Sources of Long Term Finance

chapter1

Presented by:
Pisa Tatin
MBA/14/14
North Eastern Regional Institute
of Science & Technology
Why Finance is required ?
 Start a business.
 Finance expansions to production capacity.
 To develop and market new products.
 To enter new markets.
 To pay for the day to day running of business.

Sources of Financing
 Short Term Finance

 Long Term Finance

Long Term Finance
Long term financing is a form of financing that is provided for a
period of more than a year.

Purpose of long term finance

1. Finance fixed assets.
2. To finance the permanent part of working capital.
3. To finance growth and expansion of business.

Factors determining long-term financial requirements

 Nature of Business.

 Nature of goods produced.

 Technology used.
Sources of long term finance
1. Shares
2. Debentures
3. Term loans
4. Retained Earnings
5. Leasing
 Shares
 A capital of a company is divided into small units, each unit is
called Share.
 Issue of shares is the main source of long term finance.
 Shares are issued by joint stock companies to the public.

 A person holding shares is called a shareholder.

 Investors are of different habits and temperaments.
 Shares

Preference
Equity Shares
Shares
1. Equity Shares
Equity Shares are those shares that;
 These shareholders are paid dividends only when there are

distributable profits.
 Do not enjoy any preferential right in the matter of payment of

dividend or repayment of capital

 Have no fixed rate of dividend

 Have a right to take part in the management of the company.

 As equity shares are paid only on liquidation, this source has

the minimum risk.

 Advantages of Equity share capital

 There are no fixed charges attached to ordinary shares. If a

company earns enough divisible profits it will be able to pay a
dividend but there is no legal obligation to pay dividends.

 Equity share capital has no maturity date and hence the

company has no obligation to redeem. It is a permanent source
of share capital.

 The firm with the longer equity base will have greater ability
to raise debt finance on favourable terms. Thus issue of equity
share increases the creditworthiness of the firm.
Advantages of Equity share capital

 The equity shareholders enjoy full voting right and participate in the
management of the company.

 The company can issue further share capital by making right issue
or bonus issue etc.

 Unlike debt, equity shares carry no restrictive covenants. Restrictive

covenants reduces flexibility in decision making as the firm is not
supposed to carry out certain activities with out the consent of the
lender

 If the company earns more profit, more dividend is paid. So the

value of goodwill of the company increases, It ultimately leads to
appreciate the market value of equity shares of the company.
 Disadvantages of Equity share capital
 Dividends payable to ordinary shareholders are not tax deductible
but debenture interest is tax deductible. So, the cost of equity capital
is usually higher than other source of funds. Further, the rate of
return required by equity shareholders are higher than the rate of
return required by other investors.

 It’s not an obligation to pay dividends on equity shares. Non payment

of dividends may adversely affect the share value of the company.

 The issue of new equity shares to outsiders dilutes the control of

existing owners. So small firms normally avoid equity financing as
they may not like to share control with outsiders.

 The problem of over-capitalization may arise because of excess issue

of equity shares.
2. Preference Shares
Preference Shares are the shares which carry preferential rights
over the equity shares.

 These rights are:

• Receiving dividends at a fixed rate.
• Getting back the capital in case the company is wound-up.

 Investment in these shares are safe, and a preference

shareholder also gets dividend regularly.
Types of Preference Shares
1. Cumulative or non- cumulative
2. Redeemable or irredeemable
3. Participating or non- participating
4. Convertible or non- convertible
Cumulative & Non- Cumulative

 The holder of cumulative preference shares are entitled to

recover the arrears of preference dividend before any dividend
is paid on equity shares.

 In case of non- cumulative preference shares, arrears of

dividend do not accumulate and hence, if dividend is to be
paid on equity shareholders in any year, dividend at the fixed
rate for only one year will have to be paid to preference
shareholders before equity dividend is paid.

 Note :- Unless specifically mentioned otherwise, preference

shares should be considered to be cumulative.
Redeemable & Irredeemable
 Redeemable preference shares are those preference shares
whose amount can be returned by the company to their holder
within the life time of the company subject to the terms of the
issue and the fulfillment of certain legal conditions.

 The amount of irredeemable preference shares can be returned

only when the company is wound up.
Participating & Non- participating
 Participating preference shares are entitled not only to fixed
rate of dividend but also to a share in surplus profits which
remain after dividend has been paid at a certain rate to equity
shareholders. The surplus profits are distributed in a certain
agreed ratio between the participating preference shareholder
and equity shareholder.

 Non- participating preference shares are entitled to only the

fixed rate of dividend.
Convertible & Non- convertible
 The holder of convertible preference shares enjoy the right to
get the preference shares converted into equity shares
according to the terms of issue.

 The holder of non- convertible preference share do not enjoy

this right.
 Advantages of preference shares
 Preference shareholders normally do not carry voting right.
Hence, there is no dilution of control.

 There is no legal binding to pay preference dividend.

Preference dividends are not a fixed liability like interests on
debt which has to be paid in all circumstances.

 Preference share capital is generally regarded as part of net

worth. Hence it increases the creditworthiness of the firm.

 They do not put restrictive covenants on the business.

Disadvantages of Preference Shares
 The dividend paid to preference shareholders is not a tax
deductible expense. Hence it is a very expensive source of
financing.

 Passed dividends are usually cumulative and it becomes costly to

the business to pay the cumulated dividends once profitability is
restored

 Preference shareholders get voting right if the company fails to

pay preference dividends for a certain period.

 Preference shareholders have preferential claim on the assets and

earnings of the firm over equity shareholders.
 Debentures
large companies to borrow money, at a fixed rate of interest.
• Issue of Loan Certificate given to public.
• Debenture holders have no rights to vote in the company's
general meetings.

Characteristics of Debentures
 Holders are the creditors of the company.

 Holders do not carry voting rights.

 Debentures are repayable after a fixed period of time

 Debentures are secured or ‘naked’. Secured debentures carry a

charge on the company’s assets, in case of default, the

debenture holder has recourse to the sale on the assets of the
business.
 Redeemable
Debentures

Irredeemable
Debentures
Debentures
Convertible
Debentures

Non Convertible
Debentures
Redeemable & Irredeemable Debentures
 Redeemable debentures are debentures repayable on a pre-
determined date or at any time prior to their maturity, provided
the company so desires and gives a notice to that effect.

 Irredeemable debentures are called perpetual debentures.

Accompany is not bound to repay the amount during its life
time. If the issuing company fails to pay the interest, it has to
redeem such debentures.
 Convertible Debentures & Non
Convertible Debentures
 The holders of these convertible debentures are given the
option to convert their debentures into equity shares at a time
and in a ratio as decided by the company.

 Non convertible debentures cannot be converted into equity

shares.
 Advantages of Debentures
 The cost of debenture is much lower than the cost of equity or
preference share capital since interest on debenture is a tax-
deductible expense.

 There is no dilution of control of the company by the issue of

debentures. As the debenture holders have no voting rights, so
the issue of debenture does not affect the management of the
company.

 Debentures can be redeemed when a company has surplus

fund.
 Disadvantages of Debentures
 The cost of issuing debentures is very high because of higher
rate of stamp duty.

 Debenture financing involves fixed interest and principal

repayment obligation. Any failure to meet these obligations
may paralyze the company’s operations.

 Debenture financing increases the financial risk of the

company. This will, in turn increase the cost of capital.

 There is a limit to the extent to which funds can be raised

through long-term debt.
Retained Earnings
The portion of the profits which is not distributed among the shareholders
but is retained and is used in business is called retained earnings.

The advantages of retained profits are;

 It avoids issue costs

 It avoids the in change in control that result incase of issuing new

shares.

The disadvantages are;

 Low dividends causing by reinvesting funds can lead to a fall in the

value of a company's share

 It may lead to cause of dissatisfaction among the shareholders as they

receive-a low rate of dividend.

 Management may fail to properly use the profits retained.
Term Loans
A term loan is a monetary loan that is repaid in regular payments
over a set period of time. Term loans usually last between one and
ten years, but may last as long as 30 years in some cases.
Term loan is a loan made by bank/financial institution to a business
having an initial maturity of more than one year.

Advantages;
 Debt is an allowable deduction for tax purposes hence can

increase income of the firm.

 There is no dilution of control of the company since debt holders

have no voting rights, thus the issue of debt does not affect the
management of the company.
 Term Loans
Disadvantage;
 The lender is entitled to receive a fixed periodic rate of

interest irrespective of whether the borrower ears

sufficient profits or not.
 The lender has the right to place the borrowing

company under liquidation if the company fails to

meet their contractual obligations.
 Leasing

 A leasing transaction is a commercial arrangement whereby an

equipment owner conveys the right to use the equipment in
return for payment by the equipment user of a specified rental
over a pre-agreed period of time.
 Lessor: owns the asset and receives the payments.

 Lessee: makes the lease payments.

 Some advantages of leasing:

i. the ready availability of the equipment;

ii. cost savings due to tax benefits;
 Types of Leasing

1) Finance or capital or full-payout lease:

i. the agreed term of the lease approximates to the expected
life of the asset;
ii. the lessee clearly uses the lease arrangement as an
alternative form of finance to outright acquisition;
iii. the lessee avoids having to incur the initial cash outlay
required at the outset of the project;
iv. the lessee incurs the costs of insurance and maintenance;
v. cancellation involves severe financial penalties.
 Types of Leasing (cont.)
2) Operating or part-payout lease:
i. a lease arranged for a short period, during which the lessor
incurs the risks of ownership;
ii. the lessor incurs the costs of insurance and maintenance;
iii. the lessee obtains the use of the equipment for a specific job
(e.g.: a leased airplane to operate a temporary extra airline slot);
iv. contract is easy to cancel;
v. additional risks incurred by the lessor make rental per unit of
time more expensive than under a finance lease (rental costs
incorporate a risk premium).
 Types of Lease contracts
Sale and Lease back
 Firm sells fixed asset (e.g. building) to lender/lessor and then

immediately leases back the property.

 Seller/lessee receives large inflow of cash that may be used to

finance other aspects of business and in return, enters into long-

term lease obligation.
 The lessee makes period payment to the lessor and gives up the

title of the asset.

Direct Leasing
A firm acquires the use of an asset it did not own previously. A
firm may lease an assets from the manufacture. The major lessors
are manufactures, finance companies, banks etc.
 Lease Financing

Leveraged Lease
 Involves third-party lender:

◦ Lessor (e.g. commercial bank) borrows 80% or less of cost

of asset from third-party lender.
◦ Lessor purchases asset and leases it to lessee.
 Lessor has title to asset and is thus entitled to full depreciation

benefits.
 After-tax Analysis for Lease versus
borrow/buy
Leasing generates the following cash follows:
 Costs of leasing – payments

 Benefits of leasing – tax relief on payments

Borrowing to buying generates the following cash follows:

 Interest expenses on debt which are tax deductible

 Principal payment of debt which is not tax deductible

 Tax saving accruing from depreciation on the asset

 Any operating expense such as maintenance a raising as a

result of buying the asset, which are tax deductible.

 Any residual value that may be incurred from selling the asset

at the end of it useful life.

Numerical example 1
 X Ltd is considering to lease a $50,000 equipment under a lease
that would require annual lease payment of $11,500 in arrears
(at the end of each year) for 5 years. The machine has a 5 year
life and would be depreciated straight line with zero residual
value.
 X Ltd’s cost of secured debt is 11%, and its after tax cost of
capital is 14%. X Ltd pays taxes at a 30% margin rate.

 Required;
 What is the Net-Advantage of Leasing (NAL)?
PV of leasing

Time Cash out flow Discount Net Present

factor Value
@14%
11,500 – (11,5000%) 3.4331 ($27,636.46)
= $8,050
Borrowing to buy


 PV of borrowing to buy (in
dollars)
T₁ T₂ T₃ T₄ T₅

Interest expense (5,500) (5,500 (5,500 (5,500) (5,500)

) )
Tax saving on interest (5,50030%) 1650 1650 1650 1650
=1650

Depreciation Tax 3,000 3,000 3,000 3,000 3,000

Saving
Principal repayment (50,000)

Net cash flow (850) (850) (850) (850) (50,850)

Discount Factors @ 0.877 0.769 0.675 0.592 0.519

14%
PV (745.5) (653.7 (573.8 (503.2) (26,391)
) )
NPV (28,867.35)
 Decision

Numerical example 2

 ABC Ltd can purchase a new machine for $1,000. The machine
has a 5 year life and would be depreciated straight line to a $100
residual value. The machine could be leased for 5 annual $300
lease payments in arrears (at the end of each year)
 Before tax borrowing rate = 10%, tax rate = 40% and the after
tax cost of capital for the project would be 12%.

 Required;
 What is the Net – Advantage of Leasing (NAL)?
PV of leasing

Time Cash out flow Discount factor Net Present

@12% Value
300 – (3000%) 3.6048 (648.7)
= $180
Borrowing to buy

 PV of buying (in dollars)
T₁ T₂ T₃ T₄ T₅
Interest expense (10%) (100) (100) (100) (100) (100)

Tax saving on interest (140%) 40 40 40 40

= 40
Depreciation Tax 72 72 72 72 72
Saving
Principal repayment (1,000)
Residual Value 100
Tax on Residual Value (40)
Net cash flow 12 12 12 12 (928)
Discount Factors @ 0.893 0.797 0.712 0.636 0.567
12%
PV 10.72 9.56 8.54 7.63 (526.18)
NPV (489.73)
 Decision
