Amity School Of Business Sources of Long Term Finance Module-1

Amity School Of Business 2 Sources of Finance DebtEquity Hybrid instruments Asset Based Financing Term Loans Debentures Equity Shares ADR’s GDR’s Preference Shares Convertible Securities Warrants Leasing Hire- Purchase Installment Factoring/ Forfaiting Internal Accruals FRN’s, FCCB

Amity School Of Business Ordinary Shares Ordinary Shares represent the ownership position in a company The capital represented by ordinary share is called share capital or equity capital 3

Amity School Of Business Ordinary Shares - Capital Authorized share capital: The maximum amount of capital, which a company can raise from shareholders Issued share capital: The portion of authorized share capital which has been offered to shareholders Subscribed share capital: That part of issued share capital that has been accepted by shareholders Paid – up share capital: The amount of subscribed share capital actually paid up by the shareholders. 4

Amity School Of Business Features of Ordinary Shares/ Equity Residual claim on incomeResidual claim on company’s assets in case of liquidation.Right to control: Legal power to elect directors on the boardVoting rightsLimited Liability 5

Amity School Of Business Features of Ordinary Shares/ Equity Pre – emptive rights: Entitles a shareholder to maintain his proportionate share of ownership  Rights issue: New ordinary shares must be first issued to the existing shareholders on a pro rata basis  Involves less cost  Subscription price set much below the current market price  Shareholders who fail to exercise their rights dilute their ownership 6

Amity School Of Business Merits Permanent Capital: No liability to for returning the capital Borrowing base: Increases the company’s borrowing base Dividend payment discretion: Not legally obliged to pay dividends. Demerits Higher cost: Dividends not tax deductible and higher flotation costs Risk: Uncertainty regarding dividend and capital gains; investors demand a high rate of return Earnings dilution: When profits do not increase in proportion to increase in share Ownership dilution 7

Amity School Of Business Preference Shares A hybrid security – it has features of both ordinary shares and debentures Features Prior claims on income and assets over ordinary shares Fixed Dividend: Expressed as a percentage of par value Redemption: Redeemable or perpetual preference shares can be issued 8

Amity School Of Business Features of Preference Shares Cumulative dividends: All past unpaid preference dividend will be paid before ordinary dividends are paid Call Feature: Permits the company to buy back at a stipulated buy – back or call price Participation: May participate in extra ordinary profit earned by the company Voting Rights: Contingent or conditional Convertibility: Can be converted fully/partially into ordinary shares 9

Amity School Of Business Merits of Preference Shares Risk less leverage advantage: Fixed obligationPayment of dividend can be postponed Limited voting rights: control of ordinary shareholders is preserved Fixed dividend 10

Amity School Of Business Demerits of Preference Shares Non – deductibility of dividends; costlier than debentures Commitment to pay dividend: If cumulative, then dividends have to be paid 11

Amity School Of Business Debentures A long term promissory note for raising loan capital Debentures holders are the creditors of the firm Features Interest rate: Fixed; called contractual rate of interest Interest is tax deductible Maturity: Specific period of time Claims on assets and income: Claim on company’s earnings prior to that of shareholders 12

Amity School Of Business Features of Debentures Redemption: can be done through  Sinking fund: cash set aside periodically for retiring debentures  Buy back Provision: Redeem debentures at a specified price before the maturity date Indenture/Debenture trust deed: A legal agreement between the company and debenture trustees Security: Can be secured by a lien on company’s assets; Unsecured debentures not protected by security 13

Amity School Of Business Yield of a Debenture  Current Yield: Ratio of the annual interest payment to debenture’s market price E.g. The current yield of a 14 percent Rs debenture currently selling at Rs. 750 is Annual Interest/ Market Price = 140/750 =0.187 % or 18.7 %  Yield to maturity: Takes into account payments of interest and principal over the life of a debenture; IRR of debenture 14

Amity School Of Business Types of Debentures Non – Convertible debentures: Pure debentures, no conversion Zero – interest/ Deep discount debentures: Issued at a highly discounted price. Fully convertible debentures: Convertible into shares as per the terms of the issue Partially convertible debentures: Has two parts: convertible and non - convertible 15

Amity School Of Business Merits of Debentures Less costly: Investors require lesser ROR; interest payments are tax deductible No ownership dilution Fixed payment of interest Reduced real obligation: Obligation of paying fixed interest and principal declines in real terms during inflation 16

Amity School Of Business Demerits of Debentures Obligatory payments Financial Risk: Increases firm’s leverage Cash outflows: Must be paid on maturity, involving huge cash outflows Restricted Covenants: Debenture indenture may limit company’s flexibility 17

Amity School Of Business Term Loans Term loans represent long – term debt Obtained from banks and other Financial Institutions (FIs) Purpose is mainly to finance capital expenditure Also called “Project Financing” 18

Amity School Of Business Features Maturity: Generally for 6 – 10 years Security: Always secured  The assets acquired using term loans secure them – primary security;  The company’s present and future assets also secure them – secondary/collateral security  Lender may create “fixed charge” (legal mortgage on specific assets) or “floating charge” (general mortgage on all assets) 19

Amity School Of Business Features of Term Loans Direct Negotiation: Private Placement; low cost of raising loan Restrictive covenants  Asset related: Minimum asset base to be maintained; minimum working capital, restriction on creation of further charge on assets  Liability related: Restrains in taking additional debt; reduce its debt/equity 20

Amity School Of Business Features of Term Loans Convertibility: Options of converting loans into equity Repayment Schedule/ loan amortization: Time schedule for payment of interest and principal 21

Amity School Of Business Features of Term Loans  Balloon payments: Repayment of principal in annual/semi-annual installments and payment of interest on the unpaid amount  Capital Recovery: Payment of equal loan installments including both interest and principal payments 22

Amity School Of Business Internal Accruals/ Retained Earnings Consists of Retained Earnings and Depreciation Merits Readily available internally Represent infusion of additional equity without extra cost No Dilution of control 23

Amity School Of Business Demerits Only limited amount can be raised High opportunity cost Easy availability may lead to investment in sub – optimal projects 24

Amity School Of Business Lease Financing Financial or Capital Lease It is an intermediate term to long term non cancelable arrangement. There is a primary lease period. The lessee is responsible for maintenance insurance and taxes but cannot claim depreciation. The lessee usually enjoys the option for renewing the lease for substantially reduced lease rentals. 25

Amity School Of Business Lease Financing Operating Lease The lease term is significantly less than the economic life of the equipment The lessee enjoys the right to terminate the lease at short notice without any penalty Operating know how, insurance and maintenance is provided by lessor 26

Amity School Of Business HIRE PURCHASE The Hiree purchases the asset and gives it on hire to the hirer The hirer pays regular hire purchase installment over a specified period of time. At the end of the last installment the title is transferred from the hiree to the hirer Hirer can claim depreciation. Interest is charged on a flat basis 27

Amity School Of Business Installment Installment sale is a credit sale and the legal ownership of the asset passes immediately to the buyer as soon as the agreement is made between the buyer and the seller The outstanding installments are treated as secured loan As the owner of the asset, the buyer is entitled to depreciation and interest as deductible expenses Except for the timing of the transfer of ownership, installment sale & Hire Purchase are similar in nature 28

Amity School Of Business FACTORING A factor is a financial institution which offers services relating to management and financing of debts arising from credit sales Features of a Factoring Arrangement The factor selects the accounts of the client that would be handled by it, and along with the client, the credit limits applicable The factor assumes responsibility for collecting the debt of accounts handled by it The factor advances money to the client against not yet collected and not yet due debts 29

Amity School Of Business Factoring Factoring can be on a recourse basis (credit risk is borne by the client) and non recourse basis (credit risk is borne by the factor Besides the interest on advances against debt, the factor charges a commission which may be 1 - 2% of the face value of debt factored. 30

Amity School Of Business Forfaiting Forfaiting means selling a bill of exchange at a discount, to a third party the forfaiter, who collects the payment from an overseas customer, assuming the underlying responsibility of exporters and simultaneously providing trade finance for importers by converting a short-term loan to a medium term one Approved by the Reserve Bank of India since1992 Apart from EXIM Bank, all Authorized Dealers can act as intermediaries between the Indian exporter and the overseas Forfaiting agency 31

Amity School Of Business Forfaiting Characteristics: –Credit is extended by the exporter for period ranging between 180 days to 7 years. –Minimum bill size should be US$ 250,000/-.( US$ 500,000/- is preferred) –The payment should be receivable in any major convertible currency. –A guarantee by a bank, usually in importer's country. –The contract can be for either goods or services. 32

Amity School Of Business ADR A negotiable certificate issued by a U.S. bank representing a specific number of shares of a foreign stock traded on a U.S. stock exchange They are bought and sold in the American markets just like regular stocks ADRs are generally listed on the NYSE, AMEX, or Nasdaq. However, some ADRs are not listed on an exchange, but trade on the Over-the-Counter (OTC) market The companies that issue ADRs are registered and regulated by the U. S Securities & Exchange Commission (SEC) 33

Amity School Of Business GDR Global Depository Receipt (GDR) : A certificate issued by international bank, which can be subject of worldwide circulation on capital markets GDR's are emitted by banks, which purchase shares of foreign companies and deposit it on the accounts Global Depository Receipt facilitates trade of shares, especially those from emerging markets. Prices of GDR's are often close to values of related shares 34

Amity School Of Business IDR IDR means any instrument in the form of depository receipt created by the domestic depository in India against the underlying equity shares of the issuing company This has been stipulated in the Companies (Issue of Indian Depository Receipts) Rules,

Amity School Of Business Floating Rate Notes (FRN’s) FRNs are medium- to long-term debt obligations with variable interest rates that are adjusted periodically (typically every one, three, or six months). The interest rate is usually fixed at a specified spread over one of the following specified deposit rates: - London interbank offered rate (LIBOR), - London interbank bid rate (LIBID), or - London interbank mean rate (LIMEAN) (average of LIBOR and LIBID). FRNs may also use short-term obligations of the U.S. government (Treasury bills) to establish their interest rate. Interest is payable at the end of each interest period. 36

Amity School Of Business Foreign Currency Convertible Bond - FCCB A type of convertible bond issued in a currency different than the issuer's domestic currency. In other words, the money being raised by the issuing company is in the form of a foreign currency A convertible bond is a mix between a debt and equity instrument It acts like a bond by making regular coupon and principal payments, but these bonds also give the bondholder the option to convert the bond into stock 37

Amity School Of Business Warrants A warrant entitles the purchaser to buy a fixed number of ordinary shares at a particular price during a specified period Warrants are generally issued along with debentures as “sweeteners” (to improve the marketability of the issue) May also be used in conjunction with ordinary or preference shares 38

Amity School Of Business Warrants Exercise Price of a warrant is the price at which its holder can purchase the issuing firm’s ordinary shares Exercise ratio states the number of ordinary shares that can be purchased at the exercise price per warrant Expiration date is the date when the option to buy ordinary shares in exchange rate for warrant expire A warrant can be sold separately from the security to which it was originally attached 39

Amity School Of Business Convertible Debentures A convertible debenture is a debenture that can be changed into a specified number of ordinary shares at the option of the owner The most notable feature of this debenture is that it promises a fixed income associated with debenture as well as chance of capital gains associated with equity share after the owner has exercised his conversion option 40