DAIICT: Introduction to Business Finance Topic 8: Sources of Finance & Finance Strategy Vishal Iyer, CFA DAIICT: INTRODUCTIONTO BUSINESS FINANCE TOPIC 8: SOURCES OF FINANCE 1 DAIICT: INTRODUCTION TO BUSINESS FINANCE TOPIC 8: SOURCES OF FINANCE 2 A firm should find sources of finance required to support investments in fixed assets and working capital. Major Sources Equity Referred to Shareholders Funds in B/S Equity Capital Preference Capital Internal Accruals Debt Referred to Loan Funds in B/S Term Loans Debentures Working Capital Advances Miscellaneous Sources 2014 DAIICT: Business Finance 2014 Topic 5: Sources of Finance 2 DAIICT: INTRODUCTION TO BUSINESS FINANCE TOPIC 8: SOURCES OF FINANCE 3 Equity capital represents the ownership capital as equity shareholders collectively own the company. They enjoy the rewards and bear the risks of ownership. However their liability is limited to their capital contributions. 2014 DAIICT: INTRODUCTION TO BUSINESS FINANCE TOPIC 8: SOURCES OF FINANCE 4 The amount of capital that the company can potentially issue, as per its memorandum. Authorized Capital The amount of capital offered by the company to the investors. Issued Capital The amount of issued capital subscribed by the investors. Subscribed Capital The actual amount paid up by the investors. Paid-up Capital 2014 DAIICT: Business Finance 2014 Topic 5: Sources of Finance 3 DAIICT: INTRODUCTION TO BUSINESS FINANCE TOPIC 8: SOURCES OF FINANCE 5 Also known as face value, it is value stated in the memorandum. The most popular denomination is Rs. 1 and 10. Par Value The price at which equity shares are issued (typically higher than par value). Issue Price It is the sum of paid up capital plus reserves and surplus. To obtain on a per share basis, the above is divided by number of shares. Book value It is the price at which the share shall trade in the market. Easy to obtain for listed companies. Market Value 2014 DAIICT: INTRODUCTION TO BUSINESS FINANCE TOPIC 8: SOURCES OF FINANCE 6 Right to Income The income left after satisfying the claims of all other investors belongs to equity shareholders. The income of equity shareholders may be retained by the firm or paid out as dividends. Right to Control Equity shareholder elect the BOD and have the right to vote. The BOD elects the management which controls operation of the company. Thus equity shareholders have indirect control over the company. Pre-emptive Right The law requires companies to give existing equity shareholders the first opportunity to purchase, on pro rata basis, additional issue of equity capital. Right to Liquidation The equity shareholders have a residual claim over the assets of the firm in the event of liquidation. 2014 DAIICT: Business Finance 2014 Topic 5: Sources of Finance 4 DAIICT: INTRODUCTION TO BUSINESS FINANCE TOPIC 8: SOURCES OF FINANCE 7 Merits There is no compulsion to pays dividends. It has no maturity date thus no obligation to redeem. The larger the equity capital, the greater the ability of the firm to raise debt finance at favorable terms. Demerits Sale to outsider results in dilution of control. The cost of equity capital is usually the highest. The company does not receive any tax benefit on dividends rather it has to pay distribution tax on dividends. The floatation costs are higher compared to other securities. 2014 DAIICT: INTRODUCTION TO BUSINESS FINANCE TOPIC 8: SOURCES OF FINANCE 8 However their claims rank below the claims of companys creditors, bondholders/debenture holders. Preference shares are that part of a companys capital which carry a preferential right compared to the equity shareholder with respect to: Dividend at a fixed rate or amount. Repayment of capital in case of winding-up of the company. 2014 DAIICT: Business Finance 2014 Topic 5: Sources of Finance 5 DAIICT: INTRODUCTION TO BUSINESS FINANCE TOPIC 8: SOURCES OF FINANCE 9 2014 Types of Preference Shares On Basis of Dividend Payment Cumulative Non- Cumulative On Basis of Terms of Issue Convertible Non- Convertible On Basis of Maturity Redeemable Irredeemable On Basis of Profit Sharing Participating Non- Participating DAIICT: INTRODUCTION TO BUSINESS FINANCE TOPIC 8: SOURCES OF FINANCE 10 2014 Barring a few exceptions, preference capital in India carry a cumulative feature with respect to dividends. They are typically redeemable after three to five years. They do not carry voting rights except for a few circumstances, if preference dividend is skipped. DAIICT: Business Finance 2014 Topic 5: Sources of Finance 6 DAIICT: INTRODUCTION TO BUSINESS FINANCE TOPIC 8: SOURCES OF FINANCE 11 2014 Merits There is no legal obligation to pay dividend. Redemption of preference shares can be delayed without significant penalty. It is considered a part of net worth and thus enhances credit worthiness of the firm. As they do not carry voting rights, there is no dilution of control. Demerits Compared to debt capital, it is more expensive source of financing. Though there is no legal obligation to pay dividends, skipping them can adversely affect the image of company. They have a prior claim on the assets and earnings of the firm. If the firm skips dividends for 3 years, then they have to be granted voting rights. DAIICT: INTRODUCTION TO BUSINESS FINANCE TOPIC 8: SOURCES OF FINANCE 12 Internal accruals of a firm consist of depreciation charges and retained earnings. Depreciation represents the allocation of capital expenditure to various period over which the capital expenditure is expected to benefit the firm. Retained earnings (internal equity) are that portion of equity earnings that are ploughed back in the company. 2014 DAIICT: Business Finance 2014 Topic 5: Sources of Finance 7 DAIICT: INTRODUCTION TO BUSINESS FINANCE TOPIC 8: SOURCES OF FINANCE 13 2014 Merits They are readily available and thus management dont need to talk to outsiders. There are no flotation costs associated with internal accruals. No dilution of control. Demerits The amount of funds available is limited. Cost of retained earnings is high as it is atleast equal to cost of equity. DAIICT: INTRODUCTION TO BUSINESS FINANCE TOPIC 8: SOURCES OF FINANCE 14 Term loans represent a source a debt finance which is generally repayable in less than 10 years. They are employed to finance acquisition of assets. They are different from short term bank loans which are employed to finance working capital. Historically term loans given by financial institutions and banks have been a long term source of debt for private firms and most public firms. 2014 DAIICT: Business Finance 2014 Topic 5: Sources of Finance 8 DAIICT: INTRODUCTION TO BUSINESS FINANCE TOPIC 8: SOURCES OF FINANCE 15 Currency Financial institutions and banks provide loans in rupees and foreign currency. Security Term loans typically represent secured borrowing. Usually assets, which are financed by term loan serve as prime security. Other assets of the firms may serve as collateral security. Security may created by equitable mortgage or hypothecation. 2014 DAIICT: INTRODUCTION TO BUSINESS FINANCE TOPIC 8: SOURCES OF FINANCE 16 Interest Payment and Principal Repayment Interest rate charged depends on the creditworthiness of the borrower. The interest is usually payable monthly and principal in equal quarterly or semi-annul installments over the life of the loan. They have to paid irrespective of financial situations of the company. In case of default penalty may be levied on the borrower. Covenants In order to protect their interest, financial institutions impose conditions (covenants) on the borrowers. The covenants are further divided into positive and negative covenants. Positive covenants are affirmative actions required by the company, for e.g., make time payment of statutory dues. Negative covenants are restriction placed on actions of the management, for e.g., any sale of asset to be approved by the financial institution. 2014 DAIICT: Business Finance 2014 Topic 5: Sources of Finance 9 DAIICT: INTRODUCTION TO BUSINESS FINANCE TOPIC 8: SOURCES OF FINANCE 17 2014 Submission of Loan Application Initial Processing of Loan Application Appraisal of the Proposed Project Issuance of Letter of Sanction Acceptance of Terms and Conditions by Borrower Execution of the Loan Agreement Creation of Security Disbursement of Loan Monitoring DAIICT: INTRODUCTION TO BUSINESS FINANCE TOPIC 8: SOURCES OF FINANCE 18 Debentures are instruments for raising debt finance from the financial market. Debenture holders are creditors of the company. The obligation of a company towards its debenture holders is similar to that of a borrower who promises to pay interest and principal at specified times. Debentures offer greater flexibility in structure compared to term loans. 2014 DAIICT: Business Finance 2014 Topic 5: Sources of Finance 10 DAIICT: INTRODUCTION TO BUSINESS FINANCE TOPIC 8: SOURCES OF FINANCE 19 2014 On Basis of Security Naked Secured On Basis of Maturity Redeemable Perpetual On Basis of Transferability Bearer Registered On Basis of Terms of Issue Fully Convertible Partly Convertible Non Convertible On Basis of Interest Structure Fixed Rate Floating Rate Zero Interest On Basis of Redemption Pattern Bullet Amortized Callable Putable DAIICT: INTRODUCTION TO BUSINESS FINANCE TOPIC 8: SOURCES OF FINANCE 20 2014 When a debenture issue is sold to the investing public, a trustee is appointed through a trust deed. Debentures issued in India are usually secured and redeemable. It can be issued for short term (up to 1 year), medium term (1 5 year), and long term (5 to 12 years). The short term issues are known as commercial paper. If debentures are issued for a period greater than 18 months then they have credit rated and a debenture redemption reserve has to be created. DAIICT: Business Finance 2014 Topic 5: Sources of Finance 11 DAIICT: INTRODUCTION TO BUSINESS FINANCE TOPIC 8: SOURCES OF FINANCE 21 2014 A debt rating essentially reflects the probability of timely payment of interest and principal by the borrower. The higher the debt rating, the greater the likelihood that the borrower will fulfill obligation to pay. In most cases, the cost for debt rating is borne by the borrower. DAIICT: INTRODUCTION TO BUSINESS FINANCE TOPIC 8: SOURCES OF FINANCE 22 2014 A typical example of rating symbols followed is as follows: DAIICT: Business Finance 2014 Topic 5: Sources of Finance 12 DAIICT: INTRODUCTION TO BUSINESS FINANCE TOPIC 8: SOURCES OF FINANCE 23 2014 As interest payments are tax deductible, the net interest liability for the firm is lowered on account of tax savings generated. Particulars Without Interest With Interest Difference EBIT 100 100 0 Less: Interest 0 10 -10 EBT 100 90 -10 Tax @ 30% 30 27 3 PAT 70 63 -7 DAIICT: INTRODUCTION TO BUSINESS FINANCE TOPIC 8: SOURCES OF FINANCE 24 2014 Merits Interest on debt is tax deductible. Does not result in dilution of control and no share in profits. Floatation cost are lower than equity. If interest rates are fixed, they provide protection against inflation. Demerits Fixed obligation may be difficult to meet in situations of financial distress and thus may even lead to bankruptcy. Restricts operational and financial flexibility through covenants. DAIICT: Business Finance 2014 Topic 5: Sources of Finance 13 DAIICT: INTRODUCTION TO BUSINESS FINANCE TOPIC 8: SOURCES OF FINANCE 25 2014 Commercial banks also help their customers in obtaining credit from other sources through letter of credit arrangement. They are provided by commercial banks in three primary ways: Cash credits / Overdrafts Loans Purchase / Discount of Bills Working capital advances by commercial banks represent the most important source of financing current assets. DAIICT: INTRODUCTION TO BUSINESS FINANCE TOPIC 8: SOURCES OF FINANCE 26 2014 A predetermined limit is sanctioned by the bank. The borrower can draw as per requirement up till the credit limit. Borrower can repay partially or fully when he desires within the sanction period. The interest is payable only on the amount used subject to a minimum amount. The flexibility makes its one of the most popular sources of working capital finance. DAIICT: Business Finance 2014 Topic 5: Sources of Finance 14 DAIICT: INTRODUCTION TO BUSINESS FINANCE TOPIC 8: SOURCES OF FINANCE 27 2014 Loans are advances of fixed amounts to the borrower. The interest is charged on the entire amount irrespective of the amount drawn. They may be payable of demand or in installments. They may also a possibility of renewing a loan at maturity. They are now dominant form of bank finance in India. DAIICT: INTRODUCTION TO BUSINESS FINANCE TOPIC 8: SOURCES OF FINANCE 28 2014 A bill arises out of a trade transaction where the seller draws the bill on the purchaser. The bill may be payable on demand or after usance period (max : 90 days). Once the bill the accepted by the purchaser, the seller presents the bills to bank. The bank discounts/purchases the bill and lends money after deducting charges. The bank presents the bill to the purchaser on due date and get its payment. DAIICT: Business Finance 2014 Topic 5: Sources of Finance 15 DAIICT: INTRODUCTION TO BUSINESS FINANCE TOPIC 8: SOURCES OF FINANCE 29 2014 Application and Processing Sanction and Terms and Conditions Security Hypothecation or Pledge Margin Amount DAIICT: INTRODUCTION TO BUSINESS FINANCE TOPIC 8: SOURCES OF FINANCE 30 2014 The following are several other ways in which finance may be obtained: Deferred Credit Lease Finance Hire Purchase Unsecured Loans (Promoters) and Deposits Subsidies Short term loans from Financial Institutions Commercial Paper Factoring DAIICT: Business Finance 2014 Topic 5: Sources of Finance 16 DAIICT: INTRODUCTION TO BUSINESS FINANCE TOPIC 8: SOURCES OF FINANCE 31 2014 Key issues to be addressed while forming a finance strategy are: Capital Structure Financing Instruments Method of Offering Target Markets Timing and Pricing of Issue Dividend Distribution Policy Corporate Governance DAIICT: INTRODUCTION TO BUSINESS FINANCE TOPIC 8: SOURCES OF FINANCE 32 2014 The important consideration in planning the capital structure are: Earnings per Share (EPS) Risk Control Flexibility Nature of Assets Capital structure decisions pertain to deciding the optimal proportion of debt and equity in the company. DAIICT: Business Finance 2014 Topic 5: Sources of Finance 17 DAIICT: INTRODUCTION TO BUSINESS FINANCE TOPIC 8: SOURCES OF FINANCE 33 2014 Example: Consider the following information about a company: 10 million equity shares, par value of Rs. 10 each. Tax rate is 50%. The company is planning to raise additional capital of Rs. 100 million for financing an expansion. In this context, it is evaluating two alternatives: Issue of equity shares (10 million shares of Rs. 10 per share) Issue debenture carrying 14% interest. What shall be the EPS of the company under both plans, if the EBIT is Rs. 20 million and Rs. 40 million respectively. DAIICT: INTRODUCTION TO BUSINESS FINANCE TOPIC 8: SOURCES OF FINANCE 34 2014 Particulars Equity Financing Debt Financing EBIT 20,00,000 40,00,000 20,00,000 40,00,000 Less: Interest - - 14,00,000 14,00,000 EBT 20,00,000 40,00,000 6,00,000 26,00,000 Less: Tax 10,00,000 20,00,000 3,00,000 13,00,000 EAT 10,00,000 20,00,000 3,00,000 13,00,000 No. of Shares 20,00,000 20,00,000 10,00,000 10,00,000 EPS 0.50 1.00 0.30 1.30 The EPS is more sensitive under the debt financing i.e. if the operating profit (EBIT) is high (low), the EPS is higher (lower) than equity option. DAIICT: Business Finance 2014 Topic 5: Sources of Finance 18 DAIICT: INTRODUCTION TO BUSINESS FINANCE TOPIC 8: SOURCES OF FINANCE 35 2014 Area Use more equity when Use more debt when Corporate Tax Rate Negligible High Business Risk High Low Dilution of Control Not important Important Nature of Assets Intangible Tangible Growth Options Many Few DAIICT: INTRODUCTION TO BUSINESS FINANCE TOPIC 8: SOURCES OF FINANCE 36 2014 Major Sources Equity Equity Capital Preference Capital Internal Accruals Debt Term Loans Debentures Working Capital Advances Miscellaneous Sources The firm can raise equity and debt capital from both public and private sources. DAIICT: Business Finance 2014 Topic 5: Sources of Finance 19 DAIICT: INTRODUCTION TO BUSINESS FINANCE TOPIC 8: SOURCES OF FINANCE 37 2014 Modes of Raising Finance - Primary Market: Public Offering Initial Public Offering Seasoned Offering Rights Issue Private Placement DAIICT: INTRODUCTION TO BUSINESS FINANCE TOPIC 8: SOURCES OF FINANCE 38 2014 Particulars Public Issue Right Issue Private Placement Amount that can be raised Large Moderate Moderate Cost of issue High Negligible Negligible Dilution of Control Yes No Yes Degree of Underpricing Large - Small DAIICT: Business Finance 2014 Topic 5: Sources of Finance 20 DAIICT: INTRODUCTION TO BUSINESS FINANCE TOPIC 8: SOURCES OF FINANCE 39 2014 A firm planning to raise finance may tap one or more of the following capital markets: Indian Capital Market The firm has to confirm to the regulations laid down by SEBI. Euro Capital Market The market is beyond the purview of any national regulatory markets. Firms have to take approval of MOF, FIPB and RBI. Foreign Domestic Capital Market The firm access domestic markets of foreign countries, for e.g. U.S. The firm has to obtain approval from local and foreign authorities. DAIICT: INTRODUCTION TO BUSINESS FINANCE TOPIC 8: SOURCES OF FINANCE 40 2014 Particulars Indian Capital Market Euro Capital Market Foreign Capital Market Access Easy Restricted Highly Restricted Market Small Large Large Disclosures & Transparency Less Onerous Onerous Highly Onerous Prices/Rates Not so Attractive Attractive More Attractive DAIICT: Business Finance 2014 Topic 5: Sources of Finance 21 DAIICT: INTRODUCTION TO BUSINESS FINANCE TOPIC 8: SOURCES OF FINANCE 41 2014 The following guidelines can be used: Decouple Financing and Investment Decisions Never be Greedy Ensure Intergenerational Fairness Timing: When to issue? Pricing: What price issued should be made? DAIICT: INTRODUCTION TO BUSINESS FINANCE TOPIC 8: SOURCES OF FINANCE 42 2014 Factor to be considered in distribution of earnings Earnings Prospects Funding Requirements & Liquidity Dividend Record Shareholders Preference Control Forms of distributing earnings Cash Dividends Stock Dividends (bonus shares) Share Repurchase Distribution policy is concerned with how much earnings should be distributed to investor and in what form. DAIICT: Business Finance 2014 Topic 5: Sources of Finance 22 DAIICT: INTRODUCTION TO BUSINESS FINANCE TOPIC 8: SOURCES OF FINANCE 43 2014 To ensure that investors continue to value the company properly, company should communicate intelligently with investors. The following points should be borne in mind while communicating with investors: True and Fair Financial Disclosure Avoid Financial Hype Involve Lead Investors in Company Planning Process DAIICT: INTRODUCTION TO BUSINESS FINANCE TOPIC 8: SOURCES OF FINANCE 44 2014 Corporate governance is the system of internal controls and procedures by which individual Companies are managed. It provides a framework that defines the rights, roles and responsibilities of different groups within an organization (Management, Board, controlling Shareowners and minority or non-controlling Shareowners). At its core, corporate governance is the arrangement of checks, balances, and incentives a Company needs to minimize and manage the conflicting interests between insiders and external Shareowners.