Everything you need to know about the sources of getting long-term finance for a company, firm or business.
Long-term financing is a mode of financing that is offered for more than one year. It is required by an organization during the establishment, expansion, technological innovation, and research and development.
In addition, long-term financing is required to finance long-term investment projects. Long-term funds are paid back during the lifetime of an organization.
Some of the long-term sources of finance are:- 1. Equity Shares 2. Preference Shares 3. Ploughing Back of Profits 4. Debentures 5. Financial Institutions 6. Lease Financing 7. Term Loans 8. Debt Capital 9. Internal Sources 10. Foreign Capital.
Sources of Long-Term Finance for a Company, Firm or Business
Equity Shares, also known as ordinary shares, represent the ownership capital in a company. The holders of these shares are the legal owners of the company. They have unrestricted claim on income and assets of the company and possess all the voting power in the company.
In fact, the foremost objective of a company is to maximise the value of its equity shares. Being the owners of the company, they bear the risk of ownership also. They are entitled to dividends after paying the preference dividends. The rate of dividend on these shares is not fixed and depends upon the availability of divisible profits and the intention of the directors.
They may be paid a higher rate of dividend in times of prosperity and also run the risk of no dividends in the period of adversity. Similarly, when the company is wound up, they can exercise their claim on those assets which are left after the payment of all other claims including that of preference shareholders.
Advantages of Equity / Ordinary Shares:
(A) Advantages to the Company:
Equity shares offer the following advantages to the company:
(i) Permanent Source of Funds – Equity capital is a permanent capital, and is available for use as long as the company continues. The management is free to utilise such capital and is not bound to refund it.
(ii) Increase in the Borrowing Capacity – The equity capital increases the company’s shareholder’s funds. Lenders normally lend in proportion to the amount of shareholder’s funds. Higher amount of shareholder’s funds provides higher safety to the lenders.
(iii) Not Bound to Pay Dividend – A company is not legally bound to pay dividend to its equity shareholders. The payment of dividend depends on the availability of divisible profits and the discretion of directors. A company can reinvest whole of its income, if it so desires.
(iv) No Need to Mortgage the Assets – The company need not mortgage its assets to secure equity capital. Hence, if the company desires to raise further finance from other sources, it can easily do so by mortgaging its assets.
(B) Advantages to Investors:
(i) Right to Control – Equity shareholders are the real owners of the company. They have the right to elect the directors as well as vote in the meetings of the company.
(ii) Increase in Rate of Dividends – In case of higher profits in the company, these shareholders are handsomely rewarded in the form of higher dividends.
(iii) Increase in Market Value – Usually a portion of the profits is ploughed back into the business which results in enhanced earning power of the company and increase in the market value of its shares.
(iv) Bonus Shares – Equity shareholders have a claim on the residual income of the company. This residual income is either directly distributed to them in the form of dividend or indirectly in the form of bonus shares.
(v) Right Shares – Equity shareholders are entitled to get right shares whenever the company issues new shares. The subscription price at which the right shares are offered to them is generally much below the share’s current market price.
(vi) Easy to Sell – In comparison to investment in fixed properties, the investment in equity shares is much liquid because the shares can be sold in the market whenever needed.
Disadvantages of Equity Shares:
(A) Disadvantages to the Company:
(i) High Cost of Funds – Equity shares have a higher cost for two reasons. Firstly, as compared to interest, dividends cannot be deducted from the income of the company while calculating taxes. Dividends are paid out of post-tax profits. Secondly, equity shares have high floatation cost in terms of underwriting, brokerage and other issue expenses in comparison to other securities.
(ii) No Advantage of Trading on Equity – If a Company issues only equity shares, it will be deprived of the benefits of trading on equity. For availing the benefit of trading on equity, it is essential to issue debentures or preference shares with fixed yields lower than the earning rate of the company.
(iii) Manipulation by a Group of Shareholders – Shares of a company can be purchased and sold in the stock market. Hence, a group of shareholders may control the company by purchasing shares and they may use such control for their personal advantage at the cost of company’s interests.
(B) Disadvantages to Investors:
(i) Irregular Dividend – Dividend paid on equity shares is neither regular nor at a fixed rate. In case of lower profits, the company can reduce or suspend payment of dividend. In case of higher profits too, the company is not legally bound to distribute dividends. Entire profits may be ploughed back for expansion and development of the company.
(ii) Fall in the Market Value of Shares – If the company does not earn sufficient profits, the shareholders have to bear the loss because of fall in the market value of shares.
(iii) No Real Control over the Company – There are a number of shareholders and most of them are scattered and unorganised. Hence they are unable to exercise effective and real control over the company.
(iv) Ownership Dilution – If the new shares are issued to the public, it may dilute the ownership and control of the existing shareholders. The control of the company may change to new shareholders who may reap the benefits of the company’s prosperity and progress.
(v) Loss on Liquidation – In case of liquidation, equity shareholders have to bear the maximum risk. Out of the realised value of assets, first the claims of creditors and then preference shareholders are satisfied, and the remaining balance, if any, is paid to equity shareholders. In most of the cases, equity shareholders do not get anything in case of liquidation.
To conclude, equity shares are the most convenient and popular source of long-term finance for a company. For new company recourse to equity share financing is most desirable because the management is under no legal obligation to pay dividends to shareholders and the management can retain its earnings entirely for their investment in the enterprise.
However, for obtaining further finance in case of any existing company, the management should, as far as possible, avoid issuing equity shares. From investor’s point of view, equity shares are riskier as there is uncertainty regarding dividend and capital gains. Investors who desire to invest in safe securities with a regular and fixed income have no attraction for such shares. On the contrary, the investors who are more ambitious and ready to bear risk in consideration of higher returns prefer these shares.
(2) Preference Shares:
Preference share capital is another source of long-term financing for a company. As the name suggests, these shares carry preferential rights over equity shares both regarding the payment of dividend and the return of capital. These shares carry a fixed rate of dividend and such dividend must be paid in full before the payment of any dividend on equity shares. Similarly, at the time of liquidation, the whole of preference capital must be paid before any payment is made to equity shareholders.
(3) Ploughing Back of Profits:
A new company can raise finance only from external sources such as shares, debentures, loans etc. But, an existing company can also generate finance through its internal sources, i.e., retained earnings or ploughing back of profits. When a company does not distribute whole of its profits as dividend but reinvests a part of it in the business, it is known as ploughing back of profits or retention of earnings. This method of financing is also known as self-financing or internal financing.
Ploughing back of profits is made by transferring a part of after tax profits to various reserves such as General Reserve, Reserve Fund, Replacement Fund, Dividend Equalisation Fund etc. Such retained earnings may be utilised to fulfil the long-term, medium-term and short-term financial requirements of the firm.
(i) Economical Method – It is very economical method of financing.
(ii) A Cushion to Absorb the Shocks of the Business – A concern with large reserves can easily absorb the shocks of trade cycles and the uncertainty of market.
(iii) Helpful in Following a Balanced Dividend Policy – Such a company can follow the policy of paying regular and balanced dividends because it can use retained earnings for paying dividends in the years when there are inadequate profits.
(iv) Helpful in Making the Company Self-Dependent – Ploughing back of profits makes the company self-dependent because it has not to depend upon outsiders such as banks, financial institutions, debentures etc.
(v) Increase in the Credit Worthiness of the Company – Since the company need not depend upon outside sources for its financial needs; it increases the credit worthiness of the company.
(vi) Helpful in the Repayment of Long-Term Liabilities – It enables the company to repay its long-term loans and debentures and thus relieves the company from the burden of fixed interest payments.
(B) Disadvantages or Dangers of Excessive Ploughing Back:
(i) Misuse of Retained Earnings – It is not necessary that the management may always use the retained earnings to the advantage of shareholders. They may invest the funds in unprofitable areas or may invest in other concerns under the same management, bringing little gain to the shareholders.
(ii) Over-Capitalisation – Retained earnings are used for the issue of bonus shares which may result to over-capitalisation without any corresponding increase in its earnings.
(iii) Creation of Monopolies – Continuous ploughing back of profits over a long time may lead a company to grow into a monopoly. This is more likely to occur when other companies find it difficult to procure finance from the market whereas an existing concern continues to grow through its retained earnings.
(iv) Manipulation in the Value of Shares – Ploughing back of profits provides the management an opportunity to manipulate the market value of its shares. In the name of ploughing back of profits, they may declare lower dividends and when the share values fall in the market, they may purchase them at reduced prices. Later, they may increase the rate of dividend out of past profits and may sell their shares at a profit.
(v) Dissatisfaction among the Shareholders – Excessive ploughing back of profits may create dissatisfaction among the shareholders since the rate of dividend is quite low in relation to the earnings of the company.
(vi) Hindrance in the Free Flow of Capital – According to Prof. Pigou, ”Excessive ploughing back entails social waste, because money is not made available to those who can use it to the best advantage of the community, but is retained by those who have earned it.”
Despite the above disadvantages, the ploughing back of profits is a popular source of long-term finance and is widely used by most of the companies.
Debentures are one of the frequently used methods by which a company raises long-term funds. Funds acquired by issue of debentures represent loans taken by the company and are also known as ‘debt capital’. A debenture is a certificate issued by a company under its seal acknowledging a debt due by it to its holders. In USA there is a distinction between debentures and bonds. There, the term bond refers to an instrument which is secured on the assets of the company whereas the debentures refer to unsecured instruments.
But, in India no such distinction is made between bonds and debentures and the two terms are used as synonymous. According to Section 2 (30) of the Companies Act, 2013, “the term debenture includes debenture stock, bonds and any other securities of a company whether constituting a charge on the assets of the company or not.”
(5) Loans from Financial Institutions:
Financial Institutions are another important source of long-term finance. In India, a number of special financial institutions have been established by the Government at the national level and state level to provide medium-term and long-term loans to the industrial undertakings.
Financial institutions established at the national level include Industrial Development Bank of India (IDBI), Industrial Finance Corporation of India (IFCI), Industrial Credit and Investment Corporation of India (ICICI), Industrial Reconstruction Corporation of India (IRCI), Unit Trust of India (UTI), Life Insurance Corporation of India (LIC), General Insurance Corporation (GIC) etc.
Financial institutions established at the state level include State Financial Corporations (SFCs) and State Industrial Development Corporations (SIDCs). For example, In Haryana, Haryana State Financial Corporation (HFC) and Haryana State Industrial Development Corporation (HSIDC) have been established.
Characteristics of Loans from Financial Institutions:
(i) Maturity – Maturity period of term loans provided by Financial Institutions ranges between 6 to 10 years.
(ii) Direct Negotiation – Terms and conditions of such loans are directly negotiated between the borrower and the financial institution providing the loan.
(iii) Security – Such loans are always secured. While the assets financed by loans serve as primary security, all the present as well as the future immovable assets of the borrower constitute secondary security.
(iv) Restrictive Covenants – To protect their interests the financial institutions impose a number of restrictive terms and conditions. These are called covenants. These covenants may be in respect of maintaining a minimum current ratio, not to create further charge on assets, not to sell fixed assets without the lender’s approval, restrain on taking additional loan, reduction in debt-equity ratio by issuing additional shares etc.
Financial Institutions may also restrict the payment of dividend, salaries and perks of managerial staff. Covenants may also include the appointment of nominee director by financial institutions to safeguard their interests.
(v) Convertibility – Financial institutions usually insist on the option of converting their loans into equity shares of the company,
(vi) Repayment Schedule – Such loans have to be repaid according to predetermined schedule. The common practice in India is the repayment of principal in equal instalments and payment of interest on the outstanding loan.
Advantages and Disadvantages of Loans from Financial Institutions:
Such loans offer all the advantages and disadvantages of debenture financing. An additional disadvantage from borrower’s viewpoint is that the loan contracts contain certain restrictive covenants which restrict the managerial freedom. The right of lenders to appoint nominee directors on the board of the borrowing company may further restrict the managerial freedom.
(6) Lease Financing:
Lease is a contract between the owner of an asset and the user of such asset. Owner of the asset is called ‘Lessor’ and the user is called ‘Lessee’. Under the lease contract, the owner of the asset surrenders the right to use the asset to another party for an agreed period of time for an agreed consideration called the lease rental. The lessee pays a fixed rental to the lessor at the beginning or at the end of a month, quarter, half year, or year. At the end of the period of lease contract, the asset reverts back to the lessor, who is the legal owner of the asset.
As the legal owner, it is the lessor (and not the lessee), who will be entitled to claim depreciation on the leased asset. At the end of lease period, the lessee is usually given an option to buy or further renew the lease contract for a definite period.
Leasing is, thus, a device of long term source of finance. Lessee gets the right to use the asset without buying them. His position is akin to that of a person who uses the asset with borrowed money. The real position of lessor is not renting of asset but lending of finance and hence lease financing is, in effect, a contract of lending money. The lessee is free to choose the asset according to his requirements and the lessor is actually the financier.
Advantages of Leasing:
(A) Advantages to the Lessee:
(i) Additional Source of Finance – Leasing facilitates the use of assets without making any immediate payment. Thus the scarce financial resources of the business may be preserved for other purposes.
(ii) Simplicity – Borrowing from banks and financial institutions involve time consuming and complicated procedures whereas a leasing contract is simple to negotiate and free from cumbersome procedures.
(iii) Free from Restrictive Covenants – Lease financing is free from restrictive covenants whereas the financial institutions often put a number of restrictions on borrowers, such as, conversion of loan into equity, appoint nominee directors, restrictions on payment of dividend, and so on.
(iv) Flexibility in Fixing the Rentals – Lease rentals are fixed in such a way that the lessee is able to pay them from the cash flows generated from his business operations. Thus flexibility is not available in case of loans from financial institutions where the loans are repaid in instalments resulting in heavy burden in the earlier years of a project, whereas the project may actually generate substantial cash flows in later years.
(v) Safety from the Risk of Obsolescence – In a lease contract, the lessor being the owner of the leased asset bears the risk of obsolescence. Lessee is free to cancel the lease in case of change of technology.
(vi) Benefit of Maintenance – Lessee gets the benefit of maintenance and specialized services provided by the lessor. For example, computer manufacturers who lease out computers provide such services.
(vii) No Effect on Debt-Equity Ratio – Lease is considered a ‘hidden form of debt’ because neither the leased asset nor the lease liability is depicted on the balance sheet. Lease financing, therefore, does not affect the debt raising capacity of the enterprise.
(viii) Tax Benefits – Lease rentals can be adjusted in such a way that the lessee can reduce his tax liability.
(B) Advantages to the Lessor:
(i) Fully Secured – The lessor’s interests are fully secured because he is the owner of the leased asset and can take possession of the asset in case the lessee defaults.
(ii) Tax Benefits – The lessor is entitled to claim the depreciation of leased asset and thus reduces his tax liability.
(iii) High Profitability – Leasing business is highly profitable to the lessor because the rate of return is more than what the lessor pays on his borrowings.
Limitations of Leasing:
(i) Costly Source of Finance – Lease financing is a costly source of finance for the lessee because lease rentals include a profit margin for the lessor as also the cost of risk of obsolescence.
(ii) Restrictions on the Use of Asset – Leasing contracts usually impose certain restrictions on the use of the asset or require compulsory insurance, and so on. In addition, the lessee is not free to make alterations to the leased asset.
(iii) Consequences of Default – Since the lessee is not the owner of the leased asset, the lessor may take over the possession of the same, in case of default in payment of lease rentals,
(iv) Excessive Penalties – Sometimes, lessee has to pay excessive penalties if he terminates the lease before the expiry of lease period,
(v) Not Entitled to Tax-Benefits – Lessee is not entitled to certain tax benefits like depreciation and investment allowance because he is not the owner of the asset.
Long-term financing is a mode of financing that is offered for more than one year. It is required by an organization during the establishment, expansion, technological innovation, and research and development. In addition, long-term financing is required to finance long-term investment projects. Long-term funds are paid back during the lifetime of an organization.
Shares are a part of stocks that consist of fixed assets and current assets, which may change at different situations. In addition, they can be issued at discount, par, and premium. Discounts and premiums on shares are calculated from their par value or face value. The value of shares is calculated according to various principles in different capital markets. However, prime basis on which a share is valued is the price at which it is expected to be sold.
The volatility of markets is a major factor that should be considered to determine the price of a share in the market at a particular point of time. Tax liability on dividends differs in different zones, states, and countries. For example, in India, dividends are free from tax liability for shareholders; however, the organization pays tax on dividend before its distribution at the rate of 12.5%.
There are two types of shares, namely equity and preference, issued by an organization. Each type of shares has a different set of characteristics, advantages, and disadvantages.
Let us start the discussion with the equity shares.
1. Equity Shares:
Equity shares are one of the most important financial instruments to raise long-term funds needed for the incorporation, expansion, and growth of an organization. These shares are treated as the base for capital formation of the organization. Equity shareholders are considered as the real owners of the organization. They are entitled to receive dividend out of the profit generated at the end of every financial year. The amount of dividend may vary from one financial year to another.
The characteristics of equity shares are as follows:
i. Serve as a source of long-term capital and are repaid during the lifetime of the organization. Generally, equity shares are repaid at the time of winding up of an organization.
ii. Do not require any security from the organization.
iii. Allow shareholders to receive dividend after payment is made to each and every stakeholder.
iv. Provide right to equity shareholders to share profit, assets, and control of the management.
Following points discuss the types of equity shares in brief:
i. Bonus Shares:
Refer to shares that are issued in place of dividends. Whenever an organization has accumulated surplus profit, it may distribute the profit among its existing shareholders by providing them bonus shares. In other words, bonus shares are issued when an organization has sufficient profit but is in need of more working capital at that particular time. Issuing bonus shares is beneficial for both the organization as well as the shareholders.
ii. Sweat Equity Shares:
Refer to the shares that are issued to the employees of an organization. Sweat equity shares are always issued at a discount. These shares are a kind of award for employees for the work rendered by them to organization. This makes employees feel that they are owners of the organization and motivate them to demonstrate dedication in their work. In addition, these shares help in motivating employees and increase their productivity.
After discussing the characteristics and types of equity shares, let us look at their following advantages:
i. Paying dividend on equity shares is not an obligation for an organization when there is less profit or loss
ii. Raising funds through equity shares for long-term investment as these shares are repaid during the lifetime of the organization
iii. Limiting the liability of equity shareholders to the amount of shares they hold
iv. Providing higher dividends to equity shareholders whenever an organization makes huge profit
v. Providing voting rights to equity shareholders of an organization
Equity shares have many advantages but it also have some disadvantages.
Let us have a look at the following disadvantages of equity shares:
i. Allows the equity shareholders to interfere in the internal affairs of an organization. This may hamper the smooth functioning of an organization at times.
ii. Increase cost of capital when an organization raises fund from equity shares.
iii. Result in overcapitalization if more than required equity shares are issued.
iv. Make it difficult to repay funds raised by issuing equity shares during the lifetime of an organization, even if these funds are not in use.
2. Preference Shares:
Preference shares give preferential rights to their holders in comparison to equity shares. These shares carry a fixed percent of dividend, which is lower than equity shareholders. The organization pays the dividend on preference shares before paving dividend to equity shareholders. Even during the winding up of the organization, the investment of preference shareholders is paid before equity shareholders.
The characteristics of preference shares are as follows:
i. Do not allow preference shareholders to act as real owners of the organization
ii. Make the repayment of preference shares possible during the existence of the organization
iii. Allow preference shareholders to receive dividends out of profit earned by the organization
iv. Do not bind an organization to offer any asset as security to preference shareholders
v. Carry less risk for investors as compared to equity shares
Following points discuss the different types of preference shares briefly:
i. Cumulative Preference Shares – Refer to the shares for which dividends get accumulated over a period of time. When the organization has sufficient profit, the accumulated dividend of these preference shares is paid.
ii. Non-Cumulative Preference Shares – Refer to the shares for which dividends are not accumulated over a period of time. The organization has to pay dividends on these preference shares at the end of financial year.
iii. Convertible Preference shares – Refer to the shares that can be converted into equity shares after a certain time-period. The holders of convertible preference shares have to pay conversion price at a given date for converting their shares into equity shares.
iv. Non-Convertible Preference Shares – Refer to the shares that cannot be converted into equity shares.
v. Redeemable Preference Shares – Refer to the shares that are repaid by the organization. These preference shares are issued for a fixed time-period and are paid during existence of the organization.
vi. Irredeemable Preference Shares – Refer to the shares that are not paid during the existence of the organization. These preference shares are only paid at the time of liquidation of the organization. At the time of liquidation, these shares are paid after paying all the liabilities.
The advantages of preference shares are as follows:
i. Help in raising more funds as they are less risky
ii. Release preference shareholders from any fixed liability at the time of liquidation of an organization
iii. Save an organization from unnecessary interference of preference shareholders as they do not enjoy any voting right
iv. Facilitate trading on equity
v. Prevent preference shareholders from claiming f or the assets of the organization
The disadvantages of preference shares are as follows:
i. Provide low returns to preference shareholders
ii. Characterize by fluctuations in returns
iii. Do not provide any voting rights to preference shareholders
iv. Do not allow an organization to show the dividend paid on these shares on the debit side of profit and loss account
A debenture is a form of financial instrument that provides long-term debt to an organization. In other words, a debenture is an agreement between a debenture holder and an organization, which acknowledges that the organization would repay the debt at a specified date to debenture holders. If an organization raises funds through issuing debentures, it needs to pay a fixed rate of interest at regular intervals. Debenture holders of an organization arc known as creditors.
The characteristics of debentures are as follows:
i. Provide no voting rights to debenture holders
ii. Allow debenture holders to receive fixed rate of interest
iii. Facilitate debenture holders to be paid back during the lifetime of an organization
iv. Allow the debenture holders of an organization to transfer bearer debentures to other individuals
v. Increase the liability of an organization
Following points explain the type of debentures in brief:
i. Convertible Debentures – Refer to the debentures that have right to get converted into the equity shares after a specific period of time.
ii. Non-Convertible Debentures – Refer to the debentures that have no right to get converted into the equity shares during their maturity period.
iii. Registered Debentures – Refer to the debentures that are registered in the books of the organization. Registered debenture holders cannot transfer their debentures without giving prior information to the organization.
iv. Bearer Debentures – Refer to the debentures that are not registered in the books of the organization. Bearer debenture holders can transfer their debentures without giving any prior information to the organization.
v. Redeemable Debentures – Refer to the debentures that are paid back during the existence of an organization. These are issued for a fixed period of time.
vi. Irredeemable Debentures – Refer to the debentures that are not paid back during the lifetime of an organization. An organization pays interest on the irredeemable debentures till its existence.
The advantages of debentures are as follows:
i. Involve less cost in raising funds than equity shares
ii. Help in raising funds from investors who are less likely to take risks
iii. Provide fixed returns to debenture holders even if there is no profit
iv. Allow debenture holders to receive payment before equity and preference shareholders even at the time of liquidation of an organization
The disadvantages of debentures are as follows:
i. Compel an organization to pay interest even if there is no profit or loss
ii. Make it difficult for an organization to provide security against debentures if an organization has insufficient fixed assets.
iii. Do not allow debenture holders to vote in the official meetings of the organization and influence the decision.
III. Term Loans:
Term loans are the types of long-term loans that are raised for the duration of 3 to 10 years from financial institutions. These loans carry at a floating rate of interest and predetermined maturity period. The main sources of term loans are commercial banks, Industrial development Bank of India (IDBI), Industrial Credit and Investment Corporation of India (ICICI), and Industrial Finance Corporation of India (IFCI). An organization uses term loans to purchase fixed assets and fund projects having long-gestation period.
The characteristics of term loans are as follows:
i. Do not consider the term loan providers as the owners of the organization. However, term loan providers are considered as the creditors of the organization.
ii. Allow an organization to raise secured loans. However, sometimes term loans can be unsecured in nature.
iii. Allow the organization to pay interest on a monthly, quarterly, and half yearly basis at a mutually agreed rate
iv. Bound an organization to pay interest for term loans, even if the organization is incurring losses
v. Carry high risk because term loans are secured loans and the organization has to repay them even if it is running into losses
The term loan agreement is a contract between the borrowing organization and lender financial institution.
It includes clauses and conditions, which are as follows:
i. Amount and time period of the loan
ii. Security offered against the loan
iii. Rate of interest on the loan
iv. The borrowing organization has to submit audited annual accounts report to the lender or financial institution
v. Details of fixed assets purchased from the loan
The advantages of term loans are as follows:
i. Make the raising of funds easier
ii. Help in maintaining good relation with financial institutions
iii. Help in collecting funds at the right time
iv. Make organizations more focused on profitable projects, as they have to pay interests on quarterly, half yearly, and annual basis
v. Help in overall economic development
vi. Do not allow the interference of creditors, who have provided term loans to the organization, in the internal affairs of the organization
The disadvantages of term loans are as follows:
i. Bind an organization to pay interests even in case of loss
ii. Carry high risks as these are secured loans
iii. Create pressure on an organization to make profit at any cost as the interests on these loans are very high and may be paid on quarterly and half yearly basis
iv. Increase the chances of government interference in the functioning of organization, as these loans are mainly provided by financial institutions, which are owned by the government
Long-Term Sources of Finance – Equity Capital, Preference Capital, Debt Capital, Internal Sources and Foreign Capital
In an organized sector, there are five specific sources of financing to meet the long-term requirements of a firm:
1. Equity capital;
2. Preference capital;
3. Debt capital; and
4. Internal sources of finance
5. Foreign Capital
These are discussed in the following paragraphs:
1. Equity Share Capital:
Equity shares were earlier known as ordinary shares (or common stock). These shares do not carry any preferential or special rights in respect of annual dividends and in the repayment of capital at the time of liquidation of the company. Equity capital represents the ownership capital. The equity shareholders collectively own the company and enjoy all the rewards and the risks associated with the ownership. However, unlike the sole proprietor or the partner of a firm, the risk of the shareholders in case of insolvency is limited to their capital contribution.
Equity shareholders control the business. They have voting rights to elect directors of the company and the directors control the business. Earlier all equity shares had equal voting rights. But an amendment in the Companies Act, 2000 permitted companies to issue equity shares with differential voting rights. Further, this provision has been incorporated in the corporate laws by section 43(a) (ii) of Companies Act, 2013.
The capital procured by issue of equity shares is a permanent source of funds to the company as it need not be redeemed during the lifetime of the company. At the same time, shareholders may get back money from the sale of shares in the stock exchanges. Each share has a certain face value which is also called its nominal value. Depending upon the intrinsic value of shares, the market value fluctuates. Market value is the value at which the shares are traded on the stock exchange.
The value of equity capital is computed by estimating the current market value of everything owned by the company from which the total of all liabilities is subtracted. On the balance sheet of the company, equity share capital is listed as stockholders’ equity or owner’s equity.
2. Preference Share Capital:
A company can also raise funds through issue of preference shares—a special type of share capital. They have a fixed rate of dividend and they carry preferential rights over ordinary equity shares in sharing of profits and also claim over the assets of the firm. The term ‘preference’ indicates that they rank ahead of the company’s ordinary shareholders for the payment of dividends, and have a prior claim on the company’s assets if the company is wound up. However, they rank behind the company’s creditors.
Preference shares are a long-term source of finance for a company. The law treats them as shares but they have elements of both equity shares and debt. For this reason, they are also called hybrid financing instruments. These are also known as preferred stock or preferred shares.
3. Debt Capital:
Debt capital includes debentures and term loans. They are a common source of long-term finance. Debentures normally carry a fixed interest rate and a certain date of maturity. Interest is paid every year and principal is paid on the date of maturity. Term loans carry a fixed interest rate and the payment is made in installments which consist of both principal and interest.
Their features, types, advantages and limitations are discussed in the following paragraphs:
In some markets the two terms, debentures and bonds are used synonymously, but in the US they refer to two separate kinds of debt-based securities. Bonds are generally issued by government agencies, financial institutions and large corporations, and debentures are issued by companies.
There are other functional differences between the two- bonds carry lower rate of interest and lower risk as compared to debentures, are generally secured by collateral and are paid prior to debentures in case of liquidation. In India, the two terms, bonds and debentures are used interchangeably.
A debenture is a marketable legal contract whereby the company promises to pay, whosoever owns it, a specified rate of interest for a defined period of time and to repay the principal on the specific date of maturity. Debentures are usually secured by a charge on the immovable properties of the company. The interests of the debenture holders are protected by a trustee (generally bank or an insurance company or a firm of attorneys).
The trustee is responsible for ensuring that the borrowing company fulfills the contractual obligations mentioned in the contract. Debentures are offered to the public for subscription in the same way as for issue of equity shares. They are issued under the common seal of the company acknowledging the receipt of money.
The terms loans represent a source of debt capital that is normally obtained by companies from term lending institutions. There are term lending institutions sponsored by governments or reputed banks. In India, financial institutions such as the Industrial Development Bank of India (IDBI), Industrial Finance Corporation of India (IFCI), Industrial Credit and Investment Corporation of India (ICICI) or any state level finance corporations like State Finance Corporation (SFC) and commercial banks provide term loans.
Term loans, also referred to as term finance, represent a source of debt finance, which is generally repayable in less than 10 years. They are employed to finance acquisition of fixed assets and working capital margin. Term loans differ from short-term loans which are employed to finance short-term working capital need and tend to be self-liquidating over a period of time usually less than a year.
Characteristics of Term Loans:
The basic characteristics of term loan have been discussed below:
The term loans are secured loans. Assets which are financed through term loans serve as primary security and the other assets of the company serve as collateral security.
The interest on term loans is a definite obligation that is payable irrespective of the financial condition of the firm. Generally, the financial institutions charge an interest rate that is related to the credit risk of the proposal, subject usually to a certain minimum prime lending rate (PLR) or floor rate. Financial institutions impose a penalty for defaults on the payment of installment of principal and/or interest.
The term loans carry a fixed rate of interest, but this rate is negotiated between the borrowers and lenders at the time of disbursing of loan.
The maturity period of term loans is typically longer, in case of sanctions by financial institutions, in the range of 6-10 years in comparison to 3-5 years of bank advances. However, they may be rescheduled to enable corporate borrowers to tide over temporary financial exigencies.
(e) Restrictive Covenants:
Besides asset security, the lender of the term loans imposes other restrictive covenants to the borrower depending upon the nature of the project and the financial condition of the borrowing company. Restrictive covenants are binding legal obligations written in the loan agreement to safeguard the interest of the lender. The borrower may be asked to maintain a minimum asset base, not to raise additional loans or to repay existing loans, restricting the company to sell its key assets without prior approval of the lender, inclusion of the representative of the financial institution in the borrowing company and so on.
The term loans may be converted into equity at the option and according to the terms and conditions laid down by the financial institutions.
(g) Repayment or Amortization Schedule:
The borrowing company needs to follow a repayment schedule for paying back the term loan to the financial institution. A repayment schedule is a complete table of periodic loan payments that includes an interest amount computed on the unpaid balance of the loan plus a portion of the unpaid balance of the loan. The payment of a portion of the unpaid balance of the loan is called a payment of principal.
There are generally two types of loan repayment schedules:
(i) Equal principal payments and
(ii) Equal instalments.
(i) Equal Principal Payments:
In equal principal payment schedule, the size of the principal payment is the same for every payment. It is computed by dividing the amount of the original loan by the number of payments. For example, the Rs.12,000 loan may be divided by the 12 payment periods each resulting in a principal payment of Rs.1,000 per loan payment. Interest is computed on the amount of the unpaid balance of the loan at each payment period. Because the unpaid balance of the loan decreases with each principal payment, the size of the interest payment of each loan payment also decreases.
(ii) Equal Instalments:
An equal instalment schedule is comprised of a decreasing interest payment and an increasing principal payment. The decrease in the size of the interest payment is matched by an increase in the size of the principal payment so that the size of the total loan payment remains constant over the maturity period of the loan.
Since, both debenture and term loan are a type of debt financing, they share basic characteristics of a debt and hence their pros and cons are also similar.
The advantages and disadvantages of term loans from the lender’s and borrower’s point of view are discussed below:
i. From Lender’s Point of View:
(a) Term loans are provided by banks and other financial institutions against security because of which the term loans are secured.
(b) It is obligatory on the part of the borrower to pay the interest and repayment of principal irrespective of its financial position. As a result, the lender has a regular and steady income.
(c) Financial institutions may insist the borrower to convert the term loans into equity. Therefore, they can get the right to control the affairs of the company.
ii. From, Management’s (Borrower’s) Point of View:
(a) It is less costly as a source of finance.
(b) Interest payable on term loan is tax deductible expenditure and thus tax benefit becomes available on interest that renders the cost of debt cheap.
(c) The term loans are negotiable loans between the borrowers and lenders. The terms and conditions of such type of loans are not rigid and this provides some sort of flexibility.
(d) Since term loans do not represent debt financing, neither the control nor the profit sharing of the equity shareholders is diluted.
(e) Debt financing by term loan has fixed installments till the maturity of the loan. In a rising economy with increasing inflation, the effective cost of future installments decreases due to reduction in the value of the currency.
(f) The burden of periodic installments in term loans brings in a discipline in the management for better management of cash flows and other operations.
i. From Lender’s Point of View:
(a) The terms and conditions of term loans are negotiable between borrowers and lenders and as a result, it may sometimes affect the interest of lenders.
(b) Like other sources of debt financing, the lenders of term loans do not have any right to have direct control over the affairs of the company.
ii. From Management’s (Borrower’s) Point of View:
(a) Yearly interest payment and repayment of principal is obligatory on the part of borrower. Failure to meet these payments raises a question mark on the liquidity position of the borrower and its existence may be at stake.
(b) Like any other form of debt financing, term loans also increase the financial risk of the company. Debt financing is beneficial only if the internal rate of return of the concern is greater than its cost of capital; otherwise it adversely affects the shareholders.
(c) In addition to collateral security, restrictive covenants are also imposed by the lenders which lead to unnecessary interference in the functioning of the business concern.
Special Types of Debt Instruments:
The ever growing financial requirements of the corporate sector have resulted in an intense competition between them to corner investors’ funds. Investors have also become more aware, selective and demanding.
Therefore, it has become essential for the issuer to innovate and introduce new financial instruments to cater to the different needs of the issuers and investors. Most of the new instruments are simply old conventional instruments with some added features.
Some of the new financial instruments are discussed below:
(a) Zero-Coupon Bonds (ZCB):
Zero-coupon bonds are purchased at a high discount, known as deep discount, on the face value of the bond. A holder of a zero-coupon bond does not receive any coupon or interest payments. The holder of a zero-coupon bond only receives the face value of the bond at maturity. Zero-coupon bondholders gain on the difference between what they pay for the bond and the amount they will receive at maturity. For example, a ZCB offered by a financial institution has a face value of Rs.20,000 but will be issued to the subscribers as part of this offer at Rs.11,980.
When these are redeemed on its maturity date after seven years, the holder will get Rs.20,000 for every bond. On the other hand, the holder of a conventional bond not only receives the face value of the bond at maturity but is also paid regular interests at the coupon rate over the life of the bond.
(b) Deep Discount Bonds:
A bond that is sold at a discount on its par value and has a coupon rate significantly less than the prevailing rates of fixed-income securities with a similar risk profile. These are very similar to ZCBs and there are no interest payments. They are designed to meet the long-term funds requirement of the issuer and investors who are not looking for immediate return.
These can be sold with a long maturity of 25-30 years at a deep discount on the face value of debentures. These low-coupon bonds are issued with call or put provisions. Investors are attracted to these discounted bonds because of their high return or minimal chance of being called before maturity.
(c) Zero Interest Fully Convertible Debentures (FCD):
The investors in zero-interest fully convertible debentures are not paid any interest. However, there is a notified period after which fully paid FCDs will be automatically and compulsorily converted into shares. There is a lock-in period up to which no interest will be paid. Conversion is allowed only for the fully paid FCDs. In the event of the company going for rights issue prior to the allotment of equity to the holders of FCDs, FCD holders shall be offered securities as may be determined by the company.
(d) Debentures with Warrant Option:
Both convertible and non-convertible debentures may be issued along with a detachable warrant. The warrant gives a right to the debenture holder to obtain equity shares specified in the warrant after the expiry of a certain period at a price not exceeding the cap price specified in the warrant.
Equity warrant is generally attached to non-convertible debentures as a sweetener to improve their marketability. It may also be attached to convertible debentures and equity shares also to make these instruments more attractive to investors. The warrant is a traceable negotiable instrument and is listed on stock exchanges.
(e) Secured Premium Notes (SPN) with Detachable Warrants:
SPN which is issued along with a detachable warrant, is redeemable after a notice period, say four to seven years. The warrants attached to it ensure the holder the right to apply and get allotted equity shares; provided the SPN is fully paid. There is a lock-in period for SPN during which no interest will be paid for an invested amount.
The SPN holder has an option to sell back the SPN to the company at par value after the lock-in period. If the holder exercises this option, no interest/premium will be paid on redemption. In case the SPN holder holds it further, the holder will be repaid the principal amount along with the additional amount of interest/premium on redemption in installments as decided by the company. The conversion of detachable warrants into equity shares will have to be made within the time limit notified by the issuing company.
(f) Multi-Option Convertible Debentures:
Such debentures provide many options to debenture holders. A portion of debenture can be converted into equity shares, the second portion may be redeemed after some period, and third portion may be non- convertible and continue to provide interest at the option of the holder.
4. Internal Sources of Financing:
Internal finance is also known as self-financing by a company. Internal finance includes the funds generated within the corporate unit irrespective of the nature of source. These sources are particularly important for small businesses which may find it difficult to get external finance.
In other words, the extent of profitability after tax, the size of dividend payments and the amount of depreciation provided for along with the reserves and surplus all contribute to the sources of internal funds. These funds may be used to finance the cost of acquisition of fixed assets that are needed for expansion, modernization and diversification programmes of the company.
The internal accruals, like depreciation and retained earnings, have been discussed below:
Depreciation means the decline in the value of fixed assets due to use and wear and tear. The objective of charging depreciation is to spread the cost of the fixed asset over its useful life for the purpose of ascertaining the result of operations as well as accumulation of funds for replacement of asset.
It is a source of internal financing which does not affect the working capital of the concern as it does not involve outflow of any cash like other expenses. It is recorded as expenditure in the accounting system of a firm. It is allowed to be deducted while arriving at the net profits of the firm subject to adherence of the percentages of allowable depreciation fixed under the tax laws.
Although depreciation is meant for replacement of particular assets but generally it creates a pool of funds which are available with a company to finance its working capital requirements and sometimes for acquisition of new assets including replacement of worn out plant and machinery.
Depreciation can be a very powerful accounting tool if it is applied with economic wisdom. As assets are depreciated, tax liability decreases. The saved taxes are allowed to accumulate as reserves. This is particularly important in the case of assets where the income tax laws provide for accelerated depreciation.
There exists a controversy whether depreciation should be taken as a source of finance. Whatever may be the outcome of such controversy, the fact remains that the depreciation is a sum that is set apart out of profits and retained within the business. Therefore, it can be used to finance the capital needs in the normal business routine, and as such depreciation in true academic sense can be deemed as a source of internal finance.
A company does not generally distribute all its earnings amongst its shareholders as dividends. A portion of the net profits may be retained in the business for use in the future. This is known as retained earnings. It is also referred to as ploughing back of profit. This is one of the important sources of internal financing used for fixed as well as working capital.
The profits available for ploughing back in an enterprise depend on factors like net profits, dividend policy and age of the organization. The total value of retained profits in a company can be seen in the “equity” section of the balance sheet. Also, the use of retained earnings does not require compliance of any legal formalities. It just requires a resolution to be passed in the annual general meeting of the company.
The amount of earnings retained within the business has a direct impact on the amount of dividends. The profit reinvested as retained earnings is profit that could have been paid as a dividend. The dividend policy of the company is determined by the directors. From their standpoint, retained earnings are an attractive source of finance because investment projects can be undertaken without involving either the shareholders or any outsiders.
The main characteristics of retained profits are that there is no compulsory maturity like term loans and debentures and they are not characterized by fixed burden of interest or installment payments like borrowed capital.
Evaluating Internal Sources of Finance:
The advantage of having internal accruals like depreciation and retained earnings is clearly seen in their characteristics.
These are discussed below:
(a) They are cheap although they have an opportunity cost, that is, the return they could have obtained elsewhere. However, the use of internal accruals as opposed to new shares or debentures avoids costs that are associated with fresh issues.
(b) They are very flexible as the management has complete control over how they are reinvested and what proportion is kept rather than paid as dividends.
(c) They do not dilute the ownership of the company. The less the firm relies on external sources of funding, more is the retention of the ownership of the firm. For example, if an expansion or acquisition is allowed with venture capital, the investor might demand part ownership of the firm, rather than simply a share in the profits, including a say in management.
If the firm finds an asset-based lender, who owns those assets which are required by the firm, then upon a default, the lender as part of the agreement may acquire control of the firm in lieu of seizing the assets and causing a shutdown. Dilution of control is an inherent characteristic of financing through issue of equity shares.
(d) Sometimes internal accruals as a source of finance are preferred over the other sources due to the financial and taxation position of the company’s shareholders. The capital profits emerging out of retained earnings may be preferred because of taxation considerations. A capital profit is taxed when shares are sold, rather than receiving the profits as dividends, which becomes a part of current taxable income.
(e) They strengthen the financial position of a company and appreciate the capital, which ultimately increases the market value of shares and the wealth of shareholders in case of a growing firm.
(f) The less debt the company has, the more attractive it is to potential investors and buyers. Lower debt improves a company’s debt capacity and creditworthiness, as well.
However, there are certain disadvantages of using internal accruals as a source of finance.
These are as follows:
(a) The directors of quoted companies occasionally get criticised for restricting the value of dividends and for hoarding too much cash in the business. If retained profits do not result in higher profits then there is an argument that shareholders could make better returns by having the cash for themselves.
(b) If the purpose for utilization of retained earnings is not clearly stated, it may lead to careless spending of funds.
(c) Sometimes, a conservative dividend policy leads to huge accumulation of retained earnings leading to over-capitalization.
Companies can also raise internal finance by selling off assets for cash. This can include real estate, patents, works of art, and other assets controlled by the company. Sale of assets must be made with care to avoid taking losses or exposing the company to the risk of future losses. When companies are considering new investments, they may compare available sources of finance to determine which would be most appropriate for a new endeavor.
Internal finance can be appealing for certain types of investments, while in other cases, it may be advantageous to tap external financing. The firms that choose to finance through the external sources can retain internal funds to cover the company in an emergency. The board members vote on whether or not new investments should be pursued and the type of financing the company should use.
5. Foreign Capital:
In most developing countries like India, domestic capital is inadequate for the purpose of economic growth. Foreign capital is typically seen as a way of filling in gaps between the targeted investment and locally mobilized savings. As the foreign capital plays a constructive role in a country’s economic development, it has led to a progressive reduction in regulations and restraints that had earlier inhibited the inflow of foreign capital.
The government of India made several changes in the economic policy of the country in the early 1990s. This led to the deregulation and liberalization of the Indian economy and also increased the flow of foreign capital into the country. The foreign capital may be provided by foreign government, institutions, banks, business corporations or individual investors.
There are various forms of foreign capital flowing into India that have given a major boost to the Indian economy. These are foreign direct investment, foreign portfolio investment and foreign commercial borrowings.