DEBT CAPITALITS USES AND LIMITATIONS 71. Why companies se !

e"# Capi#a$%& Wha# a'e #he $imi#a#ions o' i# % A business firm obtains capital from major source i.e, by the issue_ of ownership securities kg.d_by...The issue of creditorship securities. The amount collected by the issue of ownersliip gicuritles i.e. shares is calledeicapital and that collected by the issue of creCTITO- sItip securities is called debt capital. !enerally" all business houies use debt capital for its financial re#uirements. The debt may be of three types depending upon its period of use i.e. short-term" medium-term and long-term. Trade creditors" bills$ payable" bank o%erdraft and creditors for e&penses are important ' e&amples of short term debts. (ublic deposits and other loans of periods ranging from three to fi%e year are medium term debts. )ong term debts may be obtained from specialised financial institutions or by issue of debentures and bonds to the public. )oans which no security is issued are unfunded debts and loans against issue of security such as debentures or bonds are funded debts. Why Companies se *ebt Capital Why !oes a company se !e"# capi#a$ is a "asic ( es#ion. The answer is %ery simple. + %Oinpriirborrciws capital in order to ma&imise the profits for its shareholite -frre,to pay higher - di%idend lo them. It would continue to use this source of finance until the inc'emen#a$ 'e# 'n is hi)he' #han #he inc'emen#a$ cos# o* !e"# capi#a$. In simp$e +o'!s& i* #he pe'cen#a)e chan)e in #he ea'nin)s is
hi)he' #han #he pe'cen#a)e chan)e in #he cos# o* capi#a$& #he com pany +o $! p'e*e' !e"#,*iaancin). In some e-cep#iona$ cases& company accep#s !e"# capi#a$ a# e( i$i"'i m poin# .cos# o* capi#a$/es#i ma#e! ea'nin)s0 " # no# * '#he'. In sho'# a company ses !e"# capi#a$ #o accomp$ish #he *o$$o+in) o"1ec#i2es o's #o )e# #he *o$$o+in) a!2an#a)es.

the interest due on their debts. They are not entitled to %ote and participate in management of ti -c concern. The control is retained by the shareholders as before. .30 Trading on .#uity. It facilitates the company to trade on e#uity because the interest payable on debt capital is fi&ed and lower than the rate of earnings. It" thus ma&imises the di%idend to the shareholders. .40 To lower the o%erall cost of capital. The a%erage cost of capital e#uity shares" preference shares and debentures is lowered down by the issue of debt capital because the cost of debt capita/ 0Interest payable1 is %ery low in comparison to the cost of other capital 0di%idends on
.10 -o sharing of control. Creditors are concerned only with

preference and e#uity shares1. admissible e&penditure in computing the ta&able income Of the company while the di%idend is not a deductible e&penditure. Thus the cost is reduced by the marginal ta& rate applicable to that company.
.60 .50 Ta&-+d%antages. Interest payable on debt capital is an

structure because debt can be repaid in case it is no more re#uired by the business. !enerally seasonal re#uirements are met by the-debt capital. .70 Only source a%ailable. 2ometimes company gets it diffi cult to raise funds through any other source e&cept that through debts. +t times" especially during depression and recession" when e#uity shares are not popular with the in%estors" debt capital is the only source for raising funds.
.70 Lo+ cos# o* 8aisin) 9 n!s&,,,,:Cos# o* iss e o* !e"# capi#a$ is consi!e'a"$y $o+ in compa'ison #oe( ; capi#a$ s ch as n!e'+'i#in) commission& e-penses on ce'#ain ies e#c. Limi#a#ions on De"#,9inancia$ There are certain limitations too" on the debt financing. +

le&ibility. *ebt capital .pro%ides fle&ibility in the capital

.< 8is= o* Inso$2ency. De"# capi#a$ in2o$2es se'io s s#'ains on #he $i( i!i#y o* #he company ! e #o pe'io!ica$ *i-e! paymen# o* in#e'es# an! p'incipa$. C'e!i#o's can c$aim $i( i!a#ion o* #he company i* i# *ai$s in mee#in) i#s o"$i)a#ion

company cannot keep 3financing its affairs through debt capital to an unlimited e&tent. It keeps the following points into consideration before raising debt capital

or less a parrri4rielit charge aga lst profits. If company3s income is uncertain and irregular" it shoulo a%oid debt capital. .40 Cos# o* Bo''o+in)s. E-cessi2e "o''o+in)s ma=e #hese f%,ds ostly and uneconomic as the cost of borrowing increases with e%ery successi%e borrowing. > 041 Customs and Con%entions. Certain types of industry in " In!ia s ch as 1 #e& pape'& e$ec#'ici#y generation and distribution" 56 ping etc. rely %ery much upon the debt capital only due to customs and con%entions of the industry. .0 Con#'ac# a$ 8es#'ic#ions. Some#imes& c'e!i#o's s ch as barks or financial institutions impose certain restrictions upon the firm that further loan cannot be taken by
.30 Unce'#ain#y o* Income. Tn#i&'es# on !e"# capi#a$ is mo'e

the firm without their prior appro%al. It will be a limitation on its borrowing powers.
.70 9$ c# a#ions in #he Income o' 8e#' n. The !e"# capi#a$ c'ea#es *$ c# a#ions in #he income o' 'e# 'n #o #he sha'eho$!e's an! #he a2e'a)e is main$y?=", , 2eine! "y The !e)'ee,o**$ # a#ions in #he 'a#e o* 'e# 'n pon e( i#yho$!e's@ in2es#men# pe'mi##e! "y #he management.

Conser%ating outlook of management. + conser%ati%e management does not rely upon the debt capital as far as possible because management loses its freedom if it finances through debt capital. The management in such companies prefer e&pansion and modernisation through internal sources rather than using e&ternal sources. .A0 Chan)e in co'po'a#e #a- sys#em. Ta- p'oposa$s may some time impose certain limitation on debt financing.
.70 Types o* De"en# 'es
con!i#ions o* iss e.

De"en# 'es can "e c$assi*ie! in#o !i**e'en# #ypes acco'!in) #o #hei' #e'ms an!

en! o* #he speci*ie! pe'io! o' +i#hin #he speci*ie! pe'io! a# #he op#ion o* #he company "y )i2in) no#ice #o !e"en# 'eho$!e's o* #he in#en#ion #o 'e!eem !e"en# 'es o' "y ins#a$ men# n!e' #he #e'ms o* iss e.

7. rom 8edemption (oint of 9iew (a) 8e!eema"$e De"en# 'es. S ch !e"en# 'es a'e #o "e 'epai! "y #he company a# #he

(b) I''e!eema"$e De"en# 'es. S ch !e"en# 'es a'e #Ose #ha# a'e 'epaya"$e a# any #ime "y #he company ! 'in) i#s e-is#ence. No minim m pe'io! is *i-e! *o' #hei' 'e!emp#ion. These !e"en# 's a'e 'e!eema"$e i* #he comyany *ai$s #o pay in#e'es# on #hem 'e) $ai$y. T h e s e a ' e a$so ca$$e! pe'pe# a$ !e"en# 'es.BinBno,,,+,e, ,,, h oW e 's ca n. c i m .. , # he i ' , , , ,, ' ee n# ! ' i n ) # h e $ i * e # i m e o* # he company. :.

rom 2ecurity (oint of 9iew

.a0 Na=e!& Unsec 'e! o' Simp$e De"en# 'es. S ch !e"en# 'es ca''y no speci*ic cha')e on #he asse#s o* #he company as 'e)a'!s 'epa ym en # o* p'i nci pa$ an! i n# e'es# . B # "ei n) c'e!i # o's o* #he company& #hey ha2e )ene'a$ cha')e on #he asse#s o* #he company. ."0 Mo'#)a)e o' Sec 'e! De"en# 'es. S ch !e"en# 'es a'e iss e! +i#h a cha')e .*i-e! o' *$oa#in)0 on #he asse#s o* #he company i.e. cha')e may "e on a pa'#ic $a' asse# o' on a$$ asse#s in )ene'a$& A 'e) $a' mo'#)a)e !ee! is en#e'e! in#o "e#+een #he company an! #he #' s#ees o* #he !e"en# 'eho$!e's. ;.

rom the (oint of 9iew of Transfer

.a0 8e)is#e'e! De"en# 'es. S ch !e"en# 'es a'e 'e)is#e'e! +i#h #he company. Names& a!!'esses an! pa'#ic $a's o* ho$!in)s a'e 'eco'!e! in a 'e)is#e'
.De"en# 'eho$!e's@ 8e)is#e'0 =ep# "y #he company. A 'e) $a' #'ans*e' !ee! is 'e( i'e! a# #he #ime o* #'ans*e' o* s ch !e"en# 'es )i2in) * $$ pa'#ic $a's o* #'ans*e'e' an! #'ans*e'ee.

."0 Bea'e' De"en# 'es. S ch !e"en# 'es a'e paya"$e #o #he "ea'e' an! a'e #'ans*e'a"$e "y !e$i2e'y on$y. They a'e ne)o#ia"$e ins#' men#s an! #he company =eeps no 'eco'!s *o' #hem. In#e'es# is pai! #o #he co pon,ho$!e'. 4. rom (riority (oint of 9iew .a0 9i's# De"en# 'es a'e #hose +hich a'e #o "e pai! *i's# in #he e2en# o* +in!in) p o*

#he company.

(b) Secon! De"en# 'es a'e #hose +hich a'e #o "e 'epai! a*#e #hc paymen# o* *i's# !e"en# 'e has
"een ma!e.

6. 9'om Con2e'sion Poin# o* Cie+ .a0 Con2e'#i"$e De"en# 'es. Do$!e's o* s ch !e"en# 'es a'e )i2en an op#ion #o con2e'# #hei' ho$!in)s, in#o sha'es n!e' ce'#ain con!i#ions an! $imi#a#ions . 'e)a'!in) #he pe'io! ! 'in) +hich #he op#ion may "e e-e'cise!. S ch con!i#ions a'e men#ione! in #he !e"en# 'e,ce'#i*ica#e. ."0 Non,Con2e'#i"$e De"en# 'escanno# "e con2e'#e! in#o Bsha'es. 7. O#he' Types o* De"en# 'es Co$$a#e'a$ De"en# 'es. These !e"en# 'es a'e iss e! "y #he company *o' #he $oan #a=en *'om@a "an= o' a *inancia$ ins#i# #ion as co$$a#e'a$ sec 'i#y. They a'e e**ec#i2e on$y +hen #he company *ai$s #o pay #he $oans. E a'an#ee! De"en# 'es. The paymen# o* p'incipa$ an! #he in#e'es# on #hese !e"en# 'es a'e ) a'an#ee! "y some #hi'! pa'#y )ene'a$$y "an=s o' )o2e'nmen# a# #he #ime o* #hei' iss e. 8i)h# De"en# 'es. S ch !e"en# 'es a'e iss e! "y #he company #o i#s 'esi!en# sha'eho$!e's in #he *i-e! p'opo'#ion o* #hei' sha'eho$!in). The p 'pose o* s ch iss e #o a )men# #he $on) #e'm 'eso 'ces o* #he ccmpany *o' +o'=in) capi#a$ 'e( i'emen# an! #o 'e! ce i#s !epenOence on o#he' sho'# #e'm 'eso 'ces. S ch !e"en# 'es canno# "e iss e! *o' e-pansion an! mo!e'nisa#ion p 'poses. S ch !e"en# 'es +i$$ *i's# "e iss e! #o e-is#in) sha'eho$!e's an! #hen #o sha'eho$!e's in a!!i#ion #o #hei' @'i)h#@& !eposi#o's& an! emp$oyees an! " siness associa#es on a 'a#iona$ "asis.

0a1

0b1 0c1

<erits of (reference 2hares.3 ing ad%antages , 0+1 +d%antages from Company (oint of 9iew. The company has the following ad%antages by issue of preference shares ,
. .10 9i-e! 8e# 'nF The !i2i!en! paya"$e on p'e*e'ence sha'es is *i-e!& s a$$y $o+e' #han #ha# paya"$e on e( i#y sha'es. Th s #hey he$p #he company in ma-imisin) #he 'e# 'n #o e( i#y sha'eho$!e'@s.

9oting 8ight. (reference shareholders ha%e no %oting right on matters not directly affecting their rights hence ordinary shareholders retain control o%er the affairs of the company uninterrupted. 0:1 le&ibility in Capital 2tructure. The company can maintain fle&ibility in it capital structure by issuing redeemable preference shares as they can be redeemed under terms of issue.
0:= -o

Issue of preference shares does not pro%e a burden On the finances of the company as is in the case 0 1f debentures or bonds. *i%idends on preference shares are paid cn$y i* p'o*i#s a'e a2ai$a"$e *o' !i2i!en!.
No B '!en on 9inances.
Th s i# $ea2es #he company +i#h a s#'on)e' "a$ance shee# an! hence )'ea#e' $ee+ay *o' * # 'e "o''o+i n).

No Cha')e onG Asse#s. i,Non,paymen# o* !i2i!en! on p'e*e'ence sha'es !oes ,ne# &c'ea#e a eha')e on #he asse#s o* #he company #h s i# ena"$es #he comOany #o conse2e mo'#)a)ea"$e asse#s. I# is #he'e*o'e& 2e'y se* $@ i* i#s asse#s a'e ma!e a2ai$a"$e as co$$a#e'a$ sec 'i#y *o' "o''o+in) on !e"en# 'es. Wi!e Capi#a$ Ma'=e#. T h e i s s e o * p ' e * e ' e n c e s h a ' e s +i!ens #he scope o* capi#a$ ma'=e# as #hey p'o2i!e #he sa*e#y #o #he i n 2 e s # o ' s a s e $ $ a s a * i - e ! ' a # e o * ' e # ' n & $ * c o m p a n y ! o e s n o # iss e p'e*e'ence sha'es& i# +i$$ no# "e a"$e #o a##'ac# #he capi#a$ *'om s c= mo!e'a#e #ype o* in2es#o's. . B0 A!2an#a)es *'om In2es#o's@ Poin# o* Cie+. I n 2 e s # o ' s i n p'e*e'ence sha'es ha2e #he *o$$o+in) a!2an#a)es F

.60

0>1

P'e*e'ence sha'es ha2e #he *o$$o+,

on preference shares regularly e%en if there is no prefit. It is possible that the di%idend for the years in which company earned no pre fit or inade#uate profits" would be paid in the years of profits. 0:1 (referential 8ights. (reference shares carry preferential rights as regard to pa1 meat of di%idend and repayment of

0I1 8egular i&ed Income. In%estors get a fi&ed rate of di%i dend

capital in case of winding up of company. Thus they enjoy the minimum risk. 0;1 9oting 8ight for 2afety of Interest. (reference shareholders are gi%en %oting rights in matters directly affecting their interest. It Ineans" their interest is safeguarded. 041 )esser Capital )osses. +s the preference shareholders enjoy the preferential right of remment of their capital in case of winding up of company" it sa%es them from capital losses. 0>1 air 2ecurity. (reference shares are fair securities for the shareholders dbring depression periods when the profits of the company are going down or when the rate of interest in the market is "continuously falling down.
p'e*e'ence sha'es a'e as "e$o+.

Deme'i#s o* P'#*e'ence Sha'es. The impo'#an# !isa!2an#a)es o* #he iss e o*

.A0 Deme'i#s *o' Companies. The *o$$o+in) !isa!2an#a)es a'e &associa#e! +i#h #he iss e o* p'e*e'ence sha'es.

071 ?igher 8ate of *i%idend. Company is to pay higher di%i 'dend

on these shares than the pre%ailing rate of interest on deben4ures or bonds. Thus" it usually increases the " cost of capital for the company.
& .30 9inancia$@ B '!en. Mos# o* #he p'e*e'ence sha'es a'e iss e! c m $a#i2e +hich means
#ha# #he a''ea's o* p'e*e'ence !i2i!en! .''i s# "e pai! "e*o'e any#hin) is pai! #o e( i#y sha'eho$!e's. The company is n!e' an o"$i)a#ion #o pay !i2i!en! on s ch sha'es. I# is& #he'e*o'e& a ," '!en on #he company@s p'o*i#s.

0;1 *ilution of Claim o%er +ssets. The issue of preference shares in%ol%es dilution of e#uity shareholder3s claim o%er the assets of the company because preference shareholders ha%e the preferential right on the assets of the company in case of winding up. 041 Limi#in) #he 9$e-i"i$i#y. Some#imes& #he iss e o* p'e*e'ence sha'e $imi# #he *$e-i"i$i#y o* #he capi#a$ s#' c# 'e. In ce'#ain cases& cons#an# o* p'e*e'ence sha'eho$!e's is necessa'y #o
inc ' * '#he' !e"#e!ness.

0>1 (a%ing @ay to Insol%ency. @here business acti%ities are falling and the board of directors feels that the di%idend on prefer- ewe shares should

be paid in order to preser%e their attracti%eness. though subse#uent e%ents may pro%e that the decision was wrong. 2uch decision may pa%e the way to insol%ency. 0A1 +d%erse .ffect on credit worthiness. The credit worthiness. of the company - is seriously affected by the issue of preference shares. The creditors may anticipate that the continuance of di%idend on preference shares and

suspension of di%idend on e#uity capital may depri%e them of the chance of getting back their principal in full in the e%ent of dissolution of the company because prefer-epce capital has the preferential right o%er the assets of the company. <oreo%er" suspension of di%idend on e#uity shares may bring down the goodwill of the company in the market which" again may be am additional point in negating the creditworthniess of the company. 0B1 Ta& *isad%antage. The ta&able income of the company is not reduced by the amount ii>f preference di%idend while in case, of debentures or bonds" the interest paid to them is deductible in full.
.B0 Deme'i#s *o' In2es#o's. Main !isa!2an#a)es o* in2es#o's a'e F

No Co#in) 8i)h#. The p'e*e'ence sha'eho$!e's !o no# en1oy any 2o#in) 'i)h# e-cep# in ma##e's !i'ec#$y a**ec#in) #hei' in#e'es#.. Th s& #hey canno# pa'#icipa#e,in po$icy !ecisions. i&ed Income. The di%idend on preference shares other than participating preference shares is fi&ed e%en if the company earns higher

0:1

.60 No Ea 'an#ee o* Asse#s. Company p'o2i!es no sec 'i#y #o #he p'e*e'ence capi#a$ as is ma!e in #he case o* !e"en# 'es. Th sH #hei' in#e'es#s a'e no# p'o#ec#e! "y #he asse#s o* #he company.

profit. 0;1 -o Claim o%er 2urplus. The preferential shareholders ha%e no claim o%er the surplus. They can only ask for the return of their capital in%estment in the preference shares of the company. 041 8edemption. The company may redeem the redeemable preference shares at its option at any time when it feels con%enient_ to pay them off. It creates uncertainty in their minds. .

Basic Iss es In2o$2e! in Di2i!en! Po$icy. The *o$$o+in) iss es a'e in2o$2e! in !eci!in) a so n! !i2i!en! po$icyF,

otherwise not.
.30 .40

.10

Cost of Capital. If cost is less" di%idends may be 8ealisation Objecti%es. <a&imisation of wealth 2hareholders3 group.

paid" should he

there in deciding di%idend policy.

.50 8elease of Corporate .arnings. <anagement is to decide whether to distribute retained earnings or not actors +ffecting *i%idend (olicy. The following factors affect the di%idend policy .10 2tability of earning helps in formulating stable di%idend policy.
!i2i!e'! po$icy in compa'ison #o ne+ ones.

.30 .40 .50 .60 .70 .70 .A0

A)e o* Co'po'a#ion. O$!e' company may *o'm $a#e a c$ea' c # an! consis#en# )i#uidity of unds. <ore li#uidity" bciter ability to
"

di%idend.

pay

shareholders eimaasise distribution of di%idend.

* n!s 'e#ain p'o*i#s an! pay !i2i!en! a# $o+e' 'a#es.

.&tent of 2hare *istribution. )arge number of Nee!s *o' A!!i#iona$ Capi#a$. Ne+ companies ha2in) no a$#e'na#i2e so 'ce o* Trade Cycles. In Coom period" earnings may be

and di%idend stab ised.

retained and

other policies affect di%idend payment. followed.

.10 .I0

!o%ernment (olicy. Change in fiscal" industrial labour control Ta&ation (olicy. ?igh ta&ation reduces the rate of

di%iDnd. )egal 8e#uirements under CoBT<anies +ct 7E>A are to be

(ast *i%idend 8ates. (ast rates are to be considered and

rate should be around those past rates. market may pay higher di%idend. lower di%idend will be paid.
.40 .30 .10

current

+bility to Forrow. Companies ha%ing better access to (olicy of Control. If directors wish to control the

capital

affairs"

indebtedness pay less on shares.

8epayment of )oan. Companies ha%ing good

.150 Time *o' Paymen# o* Di2i!en!F When companies

ha%e sufficient cash.

Dividend Policies

7E.;

. A. Ta-a#ion Po$icy. Di)h #a-a#ion 'e! ces #he ea'nin)s o* #he companies an! conse( en#$y #he 'a#e o* !i2i!en! is $o+e'e! ,!o+n. Some#imes Eo2e'nmen# $e2ies !i2i!en!,#a- on !is#'i" #ion o* !i2i!en! "eyon! a ce'#ain $imi#. I# a$so a**ec#s #he 'a#e o* capi#a$ *o'ma#ion.

E. )egal 8e#uirements. In deciding on the di%idend" tile directors take the legal re#uirements too into consideration. In order to protect the interests of creditors and outsiders" the Companies +ct 7E>A prescribes certain guidelines in respect of the distribution and payment of di%idend. <oreo%er" a company is re#uired to pro%ide for depreciation on its fi&ed and tangible assets before declaring di%idend on shares. It proposes that di%idend should not be distributed out of capital in any case. )ikewise" contractual obligation should also be fulfilled" for e&ample" payment of di%idend. on preference shares in priority o%er ordinary di%idend. E. (ast *i%ide"nd 8ates. @hile formulating3 the di%idend policy" the directors must keep in mind the di%idend paid in past years. The current rate should be around the a%erage past rate. If it has been abnormally increased" the shares will be aubjected to speculation. In a new concern" the company should consider the
po$icy o* #he 'i2aLo'ianisa#ions&

75. +bility to Forrow. @ell established and large firms ha%e. better access to the capital market than the new companies and may borrow funds from other e&ternal sources if there arises any need. 2uch companies may ha%e a better di%idend pay-out ratio. @hereas smaller firms ha%e to depend on their internal sources and therefore they will ha%e to built up good reser%es by reducing the di%idend pay-out ratio for meeting any obligation re#uiring hea%y funds.
Po$icy o* Con#'o$. Po$icy& o* con#'o$ is ano#he' !e#e' minin) *ac#o' in so *a' as !i2i!en!s a'e conce'ne!. I* #he !i'ec#o's +an# #o ha2e con#'o$ on company& #hey +o $! no# $i=e #o a!! ne+ sha'eho$!e's an! #he'e*o'e& !ec$a'e a !i2i!en! a# $o+ 'a#e. BeCa se , "y a!!in) ne+ sha'eho$!e's #hey *ea' !i$ #ion ,o* con#'o$ an! !i2e'sion o* po$icies an! p'o)'ammes o* #he e-is#in) mana)emen#. So& #hey p'e*e' #o mee# #he nee!s #h'o )h 'e#aine!, ea'nin)s. I* #he !i'ec#o's !o no# "o#he' a"o # #he con#'o$ o* a**ai's #hey +i$$ *o$$o+ a $i"e'a$ !i2i!en! po$icy. Th s con#'o$ is an in*$ encin) *ac#o' in. *'amin) #he !i2i!en! po$icy. 8epaymen# o* Loan. A company ha2in) $oan in!e"#e! ness a'e 2o+e! #o a hi)h 'a#e o* 'e#en#ion ea'nin)s& n$ess some o#he' a''an)emen#s a'e ma!e *o' #he 'e!emp#ion o* !e"# on ma# 'i#y. I# +i$$ na# 'a$$y $o+e' !o+n #he 'a#e o* !i2i!en!. Some#imes& #he $en!e's .mos#$y ins#i# #iona$ $en!e's0 p # 'es#'ic#ions on #he !i2i!en! !is#'i" #ion #i$$ s ch #ime #hei' $oan is o #s#an!in). 9o'ma$ $oan con#'ac#s )ene'a$$y p'o2i!e a ce'#ain s#an!a'! o* $i( i!i#y an! so$ , 2ency #o "e main#aine!. Mana)emen# is "o n! #o hono ' s ch 'es#'ic#ions an! #o $imi# #he 'a#e o* !i2i!en! pay,o #.
Time for (ayment of *i%idend. @hen should the di%idend be paid is another consideration. (ayment of di%idend means outflow of cash. It is" therefore" desirable to distribute di%idend at a time when it is least needed by the .comps.ay because there are peak times as well as lean periods of e&penditure. @ise management should plan the payment of di%idend in such a manner that there is no cash outflosi at a time- when the undertaking is already in need of urgent

E.

75.

74.

finances.

7>. 8egularity and 2tability in *i%idend (ayment. *i%idends should be paid regularly because each in%estor is interested in the regular payment of- di%idend.. The management should" in spite. of regular payment of di%idend" consider that the rate of di%idend should be all the most constant. or this purpose sometimes companies maintain *i%idend .#ualisation und. 7A. 2tate or Capital <arket. If the capital market (osition is comfortable
in the country and the" funds may be raised from different sources without much difficulty" the managemerit may tempt to declare a high rate of di%idend to attract the in%estors and maintain the e&isting shareholders. Contrarily" if there is a slump in the stock_ market and the stockholders are not iiiterested in making the in%estment in securities" the management should follow a conser%ati%e di%idend policy" by maintaining a low rate of di%idend and ploughing back a siGable portion of profits to face any contingency. )ikewise" if the term lending financial institutions ad%ance loans of stiffer terms" it may be desirable to rely on internal sources of financing" and accordingly conser%ati%e de%idend policy should be pursued.

Types o* Di2i!en! Po$icies

Di2i!en! po$icies may "e o* !i**e'en# #ypes as *o$$o+s 0I1 2table *i%idend (olicy. Hnder this policy" stable or

almost stable rate of di%idend is maintained. Company maintains reser%es in the years of prosperity and uses them in paying di%idend in lean years. If company follows stable di%idend policy" the market price of its shares shall be higher. 3There are se%eral reasons why in%estors prefer stable di%idend policy. <ain reasons are :-(a) Confidence +mong 2hareholders. + regular and stable di%idend payment may ser%e to resol%e uncertainty in the minds of shareholders. ' Thenot 3many resorts not to cut the di%idend- rate e%en if its profits are kt; --7t_maintains the rate of di%idend-by appropriating the" from its reser%es. 2table di%idend presents a brightfutio of the company and thus gains the confidence of the shareholders and the goodwill of the company )e#ne'a$ in2es#o's. , increases in the eyes of the
.10 Income Conscio s In2es#o's. The secon! *ac#o' *a2o 'in) s#a"$e !i2i!en! po$icy is
#ha# some in2es#o's a'e income conscio s an! *a2o ' a s#a"$e 'a#e o* !i2i!en!. They& #oo& ne2e' *a2o ' an ns#a"$e 'a#e o* !i2i!en!. A s#a"$e !i2i!en! po$icy may a$so sa#is*y s ch in2es#o's.

(c) Stability in <arket (rice oi 2hares. Other things being $e#ual" the market price %ary with the rate of di%idend the company "declares on its e#uity shares. The %alue of shares of a company 3la%ing a stable di%idend policy fluctuates not widely e%en if the3 arnings of the company is lower than the pre%ious year. Thus" this policy buffer the market price of the stock. (d) Incouragement to Institutional In%estors. + stable di%idend policy

attracts in%estments from institutional in%estors. 2uch institutional in%estor generally prepare a list of securities" mainly incorporating the securities of the companies ha%ing stable di%idend policy in which they in%est their surpluses or their long-term funds such as pensions or pro%ident funds etc. In this way" stability and regularity of di%idends not only affects the market price of shares but also increases the general credit of the company that pay_s the company if3-the long run. + stable di%idend policy also pays to the firm. The company with stable di%idend policy can formulate its financial planning %ery easily because the financial manager can correctly estimate the future demand and supply of capital in the firth. Timing of di%idend payment can also be forecasted easily by preparing cash flow statement.
S#a"i$i#y o* !i2i!en!s can #a=en #h'ee B!is#inc# *o'ms Cons#an# !i2i!en! pei sha'e& (ii) Cons#an# pe'cen#a)e o* ne# ea'nin)s&

0iii1

Cons#an# !i2i!en! pe' sha'e an! e-#'a !iyi!en!.

0i1 Constant di%idend per share. Hnder this policy" the management follows the policy of paying a fi&ed amount of di%idend per share e%ery year irrespecti%e of the fluctuations in the earnings. It does not imply that the rate of di%idend will ne%er be increased. @hen the earnings of the company increase at a new le%el and the management is of the %iew that it can easily .maintain that le%el of earnings" it increases the rate of

di%idend per share.

The policy is easy to follow when company earnings are stable. lf earnings fluctuate widely" the company can t follo%rt ical>aT4 by maintaining a di%idend fluctuation fund in surplus years. The fund may be in%ested in marketable securities so that they may easily be realised in bad years to (ay the di%idend in those years.
Cons#an# Pe'cen#a)e o* Ne# Ea'ni'eJ&s. Some companies *o$$o+ #he po$icy o* payin) a *i-e! pe' cen#
o' ne# p'o*i#s as !i2i!en! e2e'y yea'& i e., , po$icy o* cons#an#@ pay,o # 'a#io. S ppose& a company a!op#s a 5< pe' cen# pay,o # 'a#io& i# means& 5< pe' cen# ne# ea'nin)s o* #he company +i$$ "e pai!,o # #o sha'eha$!e's e2e'y F5& ea' as !i2i!en!. In #he yea' o* $oss& no !i2i!en! is pai!. In#e'na$ *inancin) n!e' #his po$icy is a #oma#ic. 9o' e-amp$e& in #he a"o2e case, 7<K o* #he p'o*i#s a'e #'ans*e''e! #o 'ese'2es. Th s #he po$icy $ea2es no#hin) #o #he mana)emen# !isc'e#ion.

*i%idend (er 2hare (lus .&tra *i%idend. Hnder this policy" the management fi&es the ininimum rate of di%idend per share to yeelnce_the_epossibility of-not paying a di%idend. The

WO Constant

!i2i!en! !espi#e $a')e amo n# o* p'o*i#s. This po$icy is )ene'a$$y P 's e! in #he *o$$o+in) ci'c ms#ances.i0 The company is ne+ an! )'o+in) an! 'e( i'es h )e * n!s #o *inance i#s )'o+in) nee!s L (ll) When *i'm@s ac(ess #o capi#a$ ma'=e# is !i**ic $# o' cos# o* *inance is cos#$ie' L (iii) Sha'eho$!e's a'e +i$$in) #o +ai# *o' $on) *o' a 'e# 'n on #hei'@ in2es#men# an!& in #he mean#ime& a'e con#en# #o ha2e #hei' ho$!in)s app'ecia#e in 2a$ e .capi#a$ )ains0.

company pays e&tra di%idend in the years of prosperity. Thus" the policy commits a fi&ed rate of_di%idend per share _plus an e&tra di%idend in the periods of prosperity. 0:1 Po$icy o* no Imme!ia#e Di2i!en!. Ce'y o*#en& company !eci!es #o pay

by bonus issue to keep the profits and the share prices within manageable units.
(olicy of no di%idend is usually followed

0;1 (olicy of 8egular 2tock *i%idend. Hnder this policy" company pays di%idend in the form of bonus share instead of cash. It does not affect the li#uidity at all but increases the shareholdings of the shareholders. The policy can be justified in the following circumstances--05 The company has earnings but it needs cash to co%er its modernisation and e&pansion scheme" and (ii) the firm is deficient of cash despite high earnings. To follow this policy for long is not ad%isable because it affects the share %alue in the market ad%ersely because of the increased number of shares. " The policy is no fa%oured by those shareholders who ha%e strong preference for cash di%idend. 041 (olicy to (ay Irregular *i%idend. Companies following this
policy take a lenient %iew of di%idend and pay the di%idend in correspondence witTrifirChanging le%el of earnings. The large is the earnings the large is the di%iden# and %ice %ersa. This3 policy is based on the belief of the management that shareholders are entitled as much di%idend as the firm3s earnings and the cash position warrant. !enerally" this policy of di%idend is

followed by companies ha%ing irregular earnings.

Thus" a company may adopt any of the abo%e di%idend policies that suits the company" earnings" cash position and the management .attitude. 0i1

Types o* P'e*e'ence sha'es The p'e*e'ence sha'es may "e o* 2a'io s #ypes acco'!in) #o the rights attached to them. .10 C m $a#i2e an! Non,C m $a#i2e P'e*e'ence sha'es. C m $a#i2e p'e*e'ence sha'es en1oy #he 'i)h# #o 'ecei2e #he !i2i!en! in a''ea's *o' #he yea' in +hich company ea'ne! no p'o*i#s o' ina!e( a#e p'o*i#s. Whene2e' #he p'o*i#s pe'mi# o' in o#he' +o'!s !i2i!en! +i$$ )o on acc m $a#in) n#i$ i# is pai! in * $$ +i#h a''ea's. In ease o* non,c m $a#i2e p'e*e'ence sha'es& !i2i!en! on p'e*e'ence sha'es !oes no# acc m $a#e& an! no npai! !i2i!en! *o' #he ea'$ie' yea's +i$$ "e pai! in #he yea' o* p'o*i#s. I* #he'e is no p'o*i#s o' ina!e( a#e p'o*i#s in #he company in any pa'#ic $a' yea'& no& !i2i!en! +i$$ "e pai! #o p'e*e'ence sha'eho$!e's in #ha# yea' no' can they claim the di%idend for the year in future.
0:1 8e!eema"$e an! I''e!eema"$e P'e*e'ence Sha'es. 8e!eema"$e p'e*e'ence sha'es can "e 'e!eeme! a*#e' a pe'io! *i-e! n!e' #he #e'ms o* iss e o' a*#e'
)i2in) a p'ope' no#ice #o #he p'e*e'ence sha'eho$!e's. I# means #he company n!e'#a=es #he 'esponsi"i$i#y #o 'e# 'n #he capi#a$ n!e' #he #e'ms o* #hei' iss e. The company: ac# imposes ce'#ain 'es#'ic#ions 'e)a'!in) #he 'e!emp#ion o* p'e*e'ence sha'es. No p'e*e'ence sha'es can "e 'e!eeme! n$ess i# is * $$y pai!. S ch sha'es can "e 'e!eeme! ei#he' o # o* p'ocee!s o* *'esh iss e o' o # o* p'o*i#s o* #he company. I* s ch sha'es a'e #o "e 'e!eeme! o # o* p'o*i#s& an amo n# e( a$ #o #he nomina$ 2a$ e o* #he sha'es #o "e 'e!eeme!& sho $! "e #'ans*e''e! o # o* p'o*i#s #o a * n!& name! Capi#a$ 8e!emp#ion 8ese'2e 9 n!. P'e*e'ence sha'es +hich canno# "e 'e!eeme! ! 'in) #he $i*e,#ime o* #he company a'e I''e!eema"$e P'e*e'ence sha'es.

40 Pa'#icipa#in) an! non,pa'#icipa#in) P'e*e'ence Sha'esF The ho$!e's o* s ch sha'es ha2e a 'i)h# #o pa'#icipa#e in #he s 'p$ s p'o*i#s o* #he company 'emaine! a*#e' payin) !i2i!en! #o #he o'!ina'y

sha'eho$!e's a# a ce'#ain *i-e! 'a#e. They may a$so "e en#i#$e! #o )e# a sha'e in #he s 'p$ s asse#s o* #he company a# #he #ime o* i#s +in!in) p. S ch p'e*e'ence sha'es +hich ha2e no c$aim in #he s 'p$ s p'o*i#s o' asse#s o* #he company a'e !eeme! #o "e #he Non,pa'#icipa#in) P'e*e'ence Sha'es.

0:1 Con%ertible and -on-con%ertible (reference 2hares. The holders of con%ertible preference shares ha%e a right to con%ert their holdings into ordinary- shares within a specified period whereas the holders of non-con%ertible preference shares ha%e no such right of con%ersion. 0:1 !uaranteed (reference 2hares. 2uch preference shares are usually issued when a company is con%erted from a pri%ate limited company to a public limited company or when one company is sold to another company. The seller or any other interested party guarantee the payment of di%idend on preference shares at a specified rate for a certain numbe' o* yea's. 2hare. + share in a company is one of the units

into which the total share capital of a company is di%ided. It is a fractional part of the capital of the company which forms the basis of ownership and interests of a subscriber in the company. Sec#ion 3.570 o* #he Companies Ac# 1I67 !e*ines #he #e'm as Msha'e in #he sha'e capi#a$ o* a company& an! inc$ !es s#oc=& e-cep# +he'e a !is#inc#ion "e#+een s#oc=
an! sha'e is e-p'esse! o' imp$ie!M. This is no# an e-ha s#i2e !e*ini#ion o* sha'e. I# may "e !e*i$e! as M#he in#e'es# o* a sha'eho$!e' in #he company meas 'e! "y a s m o* money" for the purpose of liability in the first place and of interest in the second" and also consists of a series of mutual co%enants -entered into by all the shareholders inter se in accordance with the pro%isions of the Companies +ct and the +rticles of +ssociation.

2tock. 3 2tock is the aggregate consolidated holding of the share capital of a person. It is a set of shares put together in a bundle. It can be di%ided and transferred in any fractions and subdi%isions without regard to the original face %alue of shares. + company may. if +rticles so permit" con%ert its fully paid up shares into stock by an ordinary resolution of the members. 2tock may be registered or unregistered 0bearer1. The former is transferable like a share by transfer deed and the latter is transferable merely by deli%ery.
*istinction. The share and the stock may be distinguished on the following grounds ,

071 (aid up +mount. - + share may be partly paid up or fully paid up but a stock is always fully paid up. ully paid up shares only can be con%erted into stock. 0:1 Nomina$ Ca$ e. A sha'e has a nomina$ 2a$ e +he'eas a s#oc= has no nomina$ 2a$ e. 0;1 Transferability in ractions. + snare cannot be transferred in fractions. @hereas a stock can be transferred to any fraction and sub-di%ision. 041 *istinct -umbers. +ll shares bear distinct numbers representing the units of share capital while stocks disclose the consolidated %alue of the share capital. ractions of stock do not bear any number. 0>1 *enomination. +ll shares are of e#ual denomination. 2tock may be of une#ual amounts and may be transferred in different fragments. 0A1 Offer to (ublic. 2hares can be issued to the public directly in the first instance but stocks cannot be offered directly to the -public. Only fully paid up shares are con%erted into stock. 0B1 8egistration. 2hares are always registered and not transferable by deli%ery whereas stocks may be registered or bearer. If they are registered" they are transferable by transfer-deed and if unregistered" only by deli%ery.

Pe'manen# Capi#a$. I# is a )oo! so 'ce o* $on),#e'm *inance. A company is no# 'e( i'e! #o pay,"ac= #he e( i#y capi#a$ ! 'in) i#s $i*e,#ime an! so i# is a pe'manen# so 'ce o* capi#a$.

071 Lon),#e'm an!

0:1 No i&ed Furden. Hnlike preference shares" e#uity shares impose no fi&ed burden on the company3s resources" because the di%idend on these shares is subject to a%ailability of profits and the intention of the Foard of *irectors. They may not get the di%idend e%en the company has profits" or they may get the di%idend out of accumulated profits e%en of the company has earned no profit or inade#uate profits for the current year. Thus they pro%ide a cushion of safety against unfa%orable de%elopments. 0;1 Credit @orthiness. Issuance of e#uity share capital creates no charge on the assets of the company. + company can raise further finance on the security of its fi&ed assets. <oreo%er" e#uity capital pro%ides safety to the creditors. 041 8isk Capital. .#uity capital is said to be the risk capital. + company can trade on e#uity in bad periods on the risk of e#uity capital. If the company earns lesser profits by trading on e#uity" the e#uity shareholders would be the real loser. 0>1 *i%idend (olicy. + company may follow an elastic and Traditional di%idend policy and may create huge reser%es for its de%elopment programmes. .B0 A!2an#a)es #o In2es#o's. In2es#o's o' e( i#y sha'eho$!e's may en1oy #he *o$$o+in) a!2an#a)es 071 <ore Income. .#uity shareholders are the residual claimant of the profits after meeting all the fited commitments i.e., interest on debentures and preference di%idend. The company generally trades on ecpiity to add to the profits of the company. Thus e#uity capital may get di%idend at a higher rate in booni 3period. 0:1 8ight to (articipate in the Control and <anagement. .#uity shareholders ha%e %oting rights or right of control for conducting the affairs of the company" and elect competent persons as .directors on the board of directors to control and manage the affairs of the company. 0;1 Capital +ppreciation. The market %alue of

e#uity share fluctuates directly with the profits of the company and their real %alue based on the net worth of the assets of the company. +n appreciation in the net worth of the company3s assets will increase the market %alue of e#uity shares. It -brings ca pital appreciation in their in%estments. If" on the other hand" the profits of the company are accumulated" that will be distributed among the shareholders as bonus shares. This is also a capital increase.
An A##'ac#ion *o' Pe'sons ha2in) Limi#e! Income. E( i#y sha'es a'e mos#$y o* $o+e' !e#io'!na#ion an! p'esons o* $imi#e! resources can purchase these shares. marketability of these shares. 0>1 P'e,emp#i2e 8i)h#. The e( i#y sha'eho$!e's o* a company ha%e pre-empti%e right in any successi%e issue of shares of the company in a Certain proportion fi&ed by the Foard of *irectors. It is-" a statutory re#uirement under 2ection I7 of the Indian Companies +ct" 7E>A. If the company is a prospecting company" the e#uity shareholders may be benefited by such right issue. 0A1 Other +d%antages. It appeals most to the speculators.. Their prices in security market are more fluctuating. *isad%antages of .#uity 2hares 0+1 *isad%antages to Company. .#uity shares ha%e the following disad%antages to the company 071 Di$ #ion in Con#'o$. Each sa$e o* e( i#y sha'es !i$ #es #he %oting power of the e&isting e#uity shareholders" and e&tends the %oting or controlling power to the new shareholders. .#uity shares are transferable and may bring about centralisation of power in few hands. Certain groups of e#uity shareholders may manipulate control and management of company by controlling the majority holdings which may be detriment to the interest of the company. 071 T'a!in) on E( i#y no# Possi"$e. I* e( i#y sha'es a$one a'e iss e!& #he company canno# #'a!e on e( i#y. T'a!in) on e( i#y is possi"$e on$y +hen #he o#he' sec 'i#ies& "ea'in) *i-e! 'a#e o* !i2i!en!Nin#e'es# a'e iss e! an! #he !i2i!en! o' in#e'es# paya"$e on s ch securities is less than the profitability rate of company earnings. 0:1 O%er Capitalisation. .&cessi%e issue of e#uity 2hares may result in o%er-capitalisation. *i%idend per share is low in that condition which ad%ersely affects the

psychology of the in%estors. ' 0;1 No 9$e-i"i$i#y in Capi#a$ S#' c# 'e E( i#y sha'es canno# be paid back during the life-time of the company" This characOristic creates infle&ibility in capital structure of the company. @hereas redeemable preference shares or redeemable debentures are paid back as soon as the funds are not re#uired. 041 Di)h Cos#. I# cos#s mo'e #o *inance +i#h e( i#y sha'es that with -o#he' sec 'i#ies as #he se$$in) cos#s an! n!e'+'i#in) co'nn ossioJ' re paid a# a hi)he' 'a#e on #he iss e o* #hese sha'es. 2peculation. .#uity shares of good companies are subject #o $$ ec# 'i c spec $ a# i on in the stock market. Their p'ices *$ c# a#e *'e( en#$y +hich a'e no# in #he interest of the company. 0F1 *isad%antages to In%estors
071 Hncertain and Irregular Income. The payment of di%idend on e( i#y sheacs is subject to the a2ai$a"i$i#y o* p'o*i#s an! #he in#en#ion o* #he Boa'! o* Di'ec#o's& since #he income o* any comme' ,
cia$ o')ani9a#i. n Hs ne# 'ep $a' an! ce'#ain& #he e( i#y sha'eho$!e's may no# )e# any !i2i!en! in case #he'e is ins **icien# p'o*i#s o' management thinks it proper" not to pay any di%idend on these shares e%en there are sufficient profits.

0:1 Capital )oss during *epression (erio d. *uring recession or depression period the profits of the company and conse#uently the rate of di%idend come down. *ue to low rate of di%idend and certain other factors the market %alue of e#uity shares goes down resulting in a capital loss to the in%estors.
0;1 )oss on )i#uidation. In case" the company goes into li#uidation" e#uity shareholders are the worst sufferers. They are paid in the last only if any surplus is a%ailable after e%ery other claim including the claim of preference shareholders is settled.

041 It is e%ident from the ad%antages and disad%antages of e#uity share capital discussed abo%e that the issue of e#uity
taking

share capital is a must for a company" yet it should not solely depend on it. In order to make its capital structure fle&ible" it should raise funds from other sources also. It will reduce the cost of capital and pro%ide an opportunity to the company to trade on e#uity but market conditions and other rele%ant factors must be consi!e'e! any decision in this regard.

before