutions Issue of Debenture Public Deposits Term loans from banks Internal: 1. Shares Owners’ Funds  Issues of shares by companies  Owners’ injections of money for small businesses 2. Retained profits 3. Reserves 

Different kinds of Shares 1. Ordinary shares: carry one vote per share, but receive their dividend last 2. Ordinary non-voting shares 3. Preference shares: receive a fixed dividend & has priority over ordinary share for dividends 4. Cumulative preference shares: will be paid arrears of dividends when profits are ultimately made 5. Redeemable preference shares: the company has the right to buy these shares back, at a fixed date 

Owners’ Equity Advantages: 1. Dividends payable when profits are made 2.Ordinary shareholders have voting rights 3.Borrowing Capacity Disadvantages: 1. Capital is tied up in the business 2. Might be difficult to sell shares, or the business 3. Share issues are expensive to administer 

Borrowing Advantages: 1. Interest on loans is tax deductible 2. Real value of debt falls during inflation 3. Limited liability protects companies 4. Debentures can be sold on the Stock Exchange Disadvantages: 1. Borrowed funds have to be repaid 2. Limited liability does not protect businesses 3.Some loans will require collateral 4.Highly geared firms are vulnerable in 

Euro Issues • Issue of GDRs : Global Depository Receipts • A GDR is a dollar denominated instrument tradeable on a stock exchange in Europe or in the USA • E.g. A GDR of $60 = 4 equity shares of $15 each, equivalent to Rs. 600/(if exchange rate is $1=Rs.40)

SUMMING UP •

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Equity capital represents ownership capital

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Internal accruals consist of depreciation, amortisation, and retained earnings

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Preference capital represents a hybrid form of financing

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Term loans and debentures are the most important sources of long-term debt finance

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Cost, dilution of control, risk, and restraint on managerial freedom are the key criteria used for evaluating term finance the various sources of long-

Assignment-2 

What are the criteria applied by Financial institutions in India while sanctioning term finance to industrial units ?

RAISING LONG – TERM FINANCE

Methods

1.

Venture Capital

2.

Initial Public Offer

3.

Secondary Public Offer

4.

Rights Issue

5.

Private Placement

VENTURE CAPITAL

VENTURE INVESTMENT

CAPITAL IN

A

REPRESENTS HIGHLY

RISKY

FINANCIAL PROPOSITION

MADE IN THE HOPE OF EARNING A HIGH RATE OF RETURN

FEATURES OF VENTURE CAPITAL The venture capitalist ( VC ) subscribes • to equity or quasi - equity instruments . The VC takes an • guiding the assisted

active

interest

in

firm . • The VC normally plans to liquidate its investment in the assisted firm after 3 to 7 years .

GUIDELINES FOR PREPARING •

A BUSINESS PLAN

Use simple and clear language

Focus on four basic elements , • people , product , market , and competition . Give projections • with emphasis on cash flows .

for

about

two

viz .,

years

• Identify risks and develop a strategy to cope with the same . Convince that the management • talented , committed , and determined .

team

is

BENEFITS OF GOING PUBLIC •

Access to Capital

•

Respectability

•

Investor Recognition

•

Window of Opportunity

•

Liquidity

•

Diversification

COSTS OF GOING PUBLIC •

Adverse Selection

•

Dilution

•

Loss of Flexibility

•

Disclosures

•

Accountability

•

Public Pressure

•

Costs

BOOK BUILDING Book shares

building to

is

a

investors

method in

of

which

offering the

issue

price is not fixed in advance ( as is done in a fixed price offer ) but is determined through a bidding process .

ROLE OF THE LEAD OF THE ISSUE

MANAGER

The lead manager of a public issue may be likened to the ‘ conductor ’ of an opera . His principal tasks are to : • Structure the issue • Coordinate the appointment of various intermediaries • Prepare the draft prospectus and finalise the same • Market the issue • Monitor the issue during the subscription period • Finalise the allotment • Secure stock exchange listing .

RIGHTS ISSUE A rights issue is an issue of capital to the existing shareholders of a company on a pro rata basis through a Letter of Offer . Rights are negotiable and can be exercised only during a fixed period which is usually about 30 days .

VALUE OF A SHARE The value of a share , after issue , is expected to be :

the

rights

NP 0 + S N + 1 where : N = number of existing shares required for a rights share share

P 0 = cum - rights market price per

S = subscription price at which the rights share are issued

VALUE OF A RIGHT The theoretical value of a right is :

P0 – S N + 1

KEY POINTS ABOUT A RIGHTS ISSUE • The wealth of existing shareholders , per share , is not affected by the rights offering , provided , of course , the existing shareholders exercise their rights in full or sell their rights . • Theoretically , the subscription price is irrelevant because the wealth of a shareholder who subscribes to the rights shares or sells the rights remains unchanged , irrespective of what the subscription price is .

PRIVATE PLACEMENT AND ALLOTMENT

PREFERENTIAL

Private placement and preferential • allotment involve sale of securities to a limited number of sophisticated

investors such as financial institutions , mutual funds , venture capital funds , banks , and so on . In a preferential allotment , the • identity of investors is known when the issuing company seeks the approval of the shareholders , whereas in a private placement , the identity of investors is not known when the offer

PRIVATE

PLACEMENT AND PREFERENTIAL ALLOTMENT

In the Indian context we find broadly (i)

private

placement

refers

to

sale

of

equity or equity related instruments of an unlisted company or sale of debentures of a listed or unlisted company and ( ii ) preferential allotment refers to sale of equity or equity related instruments of a listed company .

DILUTION When

a

firm

plans

to

sell

securities ,

dilution is an issue that often comes up for discussion . We can think of dilution in terms of proportionate ownership or market value or book value or earnings per share .

SUMMING UP • Venture capital funds seek to support promising firms during their initial stages they are ready to make a public offering of before securities • The decision to go public is a complex one which calls for carefully weighing the benefits against costs . • An Indian company can make an IPO if it satisfies certain conditions . • A series of steps is involved in a public issue , whether it is an IPO or a secondary offer . • The manager of a public issue may be likened to the ‘ conductor ’ of an opera . • A rights issue involves selling securities in the primary market to the existing shareholders . • Private placement and preferential allotment involve sale of securities to a small number of sophisticated investors .

Additional Readings

ising Finance for African Gas - Related Projects : Lessons from Nigeria - Victor E . Eromosele

Assignment -3 A.Procedure to Raise funds through public deposits

B. D.Problems in raising finance for small firms

E. C.

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A firm is thinking of a rights issue to raise Rs. 5 Crore. It has 5 lakhshares outstanding and current

market price is Rs. 170. The subscription price on the new share will be Rs. 125 per share. 

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How many shares should be sold to raise the required funds?=400000 ii) How many rights are needed to i)