SOURCES OF LONG TERM

FINANCE

Need for long term Finance

Long term vs. short term(working

capital) funds requirements
For modernisation, expansion,
diversification; huge quantities reqd.,
irreversible decision
Asset-liability mismatch, interest rate
risk, liquidity risk, if LT reqts.met by ST
funds

Equity Capital

Authorised, Issued, Subscribed and Paid up

capital
Par/face value, Issue Price, Book value and
Market Value
Rights of equity shareholders
-Right to Income :PAT less preferred dividends
-Right to Control: voting rights
-Pre-emptive Right: for additional issues,
rights issue in the same proportion
-Right in liquidation: residual claim over assets

Pros and cons of equity

Capital

Advantages
No fixed maturity, no
obligation to redeem
No compulsion to
pay dividends
Provides leverage
capacity
Dividends tax
exempt for investors

Disadvantages
Dilution of control of
existing owners
High Cost: rate of return
expected by equityholders
higher than debtholders
Dividends are not tax
deductible: hence cost is
higher
Issue costs higher:
underwriting, brokerage,
other issue expenses
Higher servicing costs: hold
AGMs, post annual reports
etc.

Internal Accruals

Consists of retained earnings and depreciation charges

Pros
Readily available, no
talking to outsiders
Effectively additional
equity capital, however
no issue costs of loss
due to underpricing
No dilution of control
No expansion in equity
base, hence no dilution
of EPS, BV per share
etc.

Cons
Quantum very limited
High Opportunity
costs: dividends
forgone by equity
holders
Requires careful
attention to NPV of
projects

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

Preference Capital

Pros
No obligation to pay
dividend, no bankruptcy or
legal action for non payment
Financial distress of
redemption obligation not
very high
Part of net worth, hence
increases its
creditworthiness/ leverage
capacity
No dilution of control
No pledging of assets
required

Cons
Expensive source since
dividends not tax
deductible
Though no legal
consequences, liability to
pay dividends stands, can
spoil companys image
Can acquire voting rights
in some cases
Have claim prior to equity
holders

Term Loans

Provided by FIs/banks
Can be in domestic/foreign currency, liability on FC
loans translated to rupees for payment
Are typically secured against fixed assets/
hypothecation of movable properties, prime security/
collateral security
Definite obligations on interest and principal
repayment; interest paid periodically; based on credit
risk and pegged to a floor rate
Carry restrictive covenants for future financial and
operational decisions of the company, its management,
future fund raising, projects, periodic reports called for

Term Loans

Pros
Interest on debt is tax
deductible
Does not result in dilution
of control
Do not partake in value
created by the firm
Issue costs of debt is lower
Interest cost is normally
fixed, protection against
high unexpected inflation
Has a disciplining effect on
management

Cons
Entails fixed obligation for
interest and principal, non
payment can even lead to
bankruptcy/ legal action
Debt contracts impose
restrictions on firms
financial and operational
flexibility
Increases financial
leverage, excess raises cost
of equity to the firm
If inflation rate dips, cost of
debt higher than expected

Debentures

Like promissory notes, are instruments for raising LT debt

More flexible compared to term loans as they offer variety of choices
as regards maturity, interest rate, security, repayment and other
special features
Interest rate can be fixed/floating/deep discount
Convertibility : Can be FCDs, NCDs, PCDs
Warrants : Can have warrants attached, detachable or non
detachable, detachable traded separately
Option : Can be with call or put option
Redemption: Bullet payment or redeemed in instalments
Security: Secured or unsecured
Credit rating: Need to have a credit rating by a credit rating agency
Trustee: Need to appoint a trustee to ensure fulfilment of contractual
obligations by company
DRR: Company needs to create a DRR if maturity more than 18
months

Other forms of Finance

Leasing: asset leased out in lieu of lease rentals, title not

transferred, only economic use of assets given; can be financial
lease or operating (service) lease
Hire Purchase: ownership transferred to the buyer after all the
installments paid up
Securitisation: assets involving financial claims pooled and
financial instruments created, thus creating cash out of
receivables
Government Subsidies: central and state govts offer cash
subsidies to units in backward areas, classified in three categories
Sales tax deferments and exemptions : payment deferred for a
fixed period, like interest free loan; or exemptions given for certain
no. of years
Suppliers credit: available from suppliers of machinery, other fixed
assets, terms devised to defer payment, or pay in installments
over a period of time

Leasing vs. Hire Purchase

Leasing
Ownership not transferred to
lessee
Depreciation benefit to lessor
Magnitude of funds high, for big
ticket items
No margin money/down payment
required
Maintenance of asset by lessor in
operating lease
Tax benefits of depreciation taken
by lessor; lessee gets tax shield
on lease rentals
Considered off balance sheet
mode of financing, as no asset or
liability figures in balance sheet

Hire-Purchase
Ownership transferred to hirer on
payment of all instalments
Depreciation shield available to
hirer
Maybe for smaller value capital
goods
Some down payment reqd

Maintenance cost borne by hirer

Hirer allowed depreciation claim

and finance charge for taxation;
seller may claim interest on
amount borrowed to acquire asset
Asset figures in balance sheet on
complete of purchase

Raising Long Term Finance

Initial Public Offer (IPO)

Secondary Public offer
Rights Issue
Bought out deals
Euro Issues
Private Placement
Preferential allotment
Venture Capital/ Private Equity transactions
Obtaining a term loan

Initial Public Offer

Pros
Access to larger amount of
funds
Further growth limited
companies not using this route
Listing: provides exit route to
promoters; ensures
marketability of existing shares
Encash on value created in the
firm
Recognition in market
Stock prices provide useful
indicators to management
Sometimes stipulated by
private investors in the
company

Cons
Pricing may have to be
attractive to lure
investors
Loss of flexibility
Higher accountability
More disclosure
requirements to be
met
Visibility in market
Cost of making a
public issue quite high

Steps in an IPO

Approval of BOD
Shareholders approval
Appointment of lead manager(s)
Due diligence by LM
Appointment of intermediaries like registrars, printers, bankers, advertisers
Prepare draft prospectus
Filing with SEBI
Listing applications filed alongwith draft prospectus
Agreement with registrars and depositories
Appoint underwriters (if reqd.)
Make changes in draft prospectus as per SEBI observations, SE suggestions
File prospectus with ROC
Issue marketing exercise commences
Application forms dispatched
Issue opened
Basis of allotment finalised
Allotments made, refunds posted, shares listed on SEs

Other aspects of a public

issue

Eligibility criteria defined: net worth, track record of

profitability, issue in same year; secondary issues
have no such restrictions
Book Building process: process of tendering quantities
at prices within a band
Issue expenses: underwriting, brokerage commissions,
fees to managers to the issue, registrars, printers,
advertisers, listing fees, stamp duty
Issue pricing: free pricing, disclose basis for issue price
Public issue of debt: appointment of debenture
trustee, creation of DRR, credit rating reqd., security to
be created

Rights Issue
Issue of capital to existing shareholders
Offer made on a pro rata basis
Offer document called Letter of Offer
Option given to apply for additional shares
Rights renunciation : are tradeable, may be sold off in the
market
Value of a share after rights:
(NP0+S)/(N+1); N=no. of existing shares required for rights; P 0
=cum rights MP per share; S= subscription price of rights issue
Value of a right= (P0 S)/(N+1)
Comparison with Public issue : with familiar investors, hence
likely to be more successful; less floatation costs since no
underwriting; but lower pricing to benefit shareholders

Private Placement

Sale of securities directly to wholesale investors like FIs,

banks, MFs, FIIs,PE funds etc.
Called private placement in equity/equity related
instruments, in unlisted companies and in all cases of debt
Called preferential allotment in case of unlisted companies
for equity/equity related instruments
Different from reservations made for such QIBs out of a
public issue
Subject to SEBI regulations on pricing, lock in period, open
offer to be made to public
QIB placement guidelines recently issued by SEBI for
compliance and disclosures

Private Placement

Pros
Less expensive mode
Lesser SEBI and other
regulations
Easier to market the issue to
a few investors
Entry of wholesale financially
sophisticated investors in
companys profile
May use this route until IPO
decision taken
Less administrative
maintenance

Cons
Does not qualify for listing
in an unlisted company
Restrictive covenants may
be imposed by the
investors
May call for management
participation
Issue pricing more tight

Venture Capital/Private
Equity

Equity finance to potentially high growth companies

Reasonably long to medium term commitment
Hands on management approach, active participation in management
Considered value add investor
VC: primarily high risk high return investment esp. in technology oriented/
knowledge intensive businesses with long development cycles, greenfield
ventures
Can be in unlisted or listed (PIPES) Companies
Exit route to be defined at the time of investment
Restrictive clauses on promoters holding sell off and other
financial/operational issues
Detailed memorandum/business plan on company, its financials to be
prepared
Shareholders agreement to be signed by both parties
Valuation of Company key issue
Leads to dilution of control by existing promoters

Obtaining a Term Loan

Submission of loan application : a project report containing

complete details of the project given to the FI/Bank
Initial processing of loan application : prepare flash report to
decide if project worth an appraisal or not
Project Appraisal: Detailed appraisal done to decide if project taken
or not, in terms of market, technical, financial, managerial appraisal
Issue of Letter of Sanction: to the borrower containing amount
sanctioned and terms and conditions thereto
Acceptance of terms and conditions by the borrowing unit: thru
a board meeting and conveyed to the FI/Bank
Execution of loan agreement: signed by both parties
Disbursement of loan: in tranches based on progress of the project,
tie up of means of finance
Creation of security: formalities to be completed within a timeframe
Monitoring: at implementation and operational stage thru periodic
progress reports, site visits etc.