34 34 Sources of Finance

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Sources of FinanceSources of Finance

An Overview


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Subject IndexSubject Index General Classification

Equity Capital

Debentures

Preference Share Capital

Banks

Capital Financing Venture Capital Financing

Debt Securitisation

Lease Financing

Negotiable Instruments

Factoring Short term sources

Foreign Investments

Derivative & New Instruments

Ideal Capital Structure


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Corporate FinancingCorporate Financing

Internal Sources

Retained earnings

PromotersContribution

External Sources

Long Term Medium

TermShort Term

Bank Loans

Security Financing

Financial Instruments

Leasing

Other Sources


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Equity Share CapitalEquity Share Capital

Permanent Source of Finance

Raised from common public or internal sources as per the goodwill of concern

Signifies part ownership & prime risk element in an enterprise

Merits:

A basic investment in business providing security to other investors and

suppliers of money Low risk element:

- Redemption only on the liquidation of the business entity

- Payment of dividend when sufficient profits are generated

Flexibility:

- Options of bonus and right issue

- Non- voting equity shares can also be issued

- Company can buyback its own shares from the market

Security to the Shareholders of maintaining control over company

More aggressive market dealings and high market price


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Equity Share CapitalEquity Share Capital

Demerits: More cost to the payer company:

- Dividends are paid out of the post tax profits

- A Dividend distribution tax of 12.5% is additionally payable

Administrative and procedural compliances for serving the equity iscomplicated

Risk of dilution of Control of Management in the company

Conclusion:

- Cost: High

- Repayment terms: Flexible

- Control: High risk of dilution

An Inevitable Source of Finance


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DebenturesDebentures

Derived from the latin word Debre meaning to owe

Serves as an acknowledgement of debt to the investor

Fixed rate of interest paid and redemption as per commitments

Enjoys priority in Dissolution of the Company

Generally secured against assets. Can be convertible into equity

Merits: No dilution of control since Debenture holders are never given voting rights

Cost Effective:

- Tax Shield on the interest paid on debentures

Flexibility:- Scheme of Debt can be framed as per the companys needs

* Due consideration to the Paari Passu clause

- No complicated compliances serving the debt

- Own Debentures


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DebenturesDebentures Convertible Debentures:

- Effective substitute when the equity market is not very effective

Demerits:

Very High Risk:

- Interest payments at fixed rates

- Redemption as per the commitments

Effect on Equity Capital:- With increase in the financial risk, expected rate of return rises and resultantly, the

cost of equity

- Capitalization rate rises reducing the market price of the Equity share capital

Effect on Companys Assets:

- Debentures are generally secured against the companys assets, hence, the

borrowing capacity is substantially affected

Conclusion:

- Cost: Moderate

- Repayments Terms: Rigid

- Control: Not Affected


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Preference Share CapitalPreference Share Capital

Special type of shares enjoying priority over payment of dividends andredemption

Should be redeemed in a period of maximum 20 years

A fixed rate of dividends paid before equity shareholders

A hybrid of both debt and equity mix

Merits: A part of share capital of the company, hence a favorable debt equity ratio

can be maintained

Preference Capital carries no voting rights

Payment of dividend only if sufficient profits are generated

An attractive investment scheme for the investors:- A more secured investment

- A fixed rate of dividends is paid on priority basis

- Speculation tends to be generally less


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Preference Share CapitalPreference Share Capital

Demerits: High cost of serving the capital:

- Administrative and legal compliances

- Fixed rate of dividends payable at priority basis

- No tax shield on dividends. Further, a dividend distribution tax of 12.5%.

Can acquire voting rights if dividends not paid for over certain years

The unpaid dividends accumulate over the years of lower profits and aconsolidated liability is discharged when sufficient profits are generated

Conclusion:

- Cost: High

- Repayments Terms: Negotiable- Control: Moderate risk

An emerging source of finance


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Banks FinancingBanks Financing

Loans

A single advance

disbursed entirely

at one time

Interest charged

on the amount

sanctioned

Recovery of loan

at specified time

Can be secured or

unsecured

Not a running

account

Cash Credits

Bank credits a

fixed sum to loan

account

Withdrawal as

per needs

Secured against

stock

Interest charged

on the sum

withdrawn

Overdrafts

Customers

allowed to draw

in excess of their

bank accountbalances

Interest charged

on Daily balance

Secured by

Fixed Depositreceipts, stock

etc.

Can be

unsecured (Clean

OD)

SecuredAdvances

Advances given

on security of

confirmed orders,government

tenders etc.

Letter of credit

can also be given

Interest &Repayment terms

as per standards

Government

agencies also

provide such loans


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Capital FinancingCapital Financing

Seed Capital Assistance

Provided by all recognized banks

By means of loans and grants

Terms of loans sanction and repayments etc. are specified

Mainly for small and medium scale projects costing up to 1-2 Crores. A minimum

10% of promoters contribution is generally kept

A nominal interest along with a service charge varying with the volume of business

Capital Incentives

An economy promotion tool employed by the Government

Mainly for the promotion of the backward areas

Assistance is provided to the new undertakings either by way of a lumpsum subsidy

or exemption from taxes Mechanism is governed through State Finance Corporations and the provisions of the

applicable tax laws

Normally takes 1-2 years for the release of revenue. So, bridge finances can be

availed up to 85% of the sanction


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Venture Capital FinancingVenture Capital Financing

Started in 1987-88 by creation of Technology Development Fund and

guidelines for venture capital companies

To finance the upcoming modern and risky projects in sunrise sectors

Mainly in the fields of IT, Energy conservation, Quality up gradation

Main financing agencies are Asset Management Companies, FII, State

Finance Corporations, banks and private companies Common Methods of Financing:

- Equity Financing: Generally up to 49% of the total capital

- Conditional loans: Repayable as royalty ranging between 2-15%

- Income Note: Both Interest and Royalties are charged at lower rates

- Participating Debentures: Varying interest as per the operations

Venture Capital companies can claim income tax exemption under section

10(23FB) of the Income Tax Act, 1961

RB I and SEBI guidelines for registration and operations of venture capital

companies to be observed


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Debt SecuritisationDebt Securitisation Mainly a function of Non banking finance corporations (NBFC)

Recycling of funds by issue of securities against the pools of assets generatingsteady cash flow

Securitisation Process

- Locating the borrower as per credit worthiness and efficiency

-P

ooling Function:* Clubbing the receivables & advances into pools

* Structuring the pools with specific terms and conditions

* Transferring the pools to Special purpose vehicle (SPV)

- SPV to issue securities based on the Asset pool

Generally SPVs are Merchant bankers and Investors in such scheme are mutualfunds, insurance companies etc.

Transfer of ownership of Assets( Receivables) to SPV and the risk of non

payment to the investors of such schemes


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Lease/FranchiseLease/FranchiseLeasing:

An arrangement with the leasing company wherein particular assets are providedagainst periodic rent

Can be an effective alternative to purchasing the asset out of owned or borrowed

funds

Tax benefits on depreciation and lease rentals can be claimed by the respective

parties to agreement

Provisions of Hire Purchase Act, 1972 to be observed

Franchising:

A method of expanding business on less capital than would otherwise be needed

Under a franchising agreement, a franchisee pays a franchisor for the right to operate

a local business, under the franchisors trade name

The Franchisor bears all initial establishment costs

The franchisee makes regular payments to the franchisor based on the turnover &

after the agreed number of years, the ownership of business is transferred to

franchisee


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Negotiable InstrumentsNegotiable InstrumentsDiscountingofBills

Trade bills acknowledging the dues can be obtained from the customers

Credit worthiness of the parties can be exploited effectively

Banks discount the trade bills so obtained for a nominal charge

The payment due after 2-3 months can be obtained instantly

Drafting an operation of the promissory notes or bills receivable to be governed

by Indian Negotiable Instrument Act, 1881Commercial Papers

An unsecured promissory note issued as per provisions of Indian Negotiable

Instruments Act,1881

Can be issued to any extent but in the multiples of Rs. 5 Lakhs. An individual

investor cannot invest more than 25 Lakhs

Issued for a period of 30-180 days

No RBI restrictions or section 58Aof the Companies Act shall apply

Only for the companies having stock exchange lisitng and a tangible net worth of

5 crores or more

Issuer to bear all the preliminary charges


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FactoringFactoringFactoring

Provision of specialized services of credit investigation, sales management, creditcollection etc. by factor to the client under an agreement

In the agreement, the receivable accounts are sold to the factors who charges

commission & bear all the risks associated with it

For every account, factor assumes all the responsibilities and pays to the client at the

end of credit period or when the account is settled

Generally on recourse basis

Asset ReconstructionCompanies (ARC)

Asset Reconstruction Companies acquires bad loans/NPAs from Banks at a steep

discount and sell them eventually to the bidders

Banks and Financial Institutions sell their NPAs to take them out of their loan books &

improve their balance sheets This move is different from the Corporate Debt Restructuring

The borrower cannot oppose the sell of by the Banks and Finance Institutions

Generally the ARC issues security receipts as pass through certificates of certain rights

& entitlements to the investors in the assets held by the ARC

Arcil is the only functional Asset Reconstruction Company in the country


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Short Term SourcesShort Term Sources

Tradecredit

Credit period for

payment

Granted by

supplier of goods By Customers

before placing the

order

15-90 days

No cost of debt

Varies with

business volume

Regional &

Industry Standard

Inter-corporatedeposits

Flow of funds

between entities

Not Public Deposits

u/s 58A

Interest as per terms

agreed

Can be secured by

personal guarantee

Generally up to 6

months

Restrictions under

section 372A of the

Co. Act

PublicDeposits

Unsecured

Deposits

From 6 months

to 3 years

Renewable on

maturity

Covered under

section 58A

Maximum limit

of borrowing,

Interest etc. is

prescribed

Shortterm

unsecuredDebentures

For less than 18

months

A higher rate of

interest charged

No credit rating

is required

Terms should be

as per acceptable

standards


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Foreign InvestmentsForeign Investments Foreign Direct and Institutional Investment is allowed subject to the sectoral caps

Investment through Portfolio investment, foreign technology agreements, Externalcommercial borrowings

Active Involvement of FIPB, RBI and SEBI

Investor can take automatic route for simplified procedures

ADRs are traded in American Markets and GDRs worldwide

Mechanism ofADR/GDR:

Indian Co. issues shares to an overseas depository bank having office in India

Physical shares remain in India with custodian who acts as agent of the depository

bank

Against the underlying shares, depository issues receipts to foreign investors

Depository receives dividends from Indian co. in rupees and pass on to the investors

in Dollars

Foreign investor can sell the depository receipts in foreign stock exchange or can sent

back to depository & get the shares of underlying Rupee denomination

Depository receipts are convertible into equity not vice-versa

Investors in ADR/GDR are entitled to benefits of dividends, right and bonus issue

Voting rights remain with the depository who can exercise it on behalf of investors


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Derivative MarketDerivative Market Derivative: A financial instrument whose pay off depend on another financial instrument or

security. Derivatives can be used effectively for Hedging the payment risk and also for the speculation

purpose. Derivatives are of various types.

Forwards: It involves a contract initiated at one time and its performance in accordance withthe terms of contract at a subsequent time

Futures: A highly standardized & closely specified contract. They are traded on the stock

exchanges with an active involvement of the clearing houses Options: Trading of the right to buy or not to buy the underlying goods. Call option &

currency options are its types.

Swaps: An agreement between two or more parties to exchange sequence of cash flow over aperiod of time in the future.

Spot Contracts: To cover the exposure on the date of receipt/payment. Premium / discount

is already included in exchange rate & risk of currency fluctuations is to the companys accounts

RollOver Contracts: To cover the long term foreign exchange liabilities/ assets.Premium/discount is a function of interest rate differentials between US Dollar and other currency

Arbitrage: The process of buying a financial instrument in one market & selling the same inanother market. A method of making profits in an unstable market that brings the market to

equilibrium


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New InstrumentsNew InstrumentsSecured Premium Notes

Issued with a Detachable warrant Redeemable after 4-7 years. Can be convertible into equity

Option Bonds For Principal or Interest sum or both

Redemption premium is offered

Investor has the option to sell the bonds as per market situations

Junk Bonds For organizations with lower credit ratings and high risk projects

3-5% more than the normal market interest is charged

Wide usage in takeovers & buyouts

DeepDiscount Bonds Issued by IDBI in 1992

Zero interest bonds sold at a nominal sum

Redeemable after 25 years at Rs. 1 lakh with the exit option to investor in 5th, 10th, 15th

& 20th year

Inflationand floating rate bonds

Prior agreement for interest payment subject to inflation or market conditions


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Miscellaneous sourcesMiscellaneous sources

Bridge Financing:

Short term loans provided on the basis of loans pending disbursements

Repaid after the sanction of original loan

Generally provided against the Hypothecation of Current Assets, personal guarantee

& promissory notes

Generally a higher rate of interest is charged

Provided by both Banks and NBFC

Underwriting:

An agreement with the parties known as underwriters to secure the realization of

minimum subscription of the public issue of shares

Underwriters can help finding the potential investors for the issuing company

The underwriters charge a nominal commission to arrange the requisite funds

Generally Banks & Pvt. Cos. Are active as underwriters in the market

With their market contacts, underwriters can also help in proper allotment of units and

arranging other sources of finance as well


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Ideal Debt Equity MixIdeal Debt Equity Mix

Cost ofFinance: With a lower arrangement cost and being a tax deductible item, isusually cheaper than equity finance

Capital GearingofBusiness: Though debt is a cheaper source of finance, itcarries a fixed repayment obligation for interest & principal amounts

Security available: Money lenders require certain assets to be pledged against theborrowings. In the absence of good asset security, further borrowings may not be an option

Votingcontrol: Shareholders often deny those sources which tends to dilute theircontrol

Business risk: Companies with highly volatile profits should avoid heavyborrowings. High risk ventures are normally financed by the equity as there is no legal

obligation of repayment

Operating Gearing: It refers to the proportion of a companys fixed operatingcosts against its variable costs. Higher operating gearing signify a higher fixed cost element

& a more volatile operating profits.

Market State: Bearish run in the market often results in lesser returns to the entity

Currency ofBorrowing: Currency fluctuations may add to the cost of the loan


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Thank You

Documents

34 34 Sources of Finance