Financial Management I

Session 3, 4 & 5

Assets & Liabilities

Investment/Assets
Capital (Long term) Assets - Land, Building, Machinery, Long term lease, long term investments, etc. Current (Short term) Assets Inventory, Work in progress, cash, sundry debtors, bills receivable, prepaid expenditure, short term investment, etc.

Capital/Liability
Capital Shares; theoretically available forever or till firm exists.
Internal accruals & reserves capital holders claim; kept for special needs; available for continual investment (asset financing); at times application dependent on purpose of reserve creation, dividend policy of the firm and/or legislative requirement. Long term liability Long term loan, Bonds, Debentures, Long term credit for capital investment by manufacturers/suppliers, etc. Current (Short term) Liability Sundry creditors, short term loan, bank overdraft, bills payable, unpaid expenditure, etc.

Working Capital
Current assets current liabilities = working capital What should be the standard working capital? Ideal current ratio? (current assets/current liability) Implications of high current ratio

Implications of low current ratio.

Is 1:1 good enough?

Sources of long term finance

Requirements
Long term requirements (Investment Capital)
setting up of firm, expansion, modernization, diversification, replacement, etc. Big money involved for a longer term, mostly irreversible decisions, gestation period.

Short term (Working capital)

Frequent requirements of fund for short term, required for smooth execution of business activities, compliments capital investment, creates assets of short term, pays off for short term requirements, not planned or budgeted very as capital investments.

Assets Liability Match

Long term assets Long term Liability Short term assets/requirement Short term funds

Mismatch Some Long term assets Short Term Liability

Some Short Term Assets Long term Liability All Assets (Short term + Long term) Long term Liability All Assets (Short term + Long Term) Short Term Liability

Problem of asset liability mismatch

Interest rate risk Liquidity/insolvency risk Cost of fund raising Reduction in fund management flexibility Lost opportunities

Reduction in return
Bad impression on stake holders especially financers

Types of capital
Equity capital
Ownership rights (voting rights) Residual profit Liability restricted to capital contributed (limited) No fixed obligation to pay dividend Permanent capital (minimum repayment liability)

High cost of issuing equity Dividends are not tax deductible Dilution of effective control due to voting rights

Preference capital
Some attributes of equity as well as debentures Equity attributes
No obligation for payment Dividends (preference) not tax deductible

Debenture attributes
Earn a fixed rate of return for dividend payment Preference over equity shareholders in the matter of dividend payment Preference over equity holders in the matter of liquidation

Preference capitalcont.
Other attributes
Call feature (option that firm can redeem shared wholly or partly - prior to maturity at certain price) After Companies Act 1956 Preference shares voting rights arises only in following cases;
Cumulative Preference share: arrears in dividends for two or more years Due preference dividend for a period of two or more preceding consecutive years In preceding six years including the preceding FY, fir has not paid dividend for 3 or more years

Types of preference capital

Two types three categories
Cumulative vs. non cumulative
Dividends paid on a cumulative basis (in case of arrears, all previous payments has to be made in the year of payment in future before equity dividends)

Redeemable vs. non redeemable

To be redeemed after a given maturity period; perpetual will remain forever with company)

Convertible vs. non convertible

Convertible will be converted to other instrument (equity shares) after a certain time.

Debenture capital
A marketable legal contract in the nature of debt where firm promises its owner to pay a specified rate of interest for a defined period of time. After completion of such time, the firm also promises to pay the principal amount. Usually secured by charge on fixed assets Interest of debenture holders is usually represented by a trustee For debentures maturing in >18months firm has to create a debenture redemption reserve >=50% of amount before redemption Call option gives company right to redeem before maturity date at a certain price

Put option gives debenture holders right to surrender debenture at a certain price before maturity.

Types of debenture
Non convertible debenture (NCD)
Cannot be converted into equity and have to be redeemed at maturity only.

Fully convertible debentures

To be converted into equity after certain period, in part or in one go. May or may not carry interest Capital gain possibility

Partly convertible debentures

A part of debenture will be converted to equity after specified period at a certain rate Non convertible portion will be redeemed at maturity Non convertible part will earn interest till maturity but converted portion will have interest till conversion only.

Secured premium notes (SPN)

A kind of NCD with attached warrant No interest on for some initial period Subsequent repayment of principal, in installments, together with a certain amount as interest (regular income) /premium (capital gain). Warrant attached with SPN gives owner right to get equity within certain period at a certain price.

New Financial instruments

Non voting shares Detachable shares Participating debentures Participating preference shares Convertible debentures with options Third party convertible debentures Mortgage-backed securities Convertible debenture redeemable at premium Debt equity swap Zero coupon convertible note

Issue of securities
Public issue issued in primary market and then listed on exchange for trading in secondary market. (cost of issue 12%-15% can go up to 20%)
Appointment of lead manager (a SEBI registered Category - I merchant banker. Responsible for all pre and post issue activities, liaison with other intermediaries and institutions, viz. SEBI, Exchange, Registrar of Companies, etc. Preparation of prospectus responsibility of lead manager; to disseminate information about firm, promoters, objective of issue, other contents specified by legislation. Appointment of intermediaries :
Underwriters Registrars Bankers to the issue Brokers Advertising & promotion agency Agency for printing & dispatching offer document

Obtaining legal clearances and filing initial listing application Final allotment and refund activities

Rights Issue
Right is an option given to existing shareholders to get preference in new a issue which is offered to them at a lower price compared to public issue. 1 share for 4 held Right issue@ Rs 50 Existing price Rs. 60

Value of share after right issue

[(Number of shares required for a right x price per share before right) + Right subscription price] Number of shares required for a right + 1

Theoretical value of a right

price per share before right - Right subscription price Number of shares required for a right + 1

Private Placement
Direct selling of securities to small number of high net worth investors. Avoids delays, inconvenience and minimizes expenses Has fewer procedures suitable for relatively small fund raising Helps firms with relatively little proven history Merchant banker searches for investors and negotiates with them on price and terms of issue.

Bought out deals

Investors buy out a major portion of an unlisted firm for future capital gain prospects

Firm to be listed and investment to be sold to public within a given time frame.
Firm places shares for sale to public along with sponsor. At agreed time shares would be sold to public via a public issue or using OTCEI route. Less expensive & faster procurement of funds, especially for startups Offloading time and price negotiation gives flexibility for finding better value New firms which do not fulfill SEBI condition for public issue at premium, may get premium using this mechanism Issue price close to intrinsic value

Euro issues
Indian companies issues in foreign markets where they are listed and traded Usually has lower cost of capital GDRs, ADRs, Euro Convertible bonds, Foreign Currency Convertible bonds If convertible, upon conversion to equity, the underlying shares are listed and traded on the domestic exchange.

Term Loans
Normally to be repaid between 1 to 10 years

Offered by financial institutions (FI) viz. IDBI, NABARD, IFCI, ICICI, PFC, etc.
Interest rate is fixed after appraisal of project by FI (credit risk & return) and Payment of principal and interest in equal installment

Moratorium period of 1 to 2 years are allowed

Interest and principal payment defaults attract penalties Are normally secured by title deeds of immovable property, first mortgage, or hypothecation of property Restrictive covenants & placing nominee on Board Post tax cost of this source is very low and is a cheap source for big projects.

Internal accruals
Depreciation charges Retained earnings Reserves Easy availability but limited No issue expenses No dilution of control

Dividend payment considerations (opportunity cost for investors)

Good for growth oriented firms

Deferred credit
Offered by supplier of Capital Goods/ machinery in which buyer can pay for the price in installments, over a long period of time. Interest & terms of repayment are negotiable Some deferred credit schemes offered by financial institutions are:
Bill Rediscounting Scheme Supplier Line of credit Seed capital assistance Risk Capital Foundation Schemes.

Leasing
Offered by Fis, NBFCs, Banks and Manufacturers of equipments/assets. Leasing is a contractual agreement between a lessor and a lessee. Here firm (lessee) can enter into a lease deal with the manufacturer of equipment (lessor) directly or through some intermediary Contract will give right to use assets till lease maturity date Lessee has to pay a lease rent for the lease period

Hire Purchase
Very similar to lease Here ownership of the assets has to be transferred to the buyer after all installments are paid If installment is not paid the ownership of the asset remains with the financer and he claims the asset Readily available Requires good credit worthiness

Government Subsidies
The State and Central Governments provide subsidies to the industrial units in the backward areas Backward areas are classified into three categories A Districts -25% of Fixed Capital (FC) (sub. to max. Rs.25 Lakhs)

B Districts 15% of FC (sub. to max. Rs.15 Lakhs)

C Districts 10% of FC (sub. to max. Rs.10 Lakhs) State government also offers cash subsidy (normally 5% to 25% of the capital sub. to a max. ceiling of 5 to 25 lakh rupees.

Sales Tax Deferments and Exemptions

State has the power to tax (SST/ VAT) by which it exempts companies to provide inventive to operate in underdeveloped areas. Interest free deferment of sales tax is being generally allowed on sale of goods for a period of 5 12 years Deferment of sales tax is being allowed specifically on purchase of certain items from within the state (normally for a period ranging between 3 years to 9 years)

Things to Dofor You

Go through the red herring prospectus of companies who have come out with IPO, FPO. Look for innovative sources of finance employed in the recent mergers and acquisitions See the financial mix in financing a project which are different in their risk and return. Next class, Raising Long Term Finance (read through your text)