sources of long term finance 1194352169348636 3

7/30/2019 Sources of Long Term Finance 1194352169348636 3

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SOURCESOF LONG TERM

FINANCE


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Need for long term Finance

Long term vs. short term(working capital)funds requirements

For modernisation, expansion,diversification; huge quantities reqd.,irreversible decision

Asset-liability mismatch, interest rate risk,liquidity risk, if LT reqts.met by ST funds


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Equity Capital

Authorised, Issued, Subscribed and Paid upcapital

Par/face value, Issue Price, Book value andMarket Value

Rights of equity shareholders-Right to Income:PAT less preferred dividends-Right to Control: voting rights-Pre-emptive Right: for additional issues, rightsissue in the same proportion-Right in liquidation: residual claim over assets


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Pros and cons of equity Capital

Advantages

No fixed maturity, no

obligation to redeem No compulsion to pay

dividends

Provides leverage

capacity Dividends tax exempt

for investors

Disadvantages Dilution of control of existing

owners High Cost: rate of return

expected by equityholdershigher than debtholders

Dividends are not taxdeductible: hence cost ishigher

Issue costs higher:

underwriting, brokerage, otherissue expenses

Higher servicing costs: holdAGMs, post annual reports etc.


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Internal Accruals

Pros

Readily available, notalking to outsiders

Effectively additionalequity capital, howeverno issue costs of loss dueto underpricing

No dilution of control No expansion in equity

base, hence no dilution ofEPS, BV per share etc.

Cons

Quantum very limited

High Opportunity costs:

dividends forgone byequity holders

Requires careful attentionto NPV of projects

Consists of retained earnings and depreciation charges


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Preference Capital

Is a hybrid form of financing, payment after debt but before equity Equity features:-out of distributable profits-not an obligatory payment-dividends not tax deductible Debt features:-dividend rate is fixed-capital is redeemable-normally no right to vote Can have other features like cumulative, convertible,

participating..


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Preference Capital

Pros

No obligation to pay dividend,no bankruptcy or legal actionfor non payment

Financial distress ofredemption obligation not veryhigh

Part of net worth, henceincreases its creditworthiness/

leverage capacity No dilution of control

No pledging of assets required

Cons

Expensive source sincedividends not tax deductible

Though no legalconsequences, liability to paydividends stands, can spoilcompanys image

Can acquire voting rights insome cases

Have claim prior to equityholders


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Term Loans

Provided by FIs/banks

Can be in domestic/foreign currency, liability on FC loanstranslated to rupees for payment

Are typically secured against fixed assets/ hypothecationof movable properties, prime security/ collateral security

Definite obligations on interest and principal repayment;interest paid periodically; based on credit risk and

pegged to a floor rate Carry restrictive covenants for future financial and

operational decisions of the company, its management,future fund raising, projects, periodic reports called for


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Term Loans

Pros

Interest on debt is taxdeductible

Does not result in dilution ofcontrol

Do not partake in valuecreated by the firm

Issue costs of debt is lower

Interest cost is normally fixed,protection against highunexpected inflation

Has a disciplining effect onmanagement

Cons

Entails fixed obligation forinterest and principal, nonpayment can even lead tobankruptcy/ legal action

Debt contracts imposerestrictions on firms financialand operational flexibility

Increases financial leverage,

excess raises cost of equity tothe firm

If inflation rate dips, cost ofdebt higher than expected


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Debentures

Like promissory notes, are instruments for raising LT debt More flexible compared to term loans as they offer variety of

choices as regards maturity, interest rate, security, repayment andother special features

Interest rate can be fixed/floating/deep discount Convertibility : Can be FCDs, NCDs, PCDs Warrants : Can have warrants attached, detachable or non

detachable, detachable traded separately Option : Can be with call or put option Redemption: Bullet payment or redeemed in instalments Security: Secured or unsecured Credit rating: Need to have a credit rating by a credit rating agency Trustee: Need to appoint a trustee to ensure fulfilment of

contractual obligations by company DRR: Company needs to create a DRR if maturity more than 18

months


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Other forms of Finance

Leasing: asset leased out in lieu of lease rentals, title nottransferred, only economic use of assets given; can be financiallease or operating (service) lease

Hire Purchase: ownership transferred to the buyer after all the

installments paid up Securitisation: assets involving financial claims pooled and financial

instruments created, thus creating cash out of receivables Government Subsidies: central and state govts offer cash subsidies

to units in backward areas, classified in three categories Sales tax deferments and exemptions: payment deferred for a fixed

period, like interest free loan; or exemptions given for certain no. ofyears Suppliers credit: available from suppliers of machinery, other fixed

assets, terms devised to defer payment, or pay in installments overa period of time


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Leasing vs. Hire Purchase

Leasing Ownership not transferred to lessee Depreciation benefit to lessor

Magnitude of funds high, for big ticketitems

No margin money/down paymentrequired

Maintenance of asset by lessor inoperating lease

Tax benefits of depreciation taken bylessor; lessee gets tax shield on lease

rentals Considered off balance sheet mode of

financing, as no asset or liabilityfigures in balance sheet

Hire-Purchase Ownership transferred to hirer on

payment of all instalments Depreciation shield available to hirer Maybe for smaller value capital goods Some down payment reqd

Maintenance cost borne by hirer

Hirer allowed depreciation claim andfinance charge for taxation; seller mayclaim interest on amount borrowed to

acquire asset Asset figures in balance sheet on

complete of purchase


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Raising Long Term Finance

Initial Public Offer (IPO) Secondary Public offer Rights Issue Bought out deals Euro Issues Private Placement

Preferential allotment Venture Capital/ Private Equity transactions Obtaining a term loan


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Initial Public Offer

Pros Access to larger amount of funds Further growth limited companies

not using this route

Listing: provides exit route topromoters; ensures marketabilityof existing shares

Encash on value created in thefirm

Recognition in market Stock prices provide useful

indicators to management Sometimes stipulated by private

investors in the company

Cons Pricing may have to be

attractive to lure

investors Loss of flexibility Higher accountability More disclosure

requirements to be met Visibility in market Cost of making a public

issue quite high


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Steps in an IPO

Approval of BOD Shareholders approval Appointment of lead manager(s) Due diligence by LM Appointment of intermediaries like registrars, printers, bankers, advertisers

Prepare draft prospectus Filing with SEBI Listing applications filed alongwith draft prospectus Agreement with registrars and depositories Appoint underwriters (if reqd.) Make changes in draft prospectus as per SEBI observations, SE suggestions File prospectus with ROC Issue marketing exercise commences Application forms dispatched Issue opened Basis of allotment finalised Allotments made, refunds posted, shares listed on SEs


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Other aspects of a public issue

Eligibility criteria defined: net worth, track record ofprofitability, issue in same year; secondary issues haveno such restrictions

Book Building process: process of tendering quantities atprices within a band Issue expenses: underwriting, brokerage commissions,

fees to managers to the issue, registrars, printers,advertisers, listing fees, stamp duty

Issue pricing: free pricing, disclose basis for issue price Public issue of debt: appointment of debenture trustee,

creation of DRR, credit rating reqd., security to becreated


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Rights Issue

Issue of capital to existing shareholders

Offer made on a pro rata basis

Offer document called Letter of Offer

Option given to apply for additional shares Rights renunciation: are tradeable, may be sold off in the market

Value of a share after rights:

(NP0+S)/(N+1); N=no. of existing shares required for rights; P0=cum rights MP per share; S= subscription price of rights issue

Value of a right= (P0S)/(N+1) Comparison with Public issue: with familiar investors, hence

likely to be more successful; less floatation costs since nounderwriting; but lower pricing to benefit shareholders


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Private Placement

Sale of securities directly to wholesale investors like FIs, banks, MFs,FIIs,PE funds etc.

Called private placement in equity/equity related instruments, inunlisted companies and in all cases of debt

Called preferential allotment in case of unlisted companies forequity/equity related instruments

Different from reservations made for such QIBs out of a public issue Subject to SEBI regulations on pricing, lock in period, open offer to

be made to public QIB placement guidelines recently issued by SEBI for compliance

and disclosures


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Private Placement

Pros

Less expensive mode

Lesser SEBI and other

regulations Easier to market the issue to a

few investors

Entry of wholesale financiallysophisticated investors incompanys profile

May use this route until IPOdecision taken

Less administrativemaintenance

Cons

Does not qualify for listing inan unlisted company

Restrictive covenants may beimposed by the investors

May call for managementparticipation

Issue pricing more tight


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Venture Capital/Private Equity

Equity finance to potentially high growth companies Reasonably long to medium term commitment Hands on management approach, active participation in management Considered value add investor VC: primarily high risk high return investment esp. in technology oriented/ knowledge

intensive businesses with long development cycles, greenfield ventures Can be in unlisted or listed (PIPES) Companies Exit route to be defined at the time of investment Restrictive clauseson promoters holding sell off and other financial/operational

issues Detailed memorandum/business plan on company, its financials to be prepared Shareholders agreement to be signed by both parties Valuation of Company key issue Leads to dilution of control by existing promoters


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Obtaining a Term Loan

Submission of loan application:a project report containing completedetails of the project given to the FI/Bank

Initial processing of loan application:prepare flash report to decide ifproject worth an appraisal or not

Project Appraisal:Detailed appraisal done to decide if project taken ornot, in terms of market, technical, financial, managerial appraisal

Issue of Letter of Sanction:to the borrower containing amountsanctioned and terms and conditions thereto

Acceptance of terms and conditions by the borrowing unit:thru aboard meeting and conveyed to the FI/Bank

Execution of loan agreement:signed by both parties

Disbursement of loan:in tranches based on progress of the project, tieup of means of finance

Creation of security:formalities to be completed within a timeframe Monitoring:at implementation and operational stage thru periodic

progress reports, site visits etc.

sources of long term finance 1194352169348636 3

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