Download - Sources Of Long Term Finance
SOURCESSOURCES OF LONG TERM OF LONG TERM FINANCEFINANCE
Need for long term FinanceNeed for long term Finance
Long term vs. short term(working Long term vs. short term(working capital) funds requirementscapital) funds requirements
For modernisation, expansion, For modernisation, expansion, diversification; huge quantities reqd., diversification; huge quantities reqd., irreversible decisionirreversible decision
Asset-liability mismatch, interest rate Asset-liability mismatch, interest rate risk, liquidity risk, if LT reqts.met by risk, liquidity risk, if LT reqts.met by ST fundsST funds
Equity CapitalEquity Capital
Authorised, Issued, Subscribed and Paid up Authorised, Issued, Subscribed and Paid up capitalcapital
Par/face value, Issue Price, Book value and Par/face value, Issue Price, Book value and Market ValueMarket Value
Rights of equity shareholdersRights of equity shareholders--Right to IncomeRight to Income :PAT less preferred dividends :PAT less preferred dividends--Right to ControlRight to Control: voting rights: voting rights--Pre-emptive RightPre-emptive Right: for additional issues, : for additional issues, rights issue in the same proportionrights issue in the same proportion--Right in liquidationRight in liquidation: residual claim over : residual claim over assetsassets
Pros and cons of equity Pros and cons of equity CapitalCapital
AdvantagesAdvantages No fixed maturity, No fixed maturity,
no obligation to no obligation to redeemredeem
No compulsion to No compulsion to pay dividendspay dividends
Provides leverage Provides leverage capacitycapacity
Dividends tax Dividends tax exempt for investorsexempt for investors
DisadvantagesDisadvantages Dilution of control of Dilution of control of
existing ownersexisting owners High Cost: rate of return High Cost: rate of return
expected by equityholders expected by equityholders higher than debtholdershigher than debtholders
Dividends are not tax Dividends are not tax deductible: hence cost is deductible: hence cost is higherhigher
Issue costs higher: Issue costs higher: underwriting, brokerage, underwriting, brokerage, other issue expensesother issue expenses
Higher servicing costs: Higher servicing costs: hold AGMs, post annual hold AGMs, post annual reports etc.reports etc.
Internal AccrualsInternal Accruals
ProsPros Readily available, no Readily available, no
talking to outsiderstalking to outsiders Effectively additional Effectively additional
equity capital, however equity capital, however no issue costs of loss no issue costs of loss due to underpricingdue to underpricing
No dilution of controlNo dilution of control No expansion in equity No expansion in equity
base, hence no dilution base, hence no dilution of EPS, BV per share of EPS, BV per share etc.etc.
ConsCons Quantum very limitedQuantum very limited High Opportunity High Opportunity
costs: dividends costs: dividends forgone by equity forgone by equity holdersholders
Requires careful Requires careful attention to NPV of attention to NPV of projectsprojects
Consists of retained earnings and depreciation charges
Preference CapitalPreference Capital
Is a hybrid form of financingIs a hybrid form of financing, payment after debt but before , payment after debt but before equityequity
Equity featuresEquity features: : -out of distributable profits-out of distributable profits -not an obligatory payment-not an obligatory payment-dividends not tax deductible-dividends not tax deductible Debt featuresDebt features: : -dividend rate is fixed-dividend rate is fixed-capital is redeemable-capital is redeemable-normally no right to vote-normally no right to vote Can have other featuresCan have other features like cumulative, convertible, like cumulative, convertible,
participating…..participating…..
Preference CapitalPreference Capital
ProsPros No obligation to pay No obligation to pay
dividend, no bankruptcy or dividend, no bankruptcy or legal action for non paymentlegal action for non payment
Financial distress of Financial distress of redemption obligation not redemption obligation not very highvery high
Part of net worth, hence Part of net worth, hence increases its increases its creditworthiness/ leverage creditworthiness/ leverage capacitycapacity
No dilution of controlNo dilution of control No pledging of assets No pledging of assets
requiredrequired
ConsCons Expensive source since Expensive source since
dividends not tax dividends not tax deductibledeductible
Though no legal Though no legal consequences, liability to consequences, liability to pay dividends stands, can pay dividends stands, can spoil company’s imagespoil company’s image
Can acquire voting rights Can acquire voting rights in some casesin some cases
Have claim prior to equity Have claim prior to equity holdersholders
Term LoansTerm Loans
Provided byProvided by FIs/banks FIs/banks Can be in domestic/foreign currencyCan be in domestic/foreign currency, liability on FC , liability on FC
loans translated to rupees for paymentloans translated to rupees for payment Are typically securedAre typically secured against fixed assets/ against fixed assets/
hypothecation of movable properties, prime security/ hypothecation of movable properties, prime security/ collateral securitycollateral security
Definite obligationsDefinite obligations on interest and principal on interest and principal repayment; interest paid periodically; based on credit repayment; interest paid periodically; based on credit risk and pegged to a floor raterisk and pegged to a floor rate
Carry restrictive covenantsCarry restrictive covenants for future financial and for future financial and operational decisions of the company, its management, operational decisions of the company, its management, future fund raising, projects, periodic reports called forfuture fund raising, projects, periodic reports called for
Term LoansTerm Loans
ProsPros Interest on debt is tax Interest on debt is tax
deductibledeductible Does not result in dilution Does not result in dilution
of controlof control Do not partake in value Do not partake in value
created by the firmcreated by the firm Issue costs of debt is lowerIssue costs of debt is lower Interest cost is normally Interest cost is normally
fixed, protection against fixed, protection against high unexpected inflationhigh unexpected inflation
Has a disciplining effect on Has a disciplining effect on management management
ConsCons Entails fixed obligation for Entails fixed obligation for
interest and principal, non interest and principal, non payment can even lead to payment can even lead to bankruptcy/ legal actionbankruptcy/ legal action
Debt contracts impose Debt contracts impose restrictions on firm’s restrictions on firm’s financial and operational financial and operational flexibilityflexibility
Increases financial Increases financial leverage, excess raises leverage, excess raises cost of equity to the firmcost of equity to the firm
If inflation rate dips, cost of If inflation rate dips, cost of debt higher than expected debt higher than expected
DebenturesDebentures
Like promissory notesLike promissory notes, are instruments for raising LT debt, are instruments for raising LT debt More flexibleMore flexible compared to term loans as they offer variety of compared to term loans as they offer variety of
choices as regards maturity, interest rate, security, repayment and choices as regards maturity, interest rate, security, repayment and other special featuresother special features
Interest rateInterest rate can be fixed/floating/deep discount can be fixed/floating/deep discount Convertibility :Convertibility : Can be FCDs, NCDs, PCDs Can be FCDs, NCDs, PCDs Warrants :Warrants : Can have warrants attached, detachable or non Can have warrants attached, detachable or non
detachable, detachable traded separatelydetachable, detachable traded separately Option :Option : Can be with call or put option Can be with call or put option Redemption:Redemption: Bullet payment or redeemed in instalments Bullet payment or redeemed in instalments Security:Security: Secured or unsecured Secured or unsecured Credit ratingCredit rating: Need to have a credit rating by a credit rating agency: Need to have a credit rating by a credit rating agency Trustee:Trustee: Need to appoint a trustee to ensure fulfilment of Need to appoint a trustee to ensure fulfilment of
contractual obligations by companycontractual obligations by company DRRDRR: Company needs to create a DRR if maturity more than 18 : Company needs to create a DRR if maturity more than 18
monthsmonths
Other forms of FinanceOther forms of Finance
Leasing:Leasing: asset leased out in lieu of lease rentals, title not asset leased out in lieu of lease rentals, title not transferred, only economic use of assets given; can be financial transferred, only economic use of assets given; can be financial lease or operating (service) leaselease or operating (service) lease
Hire PurchaseHire Purchase: ownership transferred to the buyer after all the : ownership transferred to the buyer after all the installments paid upinstallments paid up
Securitisation:Securitisation: assets involving financial claims pooled and assets involving financial claims pooled and financial instruments created, thus creating cash out of financial instruments created, thus creating cash out of receivablesreceivables
Government SubsidiesGovernment Subsidies: central and state govts offer cash : central and state govts offer cash subsidies to units in backward areas, classified in three subsidies to units in backward areas, classified in three categoriescategories
Sales tax deferments and exemptionsSales tax deferments and exemptions: payment deferred for a : payment deferred for a fixed period, like interest free loan; or exemptions given for fixed period, like interest free loan; or exemptions given for certain no. of yearscertain no. of years
Suppliers creditSuppliers credit: available from suppliers of machinery, other : available from suppliers of machinery, other fixed assets, terms devised to defer payment, or pay in fixed assets, terms devised to defer payment, or pay in installments over a period of timeinstallments over a period of time
Leasing vs. Hire PurchaseLeasing vs. Hire Purchase
LeasingLeasing Ownership not transferred to Ownership not transferred to
lesseelessee Depreciation benefit to lessorDepreciation benefit to lessor
Magnitude of funds high, for big Magnitude of funds high, for big ticket itemsticket items
No margin money/down payment No margin money/down payment requiredrequired
Maintenance of asset by lessor in Maintenance of asset by lessor in operating leaseoperating lease
Tax benefits of depreciation taken Tax benefits of depreciation taken by lessor; lessee gets tax shield by lessor; lessee gets tax shield on lease rentalson lease rentals
Considered off balance sheet Considered off balance sheet mode of financing, as no asset or mode of financing, as no asset or liability figures in balance sheetliability figures in balance sheet
Hire-PurchaseHire-Purchase Ownership transferred to hirer on Ownership transferred to hirer on
payment of all instalmentspayment of all instalments Depreciation shield available to Depreciation shield available to
hirerhirer Maybe for smaller value capital Maybe for smaller value capital
goodsgoods Some down payment reqdSome down payment reqd
Maintenance cost borne by hirerMaintenance cost borne by hirer
Hirer allowed depreciation claim Hirer allowed depreciation claim and finance charge for taxation; and finance charge for taxation; seller may claim interest on seller may claim interest on amount borrowed to acquire assetamount borrowed to acquire asset
Asset figures in balance sheet on Asset figures in balance sheet on complete of purchasecomplete of purchase
Raising Long Term FinanceRaising Long Term Finance
Initial Public Offer (IPO)Initial Public Offer (IPO) Secondary Public offerSecondary Public offer Rights IssueRights Issue Bought out dealsBought out deals Euro IssuesEuro Issues Private PlacementPrivate Placement Preferential allotmentPreferential allotment Venture Capital/ Private Equity Venture Capital/ Private Equity
transactionstransactions Obtaining a term loanObtaining a term loan
Initial Public OfferInitial Public Offer
ProsPros Access to larger amount of Access to larger amount of
fundsfunds Further growth limited Further growth limited
companies not using this routecompanies not using this route Listing: provides exit route to Listing: provides exit route to
promoters; ensures promoters; ensures marketability of existing sharesmarketability of existing shares
Encash on value created in the Encash on value created in the firmfirm
Recognition in marketRecognition in market Stock prices provide useful Stock prices provide useful
indicators to managementindicators to management Sometimes stipulated by Sometimes stipulated by
private investors in the private investors in the companycompany
ConsCons Pricing may have to Pricing may have to
be attractive to lure be attractive to lure investorsinvestors
Loss of flexibilityLoss of flexibility Higher accountabilityHigher accountability More disclosure More disclosure
requirements to be requirements to be metmet
Visibility in marketVisibility in market Cost of making a Cost of making a
public issue quite highpublic issue quite high
Steps in an IPOSteps in an IPO
Approval of BODApproval of BOD Shareholders’ approvalShareholders’ approval Appointment of lead manager(s)Appointment of lead manager(s) Due diligence by LMDue diligence by LM Appointment of intermediaries like registrars, printers, bankers, advertisersAppointment of intermediaries like registrars, printers, bankers, advertisers Prepare draft prospectusPrepare draft prospectus Filing with SEBIFiling with SEBI Listing applications filed alongwith draft prospectusListing applications filed alongwith draft prospectus Agreement with registrars and depositoriesAgreement with registrars and depositories Appoint underwriters (if reqd.)Appoint underwriters (if reqd.) Make changes in draft prospectus as per SEBI observations, SE suggestionsMake changes in draft prospectus as per SEBI observations, SE suggestions File prospectus with ROCFile prospectus with ROC Issue marketing exercise commencesIssue marketing exercise commences Application forms dispatchedApplication forms dispatched Issue openedIssue opened Basis of allotment finalisedBasis of allotment finalised Allotments made, refunds posted, shares listed on SEsAllotments made, refunds posted, shares listed on SEs
Other aspects of a public Other aspects of a public issueissue
Eligibility criteria definedEligibility criteria defined: net worth, track record of : net worth, track record of profitability, issue in same year; secondary issues profitability, issue in same year; secondary issues have no such restrictionshave no such restrictions
Book Building processBook Building process: process of tendering : process of tendering quantities at prices within a bandquantities at prices within a band
Issue expensesIssue expenses: underwriting, brokerage : underwriting, brokerage commissions, fees to managers to the issue, commissions, fees to managers to the issue, registrars, printers, advertisers, listing fees, stamp registrars, printers, advertisers, listing fees, stamp dutyduty
Issue pricingIssue pricing: free pricing, disclose basis for issue : free pricing, disclose basis for issue priceprice
Public issue of debtPublic issue of debt: appointment of debenture : appointment of debenture trustee, creation of DRR, credit rating reqd., security trustee, creation of DRR, credit rating reqd., security to be createdto be created
Rights IssueRights Issue
• Issue of capital to Issue of capital to existing shareholdersexisting shareholders• Offer made on a pro rata basisOffer made on a pro rata basis• Offer document called Offer document called Letter of OfferLetter of Offer• Option given to apply for Option given to apply for additional sharesadditional shares• Rights renunciationRights renunciation: are tradeable, may be sold off in the : are tradeable, may be sold off in the
marketmarket• Value of a share after rights:Value of a share after rights:
(NP(NP00+S)/(N+1); N=no. of existing shares required for rights; P+S)/(N+1); N=no. of existing shares required for rights; P00 =cum rights MP per share; S= subscription price of rights =cum rights MP per share; S= subscription price of rights issueissue
• Value of a rightValue of a right= (P= (P00 –S)/(N+1) –S)/(N+1)• Comparison with Public issueComparison with Public issue: with familiar investors, hence : with familiar investors, hence
likely to be more successful; less floatation costs since no likely to be more successful; less floatation costs since no underwriting; but lower pricing to benefit shareholdersunderwriting; but lower pricing to benefit shareholders
Private PlacementPrivate Placement
Sale of securities Sale of securities directly to wholesale investorsdirectly to wholesale investors like FIs, like FIs, banks, MFs, FIIs,PE funds etc.banks, MFs, FIIs,PE funds etc.
Called Called private placementprivate placement in equity/equity related in equity/equity related instruments, in unlisted companies and in all cases of debtinstruments, in unlisted companies and in all cases of debt
Called Called preferential allotmentpreferential allotment in case of unlisted companies in case of unlisted companies for equity/equity related instrumentsfor equity/equity related instruments
Different from reservationsDifferent from reservations made for such QIBs out of a made for such QIBs out of a public issuepublic issue
Subject to SEBI regulationsSubject to SEBI regulations on pricing, lock in period, open on pricing, lock in period, open offer to be made to publicoffer to be made to public
QIB placement guidelinesQIB placement guidelines recently issued by SEBI for recently issued by SEBI for compliance and disclosurescompliance and disclosures
Private PlacementPrivate Placement
ProsPros Less expensive modeLess expensive mode Lesser SEBI and other Lesser SEBI and other
regulationsregulations Easier to market the issue Easier to market the issue
to a few investorsto a few investors Entry of wholesale Entry of wholesale
financially sophisticated financially sophisticated investors in company’s investors in company’s profileprofile
May use this route until IPO May use this route until IPO decision takendecision taken
Less administrative Less administrative maintenancemaintenance
ConsCons Does not qualify for listing Does not qualify for listing
in an unlisted companyin an unlisted company Restrictive covenants may Restrictive covenants may
be imposed by the be imposed by the investorsinvestors
May call for management May call for management participationparticipation
Issue pricing more tightIssue pricing more tight
Venture Capital/Private Venture Capital/Private EquityEquity
Equity financeEquity finance to potentially high growth companies to potentially high growth companies Reasonably longReasonably long to medium term commitment to medium term commitment Hands on managementHands on management approach, active participation in management approach, active participation in management Considered Considered value add investorvalue add investor VC: primarily high risk high returnVC: primarily high risk high return investment esp. in technology oriented/ investment esp. in technology oriented/
knowledge intensive businesses with long development cycles, greenfield knowledge intensive businesses with long development cycles, greenfield venturesventures
Can be in Can be in unlisted or listedunlisted or listed (PIPES) Companies (PIPES) Companies Exit routeExit route to be defined at the time of investment to be defined at the time of investment Restrictive clausesRestrictive clauses on promoters’ holding sell off and other on promoters’ holding sell off and other
financial/operational issuesfinancial/operational issues Detailed memorandum/businessDetailed memorandum/business plan on company, its financials to be plan on company, its financials to be
preparedprepared Shareholders agreementShareholders agreement to be signed by both parties to be signed by both parties Valuation of CompanyValuation of Company key issue key issue Leads to Leads to dilution of controldilution of control by existing promoters by existing promoters
Obtaining a Term LoanObtaining a Term Loan
Submission of loan applicationSubmission of loan application:: a project report containing a project report containing complete details of the project given to the FI/Bankcomplete details of the project given to the FI/Bank
Initial processing of loan applicationInitial processing of loan application:: prepare flash report to prepare flash report to decide if project worth an appraisal or notdecide if project worth an appraisal or not
Project Appraisal:Project Appraisal: Detailed appraisal done to decide if project taken Detailed appraisal done to decide if project taken or not, in terms of market, technical, financial, managerial appraisalor not, in terms of market, technical, financial, managerial appraisal
Issue of Letter of Sanction:Issue of Letter of Sanction: to the borrower containing amount to the borrower containing amount sanctioned and terms and conditions theretosanctioned and terms and conditions thereto
Acceptance of terms and conditions by the borrowing unit:Acceptance of terms and conditions by the borrowing unit: thru a board meeting and conveyed to the FI/Bankthru a board meeting and conveyed to the FI/Bank
Execution of loan agreement:Execution of loan agreement: signed by both parties signed by both parties Disbursement of loan:Disbursement of loan: in tranches based on progress of the project, in tranches based on progress of the project,
tie up of means of financetie up of means of finance Creation of security:Creation of security: formalities to be completed within a formalities to be completed within a
timeframetimeframe Monitoring:Monitoring: at implementation and operational stage thru periodic at implementation and operational stage thru periodic
progress reports, site visits etc.progress reports, site visits etc.