Unit IChapter 2

Sources of finance• The sources from which a business meets its

financial requirements can be classified as follows:

• 1. According to periodA. Long term sources i.e. shares, debentures, long-

term loans etc

B. Short term sources i.e. advances from commercial banks, public deposits, advances from customers and trade creditors etc

2. According to ownership

A. Own capital i.e. share capital, retained earnings and surpluses etc

B. Borrowed capital i.e. debentures, public deposits and loans etc

3. According to source of generation

A. Internal sources i.e. retained earnings and depreciation funds etc

B. External source i.e. securities like shares and debentures, loans, etc

Equity financing• They represent the ownership position in a

company.

• The holders of the ordinary shares, called shareholders, are the legal owners if the company.

• Ordinary shares are also called permanent capital since they don’t have a maturity period.

• An ordinary share is also known as variable income security.

Features of ordinary shares

• Claim on income(last)

• Claim on assets(last)

• Right to control (voting rights)

• Pre-emptive rights (right issues)

• Limited liability

Debenture financing• A debenture is a long term promissory note

for raising loan capital.

• The firm promises to pay interest and principal.

• The purchasers of debentures are called debenture holders.

Features of debentures• Interest rates (fixed, tax deductible, legal

binding) • Maturity(fixed) • Sinking fund

• Indenture (debenture trust deed between company and the trustee)

• Security(mostly secured by company’s assets)

• Claims on income (first position)

• Claims on assets (first position)

Preference financing• Preference shares are those shares which carry

preferential rights over other shares.

• It is called a hybrid security.

It is similar to ordinary share in that

• No legal obligation to pay dividend. • Not tax deductible.

• In some cases, it has no fixed maturity date.

It is similar to debentures in that

• Dividend rate is fixed.

• Do not share in the residual earnings.

• Claims on income and assets prior to ordinary shareholders.

Features of preference share• Claim on income and assets(middle position) • Fixed dividend

• Cumulative dividend(pay all dividends)

• Redemption • Sinking fund

• Call feature(buy back of shares at call price) • Participation feature(in extraordinary profits) • Voting rights(may or may not) • Convertibility

Loan financing• A loan is the purchase of the present use of money

with the promise to repay the amount in the future according to a pre-arranged schedule and at a specified rate of interest.

• Credit is extended under a formal loan arrangement.

• Use to finance your permanent working capital, purchase of new equipment, construction of buildings, business expansion, refinance existing debt and business acquisitions.

• Projected profitability and cash flow from operations are two key factors lenders consider when making term loans.

• Debt originally scheduled for repayment in more than 1 year, but generally in less than 10 years.

• Usually payments that cover both interest and principal are made quarterly, semiannually, or annually.

• Borrower is also required to pay legal expenses (loan agreement)

• Interest rates are either (1) fixed or (2) variable depending on changing market conditions -- possibly with a floor or ceiling.

• The borrower can tailor a loan to their specific needs through direct negotiation with the lender.

• Term loan financing is more readily available over time making it a more dependable source of financing than, say, the capital markets.

Project financing

• Project finance is the long term financing of infrastructure and industrial projects based upon the projected cash flows of the project rather than the balance sheets of the project sponsors.

• Project financing is substantially more expensive due to its non recourse nature.

• There is a high debt –equity ratio in financing of projects.

• Project finance is different from traditional forms of finance because the financier principally looks to the assets and revenue of the project in order to secure and service the loan.

• It avoids any negative impact of the project on the credit standing of the sponsors.

Loan syndication

• A syndicated loan is one that is provided by a group of lenders and is structured, arranged, and administered by one or several commercial banks or investment banks.

• Typically there is a lead bank or underwriter of the loan, known as the "arranger", "agent", or "lead lender".

• This lender may be putting up a proportionally bigger share of the loan, or perform duties like dispersing cash flows amongst the other syndicate members and administrative tasks.

• The main goal of syndicated lending is to spread the risk of a borrower default across multiple lenders (such as banks) or institutional investors like pensions funds and hedge funds.

•

Book Building

• Book Building is essentially a process used by companies raising capital through Public Offerings-both Initial Public Offers (IPOs) or Follow-on Public Offers ( FPOs) to aid price and demand discovery.

• It is a mechanism where, during the period for which the book for the offer is open, the bids are collected from investors at various prices, which are within the price band specified by the issuer.

• The process is directed towards both the institutional as well as the retail investors.

• The Issuer who is planning an offer nominates lead merchant banker(s) as 'book runners'.

• The Issuer specifies the number of securities to be issued and the price band for the bids.

• The Issuer also appoints syndicate members with whom orders are to be placed by the investors.

• The syndicate members input the orders into an 'electronic book'. This process is called 'bidding' and is similar to open auction.

• The book normally remains open for a period of 5 days.

• Bids have to be entered within the specified price band.

• Bids can be revised by the bidders before the book closes.

• On the close of the book building period, the book runners evaluate the bids on the basis of the demand at various price levels.

• The book runners and the Issuer decide the final price at which the securities shall be issued.

• Allocation of securities is made to the successful bidders. The rest get refund orders.

New financial institutions and instruments

Some of the new financial institutions and instruments will be discussed in the next few slides:

• Factoring • Factoring is a type of financial service whereby a

firm sells or transfers title to its account receivable to a factoring company, which than acts as a principal, not an agent.

• Factors actually buy your receivables and rely on their own credit and collection expertise.

• Essentially, your customers become their customers.

• Payments are made directly to the factor by your buyer.

• The SBI Factors and Commercial Services(Pvt.) Ltd. was the first factoring company allowed by RBI in 1991.

• Factoring provides short term finance to the company.

• It is employed to finance both domestic and export businesses.

• It encompasses financing, administration of the sales ledger, assumption of credit risk, recovery of debts and rendering consultancy services.

• The factor has to wait till the due date for getting payments

Venture capital

• One problem many new businesses face is raising sufficient capital.

• A business in its primary phase will also face a difficult challenge getting a bank loan.

• Venture capital firms offer capital in exchange for equity in a company.

• This type of financing is ideal for new businesses since venture capital firms focus mainly on the future prospects of a company when banks use past performance as a primary criteria.

• VC refers to the financing of new high risk ventures promoted by qualifies entrepreneurs who lack the necessary experience and funds to give shape to their ideas.

• VC was started in USA and in India it was initiated by GOI and was first administered by IDBI.

• It is a long term investment in growth oriented small and medium firms

• The VC institutes provide not only capital but also business skills to investee firms.

• VC financing involves high risk-return spectrum.

• Such institutions disinvest the holdings either to the promoters or in the market.

Credit rating• A credit rating estimates the credit worthiness

of an individual, corporation , or even a country.• It is an evaluation made by credit bureaus of a

borrower’s overall credit history.• It is also known as an evaluation of a potential

borrower's ability to repay debt, prepared by a credit bureau at the request of the lender.

• Credit ratings are calculated from financial history and current assets and liabilities.

Objectives• It provides guidance to investors or creditors

in determining a credit risk associated with debt instrument or credit obligation.

• Establishes a link between risk and return.• Helps investors in making investment

decisions.• Credit rating shows the exact worth of the

organization.•

• Credit rating and information services of india ltd.(CRISIL). was set up in 1987 as the first credit rating agency followed by ICRA Ltd i.e . Investment Information and Credit Rating Agency of India ltd in 1991 and CARE i.e. Credit Analysis and Research ltd in 1994.

• In India, SEBI regulates all the credit rating agency

Certificate of Deposit

• CDs are short-term borrowings in the form of Promissory Notes having a maturity of not less than 15 days up to a maximum of one year.

• They are like bank term deposits accounts. Unlike traditional time deposits these are freely negotiable instruments and are often referred to as Negotiable Certificate of Deposits

• CDs can be issued by all scheduled commercial banks except RRBs

• Minimum period 15 days• Maximum period 1 year• Minimum Amount Rs 1 lac and in multiples of Rs. 1

lac• CDs are transferable by endorsement

Commercial Paper• Commercial Paper (CP) is an unsecured money

market instrument issued in the form of a promissory note by the high worth corporate.

• The tangible net worth of the company, as per the latest audited balance sheet, is not less than Rs. 4 crore.

• All eligible participants should obtain the credit

rating for issuance of Commercial Paper

• CP can be issued for maturities between a minimum of 15 days and a maximum up to one year from the date of issue.

• If the maturity date is a holiday, the company would be liable to make payment on the immediate preceding working day.

• CP is issued to and held by individuals, banking companies, other corporate bodies registered or incorporated in India and unincorporated bodies, Non-Resident Indians (NRIs) and Foreign Institutional Investors (FIIs).

Global depository receipt• Indian companies are allowed to raise equity

capital in the international market through the issue of GDR/ADRs/FCCBs.

• These are not subject to any ceilings on investment.

• An applicant company seeking Government's approval in this regard should have a consistent track record for good performance (financial or otherwise) for a minimum period of 3 years.

• Indian companies are permitted to issue its Rupee denominated shares to persons outside India for the purpose of issuing Global Depository Receipts (GDRs) and/ American Depository Receipts (ADRs).

• Issuer is the company that plans to tap the foreign market through the global issue mechanism (the “Issuer”).

• The lead manager is the person responsible for marketing the issue .

• GDR is a bank certificate issued in more than one country for shares in a foreign company. The shares are held by a foreign branch of an international bank.

• The shares trade as domestic shares, but are offered for sale globally through the various bank branches.

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Depositories

• Depositories are companies registered under the companies act ,1956 and registered with SEBI in accordance with the provisions of SEBI n(Depositories and Participants) Regulations, 1996.

• They keep the physical custody of share certificates leading to immobilization of shares to be followed by book entry system of trading in future.

• The major players in the depository system are depositories, participants, issuers and clients.

• The investor/client has to approach the participant either to avail the depository’s services or to get the securities dematerialised.

• Depository participants are persons dealing directly with the depository on their own account or for their clients.

• Depository participant is an important link between the investor and the depository.

• An investor who wishes to avail the services will have to open an account with the depository through a depository participant.

• The depository participant can be commercial banks, financial institutions , stock exchanges etc.