Chp.

2 Source of finance

Classification of Sources of Finance

In case of proprietary and partnership concerns, the funds may be raised either from personal sources
or borrowings from banks, friends etc. In case of company form of organisation, the different sources
of business finance which are available may be categorized using different basis viz., on the basis of
the period, source of generation and the ownership. A brief explanation of these classifications and
the sources is provided as follows:

Long-term Sources of Finance - Owned Funds and Borrowed Funds, Equity Shares, Preference Shares, Debentures, Term
Loan, Lease Financing, Hire Financing
 Owned Capital/Own Funds
• Owned capital is also known as equity capital or shareholders’ funds. It refers to the capital
which is provided by the owners of an organization. In case of sole proprietorship and partnership
firm, the proprietor or the partners themselves provide funds, which are called as the owned capital.
In case of a joint stock company, funds raised through the issue of shares and reinvestment of
earnings are called as the owned capital.
• Owned capital includes external sources like equity shares, preference shares and internal
sources like retained earnings, reserves and surplus and depreciation.
• The cost of owned capital is in the form of dividend which is fluctuating for equity shares
and fixed for preference shares.
• Owned capital has an infinite life that is it is a permanent source of finance, but it is very
costly for the company to raise and maintain owned capital.
• Issue of shares is the best and the most popular method of owned capital.

 Borrowed capital/borrowed funds

 Borrowed capital is also called as debt capital or loan capital or creditorship securities These
.2 contd.
0
 are the funds borrowed from either individuals or institutions.
 In a company, borrowed capital consists of different types of debentures, bonds, bank
borrowings, public deposits etc. Borrowed capital is used to increase the profitability of
 The lenders of borrowed capital are called as the creditors of the company. The return that
is paid to them is in the form of interest which is fixed and it is at a lower rate than the
dividend which is paid to the owners on owned capital.
 A company is under legal obligation to pay interest and the principal amount on maturity.
Also lenders are provided with security as a charge against the assets of the company.
 Use of borrowed capital increases the financial risk for the company.
 Equity Shares
 Equity shares are also called as ordinary shares or common shares.
 Equity share capital represents owned capital of the company which is raised from external
sources and it is the permanent share capital of the company.
 Equity shares or ordinary shares are those shares which carry no preferential right in the
payment of dividend and refund of capital. The holders of equity shares are the real owners
of the company.
 They have control over the company and they enjoy voting rights. Equity shareholders are
paid returns in the form of dividend which is at a fluctuating rate and it is not obligatory for
the company to declare and pay dividend to the equity shareholders. These shareholders take
more risk as compared to preference shareholders
Features of Equity Shares
 The distinctive features of equity shares are listed below:
1. Risk Capital
Equity shareholders provide risk capital to the company. Equity shareholders are the real owners of
the company and they share the residual income of the company. Equity shareholders bear the highest
risk of investment and their wealth increases or decreases along with the prosperity of the company
2. Fluctuating Dividend
Equity shareholders get their dividend which is not at a fixed rate but it fluctuates according to the
profits of the company. If there are sufficient profits, they are paid a high dividend and in the absence
of profits, they may not get any dividend. Further even if there are sufficient profits, they may not
get any dividend if the management decides to retain the profits in the business. The company is
under no legal Obligation to pay dividend at a fixed rate to the equity shareholders. That is why
equity shares are also called as ‘ variable income security’.
3. Claim on Income
o Equity shareholders have a residual claim on the income of the company. They have a claim on the
income of the company after payment of interest on debt and preference dividend. They rank last as
far as payment of dividend is concerned.
4. Maturity
o Equity shares provide permanent capital to the company that is equity shares cannot be redeemed
during the lifetime of the company. Equity shareholders can demand refund of their capital only at
the time of liquidation of the company. But, at present a company can buy back its equity shares in
certain cases as per provisions of Companies Amendment Act, 2015. Also a shareholder can get
back his capital by selling the shares in the market.
5. Claim on Assets
o Equity shareholders have residuary rights and they are the last claimants to the assets of the
company. In the event of liquidation of a company, the assets are utilised first to meet the claims of
creditors and preference shareholders and thereafter the remaining amount belongs to the equity
shareholders. Thus, equity shareholders provide a cushion to absorb losses on liquidation and may,
usually, remain unpaid.
6. Limited Liability
o The most peculiar feature of equity shares is that the liability of the equity shareholders is limited to
the value of the shares that they have purchased. If a shareholder has paid the full value of the share
price, he cannot be held liable further for any losses of the company even at the time of liquidation.
1.2 contd.
1
 This means that the maximum loss for the shareholder is restricted to the full value of the shares that
he has purchased and nothing beyond that. For example if Mr. A has taken 100 shares of 10 each
in a company and he has paid 6 per share, if the company goes into liquidation, the amount that
Mr. A will be called upon to pay cannot exceed his unpaid amount that is 100 x 4 = 400. He will
have to pay 400 to the company and the maximum amount that he can lose is 1000.
7. Control
o Equity shareholders are the real owners of the company. They have voting rights which they can
exercise during the Annual General Meeting and they have a control over the working of the
company. Although a company is managed by the Board of Directors who control and direct the
affairs of the organisation, supreme control is endowed with equity shareholders. Equity shareholders
have the power to elect the directors of the company and remove any or all of them, if they desire.
In significant matters which affect the interest' of the company, approval of equity shareholders in
general meeting must be obtained by the Board of Directors.
8. Other Rights
Equity shareholders enjoy the following additional rights.
 Right to vote on each resolution presented
 Right to participate and attend the company meetings
 Right to participate in the surplus profits and property of the company
 Right to appoint proxy for using voting right
 pre-emptive right that is the right to receive additional shares of the company before they are
offered to the general public. Generally, these rights are offered at a price less than their
market value.
 Advantages of Equity Shares
Advantages to Company
1. Permanent Capital
Equity share capital constitutes the permanent capital and is a long-term source of finance for a
company A company need not worry about repayment of this capital during its lifetime.

2. No Obligation to Pay Dividend

Dividend on equity shares is subject to availability of profits and is at the discretion of the Board of
Directors. The company is under no legal obligation to pay dividend and the shareholders cannot
compel the company to declare dividend. The company is benefited and it can follow a flexible
dividend policy.

3. Assets of the Company are Free Of Any Charge

Equity shares do not create any charge on the assets of the company. The company can utilise its
assets as security for debt financing whenever required.

4. Large Amounts
It is possible for the company to raise large amounts of funds by way of issue Of equity shares.
The face value of equity shares is generally low which becomes convenient and affordable for
investors having limited means. Thus, the scope of marketability of the company's securities is
sufficiently widened.

5. No Financial Risk
Issue of equity shares does not involve any financial risk for the company. Firstly, payment of
dividend is not obligatory and secondly it is a permanent capital and the company need not worry
about repayment of capital during its lifetime.

6. Long-term Loans
It can be taken by the company by pledging the fixed assets which are acquired by the issue of e

.2 contd.
2
 Advantages to Shareholders
1. Real Gainers
Equity shareholders are the real owners of the company. No doubt they assume very high risk, but
this risk is complemented with high returns. In case of profits, they get high dividends. In case of
low profits, when they have to forego their dividends, they still stand to benefit as there is significant
capital appreciation when profits are retained in the business.

2. More Income
Equity shareholders are benefited even though the rate of dividend is not fixed. During boom period,
they get higher dividends. They also enjoy higher dividends on account of the trading on equity
policy adopted by the company.
3. Tax-free Income
The dividend received by the shareholders is tax-free in their hands, that is, they do not have to pay
any tax on the amount of dividend they receive from the company. However, the company has to
pay a tax which is called as a 'dividend distribution tax' before paying dividend to the shareholders.

4. Capital Appreciation
The market value of the equity shares is different from the face value of equity shares. The market
value fluctuates due to various factors like demand and supply position, profits of the company etc.
Shares of good companies command a high market value and shareholders stand to benefit as there is
significant capital appreciation.

5. Various Rights
Equity shareholders enjoy various rights by virtue of being the owners of the company. They have a
right to participate in the management, right to vote, preemptive right, right to control etc.

6. Small Face Value

The denomination of the equity shares is generally low which is within reach of small investors with
limited means.

7. Transfer of Interest
Shareholders can dispose-off their shares in the secondary market and realise their investment.

Disadvantages of Equity Shares

Disadvantages to Company

1. High Cost
Equity shares are very costly for the company to issue and maintain. At the time of issue of equity
shares, lot of expenses are incurred like advertising, printing and circulation of forms, prospectus,
appointing bankers, paying underwriting commission, brokerage etc. Moreover, the shareholders
expect a higher rate of return due to the high risk involved in these shares.

2. NO Benefit of Trading on Equity

0 If only equity shares are issued, then the company loses the benefit of trading on equity. Trading
on equity means use of fixed income bearing securities in order to magnify the returns for the
shareholders.

3. No tax Advantage
0 The dividend paid to equity shareholders is an appropriation out of profits. The interest which is
paid on debt is a charge against the profits of the company and the company can enjoy tax
leverage, that is, there is a reduction in the amount of tax payable when the company uses debt
capital. No such benefit arises in case of equity shares as dividend is paid out of profits after tax.
1.2 contd.
3
 4. Danger of Over-Capitalization
Excessive issue of equity shares may lead the company to a state of overcapitalization. Over-
capitalization has harmful effect on the shareholder's income, investment, future prospects, capital
appreciation etc.

5. Dilution in Control
Equity shareholders enjoy voting rights and participatory rights that result in dilution of control of
the company. A large and powerful group of equity shareholders may manipulate the affairs of the
company which may be detrimental to the interests of the company.

6. Concentration of Power in the Hands of Few

Whenever the company intends to raise capital by issue of new shares, the existing shareholders get
priority to subscribe to those shares by virtue of their pre-emptive right. This may lead to
concentration of power in the hands of few individuals.
7. Distribution of Heavy Dividends
During prosperous periods a company has to distribute heavy dividends to the equity shareholders.

8. Change in Management Policy

Equity shares are transferable and can be sold by .the shareholders in the secondary market. On
account of this feature, new shareholders replace old shareholders who may change the administrative
policy of the company. Such changes may be detrimental to the smooth and orderly conduct of the
business.

9. Speculation
Equity shares of good companies provide scope for speculation in the stock market. During
prosperous periods there is unusual rise in the market value of shares which encourages
speculation.

 Disadvantages to Shareholders
1. Risky Investment
Equity shareholders are the risk-bearers of the company. The return on their investment is not
guaranteed. Moreover, if profits of the company are low, market value of shares diminish and there
may be no capital appreciation on shares. Equity shareholder rank last as far as payment of dividend
and repayment of capital at the time of winding-up is concerned. They also stand to lose at the time of
liquidation; if no surplus is available after paying debts and preference share capital, they will not
get anything.

2. Irregular and Uncertain Income

As there is no fixed rate of dividend on equity shares and the company is under no legal obligation
to pay dividend, the income of the equity shareholders is very uncertain and irregular. Payment of
dividend is at the discretion of the Board of Directors.

3. No Asset Backing
Investments in equity capital are not made against the backing of any security, that is, no charge is
created on any assets and it is an unsecured capital. Shareholders have no right to any fixed and
regular dividend and they cannot fall back upon the security of assets due to non-payment of
dividend, unlike debenture holders.

4. Not Attractive to investors having a Desire for Fixed Income

Equity share capital is risk capital and the equity shareholders have residuary claims on the profits
of the company. Sometimes, due to lower profitability, there may be nothing left for the equity
.2 contd.
4
 shareholders. Hence, it is not suitable for cautious investors who desire a fixed income.

5. Loss in Depression
During a phase of depression, the profits of the company will be low and consequently the rate of
dividend also declines. This will also result in decline in the market value of the shares and
subsequent capital loss, which is not good for the equity shareholders.

6. Loss on Liquidation
Equity shareholders, being the owners, are the worst affected at the time of liquidation of a company.
They are given the last priority for repayment, that is, after the company has paid-off its creditors,
debt capital, preference share capital etc. If there is no surplus after meeting all the claims, they
also lose out on their original investment.

7. Right of Control is a Myth

Equity shareholders have voting rights and they also have a right to control the affairs of the
company. However in practice, such right is only a myth.
Equity shareholders are widely scattered all over the nation, ill-organised, weak and ineffective in
exercising any real control over the company. Moreover, they have very less time and interest to
devote to the company. They are more interested in their dividends and capital appreciation, as this
may be one of the many investments that they have made. They also do not have any power to
participate in the day-to-day affairs of the company.

 Preference Shares
 According to Section 85 of The Companies Act, 1956, a 'preference share' is that part of the
share capital of the company which fulfills both the following requirements, namely (i) it
carries preferential rights in respect of dividends at a fixed amount or at a fixed rate, and (ii) it
also carries preferential rights in regard to repayment of capital on winding-up or otherwise.
 In other words, preference shares enjoy preferential treatment as regards payment of dividend
and repayment of capital, that is, they are paid before' any dividend is paid to equity
shareholders but after payment of interest on debt.
 Preference shares appeal to those investors who want their money to fetch a constant rate of
return even if the earning is less. Various kinds of preference shares which a company can
issue are discussed below.

 Types of Preference Shares

1. Cumulative and Non-cumulative Preference Shares
 The holders of cumulative preference shares are sure to receive their dividend in respect
of shares held by them. If for any year, profits are insufficient to pay dividend, then the
unpaid dividend on cumulative preference shares is carried forward as arrears and becomes
the charge on the profits of the company for subsequent years. If they are not paid
dividend in any particular year, then they will be paid such arrears in the next year
before any dividend can be distributed among the equity shareholders, that is, their
dividend accumulates and is paid in the next year.

 Non-cumulative preference shares are those that are entitled to their yearly dividend only if
there are profits during the year. In case the earnings are inadequate, dividends are not paid
and the unpaid dividend cannot be carried forward for payment in subsequent years.

2. Participating and Non-participating Preference Shares

The holders of participating preference shares participate in the surplus profits of the company. They
are first paid a fixed rate of dividend and then a reasonable dividend is paid on equity shares.
Thereafter, surplus profits are shared with the participating preference shares. The mode of dividing
surplus profits between preference and equity shareholders is given in the Articles of Association.
1.2 contd.
5
 o Non-participating preference shares are those which enjoy only a fixed dividend and do not
participate in the surplus profits of the company.

3. Redeemable and Irredeemable Preference Shares

Redeemable preference shares are those which, in accordance with the terms of issue, can
be redeemed (repaid) after a certain date or at the discretion of the company. Irredeemable
preference shares are the ones which cannot be redeemed during the life of the company.
However, Companies (Amendment) Act, 1988 has abolished the category of irredeemable
preference shares.

4. Convertible Preference Shares and Non-convertible Preference Shares

In case of convertible preference shares, the holders are given the right to convert their holdings into
equity shares after a specified period.
The preference shares which cannot be converted into equity shares are called nonconvertible
preference shares.

Features of Preference Shares

preference shares have several features. Some of them are common to all the types of preference
shares while others are specific to some of them. The following are the most significant features of
preference shares:
a. Maturity
o Redeemable preference shares are repaid as per the terms of issue, after a specified period is over or
whenever the company chooses to redeem after giving a proper notice in this regard.
Irredeemable preference shares are prohibited to be issued by the Companies Act and other types of
preference shares have no final maturity date. It gives sufficient flexibility to the company to
redeem the preference shares whenever surplus funds are available.

b. Claims on Income
Preference shareholders have a claim on the income prior to the equity shareholders. A fixed rate
of dividend is payable on preference shares.
However, payment of dividend on preference capital is not obligatory for the company. If there are
profits, dividend may be paid before it is paid to the equity shareholders. No dividend will be paid
in case of insufficient profits. In case of cumulative preference shares, the unpaid dividend
accumulates and is paid in the subsequent year out of the profits.

c. Claims on Assets
Preference shareholders have a superior and preferential claim in the repayment of capital at the time
of liquidation of the company as against equity shareholders who have the last claim on assets. In
the event of the winding-up of the company, after meeting the claims of the creditors and debenture
holders, the claim of preference shareholders have to be settled first before making any payment to
the equity shareholders. The preference shareholders usually do not have any right in the surplus
assets of the company. However, participating preference shares, entitle the holders to participate in
the surplus assets of the company at the time of winding-up at an agreed ratio.

d. Control
Generally, preference shareholders do not have any voting rights, so they do have any say in the
management or control of the company. However, under section 87 of the companies Ad, 1956, they
have been given voting rights parallel to equity shareholders under the following two conditions -
a) if dividend is not paid for at least two years in case of cumulative preference shares and for six
years in case of non-cumulative preference shares and b) matters which affect the rights of
preference shareholders are being taken up at the meeting, for example resolution for winding-up of
the company, resolution for redemption or reduction of its share capital etc. Thus, it is said that
preference shareholders have limited or partial voting rights.
.2 contd.
6
 e. Hybrid Form of Security
Preference share capital is called as hybrid form of security as it combines some features of both
equity shares as well as debentures.
 It resembles equity because it possesses the following features of equity shares:
Payment of dividend is not compulsory
Dividend is paid out of the distributable profits
No tax leverage to the company
 It resembles debt financing because it possesses the following features Of debt:
It carries a fixed rate of return
It entitles to a right to its holder prior to equity shareholders
No voting rights
Preference share capital is typically repayable

Advantages of Preference Shares

1. Advantages to Company

 No Legal Obligation to Pay Dividend

Unlike debentures or bank loan, preference shares do not prove a burden on the finances of the
company. Payment of dividend is not compulsory and can be postponed due to inadequate profits.
 Provide Long-term Capital
o Preference share capital provides long-term capital to the company for its needs. The company
does not have to worry about repayment of this capital unless sufficient funds are available and the
company intends to exercise the option of redemption.

 N0 Liability to Redeem Preference Shares and No Penalty on Delaying redemption

0 There is neither liability on the part of the company to redeem preference shares nor are there
significant penalties on the company for delaying the redemption.

 Advantage of Trading on Equity

The company gets the benefit of trading on equity by using preference share capital, The dividend
payable to preference shares is usually lower and it is at a fixed rate, which results in higher
dividend for equity shareholders. This is illustrated with the help of an example as given below.

Part Capital Capital structure equity

icul structure share capital
ars Equity (rs.4,00,0000)
Share Preference Share Capital
Capital(rs. (rs.6,00.000)
10,00,000)
Prof
its Rs.2,00,0 Rs. 2,00,000
afte 00
r
Tax
Les
s 0 Rs.90,000
Pref
eren
ce
1.2 contd.
7
 Divi
den
d@
15
%
p.a.

prof Rs. Rs.1,10,000

its 2,00,000
avai
labl
e
for
Equ
ity
Sha
reho
lder
s
Ret
urn 20% 27.5%
on
Equ
ity
Sha
re
Cap
ital
Ear
ning Rs.2 Rs.2.75
s
Per
Sha
re
(FV
-
rs.1
0)
 No Dilution of Control
o Preference shareholders have limited voting rights. Hence, they do not materially disturb the
existing pattern of control of the company as compared to the issue of equity shares since
preference shareholders are entitled to vote only on such resolutions which directly affect their
interests.

 Enhances Credit Worthiness of the Company

The credit worthiness of the company is enhanced as preference share capital is regarded as a part
of the net worth of the company. Including it in the equity base strengthens the company's financial
position and the ability to borrow funds in future.

 No Charge on the Assets

No assets are pledged against preference shares, so the assets of the company are conserved. This is
beneficial for the company as it can raise additional debt capital without any difficulty, as assets are
available as collateral security.
.2 contd.
8
  Less Costly as compared to Equity Shares
Preference shares are cheaper to issue and maintain as compared to equity shares. The rate of
dividend on preference capital is lower than that which is paid to equity shareholders.

 Wider Market for Raising Capital

o Preference shares appeal to those investors who seek a fixed return along With, safety of their
investment. Thus, they provide a wider market to the company for raising capital.

 flexible capital structure

The company can maintain flexibility in its capital structure by issuing redeemable preference shares.
When other securities in the market are not favoured by the investors, then the company can issue
participating or convertible preference shares. When there are surplus funds available with the
company, then the preference shares can be redeemed. Thus, a company can control capitalisation as
per its needs.

2. Advantages to Investor
 Fixed and Regular Income
Investors receive regular and fixed dividend against preference shares. Even
though payment of dividend is not compulsory, generally companies honour their commitment as
regards payment of dividend on preference shares.

 Tax-free Income
The dividend received by the shareholders is tax-free in their hands, that is, they do not have to pay
any tax on the amount of dividend that they receive from the company. However, the company has
to pay a tax which is called as a 'dividend distribution tax' before paying dividend to the
shareholders.

 Attractive Option for Cautious Investors

Preference shares are an attractive option available to those investors who desire a fixed income
and are ready to take moderate risk.

 Superior Security over Equity Shares

Preference shareholders enjoy a superior claim than equity shareholders as regards dividend payment
and repayment of capital. Hence, their capital seems to be more secure.

 Limited Voting Rights

Even though preference shares do not carry full voting rights, they are in a position to vote when
their interests are concerned or dividend remains unpaid. In that sense, they have a say in the
management of the company and they can exercise control to a certain extent.

Disadvantages of Preference Shares

Disadvantages to Company

 Fixed Burden
The dividend on preference shares creates a burden on the company as mostly cumulative
preference shares are issued. It implies arrears of preference dividend must also be paid before
payment of dividend to equity shareholders.

 Costlier than Debt Financing

1.2 contd.
9
 o raising of funds in the form of preference shares is no doubt less costly than Raising of funds in the
form of preference equity shares, but it is more costly as compared to debt financing. As compared
to debt capital, preference share capital is more risky for the investors, so they expect a higher return
on their investment. Also the cost of raising preference share capital is higher. This makes it an
expensive source of finance.

 Burden of Cumulative Preference Shares

Issue Of cumulative preference shares imposes a burden on the company regarding payment of
dividend. This is because in case of inadequate or no profits, the dividend accumulates and needs to
be paid in the subsequent years.

 Delay in Payment of Dividend affect the Credit Worthiness

If there is a delay in payment of dividend or dividend on preference shares is unpaid, then it greatly
affects the credit worthiness of the company. The reputation of the company is impaired in the eyes
of the investors.

 Tax Disadvantage
Dividend on preference shares is paid out of profits after tax and it is not allowed as a deduction from
income for calculating tax. Hence there is no tax benefit availed by the company as regards
payment of dividend on preference shares.

 Irredeemable Preference Shares cannot be Issued

The preference shareholder may be required to get their shares redeemed even though they want to
retain their investment in the company.

Disadvantages to Investors
 No Voting Rights
Preference shareholders do not enjoy full voting rights like equity shareholders. This puts them at the
mercy of the management for the payment of dividend and redemption of their capital.

 Rate of Dividend
The rate of dividend on preference shares is lower than the rate of dividend on equity shares.
Although preference shareholders bear a substantial portion of ownership risk, their returns are
limited.

 No Charge over the Assets

Preference shareholders do not have any charge on the assets of the company. If their claims are
unsettled, even though they enjoy partial voting rights, they cannot realise their outstanding amount
by way of taking charge of the assets.

 No Claim over Surplus Profits/Assets

Participating preference shares are generally not issued by companies; as such preference
shareholders do not get a right to enjoy in the excess profits or assets of the company.

 Fluctuations in the Market Price

The market price of preference shares fluctuates more than that of debentures or bonds.

 Irredeemable Preference Shares

Due to Companies (Amendment) Act, 1988, irredeemable preference shares cannot be issued. AS
such, preference shareholders may be required to get their shares redeemed even though they want to
retain their investment in the company.
.3 contd.
0
  Loss in Depression
If the preference shares are redeemed during a period of depression, then it will mean a loss to the
investors. This is because during depression, there is a general fall in the price level, market value of
shares and corresponding level of interest rates. It may be difficult for the investors to find an
alternative attractive avenue of investment.

 No Capital Gain
There is hardly any capital appreciation in case of preference shareholders. At the time of
liquidation, they get back their amount of investment only.
Thus, to conclude, preference share capital as a source of finance will be appropriate under the
following conditions:
 There is stability of revenue.
 The average rate of income is more than the fixed rate of dividend payable
 The company has insufficient assets to pledge.
 There is possibility of increasing risk in the business.

Distinction between equity shares and preference shares

Basi Equity Preference shares

s of shares
disti
ncti
on
1.Ra The rate The rate of dividend on preference
te of of shares is fixed at the time of issue.
divi dividend
ded on equity
shares is
fluctuatin
g; it
depends
upon the
profits
and
the
decision
of the
managem
ent.
2.Pa Equity Preference shareholders get their
yme sharehold dividend before equity shareholders are
nt of ers are the paid.
divi last ones
ded to receive
their
share of
dividend
that is
after
paying
interest
1.3 contd.
1
 on debt
and
preferenc
e
dividend.
3.Re At the Preference shareholders rank second last
pay time of that is their capital is refunded before
men winding- equity shareholders.
ts of up of the
capi company,
tal equity
sharehold
ers get
their
capital
after all
other
claims are
settled.
4.Ar rrears of In case of cumulative preference shares,
rear dividend unpaid dividend in any year can be
s of cannot carried forward to be paid in the
divi accumulat subsequent year.
den e in case
d of equity
shares.
Dividend
not paid is
dividend
lost and
cannot be
carried
forward
5.Co Equity convertible Preference shares can be
nver shares converted into equity shares at a later
tibili cannot be date
ty converted
into any
other
form of
security
6.Re Equity Irredeemable preference shares cannot
dee Shares be issued by the company. So preference
mab cannot be shares are redeemable during the
ility redeemed lifetime of the company.
during the
lifetime
of the
company,
but the
company
can buy-
back a

.3 contd.
2
 part of it.
7.Fa The face The face value of preference share is
ce value of comparatively higher.
valu equity
e shares is
very
small.
8.rig Equity Preference shares may carry a right to
ht to shares receive premium on redemption.
rece cannot
ive carry a
pre right to
miu receive
m premium
on on
rede redemptio
mpti n.
on
9.vo Equity Preference shares enjoy partial voting
ting shares rights.
right enjoy full
s voting
rights.
10.fl Market Less fluctuations are observed in
uctu value of market price of preference shares.
atio equity
ns shares
in usually
mar fluctuates
ket widely.
valu
e
11.R Equity Preference shares carry moderate risk
isk shares and are suited to cautious investors.
invo holders
lved are the
real
owners of
the
company
and they
bear the
highest
risk.
Equity
shares are
suited for
bold and
enterprisi
ng
investors.

1.3 contd.
3
 [E]DEBENTURE
MEANING

The word 'debenture' is derived from the Latin word 'debere' which means taking loan. Debentures
constitute the borrowed capital of the company and they are known as creditorship securities. A
public limited company, if permitted by the memorandum of association, can raise long-term finance
by issuing debentures.
In simple terms, debenture is an acknowledgement of debt by the company. It is an instrument in
writing under which a company agrees to pay a fixed rate of interest at periodic intervals and also
agrees to repay the loan at the expiry of the stipulated time.
Debenture holders are creditors of the company and they are paid a fixed rate of interest are also
entitled to redemption of their debentures as per the terms and condition of the issue.
Definitions

According to Section 2(30) of Indian Companies Act. 2013, the term

debenture includes "debenture stock, bonds or any other instrument Of a
company evidencing debt, whether constituting a charge on the assets of
the company or not. "

Thomas Evelyn: "A debenture is a document under the company's seal

which provides for the payment of a principal sum and interest thereon at
regular intervals, which is usually, secured by a fixed or a floating charge
on the company's property or undertaking and which acknowledges a loan
to the company. "

Palmer defines a debenture as "any instrument under "' seal of the

company, evidencing Of deed the essence of it being admission of
indebtedness.

.3 contd.
4
 Types of Debentures

Debentures are classified into different types as explained below:

Basis Types of Meaning

of Debentures
Classifi
cation
1.Class (a) Registered Registered Debentures are
ificatio Debentures those for which a proper
n on record is maintained
the Registration by the company
basis of as regards name of the
registra investor, address of the
tion investor, number of
debentures held etc. The
company maintains record
in the register of debenture
holders and these debentures
can be transferred only by
executing a transfer deed.
Interest is paid to the
registered holder.

(b) Bearer Holders of bearer debentures

Debentures are not
listed with the

1.3 contd.
5
 company. These
transferred to can another
be person freely by mere
hand delivery. Interest on
these debentures is paid to
the person who produces
the interest attached to
such debentures.

2.classfication (a)Secured These debentures are

on basis Of Debentures secured by a charge on the
security assets Of the company.
The charge may be a fixed
charge or a floating
charge; in India only
secured debentures can be
issued

(b) Unsecured These debentures are not

Debentures/si secured by a charge on the
mple assets of the company.
debentures

3. Classification (a) Redeemable debentures

on the basis of Redeemable are to be repaid on or
Redemption Debentures before a specified date as
per the
terms of issue and

.3 contd.
6
 in accordance with the
provisions Of the
Companies Act, 2013.

(b) Irredeemable These are perpetual

Debentures debentures and are not
to be redeemed during
the lifetime of the
company.

4.classification Those debentures

on the basis
of conversion (a) Convertible which can be fully
Debentures- converted into equity
Fully convertible shares of the
Debenture and
partially
Convertible
debenture
company after a
specified time are
known as fully
convertible
debentures. The
rate of interest on
fully convertible
debentures is
usually lower than
that of
nonconvertible
debentures In case
of partially
convertible
debentures, a part
of the debenture is
convertible and the

1.3 contd.
7
 remaining art is non-
convertible.

(b) Non- Non convertible

Convertible debentures cannot be
Debentures converted into equity
shares.

5. classification (a) first These debentures have a

on the basis of debentures first charge on the profits
priority and the assets of the
company.

(b) second These debentures have a

debentures second claim (that is after
first debentures) on the
profits and the assets of
the company.

6. classification (a) guaranteed Debentures on

on the basis debentures
of guarantee which the payment
on interest and
repayment of
capital is
guaranteed by third
parties is banks,
financial
institutions fall in
this category. For
example Reserve
Bank of India gives

.3 contd.
8
 guarantee of debentures issued by
Industrial Finance Corporation
Of India (IFCI). Usually they are
called as bonds instead of
debentures,

(b) Debentures issued by a company

collater to a lender of money as collateral
al for a loan availed from the lender
debentu are called as collateral
res debentures. They
are like the security given to the
lenders. In case the company
makes default in payment of
interest or repayment of capital,
then the borrowing is converted
into debentures and the lenders
assume the role of a creditor for
the company.

1.3 contd.
9
 7.innovative (a) zero As the name suggests,
debentures interest bonds these bonds
Debentures do not carry
any fixed rate of interest.
The bonds are issued at
price which is lower than
the maturity value. The
difference between the
issue price and maturity
value represents the gain
for the investor.
ICICI and IDBI
usually issue such bonds
frequently.

(b) warrants These types of debentures

or optionally give an Convertible
convertible Debentures option to the
debentures holder to buy a number of
equity shares after a fixed
period of time. The holder
acquires the right but is
under no obligation to
acquire the equity shares

.4 contd.
0
 (c) secured These are the instruments
premium which can be traded with
notes the detachable warrant
against which the holder
gets equity shares after a
fixed period of time.

(d) Deep These are similar to Zero

Discount Interest Bonds. IDBI issued
Bonds (DDB) deep discount bonds for
the first time. For a deep
discount price of 2700/- an
investor gets a bond with a
face value of The DDB
appreciates to its face
value over a period of 25
years. The investor has the
option to wait till maturity
or withdraw from the
scheme after a lock in
period of five ears.

(e) Floating These bonds do not have a

Rate Bonds fixed rate of interest, but
the
interest rate is

1.4 contd.
1
 reset periodically based on a
benchmark rate. So the interest
that the bondholder receives
changes periodically, depending
upon the market rate of interest

(f) A debenture with a put option,

Debentu is the one in which the investor
res with has the right to demand back the
Call and money earlier than the
Put redemption date at a pre-
Features determined price within the
specified period.
A Debenture with a call option
is beneficial for the company
where as a pre-determined price
within the specified period.
A Debenture with a call option
is beneficial for the company
where as a debenture with a
put option is beneficial for the
investor.

.4 contd.
2
 Features Of Debentures
 . Acknowledgement Of Debt
A debenture is a written acknowledgement of debt taken by a company. It records the name of the
debenture holder, the number of debentures he'd, distinctive numbers of the debentures etc. A
debenture certificate is a proof that the name of the person mentioned in the certificate is a creditor of
the company and that the debentures are held in his name.

 Maturity
o Debentures provide long-term funds to the company, but they also mature for payment after a
specific period as decided at the time Of the issue. The company needs to honour its commitment of
repaying the principal amount on due date otherwise, the debenture holders can take charge of the
security provided or may even force winding-up of the company. In case of irredeemable debentures,
the debenture holders cannot compel the company to repay. But it also does not mean that the
company can never redeem its irredeemable debentures. In that sense, all debentures are
redeemable or mature at one time or the other.

 Claims on Income
The income for the debenture holders is in the form of interest which is at a fixed rate and it is
obligatory for the company to pay interest irrespective of whether there are profits or losses. This
interest has to be paid periodically to the debenture holders and if the company fails to pay the
interest, then the debenture holders may take recourse to law for the same. Also debenture holders
have a prior claim on the income of the company that is they are paid interest before the returns are
paid to preference shareholders and equity shareholders.

 Claims on Assets
Debenture holders are the creditors of the company. In the event of winding-up of the company, they
have a prior claim on the assets of the company over that of shareholders. This is because
shareholders are the owners and debenture holders are the creditors of the company. Thus, in case
of winding-up of the company, the principal amount of debentures has to be settled first and
thereafter claims of shareholders will be settled. However, they do not have any claim in the
surplus assests of the company.

 Control
Debenture holders being the creditors of the company, have no control over the company and they
do not enjoy any voting rights. However, in case of nonpayment of interest and principal amount
they can interfere in the working of the company by taking legal action

 Call Feature
This feature is beneficial for the company as it entitles a company to redeem its debentures at a
certain price before the maturity date.

Advantages of Debentures

Advantages to Company
 Long-term Funds
Debentures provide long-term funds to the company. The company can utilize these funds for
purchase of fixed assets. There is certainty of finance for a specific period and the company can
adjust its financial plan accordingly.

 Inexpensive
o Debentures are an inexpensive source of finance for the company. The rate of interest payable is
lower than the dividend paid on shares. Also these can be issued without incurring heavy issue and
underwriting expenses as against shares which require more expenditure.

 Raising Capital from Moderate Investors

 With the issue of debentures, companies are able to raise funds from such investors who prefer a
regular income and are not willing to take any risk. There is a wide base of conservative investors
who are wary of investing in equities, debentures provide a good option to these investors.

 Tax Advantage
The interest which is paid on debentures is allowed to be deducted from the income of the
company for the purpose of calculating tax. Thus, there is reduction in the amount of tax liability
of the company.

 No Dilution of Control
Debenture holders do not possess any voting rights. As such, there is no dilution of control and the
controlling position of the owners remain intact. Thus the company can raise additional finance
without diluting or weakening the control of existing shareholders.

 Advantage of Trading on Equity

By using debentures in the capital structure, the company can avail the advantage of trading on
equity. Thus, the earnings for the equity shareholders are enhanced.

 Flexibility
Debentures provide flexibility in the capital structure of a company. The company can redeem the
debentures whenever surplus funds are available. Also, the state of over capitalisation can be easily
controlled.

 Good Market Even during Depression

During a phase of depression, the sentiment of stock market is low and investors are reluctant to
invest in any securities. But debentures do find a market even during depression because of
certainty of income and low risk for investors.

 consolidation of debt capital

A company may have already incurred a number of small debts of short which may be costly.
These smaller debts on differing terms converted into a single issue of debentures which will be more
economical easy for the company

2. Advantages to Investors
 fixed, regular and stable source of income
Debentures provide fixed and regular income to the investors. The rate of is fixed and is paid
irrespective of profits or losses of the company.

 Safe Investment
Debentures are considered a safe investment because they carry a charge on assets of the company.
The debenture holders enjoy the status of a Superior, creditor in the event of liquidation of the
company. Also their interests are protected by the debenture trust deed and the guidelines issued by
the Securities and Exchange Board of India (SEBI) in this regard.

 Definite Maturity Value

This is another peculiar advantage of debentures which draws many investors towards it. The maturity
value of debentures is fixed unlike equity shares which has no definite maturity value.

 Liquidity and Loan against Debentures

A debenture is usually a more liquid investment and has good marketability. Also, an investor can
sell or mortgage his instrument to obtain loans from banks and financial institutions.

.4  Conversion contd.
of Loan
4
o Debenture holders can convert their holding in shares in case of convertible debentures. Hence
they are favored by the investors wherein, initially their investment fetches a fixed and stable return
and later on when the company does well, they enjoy the status of being a shareholder and reaping all
the benefits that are associated with the owners of the company.

Disadvantages of Debentures
Disadvantages to Company
 Burden of Paying Interest
The fixed interest charges haye to be paid by the company on debentures irrespective of the
profitability of the company. This creates a permanent burden on the company. Default in payment
of interest may create complications for the company and debenture holders may take legal recourse.

 Burden of Repayment of Principal Amount on Maturity

This is another obligation which the company has to fulfill; otherwise it may affect the credit
worthiness of the company. The debenture holders have the power to take control over the assets of
the company in case of default by the company and they can also file a petition for winding-up of
the company.

 Charge on the Assets

The assets of the company are pledged to the debenture holders. Non- payment of interest or
principal amount on maturity may lead the debenture holders to take control over the assets of the
company.

 Increase in Financial Risk

The use of debt financing increases the risk perception of investors in the company. This increases
the financial risk and consequently the cost of equity capital goes up.

 Increase in Cost
Cost increases due to high stamp duty and registration charges

 Unsuitable in Certain Cases

Debentures as a source of finance will be unsuitable in certain cases for example
 in case of a company having unstable income
 when the demand for the products of the company is highly elastic
 there are insufficient fixed assets to offer as security
 already existing debt component in the capital structure is high
 the company is having low proportion of fixed assets to total assets

Disadvantages to Investors
 No Voting Rights
Debenture holders are the creditors of the company and they do not enjoy any voting rights. They
do not have any say (voice) in the affairs of the company, neither can they exercise any control over
the management.

 Returns not very Attractive

The interest on debentures is generally lower than the dividend on equity shares and preference
shares. The returns are not very attractive as it is not a high risk investment.

 No Claim over the Surplus Assets

They are entitled to a fixed rate of interest which is paid to them periodically. Apart from that they
are also entitled for the repayment of capital on maturity. However, being the creditors of the
company, they have no claim over the surplus assets of the company.

 Interest is Taxable
 The interest which is received by the debenture holders is fully taxable in their hands under the
Income Tax Act, 1961. No tax benefit is derived as against shares holders, for whom the dividend is
tax free in their hands.

 Higher Denominations
Debentures are usually in higher denominations and as such common investors cannot purchase
the same.

Basis of Shares Debentures

Distinctio Owned Borrowed
n Capital Capital
1. type of Share are Debentures
Security ownership are
securities. creditorship
Shareholders securities
are securities Debentures
are the are
owners of creditors of
the company. the company.
2. Return Return is in Return is in
on the form of the form of
investmen dividend interest
t payment . payment.
3. Fixed The rate of the rate of
Income dividend on interest is
Vs preference fixed at the
fluctuatin shares is time of issue.
g income fixed
whereas it is
fluctuating
on equity
shares.
4. Charge Payment of Payment of
Vs dividend is interest is
Appropria an charge
tion appropriation against profit
out of profits and it is to be
and dividend paid even if
cannot be there are no
paid if there profits.
is no profits.
5. Priority Payment of Payment of
as to equity interest gets
payment dividend priority over
of Payment of the payment
interest/di interest gets of dividend.
vidend gets no
priority over
payment
priority over
the payment
of preference
dividend or
dividend
.4 contd. dividend gets
6
priority over
 payment of
equity
dividend
only and not
against
interest on
debts.
6. Priority Repayment Repayment of
as to of share debentures is
Repayme capital is made before
nt of made after the
Principal repayment of repayment of
during debt, if there share capital.
Winding- are any
up surplus
assets.
7. Shares are Debentures
Security not offered are secured
any security by way of a
by way of a fixed or a
charge. floating
charge on the
assets of the
company.
8. The No restrictions
Restri Companies are imposed on
ctions Act, 2013, the issue
on imposes of debentures at
Issue certain a discount.
at restrictions
Disco on issue of
unt shares at a
discount.
9. Equity shares Debentures have
Votin enjoy full no
g voting voting rights.
Right right
s
10. Equity shares Debentures can
Conv can never be be convertible.
ertibil convertible.
ity
11. Share Trust Debenture Trust
Trust Deed is not Deed
Deed required to is required to be
be executed. executed.
12.Iss Shares are Debentures are
ue generally issued for
Time issued in the expansion and
initial stage development
of business. programmes of
the company
13. The face The face value of
Face value of debentures is
Value equity shares high.
is very small.
 14. the company Debentures
Tax does not get provide tax
Adva any tax shield to the
ntage advantage in company and
case of there is a
shares. reduction in the
amount of tax
that the
company pays.
15.Su Shareholders Debenture
per have a claim holders have no
Profit on the super such claim as
s profits of the they are the
company. creditors
of the company.
16. Shareholders Debentures are
Risk are the real the creditors of
involv owners of the the company and
ed company and these securities
they bear the do not involve
highest risk. any risk. They
They are are suited for
suited for very
bold and cautious
enterprising investors.
investors

TERM LOANS
'Term loans’ refers to the loan for medium-term as well long-term. Medium term loans ranging
from 1 to 5 years while long-term loans are for periods ranging from 5 to 10 or 15 years.
A term loan is a financial loan which is paid back in the form of regular payments over definite period
of time. A term loan generally includes an unfixed interest rate that will add extra amount of money
to be paid back.

Features of term loans

 Objectives
 The objectives for granting of term loan may be:
 Establishment renovation, expansion, diversification or modernisation
 Financing the core working capital
 Redeeming bonds or retiring preference shares
The funds are provided for meeting various expenses like purchase Of land, building, plant and
machinery, miscellaneous fixed assets, preliminary expenses, acquiring technical know-how, margin
money for working capital etc.

 Security
o Term loans are usually secured against the assets of the company. They may be secured by a fixed
charge or a floating charge on the assets. Usually the assets which are financed by the term loans are
provided as a prime security. Other assets of the company may serve as a collateral security.

 Tenure
The term loans are granted for periods ranging from I year to 15 years. The repayment schedule is
decided at the time of the issue. Repayment is made by way of installments which includes an
.4 amount towards thecontd.
principal and the interest on the outstanding balance.
8
  Cost
o Cost of borrowing in the form of term loan is interest, which may be calculated on monthly,
quarterly or half yearly basis at a fixed percentage on the outstanding amount of term loan.

 Commitment Charge
o A commitment charge is a charge which is imposed on the un-utilised portion of the loan which
has already been sanctioned from the date of execution of the loan agreement in addition to the
interest payable on the actual amount.

 Agreement
o There is a formal written agreement between the lender and the borrower. This agreement provides
for the terms and conditions under which the loan will be governed the agreement may have certain
protective covenants which the borrower has to follow for example limiting the dividend rate,
conversion Of loan into share capital etc, The terms and conditions are settled through direct
negotiation between the borrower and the lender.

 payment Of Interest and Principal Repayment

o The interest and the principal repayments are definite obligations that are payable by the borrower
irrespective of his financial condition. There is also a penalty clause for default or delay in payment.
Typically. term loans provided by financial institutions are repayable in equal semi-annual
installments or equal quarterly installments.

 Syndicate Arrangement
o In case the loan amount is very large, there may be more than one lender who will jointly grant the
term loan to the borrower in an agreed ratio. Such participation is done either due to statutory
restrictions or simply for sharing the risk among different financial institutions. The larger the loan,
the greater is the participation.

 Financial Discipline
o Term loans inculcate financial discipline in the borrower. The borrower has to prepare various
projected financial statements and submit the estimates to the lenders. He needs to plan for repaying
the principal amount along with the interest. This necessitates the preparation of projected income
statement, projected balance sheet, projected cash flow statement etc. He has to pay particular
attention to the forecasting methods that he is employing because if there is an error, it may lead to
financial difficulties in repaying the loan amount.

 Project-oriented Approach
Financial institutions which offer term loans to corporates follow the project oriented approach as
against the security-oriented approach. They perform a detailed analysis and appraisal of the project
on the basis of the feasibility report and the projected statements. The viability and the profitability
of the project are examined for the purpose of assessing the repayment capacity of the borrower. A
thorough appraisal procedure is followed before sanctioning term loans to the borrowers. The loan is
sanctioned only when it satisfies their tests. Security oriented approach takes into account the
security which is being offered as collateral and only those borrowers who are able to offer security
are granted loan.

 Follow-up and Supervision

The lending institutions keep a constant watch over the functioning of the borrowing unit. They are in
close touch with the borrower till the whole amount of loan is repaid. Periodic financial statements
are also required to be submitted to the lender.

 refinance facility
IDBI provides refinance to the commercial on the basis of term loans which are sanctioned by the
commercial banks. Commercial banks do not own funds and seek support from IDBI. But the risk is
borne by the commercial banks
  special Conditions
In order to provide safegurds against their interest the financial institutions generally impose
restrictive conditions against on the borrowers. while the specific set of restrictive convants depends
on the nature of the project and the financial situation of the borrower, the general set of conditions
require the borrower to give undertaking in respect of the following matters:
 No further long-term loan shall be taken.
 The debt-equity ratio will not exceed the specified limit.
 Current ratio will be maintained at the desired level.
 Refrain from undertaking any new project or expansion or investment without the prior
approval of the financial institutions.
 selling commission to the sole selling agents shall not be disbursed unless interest and loan
instalments are paid.
 Dividend shall not be declared for a specific period or shall not exceed the agreed rate or to
seek consent from the financial institution to declare a higher rate of dividend.
 Refrain from creating further charge on its assets.
 Give financial institutions the right to appoint nominee directors.
 Loan shall become payable before maturity under specified circumstances.
 Financial data and other information as required by the lending institutions will be supplied
as and when desired.
 The directors will furnish personal guarantees for repayment of the loan in addition to the
financial institution's charge on the company's assets.

Sources of Term Loans

A notable feature of the present-day capital market of India is the existence of specialised financial
institutions set-up by the Government with the objective of stimulating industrial development in the
country by widening the channel of industrial finance in an economic way. These institutions
mainly provide medium-term and long term finance.

Major sources of term loans include:

 Specialized Financial Institutions or Development Banks
 Commercial Banks

Specialized financial institutions or development banks

 After independence Financial a large Institutions number or of Development institutions
Banks have been set-up to meet the After specific requirements Of the Indian industry and for
accelerating the growth of industries by providing financial assistance. These financial
institutions are popularly known as Development Banks'. A development bank acts as a
development catalyst which mobilizes scarce resources, such as capital, technology,
entrepreneurial and managerial talents and channelize them into industrial activities in
accordance with plan priorities. It caters to the development needs of specific sectors as
well as the economy in general.
 These specialised financial institutions play an important role in providing long-term risk
capital and loan capital to industries. They provide financial assistance as well as other
consultancy services which include marketing, technical and managerial services. They also
conduct surveys of backward regions for exploring their industrial potential and play an
important role in removing regional imbalances.
 Nowadays these institutions also participate in the management of the industrial units
financed by them. This is a welcome trend as the directors nominated by the financial
institutions can safeguard the interests of the general public and enforce social obligations and
discipline among the enterprises which operate in the private sector.
 Some of the specialised financial institutions are listed below:
(i)All India Development Banks/Financial Institutions
.5 contd.
0
 Industrial Development Bank of India Ltd. (IDBI Ltd)
  Industrial Finance Corporation of India Ltd. (IFCI)
 Industrial Credit and Investment Corporation of India Ltd. (ICICI Ltd.-now merged with
ICICI Bank Ltd).
 Small Industries Development Bank of India (SIDBI) Export Import Bank of India (EXIM
Bank)
 Industrial Investment Bank of India Ltd. (IIBI) (Earlier IRBI)
 Risk Capital and Technology Finance Corporation Ltd. (RCTC) Technology Development
and Information Company of India Ltd. (TDICI) Tourism Finance Corporation of India Ltd.
(TFCI)
 Infrastructure Development Finance Company Ltd. (IDFC)

ii) Investment Institutions

 Life Insurance Corporation of India (LIC)
 General Insurance Corporation of India (GIC)

iii) State Level Institutions

 State Financial Corporations (SFCs)
 State Industrial Development Corporations (SIDCs)
 North-Eastern Development Finance Corporation Ltd. (NEDFCL)

The overall Objective Of establishment of development banks in India is to Cover the financial gaps
of Indian companies. Financial assistance is mainly provided in the following forms:
 To provide term lending facilities
 TO subscribe to shares and debentures
 To underwrite security issues of industrial concerns
 To guarantee term loans raised by industrial concerns
 To provide guarantees in respect of deferred payments by the importer in case of purchase of
assets from foreign manufactures.
 The requirements loans by various industrial units are gradually increasing and a, t such, the
loans are provided by various institutions stated above at a certain specified rate of interest
according to their own terms and conditions.
 In recent years all India financial institutions have also started providing help to the industrial
concerns to raise funds by way of rendering financial services such as merchant banking,
leasing, venture capital etc.

2. Commercial Banks
 Commercial banks normally provided short-term financial assistance to the corporate sector.
However, recently the priority shifted towards medium-term and long-term 'ending. This was
due to the fact that the corporate sector needed long-term financing on a large scale and the
financial institutions could not cope up with this demand.
 The commercial banks came into picture to fill the gap between demand and supply of long-
term requirements. The banks started giving term loans to meet the requirements of the
industry. The IDBI refinance scheme encouraged more term lending by commercial banks.
The bank managements now are confident of extending long- term credit to the industry
without distorting the principle of liquidity.
 Commercial banks assist the industrial units by granting term-loans, subscribing to shares and
debentures of these corporate enterprises and underwriting securities issued by them.

Merits (Advantages) of Long-Term Loans

 Low Cost
The cost of term loans is lower than the cost of equity or preference share capital because interest is a
tax deductible item and the rate of interest is lower than the rate of dividend.
  Advantage of Trading on Equity
The Company gets the advantage of trading on equity if the rate of return on investment exceeds
the rate of interest on term loan.

 Better Negotiations
Term Loans are privately placed and hence it is possible to negotiate the terms and conditions to
suit the needs of the borrower and the lender.

 Availability Of finance for Development Schemes

Long-term funds are easily available through various financial institutions

 Reasonable Security Requirements

Term loan is the debt capital for the company. The security demanded by the enders is generally the
asset which is financed with the amount of loan granted, The company is in a position to offer the
assets as the demands of the lenders are generally reasonable.

 Availability of Finance during Periods Of Depression

o During a phase of depression, the investors shy away from the capital market. Due to the prevailing
uncertainty and slump in the market, there are no takers for any of the company securities. In such
a situation, term loans are a boon for the company.

 Easy Repayment Facility

The repayment facility and the other terms and conditions are negotiated between the borrower and
the lender. The repayment schedule can be structured to favor the requirements of the borrower.

Demerits (Disadvantages) of Long-Term Loans

 Risk of Financial Insolvency
There is the presence of financial risk due to a) compulsory payment of interest and b) repayment
at the scheduled time.

 Security
Adequate security is demanded by the lenders failing which, it will not be possible for the
borrower to avail the term loan.

 Increases the Risk of Shareholders

Certain restrictive covenants provided in the loan agreement may be against the interests of the
shareholders.

 Interference in Management
Usually, the financial institutions nominate one or two directors to be part of the management team.
These nominee directors will exercise control over the functioning of the company and may interfere
in the smooth functioning of the organisation.

 Restrictive Clauses
The loan agreement is known for its restrictive clauses which are in favour of the lender. For
example, the loan agreement may provide for conversion of loans into equity capital after a specified
period of time or may prevent the company from taking additional loans.

 long processing time

Usually the lenders require a number of financial statements and a detailed project report from the
borrower stating the purpose of the financial requirements The lending institutions appraise the
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proposal on the basis o, documents and reports prepared and submitted by the borrower. It is a
2 consuming procedure to get the loan sanctioned by the lenders.
  Lease financing
Lease is one of the methods of financing the fixed assets of an enterprise. An enterprise with
inadequate funds for financing the investment in plant and machinery may enter into lease agreement
with the owners of the assets. The contract of lease allows lessee to use the asset for a certain period
in return for a periodical payment. After the expiry of the period the lease agreement may be
renewed or the asset may be purchaser, by the lessee if so desired by the lessee.

Definitions
Herbert B. Mayo: "A contract for the use of an asset such as plant or equipment. The firm that owns
the asset permits the lessee to use the goods. In return the lessor enters into a contract(the lease) to
make specific payments for the "use Of the asset. The lease is usually for a specified time period
and may be renewable.
Merriam Webster dictionary : "A legal agreement that lets someone use a car, house, shop etc„ for a
period of time in return for payment. It is a contract by which one conveys real estate, equipment, or
facilities for a specified term and for a specified rent "
Raymond G. Schultz: "The user agrees to pay a rental charge and adhere to other conditions of a lease
contract in return for the right to utilise property of the owner in his operations for a specified
period. "
Institute of Chartered Accountants of India: "A lease is an agreement whereby the lessor conveys to the
lessee, in return for rent, the right to use an asset for an agreed period of time. Lessor is a person
who carries to another person (lessee) the right to use an asset in consideration of a payment of
periodical rental, under a lease agreement Lessee is a person who obtains from the lessor, the right
to use the asset for a periodical rental payment for an agreed period of time ".

 Advantages of Leasing
Advantages to the Lessee
 financing of capital goods: Lessee can obtain the right to use capital goods without any down
payment and without any obligation to pay for the price of the asset in future

 Avaibility of funds: Lessee gets the benefit of use of the asset without making any towards the
purchase of the asset. Funds thus saved can be used for working capital requirements.

 Flexibility: The lease agreement can be made to suit the needs of the lessee and lessor. There is
a lot of flexibility.

 Cheaper: It is a cheaper source of financing when compared to debt financing.

 tax advantage: The rent paid is chargeable to the profit and loss account of the lessee. Thus the
lessee gets tax advantage.

 Risk of obsolescence: Due to technological developments there is a risk of obsolescence of

assets especially with respect to machinery and equipment. This risk is averted by taking assets
on lease. The business can use the latest technology in the business by not renewing the lease
agreement. The risk of obsolescence is on the owner Of the asset and not on the lessee.

 No change in the debt-equity mix: Capital goods are or taken ownership on lease funds. Hence
Thus there theis no need for the lessee company or firm to raise loan ownership remains
undiluted and the debt —equity mix is unchanged.

 Advantages to the Lessor

 ownership of the asset: The lessor remains the owner of the asset. If the lessee defaults
in payment of lease rentals the lessor can repossess the asset.
  Depreciation and tax benefits: Lessor being the owner of the asset, can charge
deprecation on the asset to the profit and loss account and thereby enjoy tax benefit.

 Limitations/Disadvantages of Leasing

 High rate: The lessor usually charges higher rate of interest than the rate he pays on
borrowings.

 Restriction on use: The owner of the asset can impose some restriction on the use of the asset.
The lessee cannot make alterations in the asset to suit his requirements.

 Residual value: The residual value of the asset may accrue to the lessor. If the value of the
asset appreciates after the lease period, which is normally spread over the working life of the
asset, he does not get any share in the capital gain.

 Default: If the lessee defaults, the owner can repossess the capital asset, and terminate the
contract.
 Hire Financing
 Under this method of finance the purchaser acquires the possession of goods from the seller
by making a part payment called down payment. The ownership of the goods remains with
the seller. A hire purchase agreement is entered into between the hire vendor and hire-
purchaser, whereby the latter agrees to make payment towards the price of the goods in
future, by way of periodic instalments along with interest. The periodic instalments are treated
as hire charges by the hire-vendor. Hence the hire-vendor retains the ownership of the goods
till the last instalment is paid by the purchaser.
The hire purchaser becomes the owner of the goods only after the payment of the last
instalment.

Definitions
According to J. R. batiliboi, “under the purchase system, goods are delivered to o who to pay the
owners by equal periodical instalments such instalments, are to be treated as hire of these goods,
until a certain fixed amount has been paid, when these goods become the property of the hirer”.
according to hire purchase Act 1972,"Hire purchase agreement means On agreement under which
goods are let on hire and under which the hirer has an option to purchase them in accordance with
the terms of the agreement and includes an agreement under which
Possession of goods is delivered by the owner thereof to a person on condition that such person
pays the agreed amount in periodical instalments, and
The property in the goods is to pass on the payment of the last of such instalment
Characteristics of Hire Purchase System
Possession of goods: The hire-purchaser gets immediate possession of goods on signing the hire purchase
agreement. He is entitled to use the goods.
Ownership of goods: The hire-purchaser does not get the ownership of the goods on signing the
agreement. The hire-vendor retains the ownership till the last hire charge instalment is paid by the
hire- purchaser.
Payment of instalment Under the system the hire-purchaser is required to pay the hire purchase price
which includes interest for the delayed payment, in periodic instalments. Each instalment is treated as
hire charges and not as payment for ownership of goods.
Hire purchase agreement: As per the Hire Purchase Act of 1972, the hire- vendor and hire purchase
must enter into a written agreement with the following contents:
(a) The hire purchase price of the goods to which the agreement relates. (b)The cash price of the
goods.
The date on which the agreement shall be deemed to have commenced.
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4
The number of instalments by which the hire-purchase price is to be paid, the amount of each of
those instalments, and the date, or the mode of determining the date upon which it is payable, and
the person to whom and the place where it is payable; and
The goods to which the agreement relates, in a manner sufficient to identify them.
The hire purchase agreement must be signed by the parties.
loss of goods The risk of loss to the goods is on the hire-vendor, provided hire Purchaser has taken
care of goods.
Liability of hire-purchaser: The hire-purchaser is liable to keep the goods in good condition during the
period when goods are in his possession. He has no right to sell or pledge the goods as he is not yet
the owner of goods.
Right Of the hire-purchaser to buy at any time with rebate: The hirer may, at any time during the
continuance of the contract, can buy the goods, by giving 14 days notice, in writing to the vendor.
The hirer is entitled to rebate calculated as per the following formula:
Rebate = 2 x 3 Total hire purchase charges x no. of instalment not yet due

Total no. of instalment

The hirer shall pay the balance of the instalment amount less the rebate.
Default by the hire-purchaser. If the hire-purchaser fails to pay instalment the hire vendor has a right
to repossess the goods, as the ownership of goods is with the hire-vendor.
However if statutory proportion of the hire purchase price has been paid then repossession can take
place only on the sanction of the court. Statutory proportion means one half of the price when the
hire purchase price is less than 15,000 (in case of motor vehicles RS 5,000) and 3/4th the price
when the price is equal to or more than 15,000 (C 5,000 in case of motor vehicles).
Refund to the hire-purchaser: When the hire-vendor repossesses the goods for non-payment of
instalment, he is not to refund the hire purchase price already received. But if the total amount of
hire purchase price received so far plus the value of goods repossessed exceeds the amount paid by
the hire- purchaser then the difference must be refunded to the hire-purchaser.
(Hire purchase price collected + value of good repossessed) — Hire purchase price of the goods =
Refund.
Short-term Sources of Finance - Bank Overdraft, Cash Credit,
Bills Discounting, Ploughing Back of Profits
 Overdraft
An overdraft is an agreement with a bank by which a current account holder is allowed to withdraw
more than the balance to his account upto a certain limit. Interest is charged on the daily
overdrawn balance. It is a sort of demand assistance given by the bank.
The main difference between cash credit and overdraft is that overdraft is allowed for a short time
period and is a temporary accommodation whereas cash credit is allowed for a longer period.
 cash credit
A Cash credit is an arrangement by which a bank allows his customer to borrow money upto
certain limit against some tangible securities or guarantees. The customer can from his cash credit
limit according to his requirements and he can also deposit any surplus amount with him.
The interest is charged on the daily balance and not on the entire amount of the cash credit limit
sanctioned. Inventory or goods are given as security and they are either hypotheticated or pledged
with the bank. In case of hypothecation, the goods remain with the customer and in case of pledge,
the goods are under the custody of the bank. It is the most popular mode of borrowings by
industrial and commercial organisations.
 Bill Discounting or Purchasing and Discounting of Bills
Modem day business is based on credit. When the company sells on credit to its customers, bills of
exchange and promissory notes are generated. These instruments can be discounted with the bank in
exchange of cash. Thus the company gets finance against book debts.
The amount given to the company is lower than the face value Of the instrument discounted, the
difference being the amount of discount. Bank holds the bill as a security till the payment is made
by the customer. On due date of the instrument, the amount is collected from the debtor of the
company. If it is dishonoured, then the company is responsible to the bank. The bank recovers the
full amount of the credit instrument from the customer along with its expenses in that connection.
Before granting this facility, banks verify the credit worthiness of the customer and the genuineness
 of the bill.
 Ploughing Back of Profits
Meaning
A new company can raise funds from various external sources like shares, debentures, public
deposits etc. However, an existing company or a going concern, which needs finance for its future
growth and expansion, can also generate the same through its internal sources like retained earnings
or ploughing back of profits, capitalisation of profits and depreciation. Internal sources of finance are
those which are generated from within the organization out of business operations.
Strictly speaking, ploughing back of profits is not a method of raising finance but it refers to
accumulation of profits by a company to finance its developmental activities or repay loans. The
profits earned by the company can be dealt with in two ways: either they can be distributed to the
shareholders by way of dividend or retained in business. However, companies distribute some portion
as dividend and the balance is retained in business for future requirements.
Thus ,’ploughing back Of profits' is a technique of financial management under which all profits are
not distributed amongst the shareholders as dividend, but a part of the profits are retained in the
company. They are retained by transferring a part of the profits to various reserves like General
Reserve, Reserve Fund, Depreciation Fund, Replacement Fund etc. This process of retaining profits
year after year and their utilisation in the business is also known as 'Ploughing back of Profits' or
'Internal Financing' or 'Self-Financing'.
This scheme is considered as an ideal source of financing expansion and modernisation programmes
of the company. This is because there is no immediate pressure on the company to pay a return on
this amount utilised, which belongs to the company itself. In the long run, retained earnings can be
converted into the permanent capital of the company by issuing bonus shares which is called as
'Capialisation of profits'. The quantum of retained earnings is affected be a large number of factors
like extent of available surplus, tax rate, managerial attitudes, industry practices, dividend policy etc.
Among these factors, the dividend policy pursued by a company is the most significant factor. The
higher the dividend rate means less retained earnings and vice-versa.
This device can suitably be compared with the usual practice of Indian homemakers who, out of the
total earnings of the household, save a little for the rainy day, which is sometimes undisclosed to the
other family members and use it only when there is no other alternative before the family. Similarly,
internal financing is a scientific device of financing the projects of existing companies without
touching their capital structure.
According to the latest provisions of the Companies Act, a certain percentage, as prescribed by the
Central Government (not exceeding 10%) of the net profits after tax of a financial year have to be
compulsorily transferred to reserves by a company before declaring dividends for the year. It is
observed that companies normally retain 30% to 80% of profit after tax for financing its growth
activities. They are a dominant source of long-term finance for a company.

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6
Necessity of Ploughing Back of Profits
 The need for re-investment of retained earnings is felt on account of the following reasons:
 Replacement of old and obsolete assets
 Expansion and growth of the business
 Contributing towards fixed and working capital needs of the company
 Improving the efficiency of planet And machinery
 Making the company self-dependent of finance from outside sources
 Redemption of loans and debentures

Advantages of Ploughing Back of Profits

1.Advantages to Company
 A cushion to Absorb the shocks of economy
Retained earnings are readily available internally. A company with large reserves can easily withstand
the shocks of trade cycles which have adverse effects on the company. During a phase of depression,
the company finds it very difficult even to meet its day-to-day expenses, not to speak of financing the
schemes Of rationalisation or modernisation. In such a situation, it can easily fall back on the
accumulated reserves and maintain the liquidity of funds.

 Convenient, Economical and a Permanent Source of Financing

Ploughing back of profits is a very convenient and cost effective solution to the company's problem
of financing expansion, development etc. Firstly, the company does not have to depend on the
outsiders for their financial requirements; so the legal and procedural formalities are avoided.
Secondly, there is no explicit cost attached to ploughing back of profits. Thus, retained earnings
effectively represent infusion of additional equity in the company eliminating issue costs ånd losses
on account of underpricing.

 Provides for Replacement of Assets having Insufficient Depreciation Provision

When the useful life of the asset is over or it has become obsolete, the company will need to
replace the same. The asset is replaced out of the depreciation fund which has been created by
charging depreciation every year. In case of deficiency in depreciation or if the price of the new asset
increases, the company would find it difficult to provide for replacement of the asset. This deficiency
in depreciation fund is met out of retained earnings. For example, a Company has an asset costing 1
lakh and depreciation is provided @10% p.a. After 10 years when the asset has become obsolete and
a new asset has to be purchased, the amount of depreciation fund may not be sufficient to purchase
the new assets if the cost of asset at that time is 2 lakhs. Thus ploughing back of profits helps in
making good the deficiency of depreciation.
 Helps in Following Stable Dividend Policy
o Stable Dividend policy is the one in which dividend is paid regularly. A company which ploughs
back its profits can easily pay stable dividends even in the years when there are insufficient profits.
Enables to Redeem Long-term Liabilities Retained Earnings enable the company to retire the debts like
debentures, bonds etc. Thus the company is relieved of the burden of fixed interest commitments
thereby increasing the profitability.
 Flexible Financial Structure
It helps to maintain a flexible financial structure for the company. As the company need not raise
funds from external sources, its capitalisation position remains intact.
 Increase in Efficiency
Ploughing back of profits increases the operating efficiency of the business. The deficiencies of
depreciation, depletion and obsolescence can be made up by utilising the retained earnings.
 Aids in Smooth and Undisturbed Running of Business
o Ploughing back of profits adds to the strength and the stability of the company. It acts as a
stabiliser in the capital structure of a company. Funds are readily available without any delay. It
enables a firm to face the fluctuations whether seasonal or due to working capital or due to trade
cycle.
  Makes the Company Self dependent
The company does not have to depend upon outsiders like banks, financial institutions, debentures etc.
These outsiders are just like fair weather friends who may not provide funds when the company is
not doing well. A company with large reserves will not have to depend upon them.
 Increases the Creditworthiness of the Company
o Adequate reserves enhance the creditworthiness of the company because it increases owners'
equity.
 Boosts the Morale of Management
The policy of retaining the profits boosts up the morale of the management. The decisions relating
to the expansion, replacement etc. can be taken boldly by the management.

Advantages of shareholders
 increase in the value of share holders
o poughing back of profits enables a company to adopt a stable dividend policy This earns a good
name and reputation for the company thereby resulting in increase in the value of the shares in the
market. Thus, shareholders are benefited as they can dispose-off their securities at a higher profit or
they can also use their securities as better collateral for borrowing from banks and financial
institutions.
 Higher Income
Ploughing back of profits increases the earning capacity and the efficiency of the business. This
results in higher income for the owners that is the shareholders.
 No Dilution of Control
o Due to the policy of ploughing back of profits, the company need not issue new shares for their
future requirements of capital. Thus the control is retained with the existing shareholders.
 Safety of Investments
. The method of ploughing back of profits results in many benefits to the company like safety from
trade cycles, stable dividend policy, stability during difficult times, increase in reputation, higher
market value etc. All these merits provide an assurance of a minimum rate of dividend to the investor
and renders safety to their investment.
 Reduction in Tax Outflow
o When the company declares and pays dividend to the shareholder, it is required to pay Dividend
Distribution Tax. In case, profits are re-invested in business, this tax is avoided resulting in saving
for the company. Moreover,When these retained earnings are utilised in business, both the
shareholders and the company are benefited from it.

Advantages to Society or Nation

 Increases the Rate of Capital Formation
Re-investment of earnings into business increases capital formation which is very essential for the
development of any country. Expansion and development of the company results in more profits
for the company and availability of Sources of Stimulates Industrialisation
It stimulates rapid industrialisation of the country, which contributes towards national prosperity,
stability, growth and expansion. All the stakeholders and the society at large are benefited out of
this.
 Increases Productivity
o ploughing back of profits is a very economical way of financing the modernisation and
replacement activities of the company. The scarce resources are utilised in an efficient manner
resulting in increase in productivity.
 Decreases the Rate of Industrial Failure
o Due to ploughing back of profits, the company is able to withstand the trade cycles and absorb
the shocks of the economy. Capital formation increases the rate of industrial growth and brings in
.5 financial stability contd.
for the company. The magnitude of industrial failures is thereby reduced.
8  Higher Standard of Living
Increased productivity, better facilities, modern methods result in increased quality production at a
lower cost. Newer and better products are available to the customers at a reasonable price. The
stability and smooth running of the business also ensures job security and increased remuneration to
the workers and employees. Hence, the society at large is benefited by the increased standard of
living.

Limitations (Disadvantages) of Ploughing Back of Profits

 Over Capitalisation
Excessive retentions may lead the company to a situation of over capitalisation. This will be due to
the bonus issue out of retained earnings which will reduce the earnings per share. An over capitalised
company cannot make efficient and economical use of capital.
 Available only to Profitable Companies
The option of self financing is available only to profitable and existing companies. New companies or
companies with low profitability cannot rely on this method.
 Opportunity Cost
The opportunity cost of retained earnings is quite high for a company. Retained earnings represent
dividends foregone by the equity shareholders. By utilising the retained earnings, the company
should be able to generate more return than which shareholders would have earned by way of
alternate investments, if the dividends would have been distributed to them.
 No advantage of trading on equity
o the company will lose out on the benefit of trading of equity by using ploughing back of profits . use
of fixed income bearing securities in the capital structure gives the benefit of trading on equity and
maximises the returns for shareholders. By using retained earnings, the company has to forgot this
benefit.
 creation of monopolies
o continuous reinvestment of earnings may lead the company to grow in size and obtain monopoly
position in the market. It Will lead to concentration Of economic power and exploitation of the
society's scarce resources.
 depriving the freedom of the investors
o When the company retains more for future use, naturally the amount Of dividend for the
shareholders is restricted. The shareholders have to forego current income and they are deprived of
the freedom to invest their earnings in better securities of their choice.
 Misuse of Retained Earnings
o Ploughing back of profits is a very wise policy but it becomes difficult to utilise it in the larger
interest of shareholders. It is also not possible always that the savings will be used by the company
in the best interest of the shareholders. The retained earnings may sometimes be misused by the
management or diverted to those areas which are not very profitable or they could also be
transferred to other weaker units under the same management. Moreover presence of excessive
reserves may make the management extravagant and less cautious. They may also try to cover up
their inefficiency in managing the affairs of the company.
 Manipulation in the Value of Shares
o Sometimes, management having vested interest may speculate in the shares by manipulating
dividends. When lower dividends are paid under the pretext Of ploughing back of profits, the
market price of the shares registers a fall and they can purchase the shares at a reduced price.
Subsequently, next year, the rate of dividend may be increased in order to raise the market value of
the shares with an intention to dispose-off their holding at increased prices. The genuine investor
may be easily deceived by such fraudulent practices of the management
 Evasion of Taxes
Sometimes dividends are not distributed with the objective to evade taxes. The net profits are
transferred to various reserves including secret reserves, which are later utilised to issue bonus shares
that result in tax saving. Such evasion of taxed reduce the Government revenue and is detrimental
(harmful) to the interests of the nation as a whole.
 Dis-satisfaction among the Shareholders
 Non-distribution of dividend or low dividend to the shareholders definitely results in dis-satisfaction
among them. Most of the shareholders will not be happy with this policy.

Although ploughing back of profits offers innumerable advantages as discussed before, excessive
dependence on it poses many dangers. Its limitations are very well expressed in the words of Pigou,
'Excessive ploughing back entails social waste, because the money is not made available to those
who can use it to the best advantage for the community but is retained by those who have earned
it."

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