Long Term Sources of Finance

FORMS OF BUSINESS OWNERSHIP

Sole proprietorship
Decision-making is simple Can be set up easily & inexpensively The owner receives all income from business. Income is taxed at only one level (that of the owner). Subject to few regulations Unlimited liability. Limited life of the proprietorship The business has limited access to additional funds.

Partnership
The general partners are decision-makers. The owners (the partners) divide income according to partnership agreement. Income is taxed once. Set up with ease Few government regulations Unlimited liability for each partner. A limited life of partnership. Limited access to additional funds.

Corporation
The separation of ownership and decision-making. Distinct legal entity Limited liability The business enterprise has a life in perpetuity Access to additional funds through the sale of new share of stock. Income is distributed according to proportionate ownership. Double taxation on income Regulated by Companies Act

Corporation
Private Company Public Company Minimum 7 persons Unlimited Shareholders Public subscription allowed Free transfer of shares

Minimum 2 persons Maximum Shareholders 50 Public subscription not allowed Restricted rights to transfer shares Promoters enjoy unchallenged control over the firm Firms ability to raise capital is limited

Firm can raise substantial funds Cumbersome procedure for Formation

 Public Company is the most appropriate form of organisation as

Limited liability Enormous growth potential Free and easy transferability of shares

Limited Liability Partnership

Limited Liability Partnership form of business has been introduced in India in Dec 2008 Limited liability of partners.

This form is suitable for small and medium enterprises, service providers, doctors, CAs, lawyers etc. to limit liability and yet have the flexibility of a partnership structure.

Limited Liability Partnership

Features Liability of the partners would be limited to the agreed contribution of partners. Partners would not be liable for independent and unauthorized actions of other partners. Name of an LLP must end with the words LLP LLPs can have individual, body corporates, including other LLPs, foreign LLPs and Indian as well as foreign companies as partners No upper limit on maximum number of partners. The mutual rights and duties of partners shall be governed by an agreement between the partners.

Limited Liability Partnership

LLP will have perpetual succession. The rights of a partner to share the profits and losses are transferable. LLP will maintain annual accounts LLP will not be subject to Company Law Other entities such as firms, companies etc. can convert to LLP.

Sources of long term finance

Retained Earnings Equity Capital Debenture Capital Preference Capital Term Loans

Retained Earnings
Retained earnings are profit after tax and dividend.
Internal Source of Finance

From Companys point of view

Advantages Readily available No additional expenses to raise No dilution of control Disadvantages Limited Fund Opportunity cost is high. Because, it represents the dividends foregone by the shareholders.

Shareholders Point of view

Advantages Convenient as no hassle of reinvesting.
Disadvantages Lower dividend

Debenture Capital
Debentures are instruments for raising long term debt capital Characteristics
Trustee Bank , Institution, Insurance Company
Appointed through a Deed

Security Secured by a charge on assets present and future assets Debenture Redemption Reserve Coupon Rate / Interest Rate - Fixed or floating Maturity Period fixed maturity period Convertible and Non convertible

Evaluation
Companys point of view Upside
Post tax cost of debentures is lower than shares No dilution of control

Downsides
Obligatory payment

Investors point of view

Upside
Stable earnings Secured Investment

Downside
Interest is Fully taxable in the hands of investors No right to vote

Equity Capital
Represents ownership capital Enjoys the rewards and bear the risks Some Terms Authorized capital is the amount of capital that a company can potentially issue, as per its memorandum. The amount offered by the company to the investors is called the Issued Capital. The part of issued capital which has been subscribed to by the investors represents the Subscribed Capital. The actual amount paid up by the investors is called the Paid-up Capital.

Equity Capital
Authorised Capital Say: 10,00,000 Equity Shares of Rs.10 each Say :5,00,000 Equity Shares of Rs.10 each Say :4,00,000 Equity Shares of Rs.10 each

Issued capital

Subscribed Capital

Paid up Capital

Say :4,00,000 Equity Shares of Rs.5 each

Par Value
Face value of the share The stated value on a stock certificate is called the par value. The par of equity shares is generally Rs. 10, or Rs. 100.

Issue Price
The issue price is the price at which the equity share is issued.
Generally par and issue price are same for new companies

When issue price exceeds the par value, the difference is referred as share premium Market Price is the price at which the share is traded in the stock market

 Contributed Surplus Usually refers to

amounts of directly contributed equity capital in excess of the par value
For example, suppose 1,000 shares of common stock having a par value of Rs.1 each are sold to investors for Rs. 8 per share. The contributed surplus would be (8 1) 1,000 = Rs. 7,000

Rights and position of equity Shareholders

Right to Control
Elect the board Lack effective control

Right to Income = Profit After Tax

Income of the shareholder is called Dividend as recommended by the Board unchallengeable

Pre-emptive right on pro rata basis Right in liquidation

Residual claim over assets of the firm

 Pradhan enterprises has 1,000,000 outstanding equity shares with a par value of Rs.10 and a market value of Rs.20 .The firm plans to issue 500,000 additional equity shares at a price of Rs.12 per share .The market value per share after this issue is expected to drop to Rs.17.33. Now if a shareholder has 100 shares, his financial situation with respect to Pradhans equity when he exercises the preemptive rights and when he does not exercise the preemptive rights would be as shown below:

Takes Pre-emptive Rights

Value of initial holding( 20 * 100)

No Pre-emptive Rights
Value of initial holding( 20 * 100

= 2000

= 2000

Additional Subscription (12 * 50) = 600

Value of equity holding after the additional Issue (17.33 * 150) = 2600

Additional Subscription = 0

Value of equity holding after the additional Issue (17.33 * 100) =1733

Expected Price = 100*20 + 50*12 = 17.33 150

Evaluation Companys point of view

Positives
Permanent Capital- no liability for repayment Dividend Non obligatory Enhances Creditworthiness

Negatives
Investors expect High rate of return/ high cost of capital

Issue cost quite high

Underwriting commission, brokerage costs, publicity cost etc

Dilution of control

Shareholders point of view

Positives
Limited liability High rewards Equity dividend exempted from tax

Negatives
No say in Dividend matters Residual claim to income & assets Risky investment- wide fluctuations in price

Preference Capital
A hybrid form of financingand some features of Debentures It has some features of Equity

Dividend rate is fixed -Not

dividends get accumulated Not a Tax-deductible payment

an obligatory payment but

Preference dividend is paid out of profit after tax

Preference over equity shareholders No voting power Convertible into equity Redeemability

Evaluation
Companys point of view Upside
No legal obligation to pay dividend No dilution of control Enhances creditworthiness No collateral security

Downside
Pay dividend Tax No tax advantage Skipping of dividend adversely affects corporate image

Shareholders point of view

Upside
Stable dividend Dividend exempted from income tax

Downside
Can not enforce payment of dividend Modest returns

Term Loans
A source of Debt Finance
for a period more than a year For financing Fixed Assets and Working Capital

FeaturesSecurity- The borrowing is secured. The assets financed with the loan are termed as Prime Security and other assets of the firm may serve as Collateral securities.

Interest- Interest is a fixed obligation. Rate is fixed or floating.

Evaluation
Companys point of view
Upside Interest is tax deductible No dilution of control Down sides Obligatory payments

Lenders point of view

Fixed Income Secured loans No right to vote