(contd,)Sources of Finance

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Long Term Financing

Need for Finance:

Finance is required in the business in order to sustain in thelong run, to cope up with the changing circumstances i.e.technological advancement, expansion of business, R & Dactivities, etc.The finance which is required by the business can beclassified into three types:

1) Long-term finance2) Intermediate term / medium-term finance and3) Short-term finance.

1) Meaning of Long-term Finance:The finance which is required to meet the capital expenditure

is called L.T. Finance and is repayable after 5 years. If thefinance is obtained from the Bank /other financial Institutions,the repayment of first instalment of loan amount will startafter 24 months, but interest has to be paid at frequentintervals, as and when it falls due.





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I) Traditional Method:This is the most common method of financing adopted by aCompany by issue of Ownership Securities, by issue of

Creditor ship Securities.

a) Ownership Securities: This is issued in the form of ³Shares´ and is of two types namely

(i) Equity and (ii) Preference.

i) Equity Share capital is the ownership interest , theresidual claim to assets and assume the ultimate riskassociated with ownership. However, their liability isrestricted to the amount of their investment. In the event of liquidation, these shareholders have a residual claim on theassets of the company, after the claim on assets of allcreditors and preferred shareholders are settled in full.



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Ordinary shares occupy a primary position in

the capital market and may be regarded as

the corner stone of capital structure. They

are in an advantageous position when the

company is in prosperity and disadvantageous

when the company is facing depression and in

financial crunch.

Thus, the ordinary shareholders provide theventure capital to the company or business

unit.



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Rights of Equity Shareholders

1)

Right to Vote2) Right to Income

3) Right against ultravires acts of thecompany

4) The pre-emptive right ± the firstoption to buy the existing shares.

5) Right to transfer the shares

6) Right to have knowledge of

corporate affairs7) Miscellaneous rights ±

proportionate share in the N.A.V.for distribution.



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Advantages

Cushion of Safety in payment of dividends.

Permanent source of funds for raising capital No creation of charge by the company. Helps the company to exploit the opportunity of Debt Equity

ratio The obligation to repay the equity capital arises only at the

time of liquidation of the company. Helps the shareholders to increase their liquidity position,

by selling it in the stock exchange. Helps to participate in the management of the company

through voting rights.

Different terms used in Equity Shares:a) Authorized capital

b) Issued Capitalc) Called up Capitald) Subscribed Capitale) Paid up capital



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Book Value: It is the net-worth of a corporation less thepar value of preference shares outstanding, divided by the

number of ordinary shares outstanding. Liquidating Value: It is the value at which the shares

can be realised. This value will be less than the Marketvalue only.

Market Value: It is the current price at which the stock istraded, which depends on the expected future dividends

of the company and the perceived risk of share on thepart of investors.

b) Preference Shares: Preference shares are those

type of shares who have an edge over the equity, in respect of dividend and repayment of capital at the time of winding up of the company. The dividend payable on preference shares isdetermined by the Company, while it is issued . Eg.: 9%preference shares of Rs.1000 per share.



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Special Features of Preference Shares:

1) Preference as regards to income

2) Preference as regards to assets

3) Preference as regards to control

4) --- do ± Conversion

5) --- do --- redeemable preference shares.

(b) Creditorship Securities: which are represented in the

form of Debentures and Bonds, which have a definite and

significant place in the financial plan of a company.

i) Debentures: A debenture is a written acknowledgement of

debt under the seal of a company, duly signed by its authorised

representative. It carries a fixed rate of interest and is usually

secured by a charge on the company¶s assets, which may berepayable within a specified period or after a specified date or

irredeemable during the existence of the company.



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Types of Debentures

1) Simple Debentures

2) Mortgaged Debentures

3) Redeemable ³

4) Irredeemable ³

5) Convertible ³

6) Non-convertible ³ (You will belearning more about all these in

Company¶s Act in L.A.B.)



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(c ) Borrowings from Banks and FinancialInstitutions:

which may be on long term basis or short term basis.

Commercial Banks in India constitute a vital segment of

the Indian Financial System. They have expanded their

area of business activity and have assumed a significant

proportion in providing finance to business enterprises

or firms.

The Banks provide loans on long term basis towards the

following purposes:

a) Purchase of Fixed Assets by Term Loans, up to

Rs.3crores, under the refinancing schemes by Govt. of India to the banks.

b) Underwriting of Capital Issues on ad hoc basis.

c) Direct Subscription in their shares and debentures up toa limited amount.

d) Merchant Banking Facility.





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d) Retained Earnings: Retaining excess profits of a company or

retaining a portion of divisible profits for

future financial requirement is known as³Retained Earnings´ / ³Ploughing Backof Profits´.

It is a cheaper means of financing, whichdoes not involve cost of floatation andreflects the financial soundness of a

company. It helps in tax planning and does not affect

the normal functioning of the company.



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5) Venture Capital:Acc. to International Finance Corporation (IFC),³Venture Capital is equity or equity featured capitalseeking investments in new ideas, new companies, newproduction, new process or new services that offer thepotential of high returns on investments.´

Regulation 2(m) of SEBI (Venture Capital Funds)Regulation, 1996, ³Venture Capital fund means a fund

established in the form of a company or trust which raisesmoney through loans, donations, issue of securities orunits, as the case may be and makes / proposes to makeinvestments in accordance with these regulations.´

In general, it can be described as, ³The capital invested

in young, rapidly growing or changing companies thathave the potential for high growth. The Venture Capitalmay also invest in a firm that is unable to raise financethrough the conventional means.´



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II) Short Term Financing

It means funds used to meet day-to-day expenses of acompany or funds used to meet working capital requirement.The short term loan is repayable within 1 to 3 years from thedate of borrowing. The Working Capital requirement can beestimated / calculated by adopting the following measures:a) Elimination of non-current elements from current assetsb) Short term finance requirementc) Self-generation of Fundsd) Management of Current Assets.

Sources of Short Term Financing:

1)Trade Credit ±obtained from suppliers, which is allowedon purchase of goods on credit, the credit period rangingfrom 1 day to 180 days.



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2) Bank Credit- Companies take loans tomeet the need of working capital. The Banks provide

loans on short term basis towards the following

purposes:

Overdrafts

Cash Credits (also called as Working Capital Loan)

Discounting of Bills

These loans are secured and the rate of interest is low

and has to be paid at quarterly intervals.



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3) Factoring: It is an agreement with the ³Factor´

and his client in which receivables arising out of sale of

goods or services are sold to the factor as a result of which the title to the goods / services represented by thesaid receivables passes on to the factor.The Factoring services include:i) Financeii) Maintenance of accountsiii) Collection of Debtsiv) Protection against Credit Risks.The various types of Factoring area) Full service factoringb) Factoring with recourse

c) Maturity factoringd) Invoice discountinge) Bulk factoringf) Agency factoringg) Undisclosed factoring



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4) Money Market: deals with

short-term instruments with a period of maturity of one year or less. It dealswith instruments like call money market,Commercial Paper, Treasury Bills,

Certificate of Deposits, etc.,-----



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Module V

Capital Structure

Meaning: Capital Structure refers to the ³Composition of the Capital´, i.e., the mix of sources from which the long termfunds required by a business are to be collected or are raised.

Goals / Principles /Determinants of

Capital Structure:It is necessary to consider certain basic principles, which aremilitant to each other, before the deciding a suitable pattern of capital structure. It is necessary to find a golden mean bygiving proper weight age to each of them.

The following are some of the principles:1. Cost Principle

2. Risk Principle

3. Control Principle

4. Flexibility Principle

5. Timing Principle



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1) Cost Principle: Acc. to this principle, the idealcapital structure should minimize the cost of financingand maximize ³earning per share´. Debt Capital is a

cheaper form of capital due to two reasons:Firstly, the expectations of the returns of debt capitalholders are less than, those of equity shareholders.

Secondly, interest is a deductible expense, for taxpurposes, whereas dividend is an appropriation of profits.

2) Risk Principle: Acc. to this principle, an idealcapital structure should not accept an unduly high risk.Debt capital is a risky form of capital, as it involvescontractual obligations to the payment of interest andrepayment of principal sum irrespective of profits /

losses of the business.If the organization issues a large amount of preferenceshares out of its earnings, a lesser amount will be leftout for equity shareholders, as dividend on preferenceshareholders is required to be paid before any dividend



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is paid to equity shareholders. Raising the capital

through equity shares involves the least risk, as there

is no obligation as to the payment of dividend.

3) Control Principle: Acc. to this principle,

an ideal capital structure should keep intact the

controlling position of the owners. As preference

shareholders and debenture holders carry limited or no

voting right, they hardly disturb the controlling position

of the residual owners. Issuing the equity shares

disturbs the controlling position directly, as the

control of the residual owners is likely to get

diluted.4) Flexibility Principle: Acc. to this

principle, an ideal capital structure should be able to

cater to the additional requirements of funds in future,

if any. Eg: If a company has already raised a too



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Heavy debt capital by mortgaging all its asset, it will be

difficult for it to get further loans in spite of goodmarket conditions for debt capital and it will have todepend on equity shares only to do so.

Moreover, an organization should avoid capital on suchterms and conditions which limit the company¶s ability

to procure additional funds. Eg: If the co., acceptsdebt capital on the condition that it will not acceptfurther loan capital or dividend on equity shares willnot be paid beyond a certain limit, then it losesflexibility.



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5) Timing Principle: Acc. to this principle,

an ideal capital structure, should be able to seizemarket opportunities, minimize cost of raising funds

and obtain substantial savings.

Accordingly, during the days of boom and prosperity,

the company can issue equity shares to get the benefit

of investors desire to invest and take the risk.

During the days of depressions, debt capital may

be used to raise the capital, as the investors are

afraid to take any risk.



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Characteristics of an Ideal

Capital Structure

Simplicity: A few varieties of securities.

Liquidity: Sufficient cash to pay current liabilities.

Flexibility: Increase / decrease.

Balance: Ordinary and preference shares,

ownership capital and borrowed capital.

Economical: Cost of Capital

Provision against contingencies.

Business soundness

Consistent with objectives.



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Factors affecting Capital Structure

Before deciding the mix of long term sources of

funds, it is necessary to consider the variousfactors which can be broadly classified as:

A. Internal factors

B. External factors

C. General factors

A) Internal factors: The following are the

internal factors which affect the capital structure of

a company, namely:

1. Cost of Capital

2. Risk factors ± Payment of interest onDebentures / Bank borrowings, dividendto Preference share holders.

3. Control factors.



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B. External factors:The following are the external factors

which affect the capital structure of a company, namely:

1. General economic conditions

2. Level of Interest Rates

3.

Policy of Lending Institutions4. Taxation Policy ±which depends on the

interest rates.

5. Statutory Restrictions ± The companyhas to decide the capital structure

within the framework asprescribed by the Govt., andvarious statutes.



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C. General Factors: The following arethe external factors which affect the

capital structure of a company,namely:

1.Constitution of the Company ± A Pvt. Ltd.,Co., or a Public Ltd., Co.,

2. Characteristics of the Company: Size, ageand credit policy of the co.,

3. Stability of earnings

4. Attitude of the Management ± LiberalisedPolicy or Conservative Policy.



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Objectives of Capital Structure

Planning

To maximize the profits of the owners of the co. Thiscan be ensured by issuing the securities carrying alower or lesser cost of capital.

To issue the securities which are easily transferable.

This can be ensured by listing the securities on thestock exchange.

To issue the further securities in such a way that theshare of shareholding of the present owners is notaffected.

To issue such kinds of securities which areacceptable to the lenders of the capital.



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Optimum Capital Structure

The Capital Structure is said to beoptimum, when the real cost, i.e. explicitas well as implicit cost, if each source of financing is identified. With an optimumdebt and equity mix, the cost of capital isminimum and market price per share ismaximum.

It is however, difficult to find out anoptimum debt/equity mix, where the

capital structure would be optimum,because it is difficult to measure a fall inthe market value of an equity share ona/c. of increase in risk due to high debtcontent.



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The following are some of the importantfeatures of an Optimal Capital Structure:

a) Profitability

b) Flexibility

c) Conservation

d) Solvency

e) Control

Conclusion:In theory, one can speak of an optimum capital

structure but in practice, an appropriate capital

structure is a more realistic term than the former.

------



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Capital Structure Theories

Introduction:The introduction of Debt in the Capital Structure

increases the earning per share of equity shareholders.

It also increases the risk, which is the risk of

insolvency due to non-availability of cash and

variability of earnings available to equity shareholders.

As the debt component beyond a certain limit, the

expectation of the lenders of money also increases due

to the involvement of risk factor. Similarly, the

shareholders also will demand a higher rate of return

on their investment to compensate for the risk arising

out of an additional amount of debt in the capital

structure.



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As such, introductions of a heavy amount of debtcapital in the capital structure will not only reducethe valuation of the firm, but will also increase the

cost of capital. The Management may aim to have an optimum

capital structure by selecting a financing or debtequity mix, which can maximize the value of thefirm. The valuation of a firm and its cost of capitalmay be affected by the change in the financing

mix. Different views have been expressed in thiscontext.

Among them, the following four approachedare very important and are very relevant,during any situation, which are as follows:

1) Net Income Approach (NI Approach)

2) Net Operating Income Approach (NOI Approach)

3) Traditional Approach

4) Modigliani and Miller Approach.



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Basic Assumption of Approaches:The following are the assumptions of this approach,

which helps to understand the relationship b/w. debtand equity or interest and dividend.

1) Firms use only 2 types of Capital, i.e. Long termdebt capital and equity share capital to raise funds.

2) Corporate income tax does not exist and there are

no bankruptcy costs.3) Firms follow policy of 100% of its earnings by way

of dividend. So, there will be no retainedearnings.

4) Operating earnings of the firm is given and

expected to grow.5) The investment decisions are constant, i.e. the

total assets of the business unit remain constant,so also its total financing.



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6) There is perpetual life of the unit, i.e. there are

no closures due to strikes and lockouts.

7) The business risk is independent of capital

structure and financial risks and the same remainsconstant.

8) The variations in capital structure are madeimmediately and there are no transaction costs.

9) The different investors in the market anticipate the

same values of the subjective probability distbn. of the anticipated future operating earnings of eachbusiness unit.



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1) Net Income Approach (NI Approach)

Mr. David Durand, has proposed 2 important

approaches, viz, Net Income Approach (NI Approach) andNet Operating Income Approach (NOI Approach), to the

valuation of an organization. These two represent the

extremes in valuing an organization with regard to its

degree of financial leverage.

1) Net Income Approach (NI Approach):

By introducing the additional debt capital in the capital

structure, the valuation of the firm can be increased and

cost of capital can be reduced, which will be reflected in

the enhanced value of the company and also the market

price of the equity shares and vice-versa.In other words, if the degree of financial leverage increases, the

weighted average cost of capital will decline with every increase

in the debt content in total funds employed, while the value of

the firm increases.



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This approach is based on the following assumptions:

i. There is no Corporate taxation

ii. The Cost of Debt is less than cost of equity.

iii. The use of Debt content does not change the riskperception of investors, as a result of both, costof debt and cost of the equity remainingconstant.

iv. No hidden costs exist, when more and more debt

is introduced.This theory can be well understood by presenting in a

diagram:

Cost of Capital (%)

% of Debt in

financing mix

Kd

Ko

Kg



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Here the value of the firm can be

ascertained as follows:

Overall Cost of Capital = EBIT / V,where V = S + B.

S = Market Value of equity shares

B = Market Value of debtV = Total Market value of the firm

EBIT = Net Operating Income

I = Total Interest payment NI = Net Incomeavailable to equity shareholders, i.e., EBIT - I



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i) Cost of Debt = Annual interest charges

Market value of debt

= I / B

OR

Value of debt = Annual interest charges

Cost of Debt

ii) Cost of Equity = NI / S

iii) Overall Cost of Capital = EBIT

V

= Operating Profits

Value of the firm

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