Long- Term Sources of Finance

Learning Objectives
Understand the features of ordinary/equity shares

Evaluate ordinary shares as A long term source of

finance Focus on right shares Learn about preference shares Study the features and benefits of debt financing Explore term loan as long term source of financing

Topics Covered
Equity Shares/Ordinary Shares

Preference Share
Debentures (Bonds) Term loan

Equity Shares or Ordinary Shares

Equity mean Equality among shareholders Ordinary shares represent the ownership position in a

company Shareholders are the legal owners of the company Equity shareholders provide permanent source of capital or Sine Die It is also known as variable income security Equity shareholders have the maximum risk

Equity shareholders are the first to contribute to the

capital and the last to receive any return

Features of Ordinary shares

Claim on income

Claim on assets
Right to control Voting right

Pre-emptive right
Limited liability Negotiable

Advantages of Ordinary Shares from Companys view point

Permanent Capital

Dividend payment discretion

Borrowing base

Advantages from the shareholders view point Higher return Voting right Right to control Limited liability

Disadvantages of Ordinary shares from companys view point

High cost:Dividends are not tax deductible Higher floatation cost Higher expected return

Disadvantages from the shareholders view point

Earning dilution Ownership dilution No fixed return High Risk

Preference Shares: Hybrid Security

Commonalities between Ordinary Share & Preference Share: Dividends are non tax deductible

Non

payment of dividend does not leads to insolvency Irredeemable preference shares have no fixed date of maturity

Preference Shares: Hybrid Security

Commonalities between Preference Share :Debenture &

Rate of Dividend is fixed Priority claim on income and assets over ordinary

shareholders No voting right Usually do not share residual earnings

Preference Shares: Features

Preference over equity shareholders: In dividend payment In asset realization (during liquidation) Preference dividend is not tax deductible Fixed rate of dividend No voting rights (exceptions are there) Claim on income and assets Permanent/Temporary source of capital Hybrid Security

Voting Right of Preference Shares

Preference shareholders may be entitled to contingent or conditional voting right: They have a right to vote only on resolutions that directly affect the rights

attached to preference shares e.g. Winding up, repayment or reduction of share capital There are arrears in dividend for two or more years in case of cumulative preference shares; Preference dividend is due for a period of two or more consecutive preceding years; or In the preceding six years including the immediately preceding financial year, the company has not paid the preference dividend for a period of three or more years In all the above situations the preference shareholders can nominate a member on the board of the company.

Types of Preference Shares

Cumulative and Non-Cumulative preference share

Redeemable and Irredeemable/Perpetual preference

share Convertible and Non-Convertible preference share Participating and Non-Participating preference share

Advantages of Preference Share from Companys view point

Limited Voting Right

Limited amount of dividend

Dividend Postponability Non payment of dividend does not result in

insolvency Less Costly

Disadvantages of Preference Share from Companys view point

Non Tax deductibility of dividend

Limited dividend Postponability

Right Issue
A right issues involves selling securities in the

primary market by issuing rights to the existing shareholder. When a company issues additional equity capital, it has to be offered in the first instance to the existing shareholders on a pro rata basis. This is required under section 81 of the companies Act, 1956. The shareholder, however, may by a special resolution forfeit this right, partially or fully, to enable the company to issue additional capital to public.

Features of Rights
The number of rights that a shareholders gets is

dependent on the number of shares held by him The number of right acquired to subscribe to an additional share is determined by the issuing company. The price per share for additional equity, called the subscription price, is left to the discretion of the company Rights are negotiable. The holder of the right can sell them Rights can be exercised only during a fixed period and at fixed price only.

Conditions w.r.t. Right Shares

Existing shareholders, who exercise their rights in full, are given an opportunity to apply for additional shares Existing shareholder who renounce their rights, wholly or partially, are not entitled to apply for additional shares Share which becomes available, due to non-exercise of rights by some shareholders are allotted to shareholders who have applied for additional shares in proportion to their shareholding Any balance left after meeting requests for additional shares by the existing shareholders are disposed of at the ruling market price or the issue price, whichever is higher

Right Issue: Impact on Shareholders Wealth

The following data pertains to XYZ limited:Ordinary Shares Market Price of share Additional share to be issued Proposed Subscription Price 30,00,000 Rs. 65/share 10,00,000 Rs. 40/share

Right Issue: Impact on Shareholders Wealth

Number of rights required (N)= Existing Share New Shares = 30,00,000 10,00,000 = 3 rights OR 3:1, that means you need to have 3 shares to buy a new share.

Value of a right
R= = P0- Ps N+1 65-40 4 Rs. 6.25/right Rs. 6.25 x 3 Rs. 18.75/new share

= = =

Value of a share after right issues

Px = So x Po + S x Ps So + S Where Px = Price of share after right So = Number of Existing Shares S = New shares Po = Price of share before right issues Ps = Subscription price of a share

Price of Share after right issue

Px = So x Po + S x Ps So + S = (30,00,000 x 65) + (10,00,000 x 40) 30,00,000+ 10,00,000 = 19,50,00,000 + 4,00,00,000 40,00,000 = Rs. 58.75/share

Px

= N x R + Ps = 3 x 6.25 + 40 = 58.75/share

Effect of Right issue on the Wealth of SH

There are three options available to the

shareholders:

Exercise his right Sell his right Allow rights to expire

Option 1: Exercise Right

Before Right Issue 300 shares @ 65/share = 19,500 100 shares @ 40/share = 4,000 Wealth of shareholder = 23,500 Wealth of shareholder = 23,500 After right Issue 400 shares @ Rs. 58.75 = 23,500

Option II: Sell Rights

Before Right Issue After Right Issue

300 shares @ 65 = Rs. 19,500

Wealth of Shareholder = Rs. 19,500

300 shares @ Rs. 58.75

Wealth of Shareholder = 19,500

= Rs. 17,625

100 Shares rights @ Rs. 18.75/share =Rs. 1875

Option III: Allows Rights to expire

Before Right Issue After right issue

300 shares @ Rs. 65 = 19,500

Wealth of shareholder = Rs. 19,500

300 share @ Rs. 58.75 = 17,625

Wealth of shareholder = Rs. 17,625