Daiict Busi Fin Vi 08

DAIICT: Business Finance 2014
Topic 5: Sources of Finance 1

DAIICT:
Introduction
to Business
Finance
Topic 8:
Sources of Finance
& Finance Strategy
Vishal Iyer, CFA
DAIICT: INTRODUCTIONTO BUSINESS FINANCE TOPIC 8: SOURCES OF FINANCE 1
DAIICT: INTRODUCTION TO BUSINESS FINANCE TOPIC 8: SOURCES OF FINANCE 2
A firm should find sources of finance required to support
investments in fixed assets and working capital.
Major Sources
Equity
Referred to Shareholders Funds in B/S
Equity Capital
Preference
Capital
Internal
Accruals
Debt
Referred to Loan Funds in B/S
Term Loans Debentures
Working Capital
Advances
Miscellaneous
Sources
2014
Equity capital represents the ownership capital as
equity shareholders collectively own the company.
They enjoy the rewards and bear the risks of
ownership.
However their liability is limited to their capital
contributions.
2014
The amount of capital that the company can
potentially issue, as per its memorandum.
Authorized Capital
The amount of capital offered by the company to
the investors.
Issued Capital
The amount of issued capital subscribed by the
investors.
Subscribed Capital
The actual amount paid up by the investors.
Paid-up Capital
2014
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
2014
Right to Income
The income left
after satisfying the
claims of all other
investors belongs
to equity
shareholders.
The income of
equity
shareholders may
be retained by the
firm or paid out as
dividends.
Right to Control
Equity shareholder
elect the BOD and
have the right to
vote.
The BOD elects the
management
which controls
operation of the
company.
Thus equity
shareholders have
indirect control
over the company.
Pre-emptive Right
The law requires
companies to give
existing equity
shareholders the
first opportunity to
purchase, on pro
rata basis,
additional issue of
equity capital.
Right to Liquidation
The equity
shareholders have
a residual claim
over the assets of
the firm in the
event of
liquidation.
2014
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.
2014
However their claims rank below the claims of companys creditors,
bondholders/debenture holders.
Preference shares are that part of a companys capital which carry a preferential
right compared to the equity shareholder with respect to:
Dividend at a fixed rate or amount.
Repayment of capital in case of
winding-up of the company.
2014
DAIICT: INTRODUCTION TO BUSINESS FINANCE TOPIC 8: SOURCES OF FINANCE 9 2014
Types of Preference Shares
On Basis of
Dividend
Payment
Cumulative
Non-
Cumulative
On Basis of
Terms of Issue
Convertible
Non-
Convertible
On Basis of
Maturity
Redeemable Irredeemable
On Basis of Profit
Sharing
Participating
Non-
Participating
Barring a few exceptions, preference capital in India carry a
cumulative 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, if
preference 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 depreciation
charges and retained earnings.
Depreciation represents the allocation of capital
expenditure to various period over which the capital
expenditure is expected to benefit the firm.
Retained earnings (internal equity) are that portion of
equity earnings that are ploughed back in the company.
2014
Merits
They are readily available and thus management dont 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 generally
repayable in less than 10 years.
They are employed to finance acquisition of assets.
They are different from short term bank loans which are employed to
finance working capital.
Historically term loans given by financial institutions and banks have
been a long term source of debt for private firms and most public firms.
2014
Currency
Financial institutions and banks provide loans
in rupees and foreign currency.
Security
Term loans typically represent secured
borrowing.
Usually assets, which are financed by term
loan serve as prime security.
Other assets of the firms may serve as
collateral security.
Security may created by equitable mortgage
or hypothecation.
2014
Interest Payment and
Principal 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 impose
conditions (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 the
financial institution.
2014
Submission of
Loan Application
Initial Processing
of Loan
Application
Appraisal of the
Proposed Project
Issuance of Letter
of Sanction
Acceptance of
Terms and
Conditions by
Borrower
Execution of the
Loan Agreement
Creation of
Security
Disbursement of
Loan
Monitoring
Debentures are instruments for raising debt
finance 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 to
pay interest and principal at specified times.
Debentures offer greater flexibility in structure
compared to term loans.
2014
On Basis of
Security
Naked
Secured
On Basis of
Maturity
Redeemable
Perpetual
On Basis of
Transferability
Bearer
Registered
On Basis of
Terms of Issue
Fully
Convertible
Partly
Convertible
Non
Convertible
On Basis of
Interest
Structure
Fixed Rate
Floating
Rate
Zero
Interest
On Basis of
Redemption
Pattern
Bullet
Amortized
Callable
Putable
When a debenture issue is sold to the investing public, a trustee is appointed through a
trust 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 rated
and a debenture redemption reserve has to be created.
A debt rating essentially reflects the probability of timely
payment of interest and principal by the borrower.
The higher the debt rating, the greater the likelihood
that the borrower will fulfill obligation to pay.
In most cases, the cost for debt rating is borne by the
borrower.
A typical example of rating symbols followed is as follows:
As interest payments are tax deductible, the net interest liability
for the firm is lowered on account of tax savings generated.
Particulars
Without
Interest
With
Interest
Difference
EBIT 100 100 0
Less: Interest 0 10 -10
EBT 100 90 -10
Tax @ 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 through
letter 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 of
financing 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 amount
drawn.
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 a
trade transaction
where the seller
draws the bill on the
purchaser.
The bill may be
payable on demand
or after usance
period (max : 90
days).
Once the bill the
accepted by the
purchaser, the seller
presents the bills to
bank.
The bank
discounts/purchases
the bill and lends
money after
deducting charges.
The bank presents
the bill to the
purchaser on due
date and get its
payment.
Application
and Processing
Sanction and
Terms and
Conditions
Security
Hypothecation
or Pledge
Margin
Amount
The following are several other ways
in which finance may be obtained:
Deferred
Credit
Lease
Finance
Hire
Purchase
Unsecured
Loans
(Promoters)
and
Deposits
Subsidies
Short term
loans from
Financial
Institutions
Commercial
Paper
Factoring
Key issues to be addressed while forming a finance
strategy 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 per
Share (EPS)
Risk Control Flexibility
Nature of
Assets
Capital structure decisions pertain to deciding the optimal
proportion 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 for
financing 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 Financing
EBIT 20,00,000 40,00,000 20,00,000 40,00,000
Less: Interest - - 14,00,000 14,00,000
EBT 20,00,000 40,00,000 6,00,000 26,00,000
Less: Tax 10,00,000 20,00,000 3,00,000 13,00,000
EAT 10,00,000 20,00,000 3,00,000 13,00,000
No. of Shares 20,00,000 20,00,000 10,00,000 10,00,000
EPS 0.50 1.00 0.30 1.30
The EPS is more sensitive under the debt financing i.e. if the operating
profit (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
Preference
Capital
Internal
Accruals
Debt
Term Loans Debentures
Working
Capital
Advances
Miscellaneous
Sources
The firm can raise equity and debt capital from both public and private
sources.
Modes of Raising Finance
- Primary Market:
Public Offering
Initial Public Offering
Seasoned Offering
Rights Issue
Private Placement
Particulars Public Issue Right Issue
Private
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 following
capital markets:
Indian Capital
Market
The firm has to confirm to the regulations laid down by
SEBI.
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 Domestic
Capital Market
The firm access domestic markets of foreign countries, for
e.g. U.S.
The firm has to obtain approval from local and foreign
authorities.
Particulars
Indian
Capital
Market
Euro Capital
Market
Foreign
Capital
Market
Access Easy Restricted
Highly
Restricted
Market Small Large Large
Disclosures & Transparency Less Onerous Onerous
Highly
Onerous
Prices/Rates
Not so
Attractive
Attractive
More
Attractive
The following guidelines can be used:
Decouple Financing and
Investment Decisions
Never be Greedy
Ensure Intergenerational
Fairness
Timing: When to issue?
Pricing: What price issued should be made?
Factor to be considered in
distribution of earnings
Earnings Prospects
Funding Requirements & Liquidity
Dividend Record
Shareholders Preference
Control
Forms of distributing
earnings
Cash Dividends
Stock Dividends (bonus shares)
Share Repurchase
Distribution policy is concerned with how much earnings should be
distributed 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 while
communicating with investors:
True and Fair Financial
Disclosure
Avoid Financial Hype
Involve Lead Investors
in Company Planning
Process
Corporate governance is the system of internal controls and procedures
by which individual Companies are managed.
It provides a framework that defines the rights, roles and responsibilities
of 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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DAIICT: Business Finance 2014

Topic 5: Sources of Finance 1

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