Module 2 - Sources of Finance

Module II
▪ Equity
▪ Preference shares
▪ Debt
▪ Debentures/Bonds
▪ Term Loans
A public limited company may raise funds from promoters or from the investing public
by way of owner’s capital or equity capital by issuing ordinary equity shares. Some of the
characteristics of Owners/Equity Share Capital are:-
▪ It is a source of permanent capital. The holders of such share capital in the company are
called equity shareholders or ordinary shareholders.
▪ Equity shareholders are practically owners of the company as they undertake the
highest risk.
▪ A public limited company may raise funds from promoters or from the investing public
by way of owner’s capital or equity capital by issuing ordinary equity shares. Some of
the characteristics of Owners/Equity Share Capital are:-
There are various types of equity shares classified based on various things.
▪ In the financial statements of a company, equity shares are placed on the liability side of the
balance sheet. They are classified into various categories which are as follows:
▪ AUTHORIZED SHARE CAPITAL - It is the maximum amount of capital which can be issued by a
company. It can be increased from time to time. Some fee is required to be paid to legal bodies
accompanied with some formalities.
▪ ISSUED SHARE CAPITAL -It is that part of authorized capital which is offered to investors.
▪ SUBSCRIBED SHARE CAPITAL - It is that part of Issued capital which is accepted and agreed by the
investor.
▪ PAID UP CAPITAL - It is the part of subscribed capital, the amount of which is paid by the investor.
Normally, all companies accept complete money in one shot and therefore issued, subscribed and
paid capital becomes one and the same. Conceptually, paid up capital is the amount of money
which is actually invested in the business.
There are other types of equity shares discussed below: -
▪ RIGHTS SHARE - These are the shares issued to the existing shareholders of a
company. Such kind of shares is issued to protect the ownership rights of the
investors.
▪ BONUS SHARE - These are the type of shares given by the company to its
shareholders as a dividend. There are various advantages and disadvantages of
bonus shares like dividend, capital gain, limited liability, high risk, fluctuation in
the market, etc.
▪ SWEAT EQUITY SHARE - These shares are issued to exceptional employees or
directors of the company for their exceptional job in terms of providing know-how
or intellectual property rights to the company.
These are a special kind of shares; the holders of such shares enjoy priority, both as
regards to the payment of a fixed amount of dividend and also towards repayment of
capital on winding up of the company. Some of the characteristics of Preference Share
Capital are:-
▪ Long-term funds from preference shares can be raised through a public issue of shares.
▪ Such shares are normally cumulative, i.e., the dividend payable in a year of loss gets
carried over to the next year till there are adequate profits to pay the cumulative
dividends.
▪ The rate of dividend on preference shares is normally higher than the rate of interest on
debentures, loans etc.
▪ Most of preference shares these days carry a stipulation of period and the funds have to
be repaid at the end of a stipulated period.
▪ Preference share capital is a hybrid form of financing which imbibes within itself some
characteristics of equity capital and some attributes of debt capital. It is similar to
equity because preference dividend, like equity dividend is not a tax deductible
payment. It resembles debt capital because the rate of preference dividend is fixed.
▪ Preference share capital may be redeemed at a pre-decided future date or at an earlier
stage inter alia out of the profits of the company. This enables the promoters to withdraw
their capital from the company which is now self-sufficient, and the withdrawn capital
may be reinvested in other profitable ventures.
Sl. No. Type of Preference Shares Salient Features
1 Cumulative Arrear Dividend will accumulative
2 Non-cumulative No right to arrear dividend
3 Redeemable Redemption should be done
4 Participating Participate also in the surplus of firm
5 Non- Participating Over fixed rate of Dividend
6 Convertible Option of Convert into equity Shares
Loans can be raised from public by issuing debentures or bonds by public limited companies.
Some of the characteristics of Debentures are:-
▪ Debentures are normally issued in different denominations ranging from Rs.100 to Rs.1,000 and
carry different rates of interest.
▪ Normally, debentures are issued on the basis of a debenture trust deed which lists the terms and
conditions on which the debentures are floated.
▪ Debentures are either secured or unsecured.
▪ May or may not be listed on the stock exchange.
▪ The cost of capital raised through debentures may be quite low since the interest payable on
debentures can be charged as an expense before tax.
▪ From the investors’ point of view, debentures offer a more attractive prospect than the preference
shares since interest on debentures is payable whether or not the company makes profits.
▪ Debentures are thus instruments for raising long-term debt capital.
▪ The period of maturity normally varies from 3 to 10 years and may also increase for projects
having high gestation period.
Sl. No. Type of Debenture Salient Feature
1 Bearer Transferable like negotiable instruments

2 Registered Interest payable to registered person
3 Mortgage Secured by a charge on Asset(s)
4 Naked or simple Unsecured
5 Redeemable Repaid after a certain period
6 Non-Redeemable Not repayable

▪ The term loan is a long term secured debt extended by banks or financial institutions to the corporate
sector for carrying out their long-term projects maturing between 5 to 10 Years which is normally
repaid in monthly or quarterly equal installment. They are an external source of finance paid in
installments governed by loan agreement and covenants.
▪ All the capital requirements cannot be fulfilled by the promoters or equity share issues and that is
where the term loans come into the picture. Term loan or project finance is a long term source of
finance for a company normally extended by financial institutions or banks for a period of more than 5
years to a maximum of around 10 years. One common feature which helps management in relatively
substituting equity by term loans is the longer term of the loan.
▪ Suitable for: The term loan is a type of funding which is most suitable for projects involving very heavy
investment which is not possible by an individual or promoters. Big projects cannot be concluded in a
year or two.
▪ To yield return from them, the long-term perspective is required. Such big ventures are normally
financed by big banks and financial institutions. If the investment is too large, several banks come
together and finance it. Such type of term loan funding is also called as consortium loan. The term loan
is acquired for new projects, diversification of business, expansion projects, or for modernization or
technology upgradations. Here also, the underlying fact is that the investment in these projects is
normally very huge. Lack of option of funding from other sources such as equity etc for any reason also
directs a company to go for the term loan.
▪ LOAN IN ANY CURRENCY - These loans are provided both in the home or foreign currency.
Home currency loans are offered normally for a purchase of fixed assets such as land, building,
plant and machinery, preliminary and preoperative expenses, technical know-how, working capital
etc. On the other hand, foreign currency loans are offered for import of certain plant or machinery,
payment of foreign consulting fee etc.
▪ SECURED LOAN - Term loans generally come under secured category of loans. Two kinds of
securities are there – primary and collateral. Primary security is the asset which is purchased using
the loan amount and collateral security is the charge on other assets of the borrower.
▪ LOAN INSTALMENTS - Repayment of the loan is done in installments. These installments cover
both principal and interest. Normally, loan installments are decided by banks based the borrower’s
cash flow capacity. There may be installments paid monthly, quarterly, biannually, or even annually.
Installments are normally equal but they may be structured based on the borrower’s business.
Moratorium or grace period is also given by banks in which no installment or very low installment
is asked from the borrower. Sometimes, small installments are kept in the initial year or two and
then the remaining loan is split into the remaining maturity period making the later installments
higher than the initial ones.
▪ MATURITY - Normally a term loan is ranging between 5 to 10 years. Forecasting
for more than 10 years in the current changing business environment is very
difficult.
▪ LOAN AGREEMENT - An agreement is drafted between the borrower and the
bank regarding the terms and conditions of the loans which are signed by the
borrower and is preserved with a bank.
▪ LOAN COVENANT - Debt covenants are a part of a loan agreement. They are
certain statements in the agreement which states certainly do’s and dont’s for the
company. They are normally related to use of assets, creation of liabilities, cash
flow, and control of the management. They are positive/ affirmative or negative in
nature.
▪ FINANCIAL LEVERAGE AND TERM LOAN –
▪ At times, an important reason for selecting term loan is financial leverage. By
opting for debt finance like term loan, a company tries to magnify the returns to
their equity shareholders. This help management of a company achieve the core
objective of wealth maximization for its shareholders and also preserve the control
and share of existing shareholders.

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Module II

1 Bearer Transferable like negotiable instruments

6 Non-Redeemable Not repayable

▪ At times, an important reason for selecting term loan is financial leverage. By

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