Daiict Busi Fin Vi 08

DAIICT: Business Finance 2014

Topic 5: Sources of Finance 1

DAIICT:Introductionto BusinessFinanceTopic 8:Sources of Finance& Finance Strategy

Vishal Iyer, CFA

DAIICT: INTRODUCTION TO BUSINESS FINANCE TOPIC 8: SOURCES OF FINANCE 1


A firm should find sources of finance required to supportinvestments in fixed assets and working capital.

Major Sources

Equity

Referred to Shareholders Funds in B/S

Equity Capital PreferenceCapital

InternalAccruals

Debt

Referred to Loan Funds in B/S

Term Loans Debentures Working CapitalAdvances

MiscellaneousSources

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Equity capital represents the ownership capital asequity shareholders collectively own the company.

They enjoy the rewards and bear the risks ofownership.

However their liability is limited to their capitalcontributions.

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• The amount of capital that the company canpotentially issue, as per its memorandum.Authorized Capital

• The amount of capital offered by the company tothe investors.Issued Capital

• The amount of issued capital subscribed by theinvestors.Subscribed Capital

• The actual amount paid up by the investors.Paid-up Capital

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•Also known as face value, it is value stated in the memorandum.•The most popular denomination is Rs. 1 and 10.Par Value

•The price at which equity shares are issued (typically higher than par value).Issue Price• It is the sum of paid up capital plus reserves and surplus.•To obtain on a per share basis, the above is divided by number of shares.Book value• It is the price at which the share shall trade in the market.•Easy to obtain for listed companies.Market Value

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Right to Income

• The income leftafter satisfying theclaims of all otherinvestors belongsto equityshareholders.

• The income ofequityshareholders maybe retained by thefirm or paid out asdividends.

Right to Control

• Equity shareholderelect the BOD andhave the right tovote.

• The BOD elects themanagementwhich controlsoperation of thecompany.

• Thus equityshareholders haveindirect controlover the company.

Pre-emptive Right

• The law requirescompanies to giveexisting equityshareholders thefirst opportunity topurchase, on prorata basis,additional issue ofequity capital.

Right to Liquidation

• The equityshareholders havea residual claimover the assets ofthe firm in theevent ofliquidation.

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Merits• There is no compulsion to pays dividends.• It has no maturity date thus no obligation to redeem.• The larger the equity capital, the greater the ability of the firm to raise debt finance at

favorable terms.

Demerits• Sale to outsider results in dilution of control.• The cost of equity capital is usually the highest.• The company does not receive any tax benefit on dividends rather it has to pay

distribution tax on dividends.• The floatation costs are higher compared to other securities.

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However their claims rank below the claims of company‘s creditors,bondholders/debenture holders.

Preference shares are that part of a company’s capital which carry a preferentialright compared to the equity shareholder with respect to:

Dividend at a fixed rate or amount. Repayment of capital in case ofwinding-up of the company.

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Types of Preference SharesOn Basis ofDividendPayment

Cumulative Non-Cumulative

On Basis ofTerms of Issue

Convertible Non-Convertible

On Basis ofMaturity

Redeemable Irredeemable

On Basis of ProfitSharing

Participating Non-Participating


Barring a few exceptions, preference capital in India carry acumulative feature with respect to dividends.

They are typically redeemable after three to five years.

They do not carry voting rights except for a few circumstances, ifpreference dividend is skipped.




Merits• There is no legal obligation to pay dividend.• Redemption of preference shares can be delayed without significant penalty.• It is considered a part of net worth and thus enhances credit worthiness of the firm.• As they do not carry voting rights, there is no dilution of control.

Demerits• Compared to debt capital, it is more expensive source of financing.• Though there is no legal obligation to pay dividends, skipping them can adversely

affect the image of company.• They have a prior claim on the assets and earnings of the firm.• If the firm skips dividends for 3 years, then they have to be granted voting rights.


Internal accruals of a firm consist of depreciationcharges and retained earnings.

Depreciation represents the allocation of capitalexpenditure to various period over which the capital

expenditure is expected to benefit the firm.

Retained earnings (internal equity) are that portion ofequity earnings that are ploughed back in the company.

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Merits• They are readily available and thus management don’t need to talk to

outsiders.• There are no flotation costs associated with internal accruals.• No dilution of control.

Demerits• The amount of funds available is limited.• Cost of retained earnings is high as it is atleast equal to cost of equity.


Term loans represent a source a debt finance which is generallyrepayable in less than 10 years.

They are employed to finance acquisition of assets.

They are different from short term bank loans which are employed tofinance working capital.

Historically term loans given by financial institutions and banks havebeen a long term source of debt for private firms and most public firms.

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Currency • Financial institutions and banks provide loansin rupees and foreign currency.

Security

• Term loans typically represent securedborrowing.

• Usually assets, which are financed by termloan serve as prime security.

• Other assets of the firms may serve ascollateral security.

• Security may created by equitable mortgageor hypothecation.

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Interest Payment andPrincipal Repayment

• Interest rate charged depends on the creditworthiness of the borrower.• The interest is usually payable monthly and principal in equal quarterly

or semi-annul installments over the life of the loan.• They have to paid irrespective of financial situations of the company.• In case of default penalty may be levied on the borrower.

Covenants

• In order to protect their interest, financial institutions imposeconditions (covenants) on the borrowers.

• The covenants are further divided into positive and negative covenants.• Positive covenants are affirmative actions required by the company,

for e.g., make time payment of statutory dues.• Negative covenants are restriction placed on actions of the

management, for e.g., any sale of asset to be approved by thefinancial institution.

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Submission ofLoan Application

Initial Processingof Loan

Application

Appraisal of theProposed Project

Issuance of Letterof Sanction

Acceptance ofTerms and

Conditions byBorrower

Execution of theLoan Agreement

Creation ofSecurity

Disbursement ofLoan

Monitoring


Debentures are instruments for raising debtfinance from the financial market.• Debenture holders are creditors of the company.• The obligation of a company towards its debenture

holders is similar to that of a borrower who promises topay interest and principal at specified times.

• Debentures offer greater flexibility in structurecompared to term loans.

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On Basis ofSecurity

Naked

Secured

On Basis ofMaturity

Redeemable

Perpetual

On Basis ofTransferability

Bearer

Registered

On Basis ofTerms of Issue

FullyConvertible

PartlyConvertible

NonConvertible

On Basis ofInterest

Structure

Fixed Rate

FloatingRate

ZeroInterest

On Basis ofRedemption

Pattern

Bullet

Amortized

Callable

Putable


When a debenture issue is sold to the investing public, a trustee is appointed through atrust deed.

Debentures issued in India are usually secured and redeemable.

It can be issued for short term (up to 1 year), medium term (1 – 5 year), and long term(5 to 12 years). The short term issues are known as commercial paper.

If debentures are issued for a period greater than 18 months then they have credit ratedand a debenture redemption reserve has to be created.




A debt rating essentially reflects the probability of timelypayment of interest and principal by the borrower.

The higher the debt rating, the greater the likelihoodthat the borrower will fulfill obligation to pay.

In most cases, the cost for debt rating is borne by theborrower.


A typical example of rating symbols followed is as follows:




As interest payments are tax deductible, the net interest liabilityfor the firm is lowered on account of tax savings generated.

Particulars WithoutInterest

WithInterest Difference

EBIT 100 100 0Less: Interest 0 10 -10

EBT 100 90 -10Tax @ 30% 30 27 3

PAT 70 63 -7


Merits• Interest on debt is tax deductible.• Does not result in dilution of control and no share in profits.• Floatation cost are lower than equity.• If interest rates are fixed, they provide protection against inflation.

Demerits• Fixed obligation may be difficult to meet in situations of financial

distress and thus may even lead to bankruptcy.• Restricts operational and financial flexibility through covenants.




Commercial banks also help their customers in obtaining credit from other sources throughletter of credit arrangement.

They are provided by commercial banks in three primary ways:

Cash credits / Overdrafts Loans Purchase / Discount of Bills

Working capital advances by commercial banks represent the most important source offinancing current assets.


A predetermined limit is sanctioned by the bank.

The borrower can draw as per requirement up till the credit limit.

Borrower can repay partially or fully when he desires within the sanction period.

The interest is payable only on the amount used subject to a minimum amount.

The flexibility makes its one of the most popular sources of working capital finance.




Loans are advances of fixed amounts to the borrower.

The interest is charged on the entire amount irrespective of the amountdrawn.

They may be payable of demand or in installments.

They may also a possibility of renewing a loan at maturity.

They are now dominant form of bank finance in India.


A bill arises out of atrade transactionwhere the seller

draws the bill on thepurchaser.

The bill may bepayable on demand

or after usanceperiod (max : 90

days).

Once the bill theaccepted by the

purchaser, the sellerpresents the bills to

bank.

The bankdiscounts/purchases

the bill and lendsmoney after

deducting charges.

The bank presentsthe bill to the

purchaser on duedate and get its

payment.




Applicationand Processing

Sanction andTerms andConditions

Security –Hypothecation

or Pledge

MarginAmount


The following are several other waysin which finance may be obtained:

DeferredCredit

LeaseFinance

HirePurchase

UnsecuredLoans

(Promoters)and

Deposits

Subsidies

Short termloans fromFinancial

Institutions

CommercialPaper Factoring




Key issues to be addressed while forming a financestrategy are:

• Capital Structure• Financing Instruments• Method of Offering• Target Markets• Timing and Pricing of Issue• Dividend Distribution Policy• Corporate Governance


The important consideration in planning the capital structure are:

Earnings perShare (EPS) Risk Control Flexibility Nature of

Assets

Capital structure decisions pertain to deciding the optimalproportion of debt and equity in the company.




Example: Consider the following information about a company:

10 million equity shares, par value of Rs. 10 each.

Tax rate is 50%.

The company is planning to raise additional capital of Rs. 100 million forfinancing an expansion. In this context, it is evaluating two alternatives:

Issue of equity shares (10 million shares of Rs. 10 per share)

Issue debenture carrying 14% interest.

What shall be the EPS of the company under both plans, if the EBIT is Rs.20 million and Rs. 40 million respectively.


Particulars Equity Financing Debt FinancingEBIT 20,00,000 40,00,000 20,00,000 40,00,000Less: Interest - - 14,00,000 14,00,000EBT 20,00,000 40,00,000 6,00,000 26,00,000Less: Tax 10,00,000 20,00,000 3,00,000 13,00,000EAT 10,00,000 20,00,000 3,00,000 13,00,000No. of Shares 20,00,000 20,00,000 10,00,000 10,00,000EPS 0.50 1.00 0.30 1.30

The EPS is more sensitive under the debt financing i.e. if the operatingprofit (EBIT) is high (low), the EPS is higher (lower) than equity option.




Area Use more equity when Use more debt when

Corporate Tax Rate Negligible High

Business Risk High Low

Dilution of Control Not important Important

Nature of Assets Intangible Tangible

Growth Options Many Few


Major Sources

Equity

Equity Capital PreferenceCapital

InternalAccruals

Debt

Term Loans DebenturesWorkingCapital

Advances

MiscellaneousSources

The firm can raise equity and debt capital from both public and privatesources.




Modes of Raising Finance- Primary Market:

Public Offering

Initial Public Offering

Seasoned Offering

Rights Issue

Private Placement


Particulars Public Issue Right IssuePrivate

Placement

Amount that can be raised Large Moderate Moderate

Cost of issue High Negligible Negligible

Dilution of Control Yes No Yes

Degree of Underpricing Large - Small




A firm planning to raise finance may tap one or more of the followingcapital markets:

Indian CapitalMarket

• The firm has to confirm to the regulations laid down bySEBI.

Euro Capital Market• The market is beyond the purview of any national

regulatory markets.• Firms have to take approval of MOF, FIPB and RBI.

Foreign DomesticCapital Market

• The firm access domestic markets of foreign countries, fore.g. U.S.

• The firm has to obtain approval from local and foreignauthorities.


ParticularsIndianCapitalMarket

Euro CapitalMarket

ForeignCapitalMarket

Access Easy RestrictedHighly

RestrictedMarket Small Large Large

Disclosures & Transparency Less Onerous OnerousHighly

Onerous

Prices/RatesNot so

AttractiveAttractive

MoreAttractive




The following guidelines can be used:Decouple Financing and

Investment Decisions Never be Greedy Ensure IntergenerationalFairness

Timing: When to issue?Pricing: What price issued should be made?


Factor to be considered indistribution of earnings

Earnings Prospects

Funding Requirements & Liquidity

Dividend Record

Shareholder’s Preference

Control

Forms of distributingearnings

Cash Dividends

Stock Dividends (bonus shares)

Share Repurchase

Distribution policy is concerned with how much earnings should bedistributed to investor and in what form.




To ensure that investors continue to value the company properly,company should communicate intelligently with investors.

The following points should be borne in mind whilecommunicating with investors:

True and Fair FinancialDisclosure Avoid Financial Hype

Involve Lead Investorsin Company Planning

Process


Corporate governance is the system of internal controls and proceduresby which individual Companies are managed.

It provides a framework that defines the rights, roles and responsibilitiesof different groups within an organization (Management, Board,

controlling Shareowners and minority or non-controlling Shareowners).

At its core, corporate governance is the arrangement of checks,balances, and incentives a Company needs to minimize and manage the

conflicting interests between insiders and external Shareowners.

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