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Sources of Finance

Shreeya Rajpurohit

Meaning
It is required to acquire fixed assets.
Can be obtained from capital market.
Normally for the period of more than 10
years.
Required for investment in plant and
machinery,
land and building, patents goodwill and in
other
fixed assets.

Purpose of Long Term Finance


To finance fixed assets.
To finance the permanent part of working
capital.
To finance growth and expansion of business.

Factors affecting Long-Term


Financial Requirement
Nature of business
Nature of goods produced
Technology used

Equity Shares
Ordinary shares or common shares.
One of the unit into which the capital of the
company is divided.
Contribute to the capital of the company.
Provides permanent capital.
Real owners of the company
Last one to get repayment in the event of
liquidation of the company.
variable income security

Definition
Sec.2(46) of Indian Companies Act, 1956
A share means share in share capital of a
company
and includes stock except stock and shares is
expressed or implied.

Features of Equity Shares


Permanent capital.
Unsecured capital- no security.
A risk free source as company does not
commit anything on equity shares.
Enjoy voting rights and decision-making
authority.
Return in form of dividend.
No maturity upto winding up of business.
Right to share in profit that is dividend,
bonus shares.

Features of Equity Shares


Membership rights
Claim on income - residual
Cost on equity very high, dividend not tax
deductible, high cost of issue, risk factor very high

Claim on assets last claimant to assets of firm


Control
Pre-emptive rights

Advantages of Equity Shares


To Investors
Restricted liability
Capital profit
Interest in the companys activities
Best for investment those who take the risk
More income
Right to interfere in management by exercising
voting rights

Pre-emptive right
If company wants to issue additional equity shares
it is under legal obligation to offer these shares to
existing shareholders first and then to go for public
offer. This right is called as Pre-emptive right.
Voting Rights
Voting rights are proportionate to their investments
in shares, however as per some recent amendment
in the Companies Act 1956, company may issue
shares with disproportionate voting rights.

Advantages of Equity Shares


To Company
No fixed burden of dividend
A risk free source
No repayment of capital during lifetime of
company
No outflow of cash
Simple and cheap source
Increase in debt capacity
Availability of fixed capital

Disadvantages of Equity
Shares
To Investors

Uncertainty of income
Irregular income
Capital loss
Less attractive to modest investors
Loss in case of liquidation
To Company
Difficult to remove overcapitalization
Centralization of control
Change in management policy
Speculation

Preference Shares
Meaning
Represents a hybrid form of financing. Have
features of equity shares and debentures.
Definition
Preference shares are those shares which have
preference in - Payment of dividend
- repayment of capital at the time of winding
up of the company

Features

Dividend at fixed rate


Fixed maturity/redemption period
Accumulation of dividends
Convertibility of shares
Participation in surplus profits and
assets
Claim on assets or income
Restricted voting power
No participation in management

Advantages of Preference
Shares
To Investors

Priority in repayment of capital


Best security
Regular and fixed income
Less risk
Safety of interest
To Company
No interference in management
Economical financing
Availability of wide capital market
No charge on asset

Disadvantages of Preference
Shares
To Investors
Dividend at fixed rate
Uncertain position of redeemable
preference shares
No right to enjoy in excess income or
assets of the company
Limited voting rights

Disadvantages of Preference
Shares
To Company

Disadvantage to equity shareholders


Fixed economic burden
High cost of capital
Difficult to receive additional capital

Types of Preference shares


1. Cumulative Preference Shares
These carry a right to claim fixed dividend on the
past and current years out of future profits.
Accumulated arrears of dividend shall be paid
before any dividend is paid to equity shareholders.
2. Non-cumulative Preference Shares
If the dividend cannot be paid in the current year
due to the loss incurred in the previous year, it
lapses. It cannot be accumulated.

Types of Preference shares


3. Participating Preference Shares
Preference shares are entitled to a fixed
Preferential dividend and in addition, they get a
right to Participate in the surplus profit along
with
equity shareholders after equity dividend paid to
equity shareholders is paid at a certain rate.
4. Non-participating Preference Shares
They are entitled only to fixed rate of dividend.
Unless otherwise stated, all preference shares
are deemed to be non-participating preference
shares.

Types of Preference shares


5. Convertible Preference Shares
Converted into equity shares after the maturity
6. Non-convertible Preference Shares
Repaid in cash only at maturity.
7. Redeemable Preference Shares
Repaid after a specified period
8. Irredeemable Preference Shares
They are redeemed at the time of winding up of the
company. Normally redeemed after the expiry of 20
years from the date of issue.

Retained Earnings/
Ploughing back of Profits
Internal source of finance
Most suitable for an established firm for its
expansion, modernisation and
replacement etc.
It means the reinvestments by concern of
its surplus earnings in its business.
Costfree source of finance

Retained Earnings/
Ploughing back of Profits

No need to keep securities


No dilution of control
Ensures stable dividend policy
Gains confidence of the public

Advantages
To Company
A cushion to absorb the shocks of economy like shocks of
trade cycles, uncertainty of the market with comfort, preparedness
Economical method of financing not dependent on outsiders
Aids in smooth and undistributed running of
business
Helps on following stable dividend policy means payment
of dividend regularly
Flexible financial structure no need to raise loans, adds

creditworthiness of the company

Makes the company self-dependent and not dependent on

outsiders

Helps in making good the deficiencies of


depreciation
Enables to redeem long term liabilities relieves the

burden of fixed interest commitment

Advantages
To investors
Increase in the value of shareholders due to
stable dividend, goodwill of the company
Safety of investments assurance of minimum rate of
dividend, renders safety
Enhanced earning capacity with re-enhancement,
increased earning capacity and real owners get benefited
No dilution of control no new issue of shares,
Ploughing back of profits provides an opportunity for Evasion
of super tax

Advantages
To Society or Nation
Increase the rate of capital formation
promotes economic development of the nation
Stimulates industrialization by providing self-finance.
Increases productivity as scarce resources can be
exploited fully
Decreases the rate of industrial failure as
assures strength and stability indispensible for smooth and
undisturbed running of business.
Higher standard of living due to increased
productivity, better quality goods at reduced prices, job security and
increased remunerarion due to smooth running and stable business.

Disadvantages

Overcapitalisation
Creation of monopolies
Depriving the freedom of the investors
Misuse of retained earnings
Manipulation in the value of shares
Evasion of taxes
Dissatisfaction among the shareholders

Debentures
Meaning:
An instrument executed by the company
under its common seal acknowledging
indebtedness to some person or persons to
secure the sum
advance.
A security issued by a company against the
debt .Public company is allowed to raise debt
capital.

Definition
Indian Companies Act, 1956
Debenture includes debenture stock, bonds and
any other security of a company whether
constituting a charge on the assets of the
company or not.
Prof. Naidu and Datta
A debenture is an instrument issued by the
company under this common seal acknowledging
debt and setting forth the terms under which they
are issued and are to be paid.

Features of Debentures

Fixed interest rate


Fixed Maturity
No voting rights
Secured assets/claim on assets
Claim on income
No control over affairs of company

Types of Debentures
On the basis of security
Simple debentures
Debentures not secured on any asset.
Mortgage debentures
Secured either on a particular asset or on all the
assets of the company in general. In India, only
secured debentures are issued.

Types of Debentures
On the basis of registration
Bearer debentures
Not registered. Payable to the bearer. Can be
transferred merely by delivery. Interest is paid to the
persons who produces the interest coupon attached
to such debentures.
Registered debentures
Payable to the persons whose name appear in the
Register of Debentureholders. Can be transferred
only
by executing a transfer deed. Interest is paid to the
registered dealer.

Types of Debentures
On the basis of permanency
Redeemable debentures
Repayable after a specified period in lump sum
or by installments.
Irredeemable debentures
Not redeemable during the lifetime of the
company.

Types of Debentures
On the basis of priority
First debentures
Have first claim on assets
Second debentures
Have a second claim on the assets charged
On the basis of conversion
Convertible debentures
Non-convertible debentures

Advantages of Debenture
To Company

Lower rate of interest


Trading on equity
Freedom in management
Tax-benefits/Reduces tax liability
Certainty of finance secured debentures min for 7 years
Capital from moderate investors fixed and regular
income, less risk involved
Boom during depression- less interested in investing shares
as company not getting high profits
Controlling overcapitalisation by redemption

Consolidation of debts

Advantages of Debenture
To Investors
Fixed and stable income
Safety investment
Liquidity most liquid investment, ready market, used as
collateral security
Fixed maturity period
Conversion of loan

Disadvantages of Debenture
To Company
Fixed charge on assets
Fixed burden
Risk of winding up
To Investors
No control
No extra profits
Uncertainty

Bank Loans
The loans indicate liabilities accepted by the
enterprise for satisfying the short term & long
term requirements .
Banks & financial institutions have the
authority
to grant loans.

Types of Bank Loans


Short Term loans :- Duration 1 year
1. Overdrafts
2. Bills Discounting
3. Cash Credit
Medium Term Loan :- Duration :- up to 5/6 years
Long Term loans :- Duration :- more than 5 / 6
years

Term/Bank Loan
Most suitable to meet the medium-tem
demands of working capital.
Interest charges at a fixed rate
Amount of loan to be repaid by way of
installments in a number of years

Features of Term Loan

Maturity
Purpose
Flexibility
Contractual in nature
Security
Interest payment and principal repayment

Advantages of Term Loan


To Borrowers
Interest on loan is tax deductible expenditure.
Do not result in dilution of control, as lenders
do not have the right to vote.
No controlling rights
Introduces proper financial discipline in the
borrower

Advantages of Term Loan


To Lenders
Secured
Fixed rate of interest
Definite maturity period
Repayment of installment & interest at
regular interval
Bank can interfere in operations of business
by taking legal action

Disadvantages of Term Loan


To Borrowers
Obligatory interest and principal repayment
Carry restrictive covenants which may reduce
managerial freedom.
Entitle the lenders to put their nominees on
the board of the borrowing company.
Increase the financial risk of the firm. It tends
to raise the cost of equity capital.

Disadvantages of Term Loan


To Lenders
Do not carry the right to vote.
Not represented by negotiable securities (it
will be overcome by securing the term loan.)

Lease Financing
Definition:
A contractual agreement (transaction) in which a
party owning an asset (equipment) (lessor)
provides the asset for use to another (transfer the
right to use the equipment to the user) (lessee)
over a certain (for an agreed period of time) for
consideration in form of (in return for) periodic
payments (rentals) with or without a further
payment (premium).

Lease Financing
An agreement that provides a firm with the
use and control over assets without
buying and owning the same.
A form of renting assets.
A contract between the owner of the asset
(lessor) and the user of the asset (lessee)
Lessor gives the right to use the asset to the
lessee over an agreed period of time for a
consideration. It is lease agreement.

Lease Financing
Regulated by the terms and conditions of
the agreement.
Lessee pays the lease rent periodically to
the lessor as regular fixed payments over a
period of time.
At the expiry of the lease period, the asset
reverts back to the lessor who is the legal
owner of the asset.
In long term lease contracts, the lessee is
generally given an option to buy or renew
the lease.

Essentials elements of Lease


Financing

Parties to the contract


Two parties owner (lessor) and user (lessee )
Parties may be individuals, partnerships, joint
stock companies, corporations or financial
institutions.
Sometimes, there may be joint lessors and lessee.
Asset
Asset may be automobile, plant and machinery,
equipment, land and building, factory, a running
business, aircraft.
Asset may be of the lessees choice suitable for
his business needs.

Essentials elements of Lease


Financing

Ownership separated from user


Ownership vests with the lessor and its use is
allowed to the lessee. On the expiry of tenure,
the asset reverts to the lessor.
Term of lease
The period for which the agreement of lease
remains in operation.
Lease period shorter than the useful life
of the asset is operating lease.
Lease period streched over the entire
economic life of an asset is financial lease.

Essentials elements of Lease


Financing
Lease rentals
It is the consideration, the lessee pays to the
lessor for the lease transaction,
To compensate the lessor
for the investment made in the asset, interest
on investment, repairs borne by the lessor
and servicing charges over the lease period.

Essentials elements of Lease


Financing
Modes of terminating lease
Terminated at the end of the lease period and
various possible courses are The lease is renewed on a perpetual basis or for
a definite period
The asset reverts to the lessor
The asset reverts to the lessor and the lessee
sells or leases it to a third party
The lessor sells the asset to the lessee

Steps in Leasing Transaction


1)Lease decision:
Decision about the asset required and
determine the manufacturer or the supplier.

Decides requirements like


The design specifications, the price,
warranties, terms of delivery, installation
and servicing.

Steps in Leasing Transaction


2)Lease Agreement:
Contains the obligations of the lessor and the lessee as Basic/primary lease period which is irrevocable
Timing and amount of periodical rental
payments during basic lease period
Details of any option to renew the lease or
purchase the asset at the end of basic lease period
Details regarding the responsibility for payment of
cost of maintenance and repairs, taxes, insurance

Steps in Leasing Transaction


3)Lease delivery and payment
After signing the lease agreement,
the lessor contacts, manufacturer or supplier
to supply the asset to the lessee.
Lessor makes payment to the
manufacturer or supplier after the asset
has been delivered, tested and accepted
by the lessee.

Types of Lease
1) Operation or service lease
The lessor doesnot transfer all the risks and rewards incidental to
the ownership of the asset and the cost of the asset is not fully
amortized.
Generally used for computers, office equipments, automobiles,
trucks, some other equipment, telephones
2) Financial lease
For longer period and non-cancellable.
similar to debt financing
Commonly used for leasing land, building, machinery and fixed
equipments

Types of Lease
3) Sale and lease back
Sell an asset already owns to another party and lease it back from
the buyer.
Lessor receives immediate cash for his assets and repays the
rentals over stipulated period
4) Single investor lease
Only two parties lessor and lessee. Lessor funds the entire
investment by an appropriate mix of debt and equity funds
Debt raised are without resource to the lessee
Default in servicing the debt, lender is not entitled to payment from
lessee.

Types of Lease

5) Direct lease
Owner of equipment are from two different entities
a)Bipartite lease(structured as operating lease)
2 parties equipment supplier-cum-lessor and lessee
b)Tripartite lease
Involves 3 parties equipment supplier, lessor and lessee
Said-aid lease: equipment financer arranges for in various forms
Providing reference about the customer
Negotiating the terms of the lease and completing all formalities
Writing the lease on own A/c and discounting the lease
receivables with the designated leasing co.

Types of Lease
6)Leveraged lease
3 parties involved lessor, lessee and the financer
Leasing co. contributes by way of equity capital, FI and/or banks by way of
term loans towards the purchase of an asset to be leased.

7) Domestic lease
All parties are domiciled in the same country.
8) International leaseParties located in 2 different nations.
a)Import lease
Lessor and lessee from same industry but equipment supplier in
different country.
b) Cross-border lease lessor and lessee from different
countries.

Advantages of Lease Financing


To the Lease
Financing of capital goods
Additional source of finance
Less costly
Ownership preserved
Avoids conditionalities
Flexibility in structuring of rentals
Simplicity
Tax benefits
Obsolescence Risk is averted

Advantages of Lease Financing


To the Lessor
Full security
Tax benefits
High profitability
Trading on equity
High growth potential

Disadvantages of Lease
Financing
To the Lessee
High cost
Loss of Moratorium period
No alteration or change in asset
Loss of ownership incentives
Penalties on Termination of lease
Loss of salvage value of the Asset

Disadvantages of Lease
Financing
To
the Lessor

High risk of obsolescence


Competitive market
Price-level changes
Management of cash flows
Increased cost due to loss of user benefits
Long-term investment

Problem of Leasing

Resource constraint
Risk of obsolescence
Non-availability of sales tax considerations
Cut-throat competition
Lack of qualified personnel

Hire purchasing
Hiring of an asset for a period of time and
at the end of the period, purchasing the
same.
Time sharing of an asset
the person hiring the asset acquires its
possessions and the right to use it.
A legal device, being used for financing of
capital goods such as industrial finance,
financing of consumer goods and for selling
consumer goods on hire purchase.

Hire Purchasing
HP is A transaction where goods are purchased
and sold on the term that
1. Payment will be made in installments.
2. Possession of goods given to the buyer
immediately.
3. Property (ownership) in goods remains
with the vendor /owner till the payment
of last installments.
4. Seller can repossess the goods in case of
default in payment of any installments.
5. Each installment is treated as hire charges
till the payment of last installment.

Features of Hire Purchase


Contract

A proposal from the hirer to acquire the goods


and acceptance of the proposal by the owner
on mutually agreed upon terms in writing in
form of an agreement after the consent
between the parties.
An express intention to create a legal
relationship by the delivery of goods ,
with the option to purchase after a
specified period of time.

Features of hire purchase


contract

The owner and hirer should be capable to


enter into contract as per Indian Contract Act,
1872.
Contract should not oppose public policy.
Agreement supported by consideration in the
form of rentals payable by the hirer to the
owner at regular intervals for the right to use
the goods.
Agreement must confer the power of
termination prescribed under the agreement.

Clauses of hire purchase


agreement

Nature, term and commencement of


agreement
Delivery of equipment place and time and
hirer liability to bear delivery charges
Location where the equipment should be kept
Inspection examination of equipment by hirer
Repairs hirer to obtain at his cost, insurance on
the equipment
Alteration hirer not to make any alterations,
additions without prior consent of the owner

Clauses
of
Agreement

Hire

Purchase

Termination events or acts of the hirer eligible to


terminate the agreement
Risk loss and damage to be borne by the hirer
Registration and fees hirer to comply with the
relevant laws, obtain registration and all requisite
fees
Indemnity clause clauses to indemnify the
lender as per Contract Act
Stamp duty stamp duty liability to be borne by
the hirer
Schedule of equipments forming subject matter
of agreement, schedule of hire charges.

Types of Hire Purchase


Consumer installment credit
Finance offered to consumer for acquiring
consumer durables
In form of personal loan, credit sale, rental or
conditional sale
May be in the form of direct collection,
agency collection or block discounting.
Consumer acquire goods by utilizing the
funds being advanced under HP agreement.

Types of Hire Purchase


Industrial and commercial credit
Finance may be provided through loans,
credit sales, leasing, factoring or hire
purchase.
Financing house, itself purchases the
equipment from the manufacturer or dealer
through HP and lends it on HP to the said
commercial concern instead of lending money

Advantages of Hire Purchase


Higher realised income- as the calculation is on the
original price
Low NPAs company as owner, attachments of vehicle and
possibility of subsequent sale
Fewer defaulters end up in losing installments paid as
well as defaulters
Recycle recovered funds

Disadvantages of Hire
Purchase
Encourages lavish expenditure due to easy
payment, go beyond capacity.
Future income is mortgaged due to installments
over the period of time
Higher installment price than cash down price.
Difficulty in resale of goods even though right to
repossess the goods, sale becomes difficult as they are second
hand goods.

Public Deposits
Fixed deposits accepted by a business
Directly from the public
Mainly to finance their working capital
requirement
Rules for Acceptance
1.No company shall accept any deposit which is
repayable on demand.
2.Minimum duration 6 months ,Maximum
duration 36 months.

The maximum amount of deposits which a


company may accept will be 25 % of the
aggregate of paid up capital & reserves
out of which not more than 10 % should be
from a shareholder of non private limited
companies or should be guaranteed by
any directors.

Features:

Not secured
Available for a period ranging between 6
months and 3 years
Carry fixed rate of interest
Not require complicated legal formalities

Advantages of Public Deposits

Simple and easy


No charge on asset
Economical
Flexibility
High rate of return
Maturity period is short

Disadvantages of Public
Deposits
Uncertainty
Insecurity to invest in companies not very sound
Lack of attraction for professional investors no
capital appreciation, low ROR
Low ROR but commission and brokrage make uneconomical
Hindrance to growth of capital market
Overcapitalization easy, convenient and cheaper source
of raising money
Limited maturity period
Interest charged does not enjoy tax exemption.