Professional Documents
Culture Documents
Type of financial claim Debt market(fixed claim) Equity market(residual claim) Maturity of claims Money market(short term financial claims i.e short term debt instruments ) Capital market( long term financial claims i.e long term debt and equity instruments) Seasoning of claim Primary market( issuers sell new claims) Secondary market( issuers sell outstanding securities)
Timing of delivery Cash or spot market(immediate delivery) Forward markets( delivery occurs at a future date) Nature of Organisational structure Exchange traded market Over the counter market
Investment Decisions
Financing decisions take place in capital markets which are approximately perfect. While making financial decisions, you can observe the value of similar financial assets There are very few opportunities in the realm of financing that have an NPV that is significantly different from zero
Investment decisions take place in real markets which tend to be imperfect. While making investment decisions, you have to estimate the value of the capital projects. There are many opportunities in the realm of capital budgeting that have an NPV that is significantly different from zero.
Given the intense competition in capital market, financial economists argue that securities are fairly priced. Put differently, they believe that the capital market is efficient. priced. efficient.
Capital Structure
The two broad sources of finance available to a firm are : shareholders funds and Loan funds Shareholders fund come mainly in the form of Equity capital and retained earnings and secondarily in the form of preference capital Loan funds come in a variety of ways like debenture capital, term loans, deferred credit , Fixed deposit and working capital advance Ignoring preference capital the basic difference between shareholders fund (Equity) and loan funds(Debt) are:
Debt
Equity shareholders have a residual claim on the income and the wealth of the firm. firm. Dividend paid to shareholders is not deductible payment. payment. equity a tax
Creditors (suppliers of debt) have a fixed claim in the form of interest and principal payment. payment. Interest paid to creditors is a tax deductible payment. payment. Debt has a fixed maturity. maturity. Debt investors play a passive role of course, they impose certain restrictions on the way the firm is run to protect their interest. interest.
Equity ordinarily has indefinite life. life. Equity investors enjoy the prerogative to control the affairs of the firm. firm.
Debt is a cheaper but a riskier source of finance whereas equity is a costlier but safer source of finance Nature of firms assets If the assets of the firm are mainly tangible ,debt finance is used more and if assets are mainly intangible ( brands and technical know how) debt finance is used less. Business risk If the firm faces a high degree of business risk, the financial risk should be kept low but if the firm faces a low business risk ,it can assume more financial risk(demand variability, price variability, input price
Norms of lenders
More capital intensive projects may permit a higher debt equity ratio, generally the norm allowed by financial institutions is 1:1
Control consideration( extent of equity stake promoters want to have in the project)
e.g cost of project is 10,000 and promoters want a stake of 40% in the equity of the project , the total equity cannot exceed 4,000. Hence, the balance 6,000 can be in the form of debt making the debt equity ratio to be 1.5:1
Market conditions
A Checklist
Use more equity when
The corporate tax rate applicable is negligible. negligible. Business risk exposure is high. high. Dilution of control is not an important issue. issue. The assets of the project are mostly intangible. intangible. The project has many valuable growth options. options. Note: Note: Current corporate tax rate is 30% 30%,surcharge 10% and education 10% cess of 3% taking the total tax liability to be 33.99% 33.99%
The corporate tax rate applicable is high. high. Business risk exposure is low. low. Dilution of control is an issue. issue.
The assets of the project are mostly tangible. tangible. The project has few growth options. options.
Sources of Finance
Part A Sources of Finance
Internal Accruals
Term loans
Miscellaneous sources
Equity
Debt
Internal Accruals
Internal accruals of a firm consist of depreciation, amortisation, and retained earnings. Depreciation Depreciation represents the allocation of capital expenditure to various periods over which the capital expenditure is expected to benefit the firm. It is a non-cash charge. Suppose the estimated economic life of a machine costing Rs 100,000 is 5 years. The machine would be depreciated every year in the P&L a/c with Rs 20,000( straight line method) which represents a non cash expense which can be considered as an internal source of financing
Contd.
Retained Earnings That portion of Equity earnings ( PAT less preference dividend) which are ploughed back in the firm Also called internal equity or ploughed back earnings.
Pros
Do not carry any negative connotation from the point of view of stock markets
Disadvantages
The amount that may be available by way of internal accruals may be limited The opportunity cost of retained earnings is quite high. Comforted by the easy availability of internal accruals and the notion they have low cost , managements may invest in sub-marginal projects subthat destroy shareholder value
Share Capital
Funds raised by issuing shares in cash .The amount of share capital a company has can change over time because each time a business sells new shares to the public in exchange for cash ,the amount of share capital will increase The amount of share capital a company reports on its balance sheet only accounts for the initial amount for which the original shareholders purchased the shares from the issuing company Any price differences arising from appreciation /depreciation as a result of transactions in secondary market are not included
Share Capital
Authorized share capital also referred as registered capital . This is the total of share capital which a limited company is allowed to issue to its shareholders. The number is specified in MOA and AOA when a firm is incorporated ,but can be changed later with shareholders approval Issued share capital is the total of share capital issued to shareholders Paid up share capital is the issued capital paid in full by the shareholders Called up share capital
Equity shareholders elect the Board of Directors which in turn select the management which controls the operations of the firm. Hence, equity shareholders exercise an indirect control over the operations of the firm Right in Liquidation
Equity shareholders have residual claim over the assets of the firm in the event of liquidation . Claims of all others employees ,tax authorities, debenture holders, secured lenders, unsecured lenders , other creditors and preferred shareholders are settled prior to equity holders
PrePre-Emptive right
Enables existing equity holders to maintain their proportional ownership by purchasing the additional equity shares issued by the firm example: a co having 1,000,000 outstanding equity shares , you holding 100 out of them The co plans to issue additional 2,00,000 shares and you being an existing equity holder will get 100x200,000 = 20 1,000,000
Protects the existing shareholders from the dilution of their financial interest Example: 1,000,000 equity shares with a par value of Rs 10 and a MV Rs 20 You hold 100 shares out of the same Co plans to come out with 500,000 additional shares at a price Rs 12 per share. The MV per share is expected to drop to Rs 17.33{ ( 1,000,000*20+500,000*12)/1,500,000}
PrePre-emptive right
No pre emptive right pre emptive right Value of initial holding Value of initial holding = Rs 2,000 = Rs 2,000 Additional subscription Additional subscription =0 = ( 12* 50) = 600 Value of equity after value of equity after additional issue = additional issue= ( 100* 17.33) = Rs 1733 (17.33* 150) = 2,600
advantages
no compulsion to pay dividends
equity capital provides a cushion to the lenders, it enhances the creditworthiness of the company
Dividends are tax exempt in the hands of investors. The company however is required to pay a DDT of 15%
Contd.
Equity capital has no maturity date and hence the firm has no obligation to redeem Disadvantages: Dilution of control( Diluted EPS) Cost of equity capital is the highest . The rate of return required by equity holders is higher than the rate of return required by other investors and that too equity dividends are paid after PAT which makes it more costly. Cost of issuing equity(underwriting commission , brokerage costs ,other issue expenses) is higher than cost of issuing other securities
Preference Capital
Preference capital represents a hybrid form of financing(senior to equity and subordinate to debt). It partakes some characteristics of equity and some attributes of debt. Equity
Preference
No voting right The claim of preference holders is prior to the claim of equity holder Dividend is not a tax deductible expense.
Contd.
A company B has 100 common share and 100 preferred shares . Let us assume you have bought all the preferred shares The company B is thinking to start a new project, now all the equity holders can vote for this but you being a preferred holder cannot do that. If B is acquired by another company C and assume C will pay 10 crores to B . Now as you hold 50% of the shares (100 out of 200) you will get 5 crores before the equity holder
Cumulative and Non- cumulative NonParticipating preference shares and NonNonparticipating Redeemable and Non-redeemable NonConvertible and Non- convertible Non-
Preference Capital
Pros No legal obligation to pay dividends Enhances creditworthiness(part of net worth) No dilution of control
Can be converted in to common stock No security of assets is provided so the assets of the firm are conserved Cons Costly source Skipping preference dividends adversely affects image
Voting rights under certain conditions( if the firm skips dividend continuously)
Meaning
Debenture is a debt instrument that composes of debentures , bonds or any other security whether constituting a charge on the co assets or not( collateral could be fixed or floating). not( Debenture holders do not carry any voting rights Debentures in India are normally secured while unsecured ones are also used as source. Unsecured ones carry a higher rate of interest than secured ones. In case of liquidation of company bondholders are paid first than the debenture holders Convertible debentures Non convertible debentures
Features of Debentures
Trustee
When a debenture is sold to the investing public , a trustee is mandatorily appointed through a trust deed. The trustee usually a bank, financial institution, insurance co is supposed to ensure that the borrowing firm fulfills its contractual obligations . Maturity: The market for short term debt instruments(within 365 days) like commercial paper, certificate of deposit, repos is called as money market and the market for long term debt and stock is called as capital market. Credit Rating( compulsory credit rating for debentures having maturity period of 18 months or more) Redemption( creation of DRR from the profits of the co ,penalty 2% if co fails to create a DRR till a period of 12 months of the issue)
Contd.
Debentures may carry a call feature which provides the issuing co the option to redeem the debentures at a certain price before the maturity period Debentures may carry a put option which gives the holder the right to seek redemption at specified times at predetermined prices In case of debenture issue firm hardly has any freedom in renegotiating the terms of the issue.( as a firm deals with numerous investors), in case of term loans the renegotiation freedom exists(as firm deals with one or a few institutional investors) Par value of a bond: It represents the amount the lender will repay at maturity.( usually Rs 100). Coupon rate: rate of interest which the issuer will pay ( fixed, floating, zero) Maturity period( perpetual debentures) Bonds can be issue by:
Central govt ( treasury bonds) State govt bonds PSU bonds Private sector bonds
Types
Zero coupon bonds Does not carry coupon or interest rate Issued at a discount over the face value and the bondholder receives the full principal amount at the redemption date( diff bwt the issue price and redeemable price acts as interest for the holder) Helps the issuers in conserving cash flows during the life of the bond Attractive to investors as it protects them from reinvestment rate risk The issue price of this bond is inversely related to their maturity period i.e longer the maturity period lesser the issue price
Bonds with face value of Rs 20,000 maturing 20 years with a 5.5% coupon may be purchased for roughly 6757.At the end of 20 years the investor will receive 20,000. the difference between 20,000 and6757 represents the interest that compounds automatically until the bond matures.
Convertible Debentures
Convertible partially(PCD)s or fully in to equity shares(FCDs) The conversion premium and the conversion timing and guidelines should be stated in the prospectus SEBI restricts the conversion period to 36 months Compulsory credit rating in conversion period exceeds 18 months Carry a lower rate of interest than non convertible ones, so a cheaper source of finance They entail lower financial burden but can lead to expensive dilution later
Pay a variable coupon (monthly , quarterly ,semi-annually , ,semiannually)more of quarterly coupons are common. Earn a rate of interest that is matched to some reference like a T-bill rate or 10 year GOI or LIBOR OR EURIBOR At the beginning of each coupon period , the coupon is calculated by taking the reference rate for that day and adding the spread that remains constant . Coupon may be defined as 3 month USD LIBOR+0.20%, where 0.20 acts as spread. Capped FRNs maximum coupon rate is also mentioned Floored FRNs- minimum coupon rate is restricted. FRNsCollared FRNs are a variant which carry both floor and cap coupon rates.
Contd.
Benefits: They are immune to interest rate risk as when interest rates rise the coupons of FRN increase in line which keeps the prices of such bonds constant. Demerits: if the prevailing interest rates go down steeply , the return on such bonds also go down too, so careful study of interest rates has to be done while investing. IDBI floated such bonds in 1997 at a coupon of 50 basis mark with reference to 10 year yield on GOI securities. Floor rate of 13.50%(minimum) was mentioned and even the cap rate(maximum) was their SBI came out with 1000 crores of retail bond issue in October
Indexed bonds
Bonds whose payments are linked to an index like a CPI or any other index. Example : TIPS issued by US Govt represent such bonds, the value of these bonds rises with inflation while their interest rates remain fixed. Interest on TIPS is calculated semi-annually semiRBI has proposed to introduce Inflation indexed bonds(IIBs) bonds in India as India presently has Capital indexed bonds which protects only the capital /principal against inflation. Example : An IIB issued at a FV of Rs100 ,coupon 2.5% p.a ., If inflation at the time of coupon payment is 5% , the principal for calculating coupon will become Rs105 and coupon payment as Rs 2.60 .
Interest and principal repayments are backed by underlying cash flows from specified pool of assets. The pool of assets are a group of small and illiquid assets that are unable to be sold individually like credit cards, auto loans, mortgage loans etc This process of pooling the assets into financial instruments is called as securitization.
Junk Bonds
High risk and high yield bonds Coupon rates range from 16 to 25% Graded below the investment grades.
Methods of Offering
There are different ways in which a company may raise finances in the primary market Public offering Rights issue Private placement Preferential allotment
Cost
Access to a larger pool of capital Respectability Lower cost of capital compared to private placement Liquidity
Bond Offering
The bond offering process is similar to the IPO process. There are, however, some differences: Bond offering emphasises stable cash flows whereas equity offering highlights the companys growth prospects. Security Credit rating Debenture redemption reserve Trustees
Term Loans
Term loans given by banks and financial institutions has been have been the primary source of finance for private and public firms. Term loans, also referred to as term finance, represent a source of debt finance which is generally repayable in less than 10 years. Term loans represent secured borrowings which are a very important source for financing new projects as well as for expansion& modernization purposes Term loans could be short term , intermediate and long term
Features
Currency(rupee term loans and foreign currency term loans) Secured borrowing Interest payment and principal repayment( in case of default a penalty is imposed on the borrower) Generally, the principal amount is repayable in equal semisemiannual or quarterly installments over a period of 4-8 years 4after an initial grace period of 1 to 2 years.
Restrictive covenants
In order to protect their interest financial institutions put some covenants on the borrowers: Broad-base its BOD and finalize its management Broadset up in consultation with and to the satisfaction of FIs Refrain from undertaking any new project or make any investment without the prior approval of FIs Refrain from additional borrowings or seek the consent of FIs for additional borrowings Reduce the proportion of debt in capital structure Limit the dividend payment to certain rate
Restrictive Covenants
Refrain from creating further charge on assets Provide periodic information about its operations Limit the freedom of the promoters to dispose off their shareholding
Public deposits
Besides the issue of shares and debentures a company can accept deposits from the public to finance its medium and short term requirements of funds It has become a popular source as a company offers rate of interest higher than those of banks( varies from 9 to 12%) depending on the period of deposit and reputation of co) Public deposits are accepted by companies under Non Banking companies(Acceptance of Deposits) rules Can be issued by NBFCs( has more than 50% of its assets comprising financial assets and earns at least 50% of its income from financial assets and registered with RBI) and Non Banking Non finance cos too( not registered with RBI). NBFCs have to take permission from RBI for such deposits and cannot offer more than 11% p.a. Deposits with NBFCs and Non banking non finance cos are not guaranteed by either co concerned and RBI. Minimum maturity period- 6 months , maximum 5 years period-
Benefits for companies: 1) receives finance at lower rate of interest than charged by banks and financial institutions 2) interest paid on deposits is a tax deductible expense 3)administrative costs of deposits is lower than involved in issuing shares and debentures 4) depositors have no interference in the management and control of the affairs of the co as they have no voting rights 5) unsecured so co can save the assets to pledge it elsewhere
Acts as a short term financing tool. A factor is a financial institution that offers services related to management and financing of debts arising from credit sales. Could on recourse or non recourse basis Recourse means the credit risk is borne by the client and non recourse credit risk is borne by the factor. Commission(1 to 2% of the face value of debt factored) and interest on advances against debt acts as income for the factor. Can bank factors and SBI factors acts as one of the oldest .
Factoring
The call money market is an integral part of the Indian money market, where short term surplus funds( day to day) are traded. Money lent for 1 day- call money, f or 15 days referred as daymoney, Notice money, more than 15 days it is Term Money. money, T-bills are Money market instruments used to finance short term requirements of Govt of India. These are issued at a discount and investor gets the face value at redemption. Issued for 91 days, 182 days, 364 days maturity
Commercial paper
Short term debt instrument with maturity ranges from 90 to 180 days Issued by wealthy corporates which enjoy fairly high credit rating Yield of a CP is higher than T- bills and chances of default are almost Tnegligible but are not zero risk instruments. CP is sold at a discount from its face value and redeemed at par. Presently the yield of CP range from 9.25% for 3 months and 9.625% for 6 months and that of 10 year GOI bond is 8.95%. CPs are actively traded in secondary markets and are freely transferable in demat form
Certificate of deposit(CDs)
It is a short term borrowing more like a bank term deposit account CDs are having a definite maturity period, a fixed rate of interest and redemption value. The returns on CDs are higher than T-bills. TA penalty has to be paid if investor wants to come out of a CD before the due date. CDs are also short term instruments with maturities between 7 days to 1 year used by banks to raise short term money. Presently banks are offering 9.2% on 1 year CD. This scenario where short term money(CP or CD) is available at a higher rates than the long term one( 10 year GOI bond) is called as inverted yield curve.
Miscellaneous Sources
Deferred credit Subsidies and sales tax deferments and exemptions Short term loans from financial institutions Commercial paper Factoring Securitization
Euromarkets
The term euromarkets seems to be a misnomer because they do not have a physical location. Euromarkets refer to a collection of location. international banks that help firms in raising capital in a global market which is beyond the purview of any national regulatory body. body.
An Indian firm can access the euro markets to raise a Eurocurrency loan or Issue a Eurobond or Issue Global depository receipts Issue Eurocurrency convertible bonds. bonds.
Eurocurrency Loans
A eurocurrency is simply a deposit of currency in a bank outside the country of the currency. For example, a eurodollar is a dollar deposit currency. in a bank outside the US. US. The main features of eurocurrency loans, which represent the principal form of external commercial borrowing are: are:
Syndication Floating rate Multi currency option Bullet repayment or installment repayment
Eurocurrency Bonds
Firms using the euromarkets for debt financing can take out loans (called eurocurrency loans) or sell bonds (referred to as eurocurrency bonds). bonds). The important features of a eurocurrency bond are :
It is issued outside the country in whose currency it is denominated. denominated. It is managed by a syndicate of banks. banks. It is a bearer bond. bond. The interest is usually paid annually or half yearly. yearly.
US Capital Market
The US capital market is the largest national capital market, complemented by a very active derivatives market. The most prestigious funding option in the US market is a public issue of Yankee Bonds (dollar denominated bonds issued in the US capital market by foreign borrowers). A public issue of Yankee bonds has to comply with stringent listing requirements of the SEC in the US. Yankee bonds can also be offered on a private placement basis to QIBs (qualified institutional buyers ) under what is popularly known as rule 144A. Such bonds do not have to comply with the stringent listing requirements under the Securities Act, 1933. Reliance Industries Limited was perhaps the first Indian company to issue Yankee bonds in the US. Apart from tapping the US bond market, Indian companies can raise funds in the US equity market by issuing American Depository Shares (ADSs). Like GDRs, ADSs represent claims on a specific number of shares. The principal difference between the two is that the GDRs are issued in the euromarket whereas ADSs are issued in the US domestic capital market.
Other Markets
Besides the US domestic capital market, Indian companies have tapped the domestic capital markets of other countries such as Japan and UK, issuing mainly debt instruments such as Samurai Bonds (publicly issued bonds in the Japanese market), Shibosai Bonds (privately issued bonds in the Japanese market), Bulldog Bonds (UK market), and Rembrant Bonds (Dutch market).
The finance is tied to import of goods and services Up to 85 percent of the value of imports is available as finance. finance. The finance is available for long tenors at reasonable cost. cost. Export credit agencies insist on bank guarantee. guarantee.
If a new company is set up for implementing the project, the borrowings are fully secured by a first charge on the assets. assets. If the project is implemented as an expansion or diversification project of an existing company, which already has lenders with charge on assets, lenders for the new project get a pari passu charge on the entire block of assets. assets. Cash flows from the existing as well as the proposed activities are considered to judge the debt servicing ability. ability. Personal guarantee and / or corporate guarantee is given. given.
The project is set up as a separate company, called a Special Purpose Vehicle (SPV) The security package for the lenders includes a registered mortgage/hypothecation of all assets, a pledge of sponsor holdings in the SPV, an assignment of all project contracts and documents, and a charge on future receivables. receivables. The cash flow of the SPV is allocated in a pre-determined manner to various prerequirements including debt servicing Lenders do not have recourse to the sponsors and their other businesses. businesses. Being a separate entity, the SPV is bankruptcy remote from the other businesses of the sponsor. sponsor.
Financial Closure
Financial closure means that all the sources of funds required for the project have been tied up. up. In general, financial closure is achieved soon when: when:
Suitable credit enhancement is done to the satisfaction of lenders. lenders. Adequate underwriting arrangements are made for market-related marketofferings. offerings. The resourcefulness of the promoters is well established. established. The process is started early and concurrent appraisal is initiated if several lending agencies are involved. involved.
Enclosures
1. 2. 3. 4. 5. 6.
Name of the company, constitution, registered office, list of the promoters, shareholding pattern, paid up capital, and installed capacity, name of auditor, bankers, location and particulars of production facilities, number of employees etc. etc.
Memorandum & Articles List of Directors IT and WT returns for the past three years of the company and promoters. Bankers references Board resolution Shareholder resolutions for 239(1) (d) Past audited accounts for three years of the company and associated entities. Details of existing term loans, unsecured loans and existing charge holders. Group company details with Annual Reports. Bankers Report on the company and the main promoters. Copies of income tax returns filed by main promoters. NOC for ceding exclusive/pari passu charge from the existing charge holders.
(b)
Details of the present activities of the 1. company, past financial performance, details of associated companies and their 2. performances. performances.
3. 4. 5. 6.
(c)
Promoters and management structure and 1. profiles of whole time directors and key management personnel 2. 3. 4. 5. 6. 7.
Details of Shareholders Agreement and copes thereof. Details of Board of Directors, management and organisational set-up. setCopies of Joint Venture/technical collaboration agreement, if any Bankers report on Foreign Collaborator. Employment contracts with MD/Whole time Directors. Documents to substantiate the proposed promoters contribution Names of promoters who would furnish personal guarantees and net worth statement of promoters. Copies of Statutory approvals such as RBI/FIPB approval, industrial license if required. required. Clearance from the Ministry of Environment and Forests for larger projects costing above Rs. Rs. 1500 crore. crore. Other regulatory clearances from CEA/TRAI/ERC or other such authorities. authorities.
(d)
Particulars of the project 1. Cost break-up break2. Proposed financing pattern 3. Products and uses 4. Key raw materials and sourcing arrangements 5. Location and justification
1.
2. 3.
6. Technology arrangements and equipment sourcing. sourcing. 7. Manpower requirement and availability 8. Details of utilities and arrangements 9. Schedule of implementation 10. 10. Statutory approvals obtained and to be obtained
5.
6.
State level government approvals and application for NOC from Pollution Control Board. Board. Key documents such as copies of title deeds of land, location map, copies of key project contracts, collaboration or technology agreements. agreements. BackBack-up documents justifying the estimation of cost of the project such as civil work estimates, quotations for machinery, etc. etc. In case of second hand machinery, a chartered engineers certificate regarding the residual life of the machines. machines. Fuel supply/raw material sourcing agreement. agreement. Details of tie-up for marketing, firm enquiries tieif any and buyback agreements. agreements. Sources of market information. information. Details of orders on hand, supply schedules, etc. etc. Details of effluents produced and measures for treatment and discharge. discharge. Detailed bases of assumptions made for the workings and backup statements. statements.
(e)
Financial workings for the project justifying 1. the viability of the project. project.
Facets of Appraisal
Market Appraisal Technical Appraisal Financial Appraisal Economic Appraisal Managerial Appraisal
Credit risk rating is a rating assigned by a bank to its borrowers based on an analysis of their ability and willingness to repay the debt. debt. RBI guidelines require banks to have a comprehensive risk rating system that serves as a single point indicator of diverse risk factors. factors. Credit risk rating by banks is usually done across the following dimensions: dimensions: financial risk, business and industry risk, and management risk. risk. A minimum fifty percent score is generally set as the hurdle rate for sanction of new credit facilities or for continuation of existing ones. ones.
In addition, there are other financials like the availability of collaterals and guarantees which are common to all credit facilities including non-fund based support. nonsupport.
SUMMARY
A capital project may be regarded as a mini-firm. So the issues to be considered in mini-firm. financing a project are identical to those considered in financing a business firm. firm. Although the number of complex and exotic financing instruments is expanding, the financing decision, compared to the investment decision, is relatively easier to make and has a lesser impact on value. value. The two broad sources of finance available to a firm are : shareholders funds (equity funds) and loan funds (debt funds). funds). The key factors in determining the debt-equity ratio for a project are: cost, nature of debtare: assets, business risk, norms of lenders, control considerations, and market conditions. conditions. A firm should use more equity when the corporate tax rate is negligible, the business risk exposure is high, the dilution of control is not an important issue, the assets of the firm are mostly intangible in nature, and the firm has many valuable growth options. options. The firm should use more debt under opposite circumstances. circumstances. When a company is formed, it first issues equity shares to the promoters (founders) and also, in most cases, to a select group of investors. As the company grows, it may rely on investors. the following methods of raising equity capital : initial public offering, seasoned offering, rights issue, private placement, and preferential allotment. allotment.
The internal accruals of a firm consist of depreciation charges and retained earnings. Equity and debt come in a variety of forms and are raised in different ways:
Equity capital represents ownership capital as equity shareholders collectively own the firm. Equity shareholders enjoy the rewards as well as bear the risk of firm. ownership. ownership. The rights of equity shareholders consist of : (i) the right to residual income, (ii) the right to control, (iii) the pre-emptive right to purchase additional equity shares preissued by the firm, and (iv) the residual claim over assets in the event of liquidation. liquidation. The first public offering of equity shares of a company, which is followed by a listing of its shares on the market, is called an initial public offering (IPO). A (IPO). public issue by a listed company is called a seasoned offering. A rights issue offering. involves selling securities in the primary market by issuing rights to the existing shareholders. shareholders. Private placement and preferential allotment involve sale of securities to a limited number of sophisticated investors such as financial institutions, mutual funds, venture capital funds, banks, and so on. on.
Preference capital represents a hybrid form of financing it partakes some characteristics of equity and some attributes of debentures. debentures.
For large firms, debentures are a viable alternative to term loans. Debentures are loans. instruments for raising debt finance. Debentures often provide more flexibility than finance. term loans as they offer greater choice with respect to maturity, interest rate, security, repayment, and special features. features. Thanks to the latitude enjoyed by companies, a variety of debt instruments like deep discount bonds, convertible debentures, floating rate bonds, secured premium notes, and indexed bonds have been employed. Term loans represent a source of debt finance which is generally repayable in less than 10 years. They are employed to finance acquisition of fixed assets and working years. capital margin. margin. Financial institutions give rupee term loans as well as foreign currency term loans. loans. Term loans represent secured borrowing. Usually assets, which are financed with the borrowing. term loan, provide the prime security. Other assets of the firm may serve as collateral security. security. security. The principal amount of a term loan is generally repayable over a period of 4 to 7 years after an initial grace period of 1 to 2 years. In order to protect their interest, years. financial institutions impose restrictive covenants on the borrowers. borrowers. Financial institutions appraise a project from the marketing, technical, financial, economic, and managerial angles. angles.
Working capital advance by commercial banks represents the most important source for financing current assets. Working capital advance is provided by commercial assets. banks in three primary ways : (i) cash credits/overdrafts, (ii) loans, and (iii) purchase/discount of bills. bills. Apart from the principal sources like equity, internal accruals, term loans, debentures, and working capital advance there are several other ways in which finance may be obtained. obtained. These include deferred credit, lease finance, hire purchase, unsecured loans and deposits, special schemes of institutions, subsidies, sales tax deferments and exemptions, commercial paper, factoring and securitisation. securitisation. A young company that is not yet ready or willing to tap the public financial market may seek venture capital which represents financial investment in a risky proposition made in the hope of earning a high rate of return. Thanks to globalisation of capital markets, Indian firms can raise capital from euromarkets or from the domestic markets of various countries or from export credit agencies. agencies. Euromarkets refer to a collection of international banks that help firms in raising capital in a global market which is beyond the purview of any national regulatory body. body. An Indian firm can access the euromarkets to raise a eurocurrency loan or issue a eurobond. eurobond.
Eurocurrency loans, which represent the principal form of external commercial borrowings are syndicated loans carrying a floating rate generally linked to LIBOR. LIBOR. While the eurocurrency loan is the most popular form of external commercial borrowing, Indian firms also raise money by issuing eurocurrency bonds (or notes). notes). From early 1990s, Indian companies have issued global depository receipts (GDRs), 1990s, which represent indirect equity investment, in the euromarkets. euromarkets. Indian firms can also issue bonds and equities in the domestic capital market of a foreign country. country. Export credit agencies have been established by the governments of major industrialised countries for financing exports of capital goods and related services. services. Two kinds of export credit are provided : buyers credit and suppliers credit. credit. Two principal project financing structures have evolved over the years: full recourse years: structure and limited recourse structure. structure. Financial closure means that all the sources of funds required for a project are tied up.