NCERT Notes for Class 11 business studies Chapter 8 SOURCES OF BUSINESS FINANCE

Class 11 business studies Chapter 8 SOURCES OF BUSINESS FINANCE

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NCERT Notes for Class 11 business studies Chapter 8 SOURCES OF BUSINESS FINANCE

Class 11 business studies Chapter 8 SOURCES OF BUSINESS FINANCE

  • Every business, irrespective of its nature, type or size needs finance for its operation.
  • Availability of adequate fund is essential for the smooth functioning of the business.
  • Finance is the life blood of every business.
  • It is important for every entrepreneur who wants to start a business to know about different sources from which money can be raised.
  • It is also important to know the relative merits and demerits of different sources, so that choice of an appropriate source can be made.

Business Finance

  • Business finance is concerned with acquisition and utilization of capital to carry out various business activities of an organization.
  • The initial capital contributed by the entrepreneur is not always sufficient to meet all financial needs of the business.
  • A business man, therefore, has to look for different sources from where the need for funds can be met.
  • Thus business finance refers to money and credit employed in a business firm in order to carry out its operation smoothly.
  • Business finance may be defined as planning, raising, managing and controlling all types of funds needed for a business.

Nature of Business finance

  • Finance is required to commence and carry on business.
  • No growth and expansion of business can take place without sufficient finance.
  • The larger, the size of the business, the larger will be the finance required.
  • No business activity is possible without finance.

Business finance has the following special features:

a) Essential in a business

Business activities are not possible without finance.

b) Needed everywhere

All business enterprises, whether large or small need finance.

c) It includes all types of funds

It includes both owned capital and borrowed capital.

d) It is a wider term

Business finance is a wider term. It is concerned with planning, acquiring, utilizing and managing funds.

Significance of business finance

  • Finance plays a vital role in the functioning of modern enterprises.
  • It is said to be the lifeblood of business.
  • Finance needed in at every stage in the life of a business.
  • It must be available at the proper time.
  • It must be adequate for the purpose for which it is needed.
  • Insufficient fund may affect the growth of the firm adversely.
  • Finance is required to start a business, to operate it, as well as for modernization and expansion.
  • While starting a business, money is needed to purchase fixed assets and also to meet day-to-day expenses.

Classification of Sources of Funds

The various sources of funds can be classified on the on the basis of viz. (1) Period (2) Ownership and (3) Source of Generation.

Classification on the basis of period

On the basis of period of time for which finance is required, business finance can be classified into three. They are:

  1. Long term finance
  2. Medium term finance
  3. Short term finance.

Long term finance

  • Long term finance refers to the funds which are to be invested in the business for a long period, say for a period over 5 years.
  • Such finance is used for investment in fixed assets like land, building, plant, machinery, furniture etc.
  • This is known as fixed capital requirements of an organization.
  • Long term finance is acquired through issue of shares, debentures or loan from specialized financial institutions.
  • The volume of long term fund required by a business depends up on the nature and size of the business unit.
  • Manufacturing concerns requires more long term finance than trading concerns.
  • Long term finance is required for financing capital expenditure.
  • They are also known as fixed capital or block capital.

Medium term finance

  • Where the funds are required for a period of more than one year but less than five years, it is known as medium term finance.
  • The need for medium term finance may be for increasing the production capacity, introduction of a new product, modernization of plant and machinery, making an advertisement campaign etc.
  • Medium term finance can be raised through public deposits, lease financing, loan from financial institutions and commercial banks.

Short term finance (working capital)

  • Short term finance is raised for a period of less than one year.
  • It is required to meet the day to day needs of the business.
  • It is known as working capital of an organization.
  • It is the amount required for investment in current assets like stock of row materials, debtors, bills receivable also funds required for current expenses such as, wages, salaries, rent etc.
  • The current assets can be converted in to cash within a short period.
  • Trading concerns require more short term finance than manufacturing concerns.
  • Amount of working capital determines the length of operating cycle.
  • Lesser short term finance will be required, if the gap between production and sales is lesser and vice versa.
  • Main sources of short term finance are trade credit, bank loan, customer advance etc.
  • Short term finance is also known as revolving capital or circulating capital.

Operating cycle

  • Operating cycle refers to the time required for production process and realizing cash after the sale of such goods.
  • If the operating cycle is short, only small amount of short term finance is required and vice versa.

Fig: operating cycle

Classification on the basis of ownership

The business can raise its required finance from two main sources. They are (1) Owners funds (2) Borrowed funds.

Owners Fund

  • Owned capital refers to the amounts contributed by the owners into the business.
  • In a sole proprietorship, the proprietor brings the owned funds from his personal property.
  • In a partnership, the capital contributed by the partners is called owned funs.
  • Funds raised by the issue of shares and retained earnings are the owned funds in a joint stock company.
  • It will remain in the business over a long period and is not expected to be withdrawn otherwise than on the winding up of the business.

Borrowed funds

  • Borrowed funds refer to fund raised from external borrowings.
  • The sources of borrowed funds include issue of debentures, public deposits, trade credit and loans from financial institutions and banks.
  • Periodical payments of interest and repayment of loan amount on expiry date are required even if there is no profit.
  • Moreover, borrowed funds are available only on mortgage of fixed assets.

Classification on the basis of source of generation

It includes internal and external sources of funds:

Internal sources of funds

  • The sources of funds which are generated by the business itself are known as internal sources of funds.
  • Collection of receivables, retained earnings, disposing of surplus inventories etc. are the main internal sources of business finance.
  • Only limited needs of finance are fulfilled by these sources.

External sources of funds

  • External sources of funds are those that are generated from outside the business.
  • For example, loans from commercial banks and financial institutions, issue of debentures, public deposits, lease financing, trade credit, factoring etc.
  • Requirement of large amount of funds can be fulfilled by these sources.
  • The funds raised through these sources are costly as compared to the funds raised through internal sources.
  • Sometimes the business firm has to even mortgage their assets as security while raising funds from these sources.

Different sources of finance

Sources of Finance

  • A source of finance means the agency from which finance is procured for the business.
  • A business can raise funds from various sources.
  • In case of sole trading concern and partnership concern, the main sources of capital are the proprietors themselves.
  • But in joint stock companies due to the nature of large scale operations, require huge capital.
  • Each source has its own advantages and disadvantages.
  • There is not a single best source of funds for all organizations.

A brief description about various sources, along with their advantages and limitations are given below:

  1. Retained profit
  2. Trade Credit
  3. Factoring
  4. Lease Financing
  5. Public deposits
  6. Commercial Paper (CP)
  7. Issue of Shares
  8. Issue of Debentures
  9. Loan from Commercial banks
  10. Loan from Financial Institutions
  11. International Finance

1- RETAINED PROFIT (Ploughing back of profit)

  • Out of total profits earned by a company in a particular year, a certain percentage is retained in the business without distributing as dividend among share holders, this undistributed profit is known as retained profit.
  • It is a source of internal financing or self financing.
  • It is also known as ‘ploughing back of profit’.
  • It is treated as an ownership fund and will serve the purpose of long term and medium term financing.
  • It is a usual practice of a company to transfer a part of its profit to general reserve every year.
  • When these reserves are accumulated into a large amount, after a few years, this can be employed in modernization, expansion etc. of the business.

Advantages of retained earnings

This type of finance has the following advantages:-

  1. It is the most convenient source of finance. It requires no advertisement, no issue of prospectus or no legal formalities.
  2. Retained profits create no charge on the assets of the company. Further loans can be raised on the security of assets.
  3. There is risk of losing control to the management when a fresh issue of shares is made. But management retains its control when it uses retained profits.
  4. Retained profits increases the financial strength and earning capacity of the business. The company enjoys more borrowing capacity also.
  5. As an internal source, it is more dependable than external source.
  6. There is no fixed obligation to pay dividend on the profits reinvested
  7. Retained earnings is a permanent source of funds available to an organization.
  8. It may lead to increase in the market price of the equity shares of a company.

Disadvantages of retained earnings

Retained earnings as a source of funds has the following limitations:

  1. In some cases, it may lead to over capitalization. Over capitalization means presence of idle capital and reduced rate of earnings.
  2. Excessive ploughing back may cause dissatisfaction amongst the shareholders as they would get lower dividends.
  3. It is an uncertain source of funds as the profits of business are fluctuating.
  4. The company runs the risk of being converted into a monopolistic organization.
  5. Growth of companies through internal financial may attract the government restrictions as it leads to concentration of economic power.

2- Trade credit

  • Trade credit is the credit extended by one trader to another for the purchase of goods and services.
  • Trade credit facilitates the purchase of goods without immediate payment.
  • Such credit appears in the book of the buyer as sundry creditors.
  • It is commonly used by the business organization as a short term source of financing.
  • The volume and period of trade credit depends on factors such as reputation of the purchasing firm, financial position of the seller, volume of purchase, competition in the market etc.

Advantages of trade credit

  1. Trade credit is a convenient and continuous source of funds.
  2. Trade credit needs to promote the sales of an organization. It is important technique to increase sales.
  3. It does not create any charge on the asset of the company.
  4. It is a readily available source of finance.
  5. Trade credit facilitates purchase of goods and services without immediate payment.

Demerits of trade credit

  1. Trade credit may result in over trading which increases the risks of the business.
  2. Only limited amount of funds can be generated through trade credit.
  3. Trade credit is a costly source of funds as compared to other sources.

3- Factoring

  • If refers to the practice of raising funds by selling a firm’s account receivable to another company or agency.
  • Credit management is a specialized activity as it requires skill and involves a lot of time and effort.
  • Therefore debt collection is a serious problem for firms.
  • Banks usually grant working capital finance on receivables for a short period only (3 to 6 months).
  • Hence debt collection activity may be entrusted with specialized agencies called factoring organizations.
  • This agency or individual which specializes in collection and administration of debt is called a factor.

Following are some of the services provided by factoring agencies:

  1. Discounting bills of exchange.
  2. Factors collect client’s debts and provide full credit protection against bad debts.
  3. Factors also provide information about credit worthiness of prospective clients.

Factors do these services in return for a factoring commission and interest on advance granted. First factoring company in India is SBI Factors and Commercial Services Limited.

Advantages of factoring

  1. The client can concentrate on other functional areas of business as the responsibility of credit control is shouldered by the factor.
  2. Factoring ensures timely payment of account receivable. It helps the client to meet his liabilities as and when they arise.
  3. It provides protection to the firms against bad debt losses.

Limitations of Factoring

  1. This source is considered to be very expensive when the the number of invoices are large in number and amount is very small.
  2. The customer may not feel comfortable in dealing with the third party i.e, the factor.
  3. They advance finance at a higher rate of interest as compared to the usual rate of interest.

4- Lease Financing

  • A lease is a contractual agreement whereby one party i.e., the owner of an asset grants the other party the right to use the asset in return for a periodic payment.
  • Leasing is an arrangement of acquiring the right to use an equipment or asset without actually owing the same.
  • The owner of the assets is called the lessor and the user is the lessee.
  • The lessee has to pay a specified amount called lease rent to the lessor for the use of the asset.
  • Payment is made as regular fixed payments over a period of time at the beginning or at the end of a month, quarter or year.
  • Normally there is an agreement between the lessor and lessee.
  • This agreement includes provisions about period, cancellation, lease rent, purchase option, maintains etc.
  • At the end of the period, the assets revert to the lessor who is the legal owner of the asset.
  • Lessors may be a leasing company or manufactures of equipment.
  • This type of finance is very helpful in acquisition of such assets like computers, electronic equipment etc.as become obsolete very soon.

Advantages of lease financing

  1. It is an easiest source of long term finance for fixed assets.
  2. The lessee is freed from the risk of the assets becoming obsolete as he could cancel an old lease agreement.
  3. It enables the lessee firms to make full use of the assets without making immediate payment of huge purchase price. Lease rent may be matched with the cash flow of the lessee.
  4. Tax advantage. The full amount of lease rent is an admissible deduction under income tax Act.
  5. Asset is made available to the lessee for immediate use without loss of time in applying for a loan and complying with formalities in acquiring the asset.
  6. It provides finance without diluting the ownership or control of business.

Disadvantages of lease financing

  1. Lesser may impose certain restrictions on the use of assets.
  2. The normal business operations may be affected in case the lease is not renewed.
  3. It may result in higher payout obligation in case the equipment is not found useful and the lessee opts for premature termination of the lease agreement.

5- PUBLIC DEPOSITS

  • The deposits that are raised by organizations directly from the public as loan or debt are called public deposits.
  • Companies advertise in newspapers for inviting general public to invest their savings in public deposits.
  • Rate of interest offered on public deposits are usually higher than that offered on bank deposits.
  • Companies generally invite public deposits for a period up to three years.
  • It is a source of medium term or short term finance.
  • Public deposits are unsecured loans and the depositors are like ordinary creditors.

Advantages of public deposits

  1. The company need not provide any security against the public deposits,so public deposits will not create any charge on the assets.
  2. Public deposits are flexible source of short term finance. They can be accepted even for a short period of six months
  3. Public deposits are a convenient source of finance since not much legal formalities are involved
  4. As the depositors do not have voting rights, the control of the company is not diluted.
  5. Financing through public deposits is a method of trading on equity.
  6. Interest on public deposits is paid at a fixed rate.
  7. This facilitates a company to declare more dividends to its equity share holders in years of high earnings.

Disadvantages of public deposits

  1. Only large companies enjoying public confidence can raise capital through public deposits
  2. They are not secured. The depositors are considered as ordinary creditors.
  3. They are costly as most of the companies have to offer high interest to attract public deposits.
  4. The RBI has laid down certain limits on public deposits.
  5. Investors are entitled to withdraw their deposits at any time after giving prior notice to the company.

6- Commercial paper (cp)

  • It is an important source of short term finance having a maturity period of 7 days to one year.
  • Commercial paper is an unsecured promissory note issued by a firm to other business firm, insurance companies, banks etc.
  • Being an unsecured debt, CP can be issued only by the firm having good credit rating.
  • Commercial paper is usually issued at a discount from face value and reflects prevailing market interest rates.
  • It can be traded like other negotiable instrument. RBI regulates commercial paper.

Merits

  1. It is the best suitable instrument to raise shot term finance.
  2. As it is a freely transferable instrument, it has high liquidity.
  3. Companies can park their funds in commercial paper thereby earning some good return on the same.
  4. It is a continuous source of funds.

Demerits

  1. Only financially sound and highly rated firms can raise money through commercial papers. Therefore, new and moderately rated firms can’t raise funds by this method.
  2. The size of money raised through CP depends upon the liquidity position of money suppliers. It is not a sure source of finance.
  3. Issue of commercial paper is strictly regulated by RBI.

7- Issue of shares

The capital raised by issue of shares is known as share capital.

The capital of a company is divided into small units called shares.

Share holders are the owners of the company.

Each share has its nominal (Face) value. For example a company can issue 5,00,000 shares of Rs. 10 each for a total value of Rs. 50,00,000.

The person holding the share is called the share holder. There are two types of shares issued by a company. They are: (1)Equity shares and (2) preference shares.

Equity shares

  • Equity shares were earlier known as ordinary shares.
  • The holders of these shares are the real owners of the company.
  • They have a voting right in the meetings of shareh olders of the company.
  • They have a control over the working of the company.
  • Equity shareholders are paid dividend after paying it to the preference shareholders.
  • The amount of share capital which is raised by issue of equity share is known as equity share capital.
  • The rate of dividend on these shares depends upon the profits of the company.
  • They may be paid a higher rate of dividend or they may not get anything.
  • These shareholders take more risk as compared to preference shareholders.
  • Equity capital is paid after meeting all other claims including that of preference shareholders.
  • They take risk both regarding dividend and return of capital.
  • Equity share capital normally cannot be redeemed during the life time of the company.

Capital Structure – Reliance Industries Ltd.

Period

Instrument

Authorized Capital

(Rs. cr)

Issued Capital

(Rs. cr)

– P A I D U P –

From

To

Shares (nos)

Face Value

Capital (Rs. Cr)

2017

2018

Equity Share

14000.0

6334.7

6334651022

10.0

6334.7

2016

2017

Equity Share

5000.0

3251.3

3251278100

10.0

3251.3

Features of equity shares

  1. Risk bearers: Equity share holders are entitled to receive what is left after all prior claims have been paid. They provide funds to the company not on the basis of any security.
  2. No fixed rate of dividend: The rate of dividend on equity capital depends upon the availability of surplus funds. There is no fixed rate of dividend on equity capital. It is paid out of the residual profits after paying interest on debentures and dividend on preference shares.
  3. Right to vote: Equity shareholders have voting rights and elect the management of the company.
  4. Permanent source of finance: Equity share capital remains permanently with the company. It is returned only when the company is wound up.

Merits (Advantages) of Equity shares

Equity shares have the following merits.

1- Source of fixed capital

  • It is the best source of long term finance.
  • A company has no obligation to repay its equity share capital except at the time of winding up of the company subject to availability of funds.

2- No obligation to pay dividend

Payment of dividend to the equity shareholders is not compulsory.

Therefore, there is no burden on the company in this respect.

3- No charge on assets

Funds can be raised through equity share issue without creating any charge on the asset of the company .So companies assets can be used for raising additional loan.

4- Voting right

Equity share holders enjoy full voting right in the management of the company.

5- High return

If the company is successful and the level of profit is high, equity share holders enjoy very high return.

6- It create confidence among creditors

Equity capital provides credit worthiness to the company and confidence to prospective loan providers. Equity share capital act as a cushion to creditors.

7- Real Owners

Equity shareholders are the real owners of the company who have the voting rights in all matters.

Demerits (Disadvantages) of Equity shares

The major limitations of raising funds through issue of equity shares are as follows:

1- Not suitable to cautious investors

Investors who desire to invest in safe securities with a fixed income have no attraction for equity shares.

2- Dilutes the control

An additional issue of equity shares dilutes the control of existing share holders.

3- Not flexible

Equity share capital is a permanent source of finance. It can’t be refunded during the life time of the company.

4- Danger of manipulation

The management of the company may declare dividend at higher or lower rates. It will cause fluctuation in the value of shares .There is always danger of manipulation of share price.

Danger of over capitalization

Issue of equity shares in excess of its financial requirements of a company will make overcapitalized. This results in low earning capacity by the presence of idle capital.

1- Government restrictions

Raising equity share capital beyond a certain limit is subject to government restrictions.

2- Complicated procedures

More formalities and procedural delays are involved while raising funds through issue of equity share.

Preference shares

  • Preference shares are those shares which have preferential right over equity share in case of payment of dividend and repayment of capital at the time of winding up.
  • They are entitled to a fixed rate of dividend before any dividend is paid to equity share holders.
  • Preference shares are better suited to the needs of cautious and conservative investors who wants certainly of income and security of their investment.
  • However the rate of dividend specified in preference shares is not guaranteed.
  • If any year’s profit is not sufficient to declare dividend on shares the preference share holders will not get dividend.
  • There is also a restriction on their voting rights.
  • They have right to vote only on matters affecting their interest like nonpayment of dividend.

Features of preferences shares

1- Preference

  • If there is profit and dividend is declared, dividend at a fixed rate must be paid first to the preference shareholders.
  • The balance, if any, can be districted among equity share holders.
  • They also have the preference in case of repayment of capital.

2- Restricted voting right

  • Preferences shares carry limited rights over the management of the company.

3- Fixed percentage of dividend

Preferences shareholders get only fixed percentage of dividend even if the company makes good profits.

Kinds of preferences shares

Based on the terms and conditions, different types of preference shares may be issued by a company to raise funds.

1- Cumulative and Non cumulative preferences shares

  • In case of cumulative preference shares, if dividend is not paid due to inadequate profit in a particular year, the amount of dividend will accumulate and will have to be paid out of profits of future years.
  • Preference shares are always cumulative unless otherwise stated.
  • A non cumulative preference shares is one in respect of which dividend do not accumulate, if they are unpaid.
  • Arrears are not carried forward to subsequent years.

2- Participating and Non participating preference shares

  • A participating preference shares carries a right to share in surplus profits left after a fixed dividend is paid both preference and equity shares.
  • The holders of these shares get a part of residual profit in addition to the fixed rate of dividend.
  • Non participating preferences shares carry a right of only a fixed rate of dividend.
  • The holders have no right to share in the residual profit of the company.

3- Redeemable and Irredeemable preferences shares

  • Redeemable preference shares are those preference shares in which the company can repay the mount of such preference shares after a specified period.
  • Irredeemable preference shares are those shares which are redeemable only at the time of winding up of the company.
  • They can’t be paid up during the life time of the company.

4- Convertible and Non convertible preferences shares

Preferences shares which can be converted into equity shares after a fixed period is known as convertible preference shares.

The preference shares which do not carry a right of conversion into equity shares are called non convertible preference shares.

Advantages of preference shares

1- Suitable to cautious investors

It is suitable for cautious investors who look for a regular return and reasonable safety.

2- No obligation for dividend

Dividend is payable only when there is sufficient profit.

3- No interference in management

They have only restricted voting right. Preference share issue will not dilute the control of equity share holders.

4- No charge on asset

Preferences shares do not create any charge on the asset of the company.

5- Preferential right

Preference shareholders have a preferential right on repayment of capital over equity shareholders in the event of liquidation of a company.

6- Flexibility

They can be redeemed, if necessary. Issue of redeemable preferences shares help a company to replay the capital when it is no longer required in the business.

DISADVANTAGES OF PREFERENCE SHARES

The major limitations of preference shares as a source of business finance are:

1- Limited voting right

Preference shareholders are ordinarily denied the right to vote except under specific conditions.

2- Low return

Preference shares are not suitable for those investors who are willing to take risk and are interested in higher returns.

3- Costly source of finance

The rate of dividend on preference shares is generally higher than the rate of interest on debentures.

4- No tax benefit

The dividend paid is not deductable from profits as an expense. Thus, there is no tax savings as in case of interest on loan or debentures.

8- ISSUE OF DEBENTURES

  • Debenture is an important instrument for raising long term debt capital.
  • A company can raise funds through issue of debentures, which bear a fixed rate of interest.
  • A debenture is a certificate or document issued by a company under its seal as an acknowledgement of its debt.
  • It is also an undertaking by the company to repay specified borrowed sum to the debenture holder.
  • Debenture holders are creditors of the company.
  • Debenture holders are paid a fixed stated amount of interest at specified intervals.
  • Public issue of debentures requires that the issue be rated by a credit rating agency like CRISIL (Credit Rating and Information services of India Ltd).
  • The credit rating agency rate the issue on aspects like track record of the company, its profitability, debt servicing capacity, credit worthiness etc.

examples of credit rating:

  • If the rating of debenture is AAA (Triple A), then it is considered to have the highest safety for the investor.
  • If the credit rating is DDD (Triple D),, then the debenture is considered to have highest risk for the investor.)

Features of Debenture

  1. A debenture is a certificate is an acknowledgement of debt of a company.
  2. Debenture represents borrowed capital.
  3. Interest on debenture is payable at a fixed rate.
  4. Debenture holders are creditors of the company
  5. Debenture holders have no voting rights.
  6. Interest on debenture is a charge against profit.
  7. It can write as an expense on the debit side of the profit and loss account.
  8. Debenture may involve a charge on the assets of the company.

Types of debentures

1- Naked or simple debentures

  • These debentures are unsecured and do not carry any charge on the assets of the company.
  • The holders of unsecured debentures are considered as ordinary creditors in the event of winding up of the company.

2- Secured or Mortgage Debentures

  • These debentures carry a charge on the assets of the company.
  • Secured debentures have a claim on the assets of the company.
  • The charge may be fixed or floating.
  • If specified assets like machinery, building etc. are charged as security it is a fixed charge.

3- Redeemable debentures

  • Debentures issued with a condition that they will be redeemed or repaid after a specified period are called redeemable debentures.
  • It provide flexibility to the capital structure.

4- Irredeemable debentures

  • These debentures are repayable only at the time of winding up of the company.
  • They are also known as perpetual debentures.

5- Convertible debentures

  • The holders of these debentures have an option to convert their holdings into equity shares after a specified period

6- Non- Convertible debentures

  • These debentures cannot be converted in to shares in future.
  • The holders of such debenture remain creditors of the company.

7- Registered Debenture

  • In case of registered debentures, the name, address and other details of debenture holders are entered in the books of the company.
  • They cannot be transferred by mere delivery, it require a transfer deed.

8- Unregistered or Bearer Debentures

  • The company keeps no record of the holders of these debentures.
  • The company made payment to the holders of these debentures.
  • They are transferable by more delivery.

Advantages of debentures

The merits of raising funds through debentures are given as follows:

  1. It is suitable to investors who want fixed income at lesser risk. They guarantee a fixed rate of interest.
  2. Interest paid is a deductible expense. So tax savings is possible.
  3. As debentures do not carry voting rights, financing through debentures does not dilutes control of equity shareholders on management.
  4. Debentures enable the company to the advantage of trading on equity.
  5. It provides flexibility to the capital structure as debentures can be redeemed at any time when company has surplus funds

Disadvantages of debentures

A debenture as source of funds has certain limitations. They are given as follows:

  1. Interest on debenture is an obligation to the company. It is to be paid annually irrespective of the profit of the company.
  2. Debenture holders do not enjoy any voting rights in the company.
  3. Debenture issue is not suitable for companies with unstable future earnings.
  4. Debenture issue may not be possible beyond a certain limit due to inadequacy of assets to be offered as security.

DIFFERENCE BETWEEN SHARES AND DEBENTURES

Basis of Difference

Shares

Debentures

1. Ownership

A share is an ownership security

A debenture is a security

creditor ship

2. Position

A share holder is an owner of the company

A debenture holder is a creditor of the company

3. Return investment

on

Shareholders return

get dividend

as the

Debenture holders get interest as the return

4.Guarantee return

of

Rate of return is fluctuating, depending upon the earnings of the company

Rate of interest is fixed irrespective of profit or loss of the business

5. Voting right

Share holders have voting rights

Debenture holders have no voting rights

6. Redeemability

Shares can’t be redeemed (except redeemable preference shares) during the life of the company

Redeemable debentures can be redeemed during the life time of the company

7. Security

No charge is created on the assets of the company

The debentures are generally secured by creating a charge on the assets of the company

8. Priority repayment investment

for of

At the time of winding up of the company, share capital is payable after meeting all outside liabilities

Debentures are repayable in priority over share capital

IV. LOANS FROM FINANCIAL INSTITUTIONS

  • The government has established a number of financial institutions all over India to provide finance to business organizations.
  • They provide both owned capital and loan capital for long and medium term financial requirements.
  • As these institutions aim in promoting the industrial development of a country, these are also called development banks.
  • Examples for development banks are-Industrial Finance Corporation of India (IFCI), State Finance Corporation of India (SFC), Industrial Credit and Investment Corporation of India(ICICI), Industrial Development Bank of India(IDBI) etc.
  • Development banks differ from commercial banks in many respects.
  • Commercial banks grant credit for short term requirements.
  • But development banks provide finance on medium and long term basis.
  • Another major difference is that commercial banks are highly security oriented in their dealings.
  • But development banks are project oriented.

Functions of development banks

  1. Long term and medium term financial assistance to industries at a reasonable rate of interest.
  2. Subscribe shares and debentures issued by companies.
  3. Underwrite the issue of shares and debentures of companies.
  4. Give guarantee for loans obtained by such companies from other financial institutions and banks.
  5. Give loans in foreign currency for industries to import machinery.

Merits of raising loan from financial institutions

  1. They provide long term finance, which are not provided by commercial banks.
  2. Besides providing funds, many of these institutions provide financial, technical and managerial advice to business firms.
  3. They provide funds even during the periods of depression, when other sources of finance are not available.
  4. Obtaining loans from financial institutions increases the goodwill of the borrowing company in the capital market.

Loan from banks

  • Commercial banks occupy an important position as they provide funds for different purpose as well as for different time period.
  • Banks extend loan to firms in many ways like cash credit (CC), over draft (OD), term loans, discounting bills of exchange etc.
  • The borrower is required to some security or create charge on the assets of the firm before a loan is sanctioned by a commercial banks.

INTERNATIONAL SOURCES OF FINANCE

In addition to the above domestic sources of funds, there are various avenues to raise funds internationally. Various international sources from where funds may be generated include:

International agencies and development banks

  • A number of international agencies and development banks have emerged over the years to finance international trade and business.
  • These bodies provide long and medium term finance to trade and industries.
  • Examples for international bodies are International Finance Corporation (IFC) Asian Development Bank etc.

International capital market

  • Through the process of liberalization, Indian companies are now free to access global capital markets for raising finance.
  • Thus, international finance has become accessible to Indian corporate enterprises.
  • The main instruments through which companies in India can raise finance from the international capital market are Global Depository Receipts (GDRs) and American Depository Receipts (ADRs).

Global Depository Receipts (GDR)

  • Global Depository Receipts are created by overseas depository Bank and issued to non-resident investors against the issue of ordinary shares of issuing company.
  • They are dollar denominated instruments.
  • After getting approval from the Ministry of Finance and completing other formalities the issuing company issue shares to the overseas depository Bank and overseas depository then issues dollar denominated Global Depositing Receipts (GDR) against the shares registered with it.
  • The non-resident investors purchase GDR and not shares of Indian Company.
  • The Depository receives dividend, notice and reports of the company and in turn issues GDR as claims against shares held.
  • These claims are called GDR and traded as receipts in the global market.

Features

  1. It is traded in Europe
  2. The holders of GDR have no voting right.
  3. GDR help in tapping international capital for Indian companies.
  4. It is a dollar denominated negotiable instrument.

American Depository Receipt (ADR)

  • ADRs are negotiable receipts issued to nonresident, investors by an authorized depository, normally a US Bank, in lieu of shares of the issuing (Indian) Company, which is actually held by the Depository.
  • ADRs can be listed and traded in US based stock exchange and help the Indian company to be known in the highly liquid US stock exchanges.
  • ADR also help in the US based and other foreign investors to have the twin benefits of having share holding in a high grown Indian company and the convenience of trading in a highly liquid and well known stock exchange.
  • The depository receives dividend directly from Indian company in rupees and issue dividend cheques to ADR holders in dollars.

Difference between GDR and ADR

  1. ADRs are listed in American Stock Exchange. But GDRs are traded in European Stock Exchange.
  2. Both individual and Institutional investors can make investment in ADR. But only institutional investors can invest in GDR.
  3. ADR can be converted into shares and shares to ADR. But in case GDR once
  4. Converted into shares, if can’t be converted back.
  5. Legal and accounting cost is high in case of ADR as compared to GDR.

Foreign Direct Investment (FDI)

  • FDI refers to direct subscription to the equity capital of an Indian company by a multinational corporation.
  • Until 1991, FDI was permitted up to 40% of the equity capital of the company.
  • This ceiling was since removed and the government is encouraging 100% FDI.

Factors affecting the choice of the source of funds

The factors that affect (Influence) the choice of source of finance are:

1- Cost:

  • The cost of procurement of funds and cost of utilizing the funds should be taken into account while deciding about the source of funds that will be used by an organization.

2- Purpose and Time period:

  • Business should plan for fund according to the time period for which the funds are required.
  • A short period need can be met through borrowing funds at low rate of interest through trade credit, commercial paper etc.
  • For long term finance, sources such as issue of shares and debentures are more appropriate.

3- Control:

  • Business firm should choose a source of finance keeping in mind the extent to which they are willing to share their control over business.

4- Flexibility:

  • Flexibility means that, if need be, amount of capital in the business could be increased or decreased easily.
  • Reducing the amount of capital in business is possible only in case of debt capital or preference share capital.

5- Company’s Tax Exposure

  • Debt payments are tax deductible.
  • As such, if a company’s tax rate is high, using debt as a means of financing a project is attractive because the tax deductibility of the debt payments protects some income from taxes.

6- Risk:

  • Business should evaluate each of the sources of finance in terms of the risk involved.

7- Form of organization:

  • The form of business organization influences the choice of a source for raising money.
  • A sole trading concern or a partnership can’t issue shares to the public.

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