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LESSON
1
LONG-TERM FINANCE
CONTENTS
1.0 Aims and Objectives
1.1 Introduction
1.2 Types of Financial Needs
1.2.1 Fixed Capital
1.2.2 Working Capital
1.2.3 Long-term Finance
1.2.4 Short-term Finance
1.3 Methods of Raising Long-term Finance
1.3.1 Equity Capital
1.3.2 Preference Capital
1.3.3 Debenture
1.3.4 Term Loans
1.4 Sources of Long-term Finance
1.5 Capital Market
1.5.1 Classification of Capital Market
1.6 Capital Market in India
1.6.1 Securities and Exchange Board of India (SEBI)
1.6.2 National Stock Exchange (NSE)
1.7 Capital Market Instruments
1.8 Let us Sum up
1.9 Lesson End Activity
1.10 Keywords
1.11 Questions for Discussion
1.12 Suggested Readings
8
Capital Budgeting and
1.0 AIMS AND OBJECTIVES
Financing Decisions
After studying this lesson, you should be able to:
Familiarise with the financial needs of a firm
Discuss the methods of raising long-term finance
Understand about the specialized financial institution
1.1 INTRODUCTION
Finance is the process of conversion of accumulated funds for productive use. Every
business establishment needs finance irrespective of its size nature and volume. Financing
decision involves the most important and complex areas of functional management.
Effective management of financial matters is indispensable to every firm. The finance
manager, in order to maximise the wealth of the firm, faces the real challenge for the
procurement of necessary funds from the right source and also their effective utilisation
in business. This lesson deals with the raising of funds aspect only.
major aspects: (i) determining the size or amount of long-term funds required and Long-term Finance
(ii) selecting the appropriate sources. Generally the size of long-term funds requirement
depends upon the size of the business, i.e., whether industrial, commercial or service.
Similarly the composition of long-term funds refer to the capital structure of a firm and is
nothing but a judicious mix of debt and equity.
Broadly speaking there are three fundamental patterns of capital structure:
(i) Financing of capital requirements exclusively by equity;
(ii) Financing of capital requirements by equity and preferred stocks; and
(iii) Financing of capital requirements by equity, preferred stocks, bonds and debentures.
A prudent financial manager tries to make an optimum utilisation of different sources of
funds and hence the third technique of financing long-term requirements is very popular.
(b) Disadvantages
i) Raising finance through preferred stock is costly in comparison to debt capital.
ii) Skipping the payments of preference dividends may adversely affect the image
of the firm in the capital market.
iii) Non-payment of preference dividend is likely to create some controlling
problems too.
Implications to the stock holders
(a) Advantages
i) It earns stable dividend.
ii) A part of the preference dividend is tax-deductible.
(b) Disadvantages
i) Preference stock holders are vulnerable to arbitrary managerial actions.
ii) Price fluctuation of preference shares is greater than that of debentures.
1.3.3 Debenture
Debenture is one of the most frequently used methods of raising long-term funds by a
firm. It is a written instrument signed by the company under its common seal
acknowledging the debt due by it to its holders. It carries a fixed rate of interest and the
interest is payable irrespective of whether the company earns profit or not. The interest
paid on debenture is chargeable against profit and hence is a tax-deductible. Capital
collected through issue of debentures can be secured, unsecured, convertible, non-
convertible, redeemable and irredeemable.
Funds raised through issue of debentures in the pattern of financing has got wider and
deeper significance. Recourse to debt generally tends to reduce the cost of capital and
consequently help and improve the overall return of the company. Debt is considered a
cheaper source of financing not only because it is less expensive in terms of interest cost
and issuance cost than any other form of security but essentially due to the availability of
tax benefits. Faced with alternative methods of long-term financing, the finance manager
should favour the use of long-term debt if he is satisfied that sales and earnings of the
company are relatively stable and will remain so in the ensuing years.
Implication to the firm
(a) Advantages
i) It is a cheaper source of raising funds.
ii) It increases value of the firm.
iii) It does not affect the controlling process of the firm.
(b) Disadvantages
i) Raising funds through issue of debentures is risky unless the firm’s earnings
are stable.
ii) There exists a legal binding on the firm to pay interest on debentures.
12 Implication to the debenture holders
Capital Budgeting and
Financing Decisions (a) Advantages
i) Debenture holders have priority of claim to income and assets over stock
holders.
ii) Debenture holders are assured of a fixed return.
(b) Disadvantages
i) Debenture holders do not have controlling power,
ii) Debenture holders do not have voting rights.
to join the Indian Stock Exchanges Club. And at present India is having 22 recognised
stock exchanges.
Recent Developments
In a view to bring about a major reform in the financial sector the Government of India
has taken a number of steps which include, among others, establishment of SEBI and of
course very recently the NSE in order to streamline the capital market activities in the
country. The following paragraphs give a brief outline of these two organisations which
are expected to pay a very dominating role in the development of the country’s capital
market.
Write a study note on the sources of long term finance from different financial institutions
for a firm.
1.10 KEYWORDS
Term Loans: Term loans represent yet another source of debt finance which is generally
repayable after one year but within ten years.
Fixed Capital: Fixed capital refers to that part of the total capital of a firm which is
represented by investment in fixed assets like land, building, plant, machinery etc.
Working Capital: Generally there are two concepts of working capital, namely, gross
working capital and net working capital.
Long-term Finance: The requirements for long-term finance arises to purchase fixed
assets and to meet the permanent part of the working capital requirements.
SEBI: The Securities and Exchange Board of India was established in 1987 in order to
regulate the Indian capital market in one hand and to protect the investors interest in the
other.