LONG TERM FINANCE: SHARES, DEBENTURES AND TERM LOANS

LEARNING OBJECTIVES
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Explain the features of ordinary shares Focus on the benefits and valuation of rights shares Discuss the pros and cons of debentures and preference shares Highlight the features of term loans

INTRODUCTION
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Ordinary shares provide ownership rights to investors. Debentures or bonds provide loan capital to the company, and investors get the status of lenders. Loan capital is also directly available from the financial institutions to the companies.

Ordinary SharesFeatures
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Claim on Income Claim on Assets Right to Control Voting Rights Pre-Emptive Rights Limited Liability

Reporting of Ordinary Shares

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Tata Motors' Share Capital as on 31 March 2008

Ordinary SharesPros and Cons

Advantages
Permanent Capital Borrowing Base Dividend Payment Discretion

Disadvantages
Cost Risk Earnings Dilution Ownership Dilution

Public Issue of Equity

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Public issue of equity means raising of share capital directly from the public. As per the existing norms, a company with a track record is free to determine the issue price for its shares.

Underwriting of Issues
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It is legally obligatory to underwrite a public and a rights issue. In an underwriting, the underwritersgenerally banks, financial institution, brokers, etc. guarantee to buy the shares if the issue is not fully subscribed by the public. The agreement may provide for a firm buying by the underwriters. The company has to pay an underwriting commission to the underwriter for their services.

Private Placement
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Private placement involves sale of shares (or other securities) by the company to few selected investors, particularly the institutional investors. Private placement has the following advantages:
Size Cost Speed

Right Issue of Equity Shares

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Selling of Ordinary Shares to the existing shareholders of the company. Value of Right px ps r= n

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Effect on Shareholders Wealth

The shareholder has three options:
(i) he exercises his rights, (ii) he sells his rights, or (iii) he does not exercise or sell his rights.

He will lose under the third option.

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Is the Subscription Price of any Significance?

It is irrelevant in terms of the impact on the shareholders wealth. It can be fixed at any level below the current market price. The primary objective in setting the subscription price low is that after the rights offering, the market price should not fall below it.

Right Shares Pros and Cons

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Advantages
1. Control is maintained 2. Less flotation cost 3. Issue more likely to be successful

Disadvantages
1. Shareholders lose if fail to exercise their right 2. If shareholding concentrated in hands of FI

Preference Shares
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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. Preference shareholders have claims on income and assets prior to ordinary shareholders. 4. Usually do not have voting rights.

Preference SharesFeatures
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1. 2. 3. 4. 5. 6. 7. 8. 9.

Claims on Income and Assets Fixed Dividend Cumulative Dividend Redemption Sinking Fund Call Feature Participation Feature Voting Rights Convertibility

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Preference SharesPros and Cons

Advantages:
Risk less leverage advantage Dividend postponability Fixed dividend Limited Voting Rights

Disadvantages:
Non-deductibility of Dividends Commitment to pay dividends

DEBENTURES
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A debenture is a long-term promissory note for raising loan capital. The firm promises to pay interest and principal as stipulated. The purchasers of debentures are called debenture holders. An alternative form of debenture in India is a bond. Mostly public sector companies in India issue bonds.

DebenturesFeatures
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Interest Rate Maturity Redemption Sinking Fund Buy-back (call) provisions Indenture Security Yield Claims on Assets and Income

Types of Debentures
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1. 2. 3.

Non Convertible Debentures Fully Convertible Debentures Partly Convertible Debentures

DebenturesPros and Cons

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Advantages:
Less Costly No ownership Dilution Fixed payment of interest Reduced real obligation

Disadvantages:
Obligatory Payment Financial Risk Cash outflows Restricted Covenants

Term LoansFeatures
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Maturity Direct Negotiations Security Restrictive Covenants

1. 2. 3. 4. Asset related covenants Liability related covenants Cash flow related covenants Control related covenants

Convertibility Repayment Schedule