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
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

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

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

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

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; P0
=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

Initial processing of loan application: prepare flash report to decide if

details of the project given to the FI/Bank

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.