LONG TERM SOURCES OF CAPITAL

Long term finance refers to finance of permanent nature or that which is payable over a long

period of time. The most common sources of long term capital are issue of shared, long term

debt and leasing.

External Sources of Long-term Capital

1. Ordinary share capital

Ordinary shares represent the ownership position in a company. The owners of ordinary shares

are called shareholders and are the legal owners of the company. Ordinary shares are the source

of permanent capital since they do not have a maturity date. For the capital contributed by

shareholders by purchasing ordinary shares, they are entitled to dividends. The amount of rate of

divided is not fixed; the company’s board of directors decides on it.

Being the owners of the company, the shareholders bear the risk of ownership; they are entitled

to dividends after the income claims of others have been satisfied. Similarly, when the company

is wound up, they can exercise their claims on assets after the claims of other suppliers of capital

have been met.

Pubic issue is the issue of shares to the public. Here the shares are usually underwritten, that is, a

financial institution guarantees, at a fee, to buy the shares if the issue is not fully subscribed.

Private placement is where the shares of the company are sold to few selected investors.

Features of ordinary shares

1. Claim on income – Ordinary shareholders have a claim to the residual income, which, is,

earnings available for ordinary shareholders, after paying expenses, interest charges,

taxes and preference dividend, if any. This income may be split into dividends and

retained earnings. Dividends are immediate cash flows to shareholders while retained

earnings are reinvested n the business.

2. Claim on assets – Ordinary shareholders have a residual claim on the company’s assets in

the case of liquidation. Our of the realised value of assets, first the claims of debt-holders

and then preference shareholders are satisfied, and the remaining balance, if any, is paid

to ordinary shareholders.

3. Right to control – Ordinary shareholders have the legal power to elect directors and are

able to control the management of the company through their voting rights and right to

maintain proportionate ownership.

4. Voting rights – Ordinary shareholders are required to vote on a number of issues such as

elections directors. The votes are equal to the number of shares held by him. Shareholders

may vote in person or by proxy.

5. Pre-emptive rights – The pre-emptive right entitles a shareholder to maintain his

proportionate share of ownership in the company. The law grants shareholders the right

to purchase new shares in the same proportion as their current ownership. The

shareholders’ option to purchase a stated number of new shares at a specified price during

a given period is called rights. These rights can be exercised at a subscription price,

which is generally much below the share’s current market price, or they can be allowed to

expire, or they can be sold in the stock market.

6. Limited liability – Ordinary shareholders are the true owners of the company, but their

liability is limited to the amount of their investment in shares. If a shareholder has already

fully paid the issue price of shares purchased, he has nothing more to contribute in the

event of a financial distress or liquidation.

Advantages of Equity Capital

1. Permanent capital – Since ordinary shares are not redeemable the company has no liability

for cash outflow associated with its redemption. It is a permanent capital, and is available

for use as long as the company exists.

2. Borrowing base – The equity capital increases the company’s financial base, and thus its

borrowing limit. Lenders generally led in proportion to the company’s equity capital. By

issuing ordinary share, the company increases its financial capability.

3. Company is not legally obliged to pay dividend. In times of financial difficulties, it can

reduce or spend payment of dividend. Thus, it can avoid cash outflow associated with

ordinary shares.

Disadvantages of Equity capital

1. Flotation costs – Share have higher costs since dividends are not tax deductible as are

interest payments. Also, flotation costs on ordinary shares are higher than those on debt.

2. Risk –Ordinary shares are riskier form an investor’s point of view as there is uncertainty

regarding dividend and capital gains. Therefore, they require a relatively higher cost

source of finance.

3. Earnings dilution – The issue of new ordinary shares dilutes the existing shareholders’

earnings per share if the profits do not increase immediately in proportion to the increase

in the number of ordinary shares.

4. Ownership dilution – The issuance of new ordinary shares many dilute the ownership and

control of the existing shareholders. While the shareholder has a pre-emptive right to

retain their proportionate ownership, they may not have funds to invest in additional

shares. Dilution of ownership assumes great significance in the case of closely held

companies.

2. Preference Share Capital

Preference shares have the following features:

1. Claims on income and assets – Preference shareholders have a prior claim on the

company’s income in the sense that the company must first pay preference dividends

before paying ordinary dividend. They also have prior claim on the company’s assets in

the event of liquidation. Preference share is less risky than ordinary shares. Preference

shareholders generally do not have voting rights and they cannot participate in

extraordinary profits earned by the company.

2. Fixed dividend – The dividend rate is fixed and is not tax deductible. The preference

dividend rate is expressed as the percentage of the par value.

3. Cumulative dividends – All past unpaid preference dividend are to be paid before any

ordinary dividends are paid. Preference shareholders do not have power to force company

to pay dividends, thus the cumulative feature is necessary to protect their rights.

4. Redemption – Redeemable preferential shares are redeemable at the maturity date.

5. Sinking fund – A sinking fund provision may be created to redeem preference shares.

The money set aside for this purpose may be used either to purchase preference share in

the open market or to buy back the preference share.

6. Call feature – The call feature permits the company to buy back preference shares at a

stipulated buy-back or call price. The call price may be higher than the par value. The

difference between the call price and par value of the preference share is called call

premium.

7. Participation feature – Preferential shares may in some cases be entitled to participate in

extra-ordinary profit earned by the company.

8. Voting rights – Preference shareholders ordinarily do not have any voting rights. They

may be entitled to contingent or conditional voting rights.

9. Convertibility – Preference shares may be convertible or non-convertible. A convertible

preference share allows preference shareholders to convert their preference shares, fully

or partly into ordinary shares or debentures at a specified price during a given period of

time.

Advantages of Preference Shares

1. Riskless leverage advantage – Preference share provides financial leverage advantages

since preference dividend is a fixed obligation. This advantage occurs without a serious

risk of default. The non-payment of preference dividends does not force the company into

insolvency.

2. Dividend postponability – Preference share provides some financial flexibility to the

company since it can postpone payment of dividend.

3. Fixed dividend – The preference dividend payments are restricted to the stated amount.

Thus preference shareholder does not participate in excess profits as do the ordinary

shareholders.

4. Limited voting rights – Preference shareholders do not have voting rights except in case

dividend arrears exist. Thus the control of ordinary shareholders is preserved.

Disadvantages of Preference Shares

5. Non-deductibility of dividends – Preference dividend is not tax deductible. Thus it is

costlier than debenture.

6. Commitment to pay dividend – Non-payment of preference dividends can adversely

affect the image of a company, since equity holders cannot be paid any dividends unless

preference shareholders are paid dividends.

3. Debentures

A debenture is a long-term promissory note for raising loan capital. The firm promises to pay

interest and principal as stipulated. Debentures can be convertible or non- convertible.

Convertible debenture is one which can be converted, fully or partly, into shares after a specified

period of time.

Debentures are usually issued to a large number of investors, who hold debenture certificates

entitling them to claim of annual fixed interest and return of capital on maturity.

Features of debentures

1. Interest rate – The interest rate on a debenture is fixed and known. Payment of interest is

legally binding on a company. Debenture interest is tax deductible.

2. Maturity – Debentures are issued for a specific period of time. The maturity of the

debenture indicates the length of time until the company redeems the par value to

debenture-holders and terminates the debentures.

3. Redemption – Debentures are generally redeemed on maturity, and this can be

accomplished either through a sinking fund or buy-back (call) provision. The call price

may be more than the par value of the debenture.

4. Indenture – An indenture or debenture trust deed is a legal agreement between the

company issuing debentures and the debenture trustee (usually a bank or insurance

company) who represents the debenture holders. It is the responsibility of the trustee to

protect the interests of debenture holders by ensuring that the company fulfils the

contractual obligations.

5. Security – Debentures are either secured or unsecured. A secured debenture is secured

by a lien on the company’s specific assets. If the company defaults, the trustee can seize

the security on behalf of the debenture holders.

6. Yield – The yield on a debenture is related to its market price. The current yield on a

debenture is the ratio of the annual interest payment to the debenture’s market price. The

yield to maturity takes into account the payment of interest and principal over the life of

the debenture. This is the internal rate of return of the debenture.

7. Claims on assets and income – Debenture holders have a claim on the company’s

earnings prior to that of the shareholders. Debentures interest has to be paid before

paying any dividends to preference and ordinary shareholders. Defaulting on interest

payment may lead to bankruptcy.

Advantages of Debentures

1. Less costly – It involves less cost to the firm than the equity financing because investors

consider debentures as a relatively less risky investment alternative and therefore, require

a lower rate of return. Also, interest payments are tax deductible.

2. No ownership dilution – Debenture holders do not have voting rights, therefore,

debenture issue does not cause dilution of ownership.

3. Fixed payment of interest - Debenture holders do not participate in extra-ordinary profits

of the company. Thus the payments are limited to interest.

4. Reduced real obligation – During periods of high inflation, debenture issue benefits the

company. Its obligation of paying interest and principal which are fixed decline in real

terms.

Disadvantages of debentures

1. Obligatory payments – Debenture results in legal obligations of paying interest and

principal, which, if not paid, can force the company into liquidation.

2. Financial risk - It increases the firm’s financial leverage which may be particularly

disadvantageous to those firms which have fluctuating sales and earnings.

3. Cash outflows – Debentures must be paid on maturity and therefore, at some point, it

involves substantial cash outflows.

4. Restricted covenant – Debenture indenture may contain restrictive covenants which may

limit the company’s operating flexibility in future.

4. Term Loans

Term loans are obtained directly from banks and are mostly used to finance projects.

Features of term loans

1. Maturity – Term loans have a maturity for a period of 6 to 10 years. In some cases a

grace period of 1 to 2 years is granted, during with the company does not make any

payment.

2. Direct negotiation – A firm negotiates for the loan directly with the bank. Thus the costs

are lower than a public issue of debentures, where there are underwriting and flotation

costs.

3. Security – Term loans are secured by the company’s current and future assets. Also, the

lender may create wither fixed or floating charge against the firm’s assets.

4. Restrictive covenants – A financially weak fir attracts stringent terms of loan from

lenders. The borrowing firm has generally to keep the lender informed by furnishing

financial statements and other information periodically.

5. Convertibility – Term loans may have the option of being converted into equity.

Internal Sources of Long – term Capital

1. Retained Earnings

This is where the funds for the business are retained. This happens under the following

conditions:

1. When the external capital is difficult to obtain and/or carries high cost of capital. External

capital may be scarce due to general credit restraint in the money market or because the

business financial position does not allow more room for employing external funds.

2. Where the rate of income tax on shareholder dividends is very high.

3. When a company can earn a relatively higher return on its investments than the rate

shareholders can obtain from any other investment elsewhere.

4. When a firm’s share prices are temporarily depressed and/or high inflation rates have

increased interest rates in the debt market.

Advantages of Retained Earnings

1. No issue costs and hence it allows the firm use of a cheaper source of finance

2. Retention preserves the funds of the business and does not give rise to a drain on cash

funds of the business as not dividends will be declared.

3. Increases financing (capital structure) flexibility by providing a larger equity base which

can be used to raise more debt capital i.e. increases a firm’s borrowing capacity.

Disadvantages of Retained Earnings

1. Too much retention may lead to depressed share prices where low dividend payout is

understood by shareholders to convey unfavourable information.

2. It may hurt income flow to investors or shareholder whose primary objective of

investment is the realisation of income through dividends.

2. Depreciation of Fixed Assets

Depreciation is merely an allocation of cost of fixed assets to each accounting year; no funds are

necessarily set aside for the replacement of fixed asset. In this sense it is part of retained profits

in the same way that retained profits is. Furthermore, where the accounting depreciation is an

allowed expense for tax purposes, it reduces the amount of taxable profit and reduces tax payable

by the firm.

3. Leasing Financing

Equipment leasing is a term used to denote a contract that enables a user (the lessee) to secure

the use of a tangible asset over a specified period of time by making periodic payment to the

owner (the lessor). Usually, the contract specifies the details of the payment, the disposition of

income, tax benefits. There a provisions for maintenance, renewal options and other clauses.

Leases can be broadly categorized into two types:

Operating Leases (service lease)

These are short term; usually the period involved is only a fraction of the economic life of the

asset. The asset is not fully amortized over the term of the lease. They usually contain a

provision for service and maintenance i.e. the lessor provides maintenance services. They also

contain a cancellation clause that permits the lessee or the lessor to break the lease.

Financial leases (capital leases)

These are “full pay out net leases” i.e. The cost of the asset and the return to the lessor are

amortised over the term of the lease. The lessee is responsible of maintenance, service, taxes,

insurance, and other expense that arise in connection with the use of the asset. It is similar to a

bond in that it represents a non-cancellable financial obligation. The lessee may have the option

to purchase the asset at the end of the lease period.

Sale and lease back is a special type of financial lease where the firm sells its own equipment to

an investor and simultaneously enters into a lease agreement to use that property. The proceeds

from the sale provide working capital and the firm still has the use of the asset.

Leveraged lease is a type of financial lease it involves three parties: a lessee, a lessor (equity

participant) and a long term lender (debt participant). The equity participant may provide only

10% of the funds. The remaining 90% is provided by the debt participant on a non-recourse basis

to the equity participant. Thus, the repayment to the lender comes solely from the lease payment

and from the security of their lien on the leased asset. The equity participant has no financial

obligation to the debt participant if the lessee defaults on the lease agreement.

The equity participant receives 100% of the tax benefit which included an investment tax credit

and depreciation of the asset. The equity participant is frequently willing to charge the lessee a

lower effective interest rate than would have been the case in a direct lease. If the lessee is in a

negative income position (i.e. making losses) and cannot take advantage of tax, he would benefit

by trading the tax benefits that he would lose any way for a lower interest rate on the lease (i.e.

lower lease payments.

Advantages of Leasing

1. Convenience and flexibility – It is financially convenient to lease an asset that will be

needed for a short period of time. Also, companies that cannot raise funds from banks can

obtain assets. Also financial leases are less restrictive and can be negotiated faster. The

lease payments can be tailored to the lessee’s cash flows.

2. Shifting of risk of obsolescence – Where an asset is susceptible to unpredictable

technological changes e.g. computers, a lessee can, through short-term cancellable lease,

shift the risk of obsolescence to the lessor.

3. Maintenance and specialized services – With a full-service lease, a lessee can look for

advantages in maintenance and specialized services.

4. Hire Purchase Financing

In hire purchase financing, there are three parties: the manufacturer, the hiree and the hirer. The

hiree may be a manufacturer for a finance company. The manufacturer sells the asset to the hiree

who sells it to the hirer in exchange for the payment to be made over a specified period of time.

A hire purchase agreement between the hirer and the hiree involves the following three

conditions:

-The owner of the asset (the hiree or the manufacturer) gives the possession of the asset to the

hire with an understanding that the hirer will pay agreed instalments over a specified period of

time.

-The ownership of the asset will transfer to the hirer on the payment of all instalments.

-The hirer will have the option of terminating the agreement any time before the transfer of

ownership of the asset.

Thus, for the hirer, the hire purchase agreement is like a cancellable lease with a right to buy the

asset. The hirer is required to show the hired asset on his balance sheet and is entitled to claim

depreciation, although he does not own the asset until full payment has been made. The payment

is both the interest charges and repayment of principle. The hirer, thus, gets tax relief in interest

paid and not the entire payment.

SHORT – TERM SOURCES OF FINANCE

These are funds available for a period of one year or less. They mostly finance working capital.

1. Trade Credit

Trade credit refers to the credit that a customer gets form suppliers of goods in the normal course

of business. It is mostly an informal arrangement and is granted on an open account basis (as

sundry creditors), since the buyer agrees to pay the amount due as per sales terms in the invoice,

but does not formally acknowledge it as a debt. The buyer is required to repay the credit on

credit terms or conditions such as the due date, and cash discount in case of prompt payment

Trade credit may also take the form of bills payable. When the buyer signs a bill – a negotiable

instrument – to obtain trade credit, it appears on the buyer’s balance sheet as bills payable. The

bill has a specified future date. A promissory note is a formal acknowledgement of an obligation

with a promise to pay on a specified date and they appear as notes payable in the buyer’s

balance.

Advantages of trade credit

1. Easy availability – Trade credit is relatively easily to obtain. This availability is

particularly important to small firms which generally face difficulty in raising funds from

the capital markets.

2. Flexibility – Trade credit grows with the growth of the firm.

3. Informality – Trade credit is an informal, spontaneous source of finance. It does not

require any negotiations and formal agreement. It does not have restrictions

Disadvantages of trade credit

1. The cost of credit may be transferred to the buyer via the increased price of goods

supplied.

2. The supplier incurs costs in the form of the opportunity cost of funds invested in accounts

receivable and cost of any cash discount taken by the buyer. These costs are hidden to

unknowing businessmen.

3. Impairment of a firm’s credit standing as the liquidity ratio is lowered by use of too much

credit. When payments on creditors are not made within credit periods, it may affect

business relations with the suppliers’ thereby hurting the smooth operations of the

business.

2. Accrued Expenses and Deferred Income

Accrued expenses represent a liability that a firm has to pay for the services which it has already

received. They represent an interest-free source of financing.

Deferred income represents funds received by the firm for goods and services which it has

agreed to supply in future.

3. Bank Finance

A firm can draw funds from its bank within the maximum credit limit sanctioned. It can draw

funds in the following forms:

a) Overdraft – Here the borrower is allowed to withdraw funds in excess of the balance in

his current account up to certain specified limit during a stipulated period. Though the

overdrawn amount is repayable on demand, they generally continue for a long period by

annual renewals for the limits.

b) Cash credit – This is similar to the overdraft arrangement. The borrower is allowed to

withdraw fund from the bank up to the sanctioned limit. Cash credit limits are sanctioned

against the security of current assets.

c) Discounting of bills – Here a borrower can obtain credit from a bank against its bills.

d) Letters of credit – Here, a bank opens a letter of credit in favour of a customer to

facilitate the purchase of goods. If the customer does not pay to the supplier with the

credit period, the bank makes the payment under the letter of credit arrangement. This

arrangement passes the risk of the supplier to the bank.

Banks generally require security for finance in form of hypothecation, mortgage or lien

4. Commercial Paper

This is a money market instrument used by blue-chip companies which are financially sound.

The buyers of commercial papers included banks, insurance companies, unit trust and firms with

surplus funds to invest for a short period with minimum of risk.

Advantages of commercial paper

1. It is an alternative source of raising short-term finance, and proves to be handy during

periods of tight bank credit.

2. It is cheaper source of finance in comparison to the bank credit. Usually, interest yield on

commercial paper is less than the prime rate of interest.

Disadvantages of commercial paper

1. It is an impersonal method of financing. If a firm is unable to redeem its paper due to

financial difficulties, it may not be possible for it to get the maturity of paper extended.

2. It is always available to the financial sound and highest rated companies. A firm facing

temporary liquidity problems may not be able to raise funds by issuing new paper.

3. The amount of loanable funds available in the commercial paper market is limited to the

amount of excess liquidity of the various purchasers of commercial paper.

4. It cannot be redeemed until maturity. Thus if a firm doesn’t need the funds any more, it

cannot repay it until maturity and will have to incur interest costs.