Submitted by:- Swati Agarwal, BEM/422

LONG TERM FINANCE – ITS MEANING AND PURPOSE

A business requires funds to purchase fixed assets like land and building, plant
and machinery, furniture etc. These assets may be regarded as the foundation of
a business. The capital required for these assets is called fixed capital. A part of
the working capital is also of a permanent nature. Funds required for this part of
the working capital and for fixed capital is called long term finance.

PURPOSE OF LONG TERM FINANCE:

Long term finance is required for the following purposes:
1. To Finance fixed assets :
Business requires fixed assets like machines, Building, furniture etc. Finance
required to buy these assets is for a long period, because such assets can be
used for a long period and are not for resale.

2. To finance the permanent part of working capital:

Business is a continuing activity. It must have a certain amount of working capital
which would be needed again and again. This part of working capital is of a fixed
or permanent nature. This requirement is also met from long term funds.

3. To finance growth and expansion of business:

Expansion of business requires investment of a huge amount of capital
permanently or for a long period.
Sources of long term finance
The main sources of long term finance are as follows:
1. Shares:
These are issued to the general public. These may be of two types:
(i) Equity and (ii) Preference. The holders of shares are the owners of the business.
2. Debentures:
These are also issued to the general public. The holders of debentures are the
creditors of the company.
3. Public Deposits :
General public also like to deposit their savings with a popular and well established
company which can pay interest periodically and pay-back the deposit when due.
4. Retained earnings:
The company may not distribute the whole of its profits among its shareholders. It
may retain a part of the profits and utilize it as capital.
5. Term loans from banks:
Many industrial development banks, cooperative banks and commercial banks
grant medium term loans for a period of three to five years.
6. Loan from financial institutions:
There are many specialized financial institutions established by the Central and
State governments which give long term loans at reasonable rate of interest. Some
of these institutions are: Industrial Finance Corporation of India ( IFCI), Industrial
Development Bank of India (IDBI), Industrial Credit and Investment
Corporation of India (ICICI), Unit Trust of India ( UTI ), State Finance Corporations
etc.
 SOURCES OF FINANCE

EQUITY DEBT

•EQUITY •BOND
•PREFERENCE •TERM LOAN
•INTERNAL •WORKING CAPITAL
ACCRUALS ADVANCES
•MISCELLANEOUS
 Shares

Issue of shares is the main source of long term finance. Shares are issued by
joint stock companies to the public. A company divides its capital into units of
a definite face value, say of Rs. 10 each or Rs. 100 each. Each unit is called a
share. A person holding shares is called a shareholder.

Characteristics of shares:

The main characteristics of shares are following:

1. It is a unit of capital of the company.
2. Each share is of a definite face value.
3. A share certificate is issued to a shareholder indicating the number of shares
and the amount.
4. Each share has a distinct number.
5. The face value of a share indicates the interest of a person in the company and
the extent of his liability.
6. Shares are transferable units.
Investors are of different habits and temperaments. Some want to take lesser risk
and are interested in a regular income. There are others who may take greater
risk in anticipation of huge profits in future.
 In order to tap the savings of different types of people, a company may issue
different types of shares.
These are:
 Preference shares
 Equity Shares.

Preference Shares :
Preference Shares are the shares which carry preferential rights over the equity
shares. These rights are (a) receiving dividends at a fixed rate, (b) 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.

Equity Shares:
Equity shares are shares which do not enjoy any preferential right in the matter
of payment of dividend or repayment of capital. The equity shareholder gets
dividend only after the payment of dividends to the preference shares. There is
no fixed rate of dividend for equity shareholders. The rate of dividend depends
upon the surplus profits. In case of winding up of a company, the equity share
capital is refunded only after refunding the preference share capital. Equity
shareholders have the right to take part in the management of the company.
However, equity shares also carry more risk.
Preference Shares

 Similarity to Ordinary Shares:

1. Non payment of dividends does not force company to insolvency.
2. Dividends are not deductible for tax purposes.
3. In some cases it has no fixed maturity dates.
 Similarity to Debentures:
1. Dividend rate is fixed.
2. Do not share in residual earnings.
3. Usually do not have voting rights.
Preference Shares–Pros and Cons

 Advantages
1. Risk less Leverage advantage
2. Dividend postponability
3. Fixed dividend
4. Limited Voting Rights
 Disadvantages
1. Non-deductibility of Dividends
2. Commitment to pay dividends
Debentures

Whenever a company wants to borrow a large amount of fund for a long but fixed
period, it can borrow from the general public by issuing loan certificates called
Debentures. The total amount to be borrowed is divided into units of fixed amount
say of Rs.100 each. These units are called Debentures. These are offered to the
public to subscribe in the same manner as is done in the case of shares. A
debenture is issued under the common seal of the company. It is a written
acknowledgement of money borrowed. It specifies the terms and conditions, such
as rate of interest, time repayment, security offered, etc.

Characteristics of Debenture

Following are the characteristics of Debentures:

i) Debenture holders are the creditors of the company. They are entitled to periodic
payment of interest at a fixed rate.
ii) Debentures are repayable after a fixed period of time, say five years or seven
years as per agreed terms.
iii) Debenture holders do not carry voting rights.
iv) Ordinarily, debentures are secured. In case the company fails to pay interest on
debentures or repay the principal amount, the debenture holders can recover it
from the sale of the assets of the company.
Debentures–Pros and Cons

 Advantages
1. Less Costly
2. No ownership Dilution
3. Fixed payment of interest
4. Reduced real obligation
 Disadvantages
1. Obligatory Payment
2. Financial Risk
3. Cash outflows
4. Restricted Covenants
Types of Debentures :

Debentures may be classified as:

a) Redeemable Debentures and Irredeemable Debentures
b) Convertible Debentures and Non-convertible Debentures.

Redeemable Debentures :
These are debentures repayable on a pre-determined date or at an time prior to their
maturity, provided the company so desires and gives a notice to that effect.
Irredeemable Debentures :
These are also called perpetual debentures. A company 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 :
The holders of these 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:
These debentures cannot be converted into shares.
[Link]. Basis Shares Debentures

1 Status Shareholders are the owners Debenture holders

of the company. They provide are the creditors of the company.
ownership capital which is not They the company. They generally
refundable for a fixed period. Such loans are to
be paid back.

2 Nature of Share holders gets dividends. Interest is paid on debentures at a

return on The amount is not fixed. It fixed rate. Interest is payable even if
investment depends on the profit of the the company is running at the loss so
company. Hence only those it is good investment for those who
persons invest in share who do not want to take risk.
are ready to take risk.

3 Rights Share holders are the real Debenture holders do not have right
owners of the company. They to attend meetings of the company
have the right to vote and so they have no say in management
frame the objectives and of the company.
policies of the company.
4 Security No security is required to issue Generally debentures are secured.
shares Therefore sufficient fixed assets are
required when debentures are to be
issued.
Retained Earnings
Like an individual, companies also set aside a part of their profits to meet future
requirements of capital. Companies keep these savings in various accounts such
as General Reserve, Debenture Redemption Reserve and Dividend Equalization
Reserve etc. These reserves can be used to meet long term financial
requirements. The portion of the profits which is not distributed among the
shareholders but is retained and is used in business is called retained earnings or
ploughing back of profits. As per Indian Companies Act., companies are required
to transfer a part of their profits in reserves. The amount so kept in reserve may
be used to buy fixed assets. This is called internal financing.
Merits :
1. Cheap Source of Capital
2. Financial stability
3. Benefits to the shareholders
Limitation :
1. Huge Profit
2. Dissatisfaction among shareholders
3. Fear of monopoly
4. Mis-management of funds
Public Deposits
It is a very old source of finance in India. When modern banks were not there, people
used to deposit their savings with business concerns of good repute. Even today
it is a very popular and convenient method of raising medium term finance. The
period for which business undertakings accept public deposits ranges between
six months to three years.
Features :
1. These deposits are not secured.
2. They are available for a period ranging between 6 months and 3 years.
3. They carry fixed rate of interest.
4. They do not require complicated legal formalities as are required in the case of
shares or debentures.
Advantages:
1. Simple and easy
2. No charge on assets
3. Economical
4. Flexibility
Disadvantages :
1. Uncertainty
2. Insecurity
3. Lack of attraction for professional investors
4. Uneconomical
5. Hindrance to growth of capital-market
6. Over–capitalisation
Borrowing From Commercial Banks :
Traditionally, commercial banks in India do not grant long term loans. They grant
loans only for short period not extending one year. But recently they have started
giving loans for a long period. Commercial banks give term loans i.e. for more than
one year. The period of repayment of short term loan is extended at intervals and in
some cases loan is given directly for a long period. Commercial banks provide long
term finance to small scale units in the priority sector.

Merits of long term borrowings from Commercial Banks:

The merits of long-term borrowing from banks are as follows:
1. It is a flexible source of finance as loans can be repaid when the need is met.
2. Finance is available for a definite period, hence it is not a permanent burden.
3. Banks keep the financial operations of their clients secret.
4. Less time and cost is involved as compared to issue of shares, debentures etc.
5. Banks do not interfere in the internal affairs of the borrowing concern.
6. Loans can be paid-back in easy installments.
7. In case of small-scale industries and industries in villages interest charged is low

Demerits:
Following are the demerits of borrowing from commercial banks:
1. Banks require personal guarantee or pledge of assets and business cannot raise
further loans on these assets.
2. Too many formalities are to be fulfilled for getting term loans from banks. These
formalities make the borrowings from banks time consuming and inconvenient.
Capital is the life blood of business. A business requires capital to purchase its
fixed assets, which is called long term finance. The factors that determine the
long term requirements of capital are: (i) Nature of business, (ii) Size of
business, (iii) Kinds of goods produced, and (iv) Technology used.

The main sources of raising long term finance are: (i) Shares, (ii) Debentures (iii)
Public deposits, (iv) Retained earnings, (v) loans from financial institutions, and
(vi) term loans from banks.

Share is an unit of capital of a company of a definite face value. Share indicates

certain rights of its holder and the extent of his liability. Shares are mainly of two
types : (i) Equity shares (ii) Preference shares.

Preference shares are the shares which carry preferential rights of

receiving dividend and repayment of capital (in case the company is wound
up) over other shares.

Equity shares are shares which do not carry any preferential right. Holders
of these shares are the real owners of the company. They get dividends only
when dividend on preference shares has been paid.
Issue of debenture is a source of borrowed capital. A debenture is a written
acknowledgement of debt by a company. Debenture holders are the creditors
of the company. They do not enjoy any voting rights. They are secured.
Debentures may be (a) redeemable or irredeemable, and (b) convertible or
non-convertible.

Public deposits channelise savings into business. They are unsecured. They
bear fixed rate of interest. Deposits generally are for one year to three years.
An advertisement is required for inviting public deposits.

Retained earning is a portion of profit, earned by an enterprise, set aside to

finance its activities. It is also called ploughing back of profit or internal
financing.

Commercial banks traditionally give loans for a short period. But recently they
have started giving term loans both by extending the short-term loans and also
directly for a long period.
THANK YOU