Sources of Business Finance Xii Commerce Sp New Syllabus

8/11/2019 Sources of Business Finance Xii Commerce Sp New Syllabus

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SOURCES OF BUSINESS FINANCE XII COMMERCE SP NEW

SYLLABUS

2.1 Introduction2.2 Nature and significance of finance2.3 Financial requirements and Sources2.4 Methods of raising finance

(A) Equity and Preference shares(B) Retained profits(C) Debentures and Bonds(D) Public deposits(E) Loan from financial institutions(F) Loan from commercial banks(G) Trade credit

(H) Discounting of bills of exchange(I) Global Depository Receipt and American Depository Receipt

2.1 INTRODUCTIONA business transaction involves buying and selling. Buying means payment of

money and selling means receipt of money. The transaction may involve immediatepayment or it may be.on credit terms. Thus finance plays very important role in everybusiness transaction. Finance is the life blood of business economy. It provides basis forevery business activity.

Unit objective :After studying this chapter you should able to know various sources of finance

and their significance in the business i.e. shares, debentures, bonds, retained profits,public deposits, loans, trade credits, discounting bills of exchange, GDR and ADR.

2.2 NATURE AND SIGNIFICANCE OF FINANCE

In Sanskrit saying 'Artha Sachivah' (DeLe&: meefeJe:) which means "Financeis the supreme controlling factor" which brings the significance of 'finance'.

Finance is what finance does. It is a study of money. An understanding of 'Whatmoney is ?' and 'What money does?' is the base of financial knowledge.

1. Finance may be defined as the provision of money at the time it, is wanted. It isnecessary through out the activities of promotion, orgnisation and regular operations ofbusiness. It must take care of all financial needs of business.

2. Finance holds the key to all business activities. A business activity cannot be pursuedwithout financial support. Finance contributes to different business functions such aspurchasing, production, marketing and so on. It administers every business activity.Thus finance is the central theme of any business proposition.


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3. Finance enables the business to pay its obligations promptly and without any difficulty.Finance is accepted as weapon to pay its bills promptly.

4. Finance is concerned not only with measuring profitability but setting minimumstandards for profitability. It is also concerned with measuring cost of capital for any

given industry.

5. Finance is required to generate finance. Its generation depends upon a co-ordination ofdifferent business functions. The financial proposition would be successful, if it is usedeffectively in different business activities. Thus finance is said to be 'circulatory system'of economic body. It makes possible co-operation between many units of businessactivity.

Thus, finance is a 'specialized operation'. It is an inseparable, part of businessadministration. Finance has been described in several ways. It is related to money andmoney, management. It is also related to the inflow and outflow of funds. In fact it is a

sinew i.e. strength of business activity. Finance is aptly described as key determinant ofsuccess of business.

Inconclusion it may be stated that all activities or functions of a business areultimately related to finance.

2.3 FINANCIAL REQUIREMENTS AND SOURCESFund raising is not merely a question of how much money is to be raised, but in

what form should the finance be raised is an important matter of policy.

A businesses organization requires finance

(a) For various purposes,(b) At different stages and(c) For different period.

Even the size and nature of its business, determines the actual requirement offunds. Business organization collects huge funds.through different sources.

The various sources of finance available to business may be classified as(A) External Sources.(B) Internal Sources.

(A) External Sources: External sources are outside of the firm. They are usedextensively for collecting initial capital. The important external sources are -

1) Issue of shares2) Issue of debentures3) Public deposits4) Loan from institutions5) Bank Credit


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(B) Internal Sources: Internal sources are available within the firm. They develop afterfew years of profitable working of the firm. The important internal source of finance is'retained profit'. It is also called as 'ploughing back of profit'. Here the undistributedprofit of the firm is reinvested in the business.

The external source and internal source, may be further classified as(a) Long term source(b) Short term source

(a) Long term source: A business firm requires long term finance for meeting fixedcapital needs. These funds are required generally for long duration. The main sourcesof long term finance may lie divided into

(1) Owned Capital(2) Debt Capital

(b) Short term source : The short term funds are required for meeting working capitalrequirement. These funds are required for a short period. The short term funds can bearranged from taking short term loans, accepting deposits, etc.

The various sources of finance available to business, may be explained with followingchart.

Sources of finance

2.4 METHODS OF RAISING FINANCE

A) SharesThe term 'share' is defined by section 2(46) of the Companies Act -1956 as -

"share means a share in the share capital of a company and includes the stock where adistinction between stock and shares is expressed or implied".

Share is a unit by which the share capital is divided. Share is a small unit of thecapital of a company. The total capital of company is divided into small parts and eachsuch part is called 'share'. The capital of company is divided into large number ofshares. It facilitates the public to subscribe the capital in smaller amount. Thus a shareis indivisible unit of share capital.

A person can purchase any number of shares as he wishes. A person whopurchases shares of a company is known as a shareholder of that company.

Features of Shares

1. A share is the smallest unit of share capital.

2. It shows the ownership of a shareholder.


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3. Each share has distinct number, which is noted in the share certificate.

4. Share is a movable property of a member.

5. A share-is not any visible thing. It is shown by share certificate or in the form the

'demat' share.

6. Each share has value expressed in terms of money. There may be

a) Face value: This value is written on the share certificate and mentioned in theMemorandum of Association.

b) Issue value: It is the price at which company sells its shares. For example, issue atpar or at premium or at discount.

c) Market value: This value of share is determined by demand and supply forces in theshare market.

7. A Shareholder is entitled to get a share in the net profit of the company. It is called'dividend'.

8. A company can issue two types of shares -a) Equity shares b) Preference shares

Kinds of sharesThere may be different types of shares depending upon right to control, income,

and risk. The following chart gives the snapshot view of different kinds of shares.

SHARE

Equity Shares Preference shares(i) Equity shares with i) Cumulative preference shares

normal voting eight ii) Non Cumulative preference(ii) Equity shares with shares

differential voting right iii) Participating preference sharesiv) Non Participating preference

sharesv) Convertible preference share

vi) Non Convertible preference sharevii) Redeemable preference sharesviii) Non Redeemable preference

shares

1. Equity Shares


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Equity shares are also known as 'ordinary shares' For legal reason, a companycan not exist without equity shares.

Companies Act 1956 defines equity shares as "those shares which are notpreference shares'".

The above definition reveals the two important features of equity shares

1. The equity shares do not enjoy preference in getting dividend.

2. The equity shares do not have priority for payment of capital at the time of winding upof the company.

Thus, equity shareholders do not enjoy any special privilege in respect ofpayment of dividend and repayment of capital at the time of winding up of thecompany.

Equity shares are fundamental and basic source of financing activities ofbusiness. Equity shareholders own the company and bear ultimate risk associated withthe ownership. They bear maximum risk of business. After paying claims of all otherinvestors the remaining funds belong to equity shareholders. Thus equity shareholdersare 'residual claimants' against the assets and income.

Equity shares do not carry any, fixed commitment charge. They are paiddividend at the rate recommended by Board of Directors. If there is no profit, nodividend will be payable. Similarly if there is less profit lesser dividend will be paid. It isexactly because of this position, equity capital is known as `Risk capital'. The owners of

equity shares are real risk bearers.

However, equity shareholders participate in the management of the company.They are invited to general meeting and are given normal voting rights. They elect theirrepresentatives for the management of the company. Equity shareholders are realowners of the company.

Features of equity shares

1. Permanent capital : Equity, shares are irredeemable shares. The amount receivedfrom equity shares is not refundable by the company during the life time. Equity sharesbecome redeemable, only in the event of winding up of the company. Equityshareholders provide long term and permanent capital to the company.

2. Fluctuating dividend: Equity shares do not have a fixed rate of dividend. The rate ofdividend depends upon amount of profit earned by company. If company earns moreprofit, dividend is paid at higher rate. On the other hand if there is insufficient profit,Board of Directors may postpone the payment of dividend. The shareholders can not


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compel them to declare and pay the dividend. The income of equity shares is irregularand uncertain. They get dividend which is always fluctuating.

3. No preferential right: Equity shareholders do not enjoy preferential right in respectof payment of dividend It means equity shareholders are paid dividend only after

dividend on preference shares has been paid.

At the time of winding up of the company also the equity shareholders are paid in thelast. They are the last claimants. If no surplus amount is available after paying debtsand preference shares, equity shareholders will not get anything. Thus, equityshareholders stand second in case of getting dividend on their shares as well as gettingback their capital at the time of liquidation of company.

4. Rights: Equity shareholders enjoy certain rights. These include

a) Right to share in profit, when distributed as dividend, is the most important right of

equity shareholder. If company is successful and makes handsome profit, they haveadvantage of large dividend.b) Right to vote is the basic right of equity shareholders by Which they elect directors,

amend Memorandum, Articles etc.

c) Right to inspect books of account of their company of which they are owners.

d) Right to transfer shares is one of the most important right of shareholder.

5. Control : The control of company is vested in equity shareholders. They are oftendescribed as real masters of the company. It is because they enjoy exclusive voting

right. The voting rights of equity shareholder are protected as far as possible. Equityshareholders may exercise their voting rights by proxies, without attending meeting inperson. The Act provides the right to cast vote in proportion to number ofshareholdings.

Equity shareholders participate in the management of the company. They elect theirrepresentatives called Directors on the Board for the management of company.

6. Risk: Equity shareholders. bear maximum risk in the company. They are described as'shock absorbers' when company has financial crisis. If the income of company falls, therate of dividend also comes down. Due to this, market value of equity shares goes

down resulting into capital loss. Thus, equity shareholders are main risk takers.

7. Residual claimants: Equity shareholders are owners and they are residual claimantsto all earning after expenses, taxes, etc. have been paid.

Although equity shareholders are last claimants they have advantage of receiving entireearnings that is left over.


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8. Face value: The face value of equity shares is low, in comparison to preferenceshares. It is generally Rs 10/- per share or even Rs 1/- per share.

9. Market Value : There is more fluctuation in the market value of equity shares incomparison to other securities. Therefore, equity shares are more appealing to the

speculators.

10. Bonus and Right Issue: Bonus shares are issued as gift to equity shareholders. Theyare issued 'free of cost' to them. These shares are issued out of accumulated profits.These shares are issued to existing equity shareholders in certain ratio or proportion oftheir existing shareholdings.

Equity shares get the benefit of rights issue. When a company raises further capital byissue of shares, the existing shareholders are given priority to get newly offered shares.This is called right issue. Thus equity shareholders get the advantage of bonus andright issue.

11. No charge on assets: The equity shares do not create any charge on assets of thecompany.

"It is often said that equity shareholders do not enjoy any special privilege, thoughthey have special rights". How would you comment on this contradiction?

Types of equity sharesAs per Section 86 of Indian Companies Act 1956, as amended by the Companies

(Amendment) Act 2000, the equity share capital can be of two types

(i) with normal voting right

(ii) with differential voting right

(i) Equity shares with normal voting right: Voting right of such equity holders shall be inproportion to his share of paid up equity capital.

(ii) Equity shares with differential voting right: Voting right of such equity holders shall beas to dividend, voting or otherwise in accordance with Companies Rule 2001.

Due to the provision for issuing such shares, company can issue shares withlimited voting rights or no voting rights. They may be entitled to extra rate of dividendif any.

2. Preference sharesAs the name indicates, these shares have certain privileges and preferential

rights distinct from those attaching to equity shares.

The shares which carry following preferential rights are termed as preferenceshares.


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(a) A preferential right as to the payment of dividend during the life time of the company.

(b) A preferential right as to the return of capital in the event of winding up of thecompany.

Holder of these shares have a prior right to receive the fixed rate of dividendbefore any dividend is paid to equity shares. The rate of dividend is prescribed in theissue.

Normally preference shares carry no voting power. They have voting right onlyon those matters which affect their interest such as selling of undertaking or changingrights of preference holder, etc.

The preference shareholders are co-owners of the company but not controllers.These shares are purchased by cautious investors who crave for safety of principal andare satisfied with low but definite and regular income. Preference shares occupy on 'in

between' position in the capital structure.

Features of preference shares1. Preferential dividend : The dividend is payable to preference shareholders before

anything else is paid to equity shares. The company must assure their preferential rightas to payment of dividend during the life of the company.

2. Prior repayment of capital: Preference shareholders have a preference over equityshareholders in respect of return of capital when the company is liquidated. It savespreference shareholder from capital losses.

3. Fixed return : These shares carry dividend at a fixed rate. The rate of dividend ispredetermined. It may be in the form of fixed sum or may be calculated at a fixed rate.

One point must be made clear. The preference shareholders are entitled to dividendwhich can be paid only out of profit. Although the rate of dividend is fixed, thedirectors; in financial prudence, decide that no dividend be paid as there are no profits,the preference shareholders have no claims for dividend.

4. Nature of capital: Preference shares do not provide permanent share capital. Theyare redeemed after certain period of time. As per Companies (Amendment) Act 1988, acompany can not issue irredeemable preference shares.

5. Market value: The market value of preference share does not change as-the rate ofdividend payable to them is fixed. The capital appreciation is considered to be low ascompared with equity shares.

6. Voting right : The preference shares do not have normal voting rights. They havevoting rights in respect of those matters which affect their interests. The preferenceshares do not enjoy right of control on the affairs of the company.


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7. Risk: The investors who are cautious, generally purchase preference shares. Safety ofcapital and fixed return on investment are advantages attached to preference shares.They attract moderate type of investors. These shares are boon for shareholders duringdepression period when interest rate is continuously falling.

8. Face Value : Face value of preference shares is relatively higher than that of equityshares. They are normally issued at a face value of Rs. 100/-

9. Right or Bonus issue : Preferential shareholders are not entitled for right or bonusshares.

"Preference shareholders are the owners but not controllers."Do you agree with this statement? Discuss.

Kind of preference shares

Preference shares

1. Cumulative preference shares :Cumulative preference shares are those shares on which dividend goes on accumulatinguntil it is fully paid. This means, if the dividend is not paid in one or more years due toinadequate profit, then such unpaid dividend gets accumulated. The accumulateddividend is paid when company performs well. The arrears of dividend. are paid beforemaking payment to equity shareholders. The preference shares are always cumulativeunless otherwise stated in the Articles of Association. It means that if dividend is notpaid in any year or falls short of prescribed rate, the unpaid amount is carried forwardto next year and so on; until all arrears have been paid.

2. Non-cumulative preference shares- Dividend on these shares does notaccumulate. This means, the dividend on shares can be paid only out of profits of thatyear. The right to claim dividend will lapse, if company does not make profit in thatparticular year. If dividend is not paid in any year, it is lost.

3. Participating preference shares: The holders of these shares are entitled toparticipate in surplus profit besides preferential dividend. The surplus profit whichremains after the dividend has been paid to equity shareholders up to certain limit, isdistributed to preference shareholders.

4. Non-participating preference shares : The preference shares are deemed to be

non-participating, if there is no clear provision in Articles of Association. Theseshareholders are entitled only to fixed rate of dividend prescribed in the issue.

5. Convertible preference shares : These shareholders have a right to convert theirpreference shares into equity shares. The conversion takes place within a certain fixedperiod.

6. Non-convertible preference shares: These shares can not be converted into equityshares.


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7. Redeemable preference shares : Shares which can be redeemed after a certainfixed period are called redeemable preference shares. A company limited by shares, ifauthorized by Articles of Association, issues redeemable preference shares. Such sharesmust be fully paid. These shares are redeemed out of divisible profit only or out of fresh

issue of shares made for this purpose.

8. Irredeemable preference shares : Shares which are not redeemable i.e. payableonly on the winding up of the company are called irredeemable preference shares. Asper Companies Act (Amendment made in 1988) the company can not issueirredeemable preference shares.

Distinction between

Sr.No.

Points Equity Shares Preference shares

1. Meaning Equity shares have no priority

right while receiving dividendand repayment of capital atthe time of winding up ofcompany.

Preference shares carry

preferential right in respect ofdividend payment andrepayment of capital inwinding up of company.

2. Rate ofdividend

Equity share holders are givendividend at fluctuating ratedepending upon the profits ofthe company.

Preference share holders getdivided at fixed rate.

3. Vote right Equity shareholders enjoynormal voting right. They

participate in the managementof their company.

Preference shareholders donot enjoy normal voting right.

They can vote only on mattersaffecting their interest.

4. Nature ofcapital

Equity share capital ispermanent capital. It is knownas 'Risk capital'

Preference share capital is'safe capital with stable return

5. Nature ofInvestor

The investor who are ready totake risk invest in equityshares.

The investors who arecautious about safety of theirinvestment, invest inpreference shars.

6. Face value The face value of equityshares is generally Rs. 1/- or

Rs. 10/- It is relatively low.

The face value of preferenceshares is relatively higher i.e.

Rs. 100/- and so on.7. Types Equity shares are classified

intoa) equity voting with normal

voting rightb) equity shares with different

voting right

Preference shares areclassified asa) Cumulative preferencesharesb) Non-cumulative preferenceshares


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c) Convertible preferenceshares.d) Non-convertible preferencesharese) Redeemable preference

sharesf) Irredeemable preferencesharesg) Participating preferencesharesh) Non-participatingpreference shares

8. Right andbonus issue

Equity shareholder is entitledto get right and bonus shares.

Preference shareholders arenot eligible for right andbonus shares.

9.

Capitalappreciation Market value of equity sharesincreases with the prosperityof company. It leads toincrease in the value ofshares.

Market value of preferenceshares does not fluctuate. Sothere is no possibility ofcapital appreciation.

10. Risk Equity shares are subject tohigher risk. That is because offluctuating rate of dividendand no guarantee of refund ofcapital and repayment ofcapital

Preference shares are subjectto less risk. It is because of fixrate of dividend andpreferential right as regardsdividend and repayment ofcapital.

(B) Retained profitsBusiness organizations are subject to variation in earnings. It would be a wise

decision on the. part of management, to keep aside a part of earning during a period ofhigh profit. It helps a company to overcome the downswing in the business cycle.

Retained profits are earnings of the company which are retained in the business.It is a sum total of those profits, accumulated over years and reinvested in the businessrather than distributed as dividend.

"The process of accumulating corporate profits and their utilization in business is

called retained earning".

In simple words, a part of net profit which is not distributed to shareholders asdividend, is retained by company in the form of 'reserve fund'. These reserves are`retained profits' of the company. The policy of using such retained profit in thebusiness is known as `self financing' or 'ploughing back of profit'. The management canconvert this retained profit into permanent capital which is known as 'capitalisation ofprofit' by issuing bonus shares.


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The above definitions bring out the clear meaning of debenture. Firstly it is aninstrument issued in the form of 'debenture certificate' under the common seal of thecompany. Being an instrument it is transferable. It is an evidence of indebtedness. Thusdebenture holder is creditor of the company. Being a loan it is secured by charge onasset. It is refundable.

The term debenture has not been defined clearly under Companies Act 1956.

Sec 2 (12) of companies Act 1956 only states that, "the word debenture includesdebenture stock, bonds and any other security of the company whether constituting acharge on asset of the company or not."

Under the existing definition debenture means a document which either createsor acknowledges debt. Ordinarily debenture constitutes a charge on company, on somepart of its property, but there may be a debenture without such charge.

Here a point to be noted that as per Companies (Amendment) Act 2000,company can not issue unsecured debentures.

Characteristics of Debentures a snap shot view

Promise Face valueTime of payment Interest

Assurance of repayment Parties to debentureRights of debenture holders Terms of issueSecurity Listing

Characteristics of Debentures

1. Promise: Debenture is a written promise by company that it owes specified sum. ofmoney to holder of the debenture.

2. Face value: The face value of debenture normally carries high denomination. It is Rs.100/- or multiples of Rs. 100.

3. Time of payment : Debentures are issued with due date stated in the 'DebentureCertificate'. A debenture provides for the repayment of principal amount on maturitydate.

4. Interest : A fixed rate of interest is agreed upon and is paid periodically in case ofdebentures. The rate of interest that company offers depends upon the marketconditions and nature of the business.

5. Assurance of repayment : Debentures constitute a long term debt. They carry anassurance of repayment on due date.

6. Parties to debentures: There are certain parties to debentures such as


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This is the entity which borrows money.

This is a party through whom the company deals with debenture holders. The companymakes an agreement with trustees and debenture holders. It is known as `Trust Deed'.It contains the obligations of company, rights of debenture holders, etc.

olders: These are the parties who provide loan and receive `debenture certificate' as evidenceof participation.

7. Rights of Debenture holder : Debenture holders have no right to vote at generalmeeting of the company.

8. Terms of issue of debentures :a) Debentures can be issued at par, at premium and even at discount.b) According to Companies Act, company can not issue debentures carrying voting rights.c) According to Companies Act, Sec 292 (1) the Board of Directors has the power to issue

debentures.

9. Security: Debentures can be secured with some property of the company.

10. Listing: Debentures must be listed with at least one recognized' stock exchange.

Types of Debentures

Debentures

The debentures can be of different kinds according to their terms of issue,

conversion, provision of security, repayment etc. Let us discuss them in detail.

1. Secured debentures: The debentures can be secured. The property of company maybe charged as security for loan. The security may be for some particular asset (fixedcharge) or it may be the asset in general (floating charge). The debentures are securedthrough `Trust Deed'

2. Unsecured debentures: These are the debentures that have no security. The issueof unsecured debenture is now prohibited by Companies (Amendment) Act, 2000.

3. Registered debentures : Registered debentures are those on which the name of

holders are recorded. A company maintains a register of debenture holders in which thenames, addresses and particulars of holdings of debenture holders are entered. Thetransfer of debentures in this case requires the execution of regular transfer deed.

4. Bearer debenture : Name of holders are not recorded on the bearer debentures.Their names do not appear on the register of debenture holders. Such debentures aretransferable by mere delivery. Payment of interest is made by means of couponsattached to debenture certificate.


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5. Redeemable debentures: Debentures are mostly redeemable i.e. payable at the endof some fixed period, as mentioned on the debenture certificate. Repayment can bemade at fixed date at the end of specific period or by instalments during the life time ofthe company. The provision of repayment is normally made in a trust deed.

6. Irredeemable debentures: These kind of debentures are not repayable during lifetime of the, company. They are repayable only after the liquidation of the company orwhen there is breach of any condition or when some contingency arises.

7. Convertible debentures: Convertible debentures give the right to the holder toconvert them into equity shares after a specific period. Such right is mentioned in thedebenture certificate. The issue of convertible debenture must be approved by special"resolution in general meeting before they are issued to public. These debentures areadvantageous for holder. Because of this conversion right, convertible debenture holderis entitled to equity shares at a rate lower than market value and even he participates

in the profit of the company.

8. Non-convertible debentures : Non convertible debentures are not convertible intoequity shares on maturity. These debentures are normally redeemed on maturity date.These debentures suffer from the disadvantage that there is no appreciation in value.

Why have debentures not made much progress in Indian capital market?Discuss with your teacher.

Distinction between

Sr.No. Points

Shares

Debenture

1. Meaning It is a smallest unit in the totalshare capital of the company.

Debenture is an instrumentunder seal evidencing debt.

2. Nature It is a permanent capital. It isnot repaid during the life timeof the company.

It is temporary capital.Generally it is repaid after aspecific period.

3. Status Share capital is ownershipcapital. A shareholder is theowner of the company.

Debenture capital is borrowed/ loan capital. A debentureholder is creditor of thecompany

4. Voting right Shareholder being ownerenjoys voting rights.Shareholders participate in themanagement of the company.

Debenture holder beingcompany's creditor does nothave any voting right. He cannot participate in themanagement of company.

5. Return oninvestment

Shareholders are paid dividedEquity shareholders receive

Debenture holders are paidinterest at fixed rate. Interest


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dividend at fluctuating ratewhere as preferenceshareholders receive dividedat fixed rate.

is paid even when companyhas no profit.

6. Security Share capital is unsecured

capital. No security is offeredto the shareholder.

Debenture capital being loan

capital is secured by creatinga charge on its property.

7. Time of issue Shares are issued in the initialstage of the company

Debentures can be issued atthe later stage, when thecompany has securities tooffer.

8. Types Shares are classified into two:a) Equity sharesb) Preference shares

Debentures can be issued atthe later stage, when thecompany has securities tooffer.

9. Position onliquidation On liquidation of a companyshareholders rank last in thelist of claimants.

Debenture holders beingcreditors rank prior toshareholders for repaymenton liquidation of company.

10. Suitability Shares are suitable for longterms finance.

Debentures are suitable formedium term finace.

(C) 2. BondsBond is a debt security. The company borrows money and issues bonds as

evidence ofdebt. Bond holder is creditor of the company. The amount of interest is paidort bond. It is a fixed charge and must be paid even profit is not available. All bonds

have maturity date and is paid off in cash at certain date in future. Since they axecreditors and non-owners, they are not entitled to participate in general meeting.

According to Webster Dictionary, 'a bond is an interest bearing certificate issuedby a government or business lira, promising to pay the holder a specific sum at aspecified date.

Thus a bond is a formal contract to repay borrowed money with interest. Interestis payable at fixed interval or on maturity of bond. Bond is a loan. The holder of bond islender of the institution. He gas fixed rate of interest.

Features of Bonds

1. Nature of finance : It is a debt or loan finance. It provides long term finance. Thebondscan. be issued for longer period i.e. 5 years, 10 years and so.on.

2. Status of Investor: The bondholders are creditors. Bond is a kind of security for aloan/debt taken. Bondholder has no right to vote and to participate in the management.
http://can.be/http://can.be/


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3. Return on bonds: The bondholders get a fixed rate of interest. It is payable on thematurity or at regular interval. Interest payable to bondholder is a fixed charge.

4. Repayment: A bond is a formal contract to repay borrowed money. Bonds havespecific maturity date at which time the repayment of principal is due.

Types of Bonds

Bonds continue to be the most important corporate securities. They are of such alarge variety that it is very difficult to arrive at a single classification. There arevariations in terms and conditions, purpose of issue, methods of paying interestand,principal, features etc. There is a lot of overlapping in classification of bonds.Therefore, we shall classify the few of them in simple manner.

Bonds

Based on coupon Based on option Based on Redemption

1. Fixed rate bonds 1. Bond with 1. Single Redemption

2. Floating rate bonds call option 2. Amortising Bonds3. Zero coupon bonds 2. Bonds with4. Deep discount bonds put option5. Inflation - indexed bonds.

(a) Based on coupon / interest

1. Fixed rate bonds: Fixed rate bonds have the coupon that remains constantthroughout the life of the bond.

2. Floating rate bonds: These bonds have variable rate of interest. Interest rates arerecalculated periodically.

3. Zero coupon bonds: No coupons are paid to zero coupon bonds. The bond is issuedat discount. On the maturity these bonds are redeemed at par. The difference betweenacquisition cost of bond and face value of bond is profit to investor.

4. Deep Discount bonds: These bonds are similar to zero interest bonds but have hugediscount and long period of maturity i.e. 25 years and more. These bonds are notentitled to any interest. The difference between cost and maturity value is profit for theinvestor.

5. Inflation - indexed bonds: The principal amount of bond and the interest paymentsare indexed in inflation. The principal amount grows and payment of interest increaseswith the inflation.

(b) Based on option


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1. Bond with call option (Callable bonds) : This feature gives right to issuer, the rightto redeem his issue of bonds before maturity of bonds at the predetermined price anddate.

2. Bond with put option (Puttable Bond): This feature gives bondholder the right to

sell their bonds back to issuer at the pre-determined price and date.

(c) Based on redemption

1. Bonds with single redemption: In this case, principal amount of bond is paid at thetime of maturity only.

2. Amortising Bonds: In this case, payment ismade by borrower on maturity, includesboth interest and principal.

Collect information about various latest bond issued by government and financialinstitutions. Note down the features of bonds.

(D) Public Deposits

Public deposit is an important source of financing short term requirement ofcompany. Companies generally receive public deposits for the period ranging from 6months to 36 months.

Under this method, general public is invited to deposit their savings with thecompany for varied period. Interest is paid by companies on such deposits. The rates ofinterest are higher than those allowed by commercial banks. The company issues'Deposit Receipt' to the depositor. The term of deposit is mentioned in the 'DepositReceipt'. Deposit Receipt is an acknowledgement of debt by the company. Deposits areunsecured loans offered to company. It is considered as risky investment but investorscan earn high return on public deposits.

Companies Act 1956, Section 58-A, provides the power to the centralgovernment to make rules and regulations for controlling public deposits. Governmentof India has made Companies (Acceptance of Deposits) Rule 1975. These rules are asunder

1. Ceiling on deposits :

a) Company can accept public deposits up to the 25% of total paid up capital and freereserves.

b) Company can accept public deposits from existing shareholders and debenture holdersup to 10% of total paid up capital and free reserves.

2. Maturity of Deposits: Company has to accept, deposits from public minimum for 6months and maximum for 36 months.


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3. Interest on deposits: Company can fix rate of interest on deposit money accordingto the regulations of Reserve Bank of India.

4. Register of Deposit: Company should record name, address, deposit money, date,maturity date, rate of interest in `Register of Deposits'.

5. Status of Deposit holder: Deposit holders are creditors of the company.

(E) Loan from financial institutions

First Industrial Policy was declared in 1948 for rapid industrial development inthe country. The Government of India established special financial institutions forproviding industrial finance. There are 12 financial institutions .at.national level and 46at, state level. These institutions provide medium and long term finance. The assistanceof these institutions has become important for new companies as well as goingconcerns.

The following chart will give brief idea about the network of All India FinancialInstitutions. They are classified into four categories as follows

Finance Institutions

Development Financial Investment State levelBanks Institutions Institutions Institutions

1. IDBI 1. RCTC 1. LIC 1. SFC2. IFCI 2. TDICI 2. UTI 2. SIDC3. ICICI 3. TFCI 3. GIC 4. SIDBI

5. IRBI

I. Development Banks1. Industrial Development Bank of India (IDBI)2. Industrial Finance Corporation of India Ltd. (IFCI)3. Industrial Credit and Investment Corporation of India Ltd. (ICICI)4. Small Industries Development Bank of India (SIDBI)5. Industrial Reconstruction Bank of India (IRBI)

II. Financial Institutions

1. Risk capital and Technology Finance, Corporation Ltd. (RCTC)

2. Technology Development and Information Company of India Ltd (TDICI)3. Tourism Finance Corporation of India Ltd. (TFCI)III Investment Institutions

1. Life Insurance Corporation of India (LIC)2. Unit Trust of India (UIT)3. General Insurance Corporation of India (GIC)

IV State level institutions


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1. State Financial corporations (SFC)2. State Industrial Development Corporation (SIDC)

Above mentioned institutions provide assistance in the following forms :-1. To subscribe to shares / debentures

2. To underwrite the issue of securities3. To lend money4. To guarantee term loans raised by company

Importance and need of institutional financing

1. To develop sound capital market: Financial institutions help in developing a soundfinancial capital market. They help in promotion and financing of business enterpriseseither by underwriting issues or by subscribing shares.

2. To mobilize financial resources: Most of the economically backward countries fail

to mobilize financial resources for development of industry. Capital is reluctantlyprovided to new ventures. Financial corporations have become significant for economicbetterment of such countries. They held initial investigation and bear pioneering risk.

3. Capital formation: Under developed countries suffer from shortage of finance due tolow rate of capital formation. The gap between saving and investment is filled by suchfinance corporations. They have taken the position of investors.

4. Planned economy: A special finance corporation plays an important role in plannedeconomic development of country. The projects of national importance are taken up bythese corporations so that scarce finance resources can be utilized at the optimum

level. Certain basic industries can be developed by government through these specialbodies.

5. Financing small business: Special corporations have been established for financingthe small scale industries. The problems related to small business are of specialcharacter. They can be tackled by financial institutions created specially for thispurpose.

6. Foreign exchange need : The shortage of foreign exchange is also one of the factorsfor development of these institutions. These institutions provide long term loans inforeign currencies also. Even first rate companies seek the assistance of these

institutions.

7. Government taxation policy: The interest payable on borrowed fund is a deductiblecharge from profit and loss account, resulting in 'Tax-shield'. Therefore, business unitsare more dependent on debt capital. These finance institutions are the best source ofdebt.


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8. Rate of Interest: These corporations charge uniform rate of interest, irrespective ofamount of loan, in relation to total cost. This has also led to borrow heavily from theseinstitutions.

(F) Loans from commercial banks

Commercial banks play an important role in providing short term finance. Nowbanks have become primary source of financing working capital of businessorganizations. In India, primary source of financing working capital are bank credit andtrade credit.

Bank credit is primary institutional source of finance. The borrower approaches abank to obtain bank credit. For this, he has to submit necessary supporting data. Thebank sanctions amount of credit on the basis of margin requirement. Margin meanspercentage' of value of asset that is offered as security of borrower. The margin is laiddown by RBI. It is changed from time to time as per the requirement of credit policy.

Banks have introduced many innovative schemes for disbursement of credit.Providing loans to business is one of the primary functions of bank. Banks aredepositories of the cash resource of community, a part of it is made available for loans.Banks lend money in different ways -

Types of Bank credit

1. Overdraft :A company having current account with a bank, is allowed overdraftfacility. The borrower can withdraw the funds, as and when needed. He is allowed tooverdraw on his current account, up to the credit limit which is sactioned by the bank.

Within this stipulated limit any number of drawings are permitted. Repayments can bemade whenever required during the time period. The interest is determined on thebasis of actual amount overdrawn.

2. Cash Credit : It is also an important and popular form of financial aid. This form ofcredit is operated in the same manner as overdraft facility. The borrower can withdrawamount from his current account up to a stipulated limit based on security margin. CashCredit is given against pledge or hypothecation of goods or by providing alternativesecurities. Interest is charged on outstanding amount borrowed and not on the creditlimit sanctioned.

3. Cash loans (Loan arrangement): Under this the total amount of loan is credited bybank to the borrower's account. Interest is payable on entire amount sactioned as loan.If the loan is repaid in installments, interest is payable on actual balance outstanding.

(G) Trade creditNo business can be run without 'credit'. It is considered as soul of business.

Trade credit financing is common to all businesses. It is a short term financing tobusiness.


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Manufactures, wholesalers and suppliers of goods or materials are called `Tradecreditors'. They sell tangible goods to other business concerns on the basis of futurepayment i.e. deferred payment. Credit is extended by these business concerns with anintention to increase their sales. These business firms extent credit, also because of the

custom that has been built up over time. Such credit is not cash-loan. It results from asale of goods/services, which have to be paid some time after the sale takes place.

In short, `trade credit' is said to be granted when goods are delivered bysupplier to a customer, in advance of payment.

In distributive trade this kind of credit has great significance. The small retailers,to a large extent rely on obtaining trade credit from their suppliers. It is a cheapmethod of financing. It is the easy kind of credit which can be obtained without signingany debt instrument.

Suppliers sell goods and willingly allow 30 days or more for a bill to be paid.

Even they offer discounts, if bills are cleared within a short period such as 10 days 15days, etc.

There are several advantages attached to Trade Credit. Some of them are asfollows:

1. Trade credit is the cheapest and easiest method of raising short term finance.

2. It does not require any formal and written agreement.

3. It is readily available at any time.

4. It is free of cost source of financing.

5. The terms of credit are not rigid.

Compare trade credit with bank credit and discuss with the teacher.

(H) Discounting of Bill of Exchange :

Discounting of bill is relatively of recent origin in India. Reserve Bank of India hasintroduced `New Bill Market Scheme' in 1970. According to this, bank credit is beingmade available through discounting of bill by banks. In short, under the scheme, RBIhas considered use of bill as an instrument of credit.

Meaning of bill of exchange :

Negotiable Instrument Act 1881, defines,

"A bill of exchange is an instrument in writing containing an unconditional order signedby maker, directing a certain person to pay a certain sum of money only to or to theorder of certain person or to the bearer of instrument."


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The above definition reveals important features of a bill of exchange :1. It is an unconditional order.2. It contains name of person to whom it is payable.3. It specifies amount to be paid.

4. It is in writing.5. It is dated and signed.In brief, the seller gets a definite promise in writing from buyer, for paying the

amount on a specific date. This written promise is known as Bill of Exchange.

What is discounting of bill of exchange?The drawer of the bill (i.e. seller) can receive money from drawee (i.e. buyer) on

the due date or after the due date. Drawer can receive money before the due date bydiscounting the bill with a bank. This is nothing but selling the bill to the bank Drawergets money immediately from bank against the bill. The bank gives money to drawer

less than the face value of the bill. The amount received less is called `discount'. It isthe interest charged by bank. The bank deposits money into the account of drawer. Onthe due date bank collects money from drawee against the bill.

Thus, bills of exchange are trade bills. These written promises are common inbusiness world. They are accepted by banks and cash is advanced against them.

(I) Global Depository Receipt (GDR), and American Depository Receipt (ADR)

Every public company issues shares. These shares are listed and traded onvarious share markets. Companies in India issue shares which are traded on Indian

share markets like BSE ( Bombay Stock Exchange) and NSE (National Stock Exchange)etc.

With adoption of free economic policy and due to globalisation, shares of someof the Indian companies are also listed and traded on foreign stock exchanges likeNYSE ( New York Stock Exchange) or NASDAQ (National Association of SecuritiesDealers Automated Quotation.).

To list shares on stock exchanges, a company has to comply with policies ofthose stock exchanges. These policies are much more different from the policies ofIndian stock exchange. Therefore, those Indian companies which can not list their

shares directly on foreign stock exchange, get listed on these stock exchanges indirectlyusing GDR and ADR.

Indian companies raise equity capital in international market through GDR andADR It is dollar/ Euro denominated instrument traded on stock exchanges of USA andEurope. Company issues shares to an intermediary called `depository.' Bank of New

York, City group etc. act as Foreign Depository Banks. The Depository banks issue GDRsOr ADRs to investors against these shares. Each `Depository Receipt' is having fixed


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number of shares. These `Depository Receipts' are then sold to people of a foreigncountry. The Depository Receipts are listed on the stock exchanges. These DepositoryReceipts are traded like ordinary shares. In simple words, the depository bank storesthe shares on behalf of the receipt-holder.

Both ADR and GDR are depository receipts. They represent a claim on underlying

shares. The only difference is the location where they are traded. If the DepositoryReceipt is traded in U.S.A, it is called `American depository Receipt' (ADR). If theDepository Receipt is traded in a country other than USA, it is called `Global Depositoryreceipt (GDR).'

ADR and GDR are means of investment for NRI (Non-Resident Indians) andforeign nationals, wanting to invest money in India. By purchasing ADR or GDR, they,can invest directly in Indian companies. NRI and foreigners can buy Depository Receiptsusing their regular equity trading account. The companies pay dividend in homecurrency to depositories and depositories convert it into the currency of investor andpays dividend.

List of Indian companies having ADR and GDR

Name of company ADR GDR1. Bajaj Auto Ltd. No Yes2. HDFC Yes Yes3. ICICI Bank Yes Yes4. Infosys Technologies Yes Yes5. ITC No Yes6. L & T No Yes7. MTNL Yes Yes

8.

Hindalco

No

Yes

9. Ranbaxy Laboratories No Yes10. Tata Motors Yes No11. State Bank of India No Yes12. VSNL Yes No13. WIPRO Yes Yes

Advantages

1. GDR and ADR allow investors to invest in foreign companies without worrying aboutforeign trading practices, different laws, accounting rules, etc.

2. They offer voting rights to the holders of Depository Receipts.

3. The other benefits are easier trading and payment of dividend in the native currency.

4. The major benefit of Depository Receipts is that the institutional investors can buythem.

5. Depository Receipts also overcome limits or restrictions on foreign ownership that maybe imposed by the country of issuer.


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6. They eliminate local taxes or transfer taxes that would be due, if the company sharesare bought or sold directly

7. The main benefit to the company is, to increase coverage in new markets, large andmore diverse shareholders base and ability to raise more capital in internationalmarkets.

The exchanges on which GDR is traded are as follows

1. London Stock Exchange

2. Luxin Bourg Stock Exchange

3. NASDAQ, Dubai.

4. Singapore Stock Exchange

5. Hong Kong Stock Exchange.

SUMMARY

Finance may be defined as `study of money management'. It holds the key to allactivities of an organization.

The various sources of finance available can be divided as long term and short termfinance, as well as owned capital and borrowed capital.

There are various methods of raising finance viz shares, debentures, bonds, retainedprofits, public deposits, trade credit, GDR, ADR, etc. Share is a small unit of the sharecapital of a company.

Equity shares do not enjoy preference for dividend and do not have priority for paymentof capital at the time of winding up of company.

Preference shares have prior right to receive fixed rate of dividend and return capital inthe event of winding up of company.

The debt acknowledged by a company by issuing debenture certificate is calleddebenture. Bond is an instrument issued by Government or business firm as anevidence of debt. Retained profit is sum total of accumulated profit which arereinvested in the business. Public deposit is a sort loan accepted by company for short

term period ranging from 6 months to 36 months.

Company can raise loans from banks in the form of overdraft, cash credit, cash loans,etc. Government has set up financial institutions for providing financial aid to companiesetc. Trade credit is a credit extended by manufacturers, suppliersetc. to customers.
http://etc.to/http://etc.to/


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Bill of exchange is a trade bill which is accepted by bank and cash is advanced againstit. ADR and GDR are depository receipts through which Indian companies raise equitycapital in international market.

Key Terms

: Study of money management

: Small unit of share capital.

: Shares other than preference shares.

: Preferential right to receive fixed rate of dividend and return of capital

: Evidence of debt / debt security.

: Debt security.

: Accumulated profit retained by company.

: Unsecured short-term loan.

: Loan sactioned by bank.

: Sale of goods on the basis of deferred payment.

: Trade bill.

: Bank stores the shares on behalf of receipt holder.

EXERCISE

A Select the correct answer from the possible choices given below and rewritethe statements.

1. The .............. is considered as supreme controlling factor in business.a) finance b) material c) machinery

2. A business firm requires long term finance for meeting ............... captial needs.a) working b) fixed c) circulating

3. A ............... is indivisible unit of share capital.a) debenture b) share c) bond

4. A person who purchases. shares of a company is known as ............... of the company.

a) shareholder b) bond holder c) creditor

5. A shareholder is entitled to receive ........... as return on investment.a) dividend b) interest c) discount

6. A company can not exist without ............... shares.a) preference b) bonus c) equity


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7. The ............... shares bear ultimate risk associated with the ownershipa) equity b) preference c) deferred

8. Equity shares are paid dividend at ............... rate.a) fluctuating b) fixed c) high

9. Bonus shares are issued as gift to ............... shareholders.a) equity b) preference c) deferred

10. Preference shares carry dividend at ............... rate.a) fixed b) fluctuating c) lower

11. Accumulated dividend is paid to ............... preference shares.a) redeemable b) cumulative c) convertible

12. The holder of ............... preference shares have right to convert their shares intoequity shares.a) cumulative b) convertible c) redeemable.

13. Retained earnings are ............... source of financing.a) internal b) external c) additional

14. Debentureholders are ............... of the company.a) creditor b) owner c) supplier

15. Debentures are issued to raise .............. capital.a) borrowed b) owned c) internal

16. Debentureholders get fixed rate of ............... as return on their investment.a) interest b) dividend c) discount

17. Debentures are secured through ...............a) agreement b) contract c) Trust Deed

18. Convertible debentures are converted into ............... after a specified period.a) equity shares b) bonds c) deposits

19. The holder of the bond is ............... of the institution.a) owner b) creditor c) secretary

20. Company can accept deposits from public, minimum for .............. months.a) Six b) Nine c) Twelve

21. Company can accept deposits from public, maximum for ............... monthsa) 12 b) 24 c) 36

22. Overdraft facility is allowed to ............... account holder.a) current b) saving c) recurring


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23. Small retailers rely on .............. credit from their suppliers.a) cash b) trade c) bank

24. A Depository receipt traded in ............. is called `American Depository Receipt'.

a) London b) Japan c) USA

25. The main benefit of `Depository Receipt' is ability to raise more capital in ..............market.a) national b) local c) international

Q.1 B Match the pairs.

Group A Group B

a) Equity share capitalb) Debentureholderc) Retained profit

d) Public deposite) Overdraft facility

1) Maximum 5 years2) Owner of the company3) Redeemable capital

4) Permanent capital5) Creditor of the company6) Current Account7) Maximum 3 years8) Capitalisation of profit9) Saving Account10) Distributor of profit

C Write a word or a term or a phrase which can substitute each of the followingstatements .

1. Name the shareholders who participate in the management of company.

2. The value of share which is written on the share certificate and mentioned in theMemorandum of Association.

3. The value of share which is determined by demand and supply forces in the sharemarket.

4. Name the shareholders who are `residual claimants' against the assets and income.

5. Name the shareholders who are real masters of the company.

6. Type of the shares who have preferential right over equity shares in respect of dividendand return of capital.

7. Type of shares which can be redeemed after a certain period of time.

8. The policy of using undistributed profit into business.

9. A bond on which no interest is paid but issued at discount.

10. Name the bond, on which the rate of interest remains constant through out the life ofthe bond.


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11. Money raised by company form public for minimum 6 months to maximum, 3 years.

12. Credit extended by suppliers with an intention to increase their sales.

13. A definite promise in writing from buyer for paying the amount on a specific date.

14. Dollar denominated instrument traded in stock exchange of USA.

15. The `Depository Receipt' traded in the country other than USA.

Distinguish between the following.

1. Equity shares and Preference shares

2. Shares and Debentures

Write notes on.

Features of equity shares

Features of preference sharesTypes of debentures

Public deposits

Retained profits

Types of bank credit

Trade credit

Global Depository Receipt

Need and importance of financial institutions

Discounting of Bill of exchangeQ.4 State, with reasons, whether the following statements are True or False.

Equity shareholders are real owners and controllers of company.

Preference shareholders do not enjoy normal voting rights.

Debentures can be secured with some property of the company.

Retained earning is difficult and costly method of raising capital.

The bond holders are owners of the company.

Public deposit is good source for long term financing.

Providing loan to business is primary function of bank:

Financial institutions do not have any role in financing industrial firms.

Answer in brief.

What is share? State the features of shares.

State the features of debentures.


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What is bond? State various types of bonds.

What are the determinants of retained earnings?

Answer the following questions.

What is equity share ? State the features of equity shares.

Define preference shares. State various types of preference shares.

What is debenture? State features of debentures

Define debenture. State and explain types of debentures.Labels:SOURCES OF BUSINESS FINANCE XII COMMERCE SP NEW SYLLABUS
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Sources of Business Finance Xii Commerce Sp New Syllabus

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