lec.7 sources of finance

8/13/2019 Lec.7 Sources of Finance

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Long Term Sources of Finance


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FORMS OF BUSINESS OWNERSHIP

Sole proprietorship

Decision-making issimple

Can be set up easily &inexpensively

The owner receives allincome from business.

Income is taxed at onlyone level (that of theowner).

Subject to few

regulationsUnlimited liability.

Limited life of theproprietorship

The business has limitedaccess to additional

funds.

The general partners aredecision-makers.

The owners (the partners)divide income according topartnership agreement.

Income is taxed once.

Set up with ease

Few government regulations

Unlimited liability for eachpartner.

A limited life of partnership.

Limited access to additionalfunds.

The separation of ownershipand decision-making.

Distinct legal entity

Limited liabilityThe business enterprise has alife in perpetuity

Access to additional fundsthrough the sale of new shareof stock.

Income is distributedaccording to proportionateownership.

Double taxation on income

Regulated by Companies Act

Partnership Corporation


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Corporation

Private Company Public Company

Minimum 2 persons

Maximum Shareholders 50

Public subscription not allowed

Restricted rights to transfer shares

Promoters enjoy unchallenged

control over the firm

Firms ability to raise capital islimited

Minimum 7 persons

Unlimited Shareholders

Public subscription allowedFree transfer of shares

Firm can raise substantial fundsCumbersome procedure for

Formation


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Public Company is the most appropriate

form of organisation as

Limited liability

Enormous growth potential

Free and easy transferability of shares


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Limited Liability Partnership

Limited Liability Partnership form of business has

been introduced in India in Dec 2008

Limited liability of partners.

This form is suitable for small and medium

enterprises, service providers, doctors, CAs,

lawyers etc. to limit liability and yet have theflexibility of a partnership structure.


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Features- Liability of the partners would be limited to the agreed contribution of

partners.

Partners would not be liable for independent and unauthorized actionsof other partners.

Name of an LLP must end with the words LLP

LLPs can have individual, body corporates, including other LLPs,foreign LLPs and Indian as well as foreign companies as partners

No upper limit on maximum number of partners.

The mutual rights and duties of partners shall be governed by anagreement between the partners.



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LLP will have perpetual succession. The rights of a partner to share the profits

and losses are transferable.

LLP will maintain annual accounts LLP will not be subject to Company Law

Other entities such as firms, companies etc.

can convert to LLP.



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Sources of long term finance

Retained Earnings

Equity Capital

Debenture Capital

Preference Capital

Term Loans


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Retained Earnings

Retained earnings are profit after tax and

dividend.

Internal Source of Finance


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From Companys point of view

Advantages

Readily available

No additional expenses to raise

No dilution of control

Disadvantages

Limited Fund Opportunity cost is high. Because, it represents the

dividends foregone by the shareholders.


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Shareholders Point of view

Advantages

Convenient as no hassle of reinvesting.

Disadvantages

Lower dividend


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Equity Capital

Represents ownership capital

Enjoys the rewards and bear the risks

Some Terms

Authorized capital is the amount of capital that acompany can potentially issue, as per its memorandum.

The amount offered by the company to the investors iscalled the Issued Capital.

The part of issued capital which has been subscribed toby the investors represents the Subscribed Capital.

The actual amount paid up by the investors is called thePaid-up Capital.


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Equity Capital

Authorised Capital Say: 10,00,000 Equity

Shares of Rs.10 each

Issued capital Say :5,00,000 EquityShares of Rs.10 each

Subscribed Capital Say :4,00,000 EquityShares of Rs.10 each

Paid up Capital Say :4,00,000 EquityShares of Rs.5 each


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Par Value

Face value of the share

The stated value on a stock certificate is called the par value.The par of equity shares is generally Rs. 10, or Rs. 100.

Issue Price

The issue price is the price at which the equity share isissued.

Generally par and issue price are same for new companies

When issue price exceeds the par value, the difference is

referred as share premium

Market Price is the price at which the share is traded in the

stock market


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Contributed SurplusUsually refers toamounts of directly contributed equity capital in

excess of the par value

For example, suppose 1,000 shares of common stock

having a par value of Rs.1 each are sold to investors for

Rs. 8 per share. The contributed surplus would be

(81) 1,000 = Rs. 7,000


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Rights and position of equity

Shareholders

Right to Control

Elect the board

Lack effective control

Right to Income = Profit After Tax

Income of the shareholder is called Dividend

as recommended by the Board

unchallengeable


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Pre-emptive right on pro rata basis: pre-emptiverights is the right of existing shareholders toacquire newly issued shares issued by a companyin a right issues, a usually but not always publicofferings. Also called subscription privilege orsubscription rights.

Right in liquidation

Residual claim over assets of the firm


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Pradhan enterprises has 1,000,000 outstanding equityshares with a par value of Rs.10 and a market value of

Rs.20 .The firm plans to issue 500,000 additional equity

shares at a price of Rs.12 per share .The market value per

share after this issue is expected to drop to Rs.17.33. Now

if a shareholder has 100 shares, his financial situation with

respect to Pradhans equity when he exercises the

preemptive rights and when he does not exercise the

preemptive rights would be as shown below:


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Takes Pre-emptive Rights

Value of initial

holding( 20 * 100) = 2000

Additional Subscription

(12 * 50) = 600

Value of equity holdingafter the additional

Issue (17.33 * 150) = 2600

No Pre-emptive Rights

Value of initial

holding( 20 * 100 = 2000

Additional Subscription = 0

Value of equity holdingafter the additional

Issue (17.33 * 100) =1733

Expected Price = 100*20 + 50*12 = 17.33

150


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EvaluationCompanys point of view

Positives

Permanent Capital- no liability for repayment

Dividend Non obligatory

Enhances Creditworthiness

Negatives

Investors expect High rate of return/ high cost of capital

Issue cost quite high Underwriting commission, brokerage costs, publicity cost etc

Dilution of control


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Shareholders point of view

Positives

Limited liability

High rewards

Equity dividend exempted from tax

Negatives

No say in Dividend matters

Residual claim to income & assets

Risky investment- wide fluctuations in price

lec.7 sources of finance

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