Long Term Finance:

Shares, Debentures and

Term Loans
 Ordinary SharesFeatures
Claim on Income :
ordinary shareholders will have a residual
ownership claim. They have a claim to the
residual income which is available to ordinary
shareholders, after paying expenses, interest
charges, taxes and preference dividend, if
any.
This income may be split into two parts:
dividends and retained earnings.
Dividends are immediate cashflows to the
shareholders and retained earnings are
reinvested in the business. 2
 Claim on Assets
Ordinary shareholders will have the
residual claim on the companys assets
in the case of a liquidation.
Right to Control
Ordinary shareholders have the legal
power to elect directors on the board.
Voting Rights:
They can control the management of the co
through their voting rights and right to
maintain proportionate ownership.
Shareholders may vote in person or by proxy.

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Ordinary SharesPros and
Cons
Advantages
1. Permanent Capital: ordinary share capital is
not redeemable. So company has no
liability for cash outflow associated with its
redemption.
2. Borrowing Base: the equity capital
increases the companys financial bases,
and thus its borrowing limit.
3. Dividend Payment Discretion: A company is
not legally obliged to pay dividend. In times
of finacial difficulties it can reduce or
suspend payment of dividend.
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 Pre-Emptive Rights
The pre-emptive right entitles a
shareholder to maintain his proportionate
share of ownership in the company.
The law grants shareholders the right to
purchase new shares in the same
proportion as their current ownership.
For eg, if the shareholder has 1% shares,
he has the right to purchase 1% of new
shares issued.
A shareholder may decline to exercise this
right.
Limited Liability : their liability is limited to
the amount of their investment in shares.

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Disadvantages
Cost: Shares have a higher cost because
dividends are not tax deductible as are interest
payments, and the floatation costs on ordinary
shares are higher than those on debt.
Risk: Ordinary shares are riskier from investors
point of view as there is uncertainty regarding
dividend and capital gains.
Earning dilution: Issue of new ordinary share
dilutes the existing shareholders earning per
share if the profits do not increase
proportionately to the increase in the no of
ordinary shares
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Debentures
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.
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 DebenturesFeatures

Interest Rate: The interest rate on a debenture is fixed and known.

It is a contractual rate of interest. It is also called coupon rate.
Maturity : Debentures are issued for a specific period. It has a
maturity period.
Redemption : Bonds are redeemable on maturity. Redemption of
debentures can be accomplished through a sinking fund or buy
back (call) option.
Sinking Fund: A sinking fund is cash set aside periodically for
retiring debentures. It eliminates the potential danger of spending
huge amount to redeem bonds at maturity.
Buy-back (call) provisions: it helps the co to redeem debentures
at a specified price before the maturity date. The buyback (call) price
may be more than the par value of the debenture. This difference is
called call or buy-back premium. In India. It is generally 5%

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 Yield:
The yield on a debenture is related to its market price;
therefore, it could be different from the coupon rate of
interest.
Two types of yields can be distinguished.
The current yield on a debenture is ratio of the annual
interest payment to the debentures market price. For
example, a debenture is issued for Rs.1000 face value with a
coupon rate of 12% and market value of Rs.750. The Current
yield = Annual interest/market price= Rs.120 / 750 = 0.16 or
16%
The yield to maturity takes into account the payments of
interest and principal, over the life of the debentures. It is the
Internal Rate of Return of the debenture.

Claim on Assets and Income: Debenture holders

have a claim on the companys earnings, prior to that
of the shareholders.

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Debenture features.
Indenture: or debenture trust deed
Is a legal agreement between the company issuing
debentures and the debenture trustee who represents
the debenture holders.
It provides the specific terms of the agreement,
including a description of debentures, rights of
debenture holders, rights of the issuing company and
responsibilities of the trustee.
Security :
Debentures are either secured or unsecured. A secured
debenture is secured a lien on the companys specific
assets.
If the company defaults , the trustees can seize the
security on behalf of debenture holders.

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 Types of Debentures
Non Convertible Debentures: NCDs
are pure debentures without the feature
of conversion. They are repayable on
maturity.
Fully Convertible Debentures: FCDs
are converted to shares as per terms of
the issue with regard to the price and
time of conversion. Normally interest
rate is less for FCDs.
Partly Convertible Debentures two
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DebenturesPros and Cons
Advantages
1. Less Costly
2. No ownership Dilution
3. Fixed payment of interest
4. Reduced real obligation
Disadvantages
1. Obligatory Payment
2. Financial Risk
3. Cash outflows
4. Restricted Covenants

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Preference Shares
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. Usually do not have voting rights.
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Preference SharesFeatures
Claim 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
1. Risk less Leverage advantage
2. Dividend postponability
3. Fixed dividend
4. Limited Voting Rights
Disadvantages
1. Non-deductibility of Dividends
2. Commitment to pay dividends

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Term LoansFeatures
Maturity
Direct Negotiations
Security
Restrictive Covenants
1. Asset related covenants
2. Liability related covenants
3. Cash flow related covenants
4. Control related covenants

Repayment Schedule

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 Public Deposits
Accepting deposits from the public
has gained popularity with the public
and companies.
Company deposits have been a very
old source of finance in India.
Company fixed deposits are deposits
placed by investors with companies
for a fixed term and carry a
prescribed interest rate which is
above the rates offered by banks.
 Public deposits
Public deposit implies funds received by a
company in the forms of deposits or loans
collected from the public.
The word public includes the general
public, employees, and share holders of the
company.
Company deposits are normally unsecured,
so more risky.
When companies face cash crunch, they
offer deposits at attractive rates.
 Features of public deposits
Who can accept company
deposit?
Under Companies Act, 2013, only the
following entities are allowed to invite,
accept and renew public deposits:
Public limited companies having the
prescribed net worth of Rs.100 crore or turn
over of Rs.500 crore.
Banking companies
Non-Banking Financial Companies (NBFCs)
 Minimum Investment
Varies from company to company
Normally minimum is Rs.5000
No upper ceiling
In case of recurring deposits, minimum is Rs.100
per month.
Duration of the deposits vary from a minimum of six
months to three years.
Interest payment
Fixed interest rate governed by RBI rule.
Higher than that of bank and postal deposits.
Interest payable on monthly or quarterly
In cse of cumulative deposits, interest is accumulated
and paid along with the principal on maturity.
Recurring deposits are similar to RDs of banks.
 Mode of holding
A physical receipt is issued to the depositor.
Security
Company deposits are not secured normally.
The New Companies Act, 2013, permits the
companies to issue secured as well as unsecured
deposits, while it was not under the companies
Act,1956.
Liquidity: Some companies offer loans against
deposits and a premature withdrawal facility .
But there will be a loss of interest.
Advertisement: required if deposits are accepted
from general public.
Only a circular is required if accepted from
shareholders or employees.
 Rating: Unser the Companies Act, 2013,
companies have to obtain credit rating before
they issue deposits to the public.
CRISIL rating of FAAA is considered to carry the
highest safety rating.
Dividend payment: If the company fails to comply
with the provisions related to acceptance of
deposits and in the event of default in repayment
of deposits, the companies are not allowed to
declare dividend.
Appoint trustee : a company before accepting
deposits has to appoint one or more trustees and
execute the trust deed.
The trustee act and protect the interest of the
public.
 TDS: Tax is not deducted if the
interest per depositor is less than
Rs.10,000 per annum.
Nomination facility: available for
company deposits also.
Marketing : can be done through
agents who get commission.
Advantages
Simple and safe: no legal
formalities
Cheaper source of finance:
Cheaper than bank loans
 Income Tax advantage: the interest paid on deposits is
a deductible expense to companies for income tax
purpose.
Trading on equity: return on equity increases.
No loss of control: deposit holders have no voting
rights. They cannot interfere in the internal matters.
Additional source of finance: public deposits are not
backed by any charge on the assets of the company. So
these assets can be used for borrowing.
Flexibility: it provides flexibility to the financial
structure of the company. There is no risk of over
capitalization and the company can repay the deposits
when they are not required.
Larger base: contact with a large no. of investors.
Good return to depositors: higher rate of interest to
the investor .
 Disadvantages of public
deposits
Undependable source of finance
Available for short- term only , not a long-term source.
Misuse : since it is unsecured, co. may misuse them, raised
when not required. Diversion of funds.
New companies: public deposits are not available to new
companies and those with uncertain earnings.
Legal restriction: there are legal restrictions on the
acceptance and renewal of public deposits. A co. cannot
raise unlimited amounts from this source.
Hindrance to growth of capital market.
No security for depositors.
Less capital appreciation.
No tax advantage : interest is taxable.
 Hire Purchase
Hire Purchase Act 1972, defines a
hire purchase as an agreement under
which goods are let on hire and
under which the hirer has an option
to purchase them in accordance with
the terms of the agreement.
 Hire Purchase Agreement
The hire purchase agreement contains the
following clauses:
The owner delivers possession of goods to a person, a
hirer, with the condition that such a person pays the
agreed amount in periodic instalments which is in the
nature of rental.
Instalment is inclusive of the principal and interest.
Specify the rights and obligations of the owner as well as
the hirer.
The ownership of the goods passes to the hirer only on
the payment of the last instalment.
The hirer has a right to terminate the agreement at any
time, before receiving the title in the property.
 Features of Hire Purchase
A higher rate of interest can be charged .
As the calculation is on the original advance, higher
would be realized.
As the company is the owner of the asset in hire
purchase, attachment of the asset and subsequent
sales, even by private auction would keep the non-
performing assets low.
The possibility of defaults is very less in hire
purchase, as the borrowers would end up losing the
installments paid as well as the asset.
The company can effectively recycle the funds
recovered in hire purchase.
 Tax consideration of Hire
Purchase
Income tax aspect : the hirer is entitled to the tax
shield on depreciation and on the consideration for
the hire.
Sales tax aspects:
For the purpose of levying sales tax, a sale is
deemed to take place only when the hirer exercises
an option to purchase.
When the hirer exercises the purchase option, the
amount of sales tax must be determined with
reference to the depreciated value of the goods.
The State in which the goods have been delivered is
entitled to levy and collect sales tax.
 Sales tax cannot be levied on hire purchase transactions
structured by finance companies, provided these
companies are not dealers in the class of goods let on
hire.
There is no uniform rate of sales tax applicable to hire
purchase transactions as the rate varies from state to
state.
Interest Tax Aspects: the interest tax implications are:
Interest tax is payable on the total amount of interest
aggregating to a hire purchase company in the previous
year at the rate of 3 per cent.
The interest tax payable by the hire purchase company is
treated as tax deductible expenses for the purpose of
computing the taxable income under the Income Tax act.
 VENTURE CAPITAL

Venture capital is a form of risk

finance extended to units with new
and untried or advanced
technologies.
VC financing is normally by way of
equity participation.
VC was started in 1985 in India.
VCs enjoy certain tax concessions.
 The concept
VC is defined as a form of risk finance
provided to enterprises which either because
of their size, the stage of development, the
degree of leverage or the nature of their
business cannot raise funds from the capital
market or from the banking system.
The main purpose of venture capital
financing is to exploit new and untried or
advanced technologies and turn them into
commercially viable propositions with an
expectation of spectacular return later.
 Need for venture capital
finance
The risk involved in implementing new
inventions for commercial use is high.
Commercial banks are generally averse to
financing such high risk projects.
In such a situation, the system of VC financing
comes in very handy to obtain financial
assistance to the deserving and eligible
projects.
The method of financing such high-risk projects
is usually done by way of equity participation.
 Features of Venture Capital
Long time horizon : gestation period
is high.
Lack of liquidity
High risk
High-tech
Equity participation
Participation in management- to
provide managerial expertise to
entrepreneurs and protect his fund.
 Need for venture capital
finance
The risk involved in implementing new
inventions for commercial use is high.
Commercial banks are generally averse to
financing such high risk projects.
In such a situation, the system of VC financing
comes in very handy to obtain financial
assistance to the deserving and eligible
projects.
The method of financing such high-risk projects
is usually done by way of equity participation.
 Features of Venture Capital
Long time horizon : gestation period
is high.
Lack of liquidity
High risk
High-tech
Equity participation
Participation in management- to
provide managerial expertise to
entrepreneurs and protect his fund.
 Detachment : once the venture reaches its
full potential, the venture capitalist
disinvests his holdings either to the
promoter or to outsiders as per the prior
agreement on this account.
This enables the venture capitalist to enjoy
capital gains and he is not interested in
regular income.
Investment size : small and medium
enterprises
 Stages in VC financing
Seed money : this is the initial fund required to
set up a new business.
Start-up fund : fund for R&D and for preparing
initial marketing and production plan.
Second round financing: this is provided to
increase production/service providing activities.
Third round financing: this is provided to
increase sales and achieve break-even cash
flow.
Bridge financing : this is provided to enable a
company to carry out an initial public offering of
its shares
 Valuation of a VCU
VCU is valued at two points of time-
starting point and exit point (when
the investment is recouped).
Components of such valuation are :
1. Annual revenue at entry time is
projected till the exit time by
assuming and expected year-by-year
growth rate in the intervening period.
2. The expected after-tax earnings level at the
exit-time is computed.
3. The market value of the VCU on exit is
computed by multiplying the projected earnings
level by the expected P/E (price/earning ratio).
4. From the future market value, the present value
of the VCU (at entry time) is computed by using
a suitable discount factor.
5. The equity participation demanded by the VCF
will be proportionate to its funding of the total
present value of the VCU.
The defect of this method is that only entry and
exit period are considered. Intervening period is
ignored.
 Structuring of a VC Deal
Two types of financial instruments are
used:
1. EQUITY INSTRUMENTS: ordinary
shares, non-voting equity shares,
preference shares, convertible
preference shares etc.
2. DEBT INSTRUMENTS : loans,
non-convertible debentures, partially
convertible debentures etc.
 Retained earnings
Ploughing back of profits in to the
business.
Cost effective method of financing
Can be used for medium and long
term financing
Cushion against uncertainties.
Financing risky and innovative
projects
Can be used to issue bonus shares.
 Disadvantages of retained
profits
Concentration of economic power by
business houses
Scope for manipulation/misuse of
funds
Over capitalization
Interferes with the interest of
shareholders
 Commercial Paper
CP is a money market instrument issued
by large-sized corporates to raise short-
term funds.
This is an unsecured instrument supported
by the promise of the issuer or his banker
for the payment of the face value on the
due date specified on the paper.
Only big companies enjoying high level of
goodwill and credit ratings can raise funds
through this route at reasonable rates.
 Features of Commercial
Paper
Duration: 7 days to 1 year.
Repayment : on maturity date.
No renewal allowed. In case of need,
fresh issue may be done with RBI
approval.
Minimum investment: Rs.5 lacs and
multiple thereof.
 Pros and cons of CP
Pros
Alternative source of finance
Cheaper and convenient than bank finance.
Safe investment for short term funds of
investors.
Cons
Rigid: guidelines are not flexible. Maturity
cant be extended.
Possible only for highest rating comapanies
No premature payement.
 Angel Investing
It is investing in unproven business
venture.
Angel investing means the
willingness of an individual or
network of individual to invest in an
unproven but well researched startup
business, taking an advisory role with
out making demands.
Money from heaven
 Type of angel investors
Core angels:
They are with extensive business
experience, investing in diversified
industries, including private and public
equity and real estate.
They might have earned vast wealth
over a long period of time
They are committed to their job of angel
investing despite losses.
 High-tech angels
They have less experience, but invest
largely in latest technology.
They enjoy the risk of their deals and brining
a new technology to the market.

Return on Investment (ROI) angels:

Primarily concerned with the financial reward of
high risk investment.
They wont actively involve in the invested firm.
They keep away from investment when the
market is not performing and comes back once
the market is stable and growing.
 Corporate angels
They are senior managers who would
have taken an early retirement.
In addition to accepting money the
entrepreneur may insist the angel to take
a senior management position.
Professional angels:
Professional angels (doctors, engineers,
lawyers etc.) like to invest in a company
that offer a product or service with which
they have some experience.
They never accept a board seat.
 Advantages of angel
investing
They invests where most formal
investors will not be interested.
They are keen in investing in start-
ups and operate at smaller level than
VCs.
They are established business men
who can bring in more experience to
the venture.
More private funders may be
attracted.
 Disadvantages
They are hard to find as they would
be running after their own business.
Entrepreneur and the investor must
share same vision to work together,
which is rare.
They will invest only after seeing the
business plan.
 Private equity
Equity not quoted in the stock exchange.
Consists of investors who make investments
directly to private companies or
Conducts buy-outs of public companies that result
in delisting of public company.
Capital for PE can be raised from retail and
institutional investors.
Can be used to fund new technologies, expanding
working capital, making acquisitions etc.
Duration of stay of PE holder in business is 3 to 6
years
 Types of PE investors
Individual investors:
Invest directly or through financial
intermediaries
Typically invest in the early stage,
before the business has significant
sales.
Institutional Investors
Invest usually thorugh financial
intermediaries, primarily VCF
Also invest directly in companies.
 Advantages of PE
Substantial liquidity
Growth capital
Eliminate personal guarantee and retain
operational control with management team.
Obtain a strong partner with aligned goals:
Partner with those who can find new customers
and suppliers.
They will participate in the board of directors
level, and share their experience in operations
and also M&A experience.
 Disadvantages
Debt burden: debt should be serviced every
month and it will have a draining effect on
profit.
If the operations are not as desired it will
increase the burden.
Board seats: irrespective of the share of
investment (majority or minority) investors will
ask for board seat to closely monitor their
investment.
Required exit strategy: 6-7 years must be
required to pay back the investors.
 Warrants
Warrant is a type of financial instrument
usually issued together with a security
(normally shares or bonds) that has a
separate life and value.
A warrant allows the investor to
purchase ordinary shares at a fixed price
over a period of time or to perpetuity.
A warrant is freely transferable and
tradable separately.
 Features of Warrants
Exercises price: the price at which holders of
warrants can purchase a specified no.of
shares of common stock is normally referred
to as the exercise (option) price. This price is
usually set at 10 to 20 % above the market
price of the firms stock at the time of
issuance.
Until the stock price exceeds the exercise
price, holders of warrants will not exercise
them, because they can purchase the stock
more inexpensively in the market price.
 Warrant is tradable.- a warrant can be
sold separately from the debenture or PS
to which it is attached is called
detachable warrants. A non-detachable
warrant can not be sold separately.
Exercise ratio: states the number of
ordinary shares that can be purchased at
the exercise price per warrant.
Expiration date: the expiration date is the
date when the option to buy ordinary
shares in exchange for warrant expires.
Some warrants are perpetual.
 Why issue warrants?
Sweetening of debt security.
Issuing ordinary shares in future.
Obtaning capital in future.
 Convertibles
A convertible security is one that may be exchanged
for common stock by the holder according to agreed
upon terms.
Eg. Convertible bonds
Convertible preferred stock.
A specified no. of shares of stock are received by the
holder of the convertible security when he or she
makes the exchange.
This is referred to as conversion ratio, which equals:
Par value of convertible security
Conversion price
 Suppose par value of a convertible
debenture is Rs.125 and the
conversion price is Rs.62.50,
The conversion ratio is = 125/62.50
=2
ie, a debenture holder will get 2 equity
shares.
 Why issue conversion
debentures?
Sweetening debenture offers to
make them attractive
Selling ordinary shares in the future
at a higher price
Avoiding immediate dilution of
earnings
Using low cost capital initially.