Long term
Financing
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1. Concept of Long Term Financing
Financing has a great significance for modern business which requires huge capital. Funds required for a business may be classified as long-term and short term financing. The capital or fund needed to purchase the fixed assets like house, land; machinery, equipment, and furniture are called long-term funds/financing. The long term financing is essential to a business. It is equally compulsory to all types of small and big businesses. In other words, fund which is raised by a company for a period of time longer than a year is called long term financing. The main factor affecting long term financing are Nature of business, nature of goods produced and technology used in the business. The purposes of using long term financing are to finance fixed assets, to finance the permanent part of working capital and to finance growth and expansion of business. The sources of long term financing are:
a) Long-term debt
b) Preferred stock
c) Common stock
d) Retained earning
2. Long-term debt
Meaning of Long-term debt:
If the firm decides to use long-term financing for its development, the most popular sources of financing is long-term debt. The debt to be repaid after more than one year in future is called long-term debt Bonds issued by a company and term loan raised from financial institutions are two major sources of long term debt financing. The long term debt should not be used without caution. The use of long term debt is one of the important decisions of a firm. It is because the long term debt may have great impact in the future of the firm. If more loans are taken, the firm may not be able to bear its liabilities and eventually the firm may be bankrupt. After taking or using long term debt the fixed interest rate should be paid according to definite schedule and the principal should be repaid in a definite time.
Features of Long-term debt:
Long-term debt instruments have a number of features. Some of them are explained below:
a) Par Value or Face Value:The Par Value is the stated face value of the debt, which is generally set at Rs. 1000 for a bond. It generally, represents the amount of money the firm borrows and promises to repay on the maturity date.
b) Coupon interest rate: The coupon is the amount that debt holders/ bond holder will receive as interest payment. The interest rate is fixed at the time of debt issue. Interest may be paid annually or semiannually or quarterly. The coupon is express as a percentage of par values.
c) Maturity: All the debts issued by a corporation mature on the predetermined date stated in the certificate. It refers to the expiry period of debts. The specified date on which the principal is repaid is called maturity date.
d) Indenture: An indenture is a legal document or contract that contains terms and conditions of debt issue. It includes details of debt issue, description of property pledged (if any), and the methods of principal repayment, restrictions placed on the firm by the lenders, right and responsibilities of both borrower & lender.
e) Trustee: A trustee is the representative of the debt holders, who deals with the issuing company. Usually a commercial bank or finance company is appointed as a trustee.
f) Sinking Fund: Sinking fund is a provision in a debt contract that facilitates the orderly retirement of the debt. In some cases, the firm may be required to deposit money with trustee, which invests the funds and then uses the accumulated sum to redeem the debts at maturity.
Types of Long-term debt
There are different types of long-term debt. They are explained below:
a) Term loan: A term loan is a loan obtained from a bank or other financial institution for which the borrower agrees to make a series of payments consisting of interest and principal on specifies dates.
b) Bonds: A bond is a long-term contract under which a borrower agrees to make payments of interest and principal on specific dates, to the holders of the bonds. Generally, bond issuer pays a fixed interest payment each period until the bond matures.
Types of Corporate bond
There are various types of bonds in the financial market. Some of them are summarized below:
i) Mortgage bonds: The long term debt secured by the collateral of specific assets like machinery, equipment of issuing company is called mortgage bond. If the company in unable to pay the bond amount, the bond holders may raise their money by selling fixed assets to satisfy their claims.
ii) Unsecured Bond or Debenture: A debenture is an unsecured bond issued by a company without providing any specific assets as collateral. The use of debenture depends on the nature of asset of the firm and general credit strength. Therefore, debenture holders are general creditors of the firm.
iii) Convertible Bonds: The bond which can convert into ordinary shares after sometime according to the desire of the bond holders is called convertible bond. Such rights are specified in the indenture.
iv) Callable bond: A callable bond can be called or redeemed, by the issuer before maturity period. Borrowers prefer callable bonds if they are concerned that interest rates will fall in the futures. If this occurs, the borrower can call the bond, paying off the principal early, and then issue new bonds at the lower interest rate.
v) Income bond: An income bond is a bond on which interest is paid only if there is sufficient earning available with company for interest payment. Some income bonds have cumulative feature. It means that the interest not paid goes on cumulating and should be paid fully before the stockholders receive dividend.
vi) Zero Coupon bonds:The bonds, which have no coupon rate and sold at a discount basis is called zero coupon bonds. This bond is also called pure discount bonds. The investors receive attractive returns from the difference between issue price and par value. Companies prefer to issue zero coupon bonds when their cash flows are not regular.
vii) Junk bond: A junk bond has a relatively high risk of default. Junk bonds are riskier than most other bonds and thus pay a high interest rate. So, this bond is also known as a "high yield bond" or "speculative bond".
viii) Floating Rate Bond:Company can issue floating rate bonds instead of issuing fixed interest rate debt instrument. Generally interest rate on such bonds is tied to the Treasury bond (government Bond) or some market rates. In a volatile interest rate environment, companies are reluctant to commit to long term debt. They use floating rate bonds in this situation to reduce risk.
Advantages of Long-term Debt
The long term debt has following advantages to the issuing company (Borrower's) and Investors.
a) Issuing Company:
The issuing company receives following advantage from the use of debts.
i) Less Costly: It involves less cost to the firm than the equity financing because investors consider debt as a relatively less risky investment alternative and therefore, required a lower rate of return.
ii) No loss of control: Since control is not allocated among bond holders in corporate bond the firm is able to raise capital without losing control. In general, the bond holders do not having voting right in the election of board of directors.
iii) Tax Deductible: The interest paid on debt can be deducted as tax expenditure. In other words, while paying tax, interest can be deducted as expenditure.
iv) Flexibility: The Corporation can bring flexibility in its capital structure by issuing bonds because the call provision can be kept in bond indenture. Some loans can be repaid before being matured.
v) Limited cost: The cost of the loan is definitely limited. When the company earns high profit, the bond holders cannot receive its share. Since the bond holders receive only definite, limited income, the ordinary shareholders receive more income.
b) Investors:
The investors receive following benefits from debts.
i) Low risk: The bond is risk less to the investors. Their money is safe because in many bonds assets are being kept as security.
ii) Stable/Fixed Income:There is fixed interest rate in the bond, except in income bond. So the investors receive stable and definite income regularly.
iii) Control: The bond holders usually do not have the right to vote. But if the firm fails to repay to loan, they can take company into control.
iv) Right of conversion: In certain circumstances, the bonds are convertible. In such situation the bond holders can convert bonds into shares.
v) Liquidity: The bond is more marketable than shares. Since bonds can be easily sold, the investors are able to get liquidity.
Disadvantages of Long term debt
The disadvantages of debt are as follows:
a) Issuing company (Borrowers):
i) Increase financial risk: It increases the firm's financial leverage, which may be particularly disadvantageous to those firms which have fluctuating sales and earnings.
ii) Restricted covenants:Debt contracts impose restrictions that limit the borrowing firm’s financial and operating flexibility.
iii) Limit of the loan: There is a limit to the extension of raising fund through the long term debt. According to the financial policy the loan ratio should not cross certain limit. If loan is taken more than this limit, the cost of the loan rapidly increases.
iv) Cash outflows:Debt usually has a fixed maturity date. The debt must be paid on maturity and therefore, at some points, they involve substantial cash outflows.
b) Investors:
i) Limited Income: The fixed charge should be paid on debt. Hence, if the income of the company widely fluctuates, it may be unable to pay such charges. The debt holders will not receive extra profit; they only receive limited income as interest.
ii) No voting right: The debt holders do not have voting right in the affairs of the firm and in election of Board of Directors.
iii) Low return: As compared to preferred stock and common stock, the bond/debt has the lower rate of return.
3. Preferred stock:
Meaning of preferred stock:
Another important source of financing is preferred stock or preference share. Preferred stock is a unique type of long-term financing in that sense sit combine some of the features of equity as well as debt. A fixed interest in paid annually in each share of stock. The preferred stock is usually used by the firm to maintain reasonable balance between equity capital and debt. The preferred stockholders are regarded 'senior' to common stock holders because only the dividend left after the preference stock holders received fixed annual dividend is received by the common stock holders.
Features of preferred stock:
The features of preferred stock are briefly explained below:
a) Priority: Preferred stock holders always receive their dividend first than common stock holders and in the event if the company goes bankrupts preferred stock holders are paid off before common stockholders. Hence, the preferred stockholders are regarded 'senior' to common stock holders.
b) Par value: Par value is stated price in the certificate of preferred stock. Like bonds, the preferred stocks always have par value. The par value of preferred stock is usually Rs.100. Hence, the par value is important to compute amount of dividend.
c) Fixed dividend: Preferred stockholders get fixed amount of dividend. Preferred stock dividend may be expressed amount or stated as a percentage of par value. For example Rs.10 per share or 10% of par value.
d) Cumulative dividend:–Most of preferred stock has cumulative features. It means the unpaid dividend is any year is carried forward before any common stock dividends are declared and paid.
e) No voting rights: – Unlike common stockholders, generally, preferred stockholders do not have the right to vote for the company's board of directors. However, preferred stockholders are gives voting right if the company omits its preferred stock dividends for a specified period.
f) Convertibility:– The preferred stock has usually conversion feature too. The preferred stock having such feature can be converted into specific number of common stock. However, the decision to convert or not to convert depends on the wishes of the Investors.
Merits/Advantage of preferred stock:
Preferred stock offers the following advantages.
a) To issuer (Company view point)
i) No obligatory payment:–There is no legal obligation to pay preference dividend. A company does not face bankruptcy or legal action if it skips preference dividend.
ii) Fixed dividend:–The preference dividend payments are restricted to the stated amount. Thus, preference shareholders do not participate in excess profits as do the ordinary shareholders.
iii) No Risk of Liquidation: – The preferred stock is a kind of permanent source of finance. The shareholders cannot be compelled for bankruptcy, like creditors in case, dividend cannot be paid.
iv) Increase creditworthiness:–Preference capital is generally, regarded as part of net worth. Thus it enhances the creditworthiness of the firm. The firm can use more amount of debt.
v) No Dilution of control: –In general, preferred stock does not carry voting rights. Therefore, there is no dilution of control. While financing through preferred stock, the control of the shareholders on the firm is protected.
b) To Investors:
i) Stable Income: – The preferred stock provides reasonably regular and stable to the investors. Because, the rate of dividend which should be paid on annual basis is already fixed.
ii) Priority in earning and assets: – In case of Liquidation of the firm priority is given to the preferred stockholders before common shareholders. They have full claim on the earning and assets of the firm.
iii) Tax exemption: – Many companies like to purchase preferred stock as investment. Because, most of the dividend received on shares is tax–exempt.
Limitations or Disadvantages of preferred stock:
The preferred stock has following disadvantages to company and to the investor.
a) To Issuer (Company View Point)
i) High Cost: It is costly because generally, dividend rate on such shares is higher than interest rate payable on debt (like bond and debentures).
ii) Difficult to Sale: Unlike bondholders, there is no guarantee of the payment of dividend of preference shareholders. The preference shareholders take additional risk than the bondholders. Therefore, it is difficult to sell preference share in the market.
iii) No Tax saving:–Preferred stock dividends are not deductible as a tax expenses. As a result, there is increase in tax liabilities.
iv) Prior Right: –Compared to equity shareholders, preferred stockholders have a prior claim on the assets and earning of the firm.
b) To Investors:
i) No Voting Rights: The preference shareholders do not have voting rights in the affairs of the firm and in election of the board of Directors. They are in management of the company.
ii) Limited Income: The return of preferred stock is limited. Therefore, the investors may not like to invest on preferred stock.
iii) No enforceable legal right: The preferred stockholders do not have legally enforceable right to dividend as opposed to that of bondholders to interest.
iv) More Price fluctuation: the prices of preferred stock fluctuate more than that of bond (debt). Nevertheless, the return is high on bond than on share.
4. Common Stock
Meaning of common stock
The most important form of corporate stock is common stock or ordinary shares or equity capital. It is the first sources of fund of any type of organization like corporation, partnership etc. The Common stockholders are the real owners of a firm. They invest on the firm with the expectation of return in future. It is because, they receive only the residual income after satisfying the claims of all on firm's assets and income.
Common stock certificates are legal documents that evidence ownership in a company that is organized as corporation.
Features of common stock:
The following are the basis features of common stock financing.
i) Par value: – Par value is regarded to represent per share initial investment of the owners in the firm. It is also known as face value or maturity value. Generally the par value of the common stock is Rs 100. The real importance of the par value is that the stockholder should not be given any dividend which reduces the net worth.
ii) No fixed maturity:Generally, in common stock, there is no maturity date because such stocks are residual security. The stocks remain as long as the firm survives. They cannot be redeemed but only ownership can be transferred from one shareholder to another shareholders.
iii) Voting Right: Generally, each share of common stock entitles the holder to one vote in the election of directors and in major decisions. Common stock holders can attend at the annual general meeting and cast vote in person or by means of proxy. A proxy is a legal document giving one person the authority to represent on behalf of others.
iv) Preemptive Right:Preemptive right is also an important feature of common stockholders in the company. It means the existing (old) shareholders of the will get first priority to buy the new common stocks at subscription price. To concentrate management right within limited people. This type of right can be given to the existing (old) shareholders.
v) Limited liability: If a company/corporation goes bankrupt and common stockholders cannot be forced to participants in the payment of unpaid bills. Stockholders cannot sale more than the cost of their investment.
Rights and Privileges of Common Stocks: The common stockholders are the real owners of the company and as such they have certain rights and privileges. There rights may be grouped as collective rights and specific rights.
Collective rights:
a) Right to amends the charter of the company.
b) Right to adopt and amend by laws.
c) Right to elect the directors of the company.
d) Right to authorize the sale of fixed Assets.
e) Right to change the authorized capital of company.
f) Right to authorize the issue of preferred stock, debentures and other securities.
Specific or Individual Rights
a) Right to attend in shareholder's meeting.
b) Right to vote in shareholders' meeting.
c) Right to inspect the corporate books of account.
d) Right to sell share certificates.
e) Right to share in residual income.
f) Right to share in residual assets in case of liquidation.
Advantages of Common Stock:
The advantages of common stock to issuer and investor are as follows:–
a) To Issuer (Company)
i) Minimum restrictions:The firm has minimum restrictions from common stock financing. The firm has no legal obligation to pay dividend. The company has to pay a dividend to the common stock if it makes earnings.
ii) Maturity: There is no fixed maturity in common stock. Hence, it reduces the obligation to make repayment in future.
iii) Sold easily: The common stock can be sold more easily than bond. It is attractive to certain investor due to more expected return than in preferred stock and bond.
iv) Increasing in borrowing capacity: The financing through common stock increase the future borrowing capacity of the firm. If the equity capital is more, the financial manager receives flexibility. It became easier to borrow fund in future.
b) To Investors:
i) More income: – The common stockholders are residual claimers. Hence, they receive all portion of profit left after making all other payments. Bonus share is also received in common stock.
ii) Participation in management: – Common stockholders can participate in management using their voting rights. Thus, they can maintain control over the company. The bondholders and stockholders do not have such rights.
iii) Best for investments:–The person who enjoys taking risk investment in equity share is good investment. They are able to take benefit from it.
iv) Ownership: – As a real owner of the company the common stockholders have voting right. So, they have the right of ownership till they hold the share. While buying the common stock the investor receives share certificate at which the number and the prices of share are mentioned.
Disadvantages of Common Stock:
The disadvantages of common stock to issuer and investor are as follows:–
a) To issuers (company)
i) High Cost: Common stock is an expensive source of long-term finance. The common stock is regarded as a more risky security than bond or preferred stock. Moreover, flotation costs that include underwriting commission, brokerage fee and other expenses usually are higher than those for debt and preferred stock.
ii) Distribution of Heavy Dividend: When large amount of stocks are issued by the company, it has to pay large amount of profit as dividend. It cannot maintain different type of funds for future investment
iii) No tax benefit: The dividend given on common stock is not tax deductible. In other words, while calculating the taxable income of the firm, the dividend cannot be deducted as expenditure, whereas the interest of the bond is deductible.
iv) Obstacle in management and control:When company issue large number of equity share, total number of equity shares holders will be increased. Due to large number of equity share holders and right on management, it creates power group is m, which makes obstacle in management and decision making.
v) Danger of over capitalization: The amount of capital collected from equity capital cannot be refunded easily like debt or preferred stock. Due to more capital, the company may have to face the problem of over capitalization in the future.
b) To Investors
i) Irregular Income: Since there is no fixed dividend in common stock, the income is irregular and uncertain. The board of director may decide not to give the dividend. There is no legal obligation to provide dividend.
ii) Low priority in the Liquidation: They get last priority in the liquidation. In other words, the common stock holders receive what is left after distributing to the preferred stock holders and bond holders.
iii) Loss in business cycle:The income of the company decreases during periods of recession and depression of trade cycle. Due to this the rate of dividend of common stock decreases. The market price of common stock also decreases as well. Consequently, the investor has the loss of capital.
Difference between common stock and Bond:
Basis
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Common stocks
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Bonds
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Par Value
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Shares of common stock are generally issued with a par value of Rs. 100 per share.
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Bonds generally are issued with a par value of Rs.1000 per bond.
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Voting rights
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Common stock holders have voting right. They can cast their votes in general meeting of shareholders to elect directors.
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Generally, bond holders do not have voting right & they cannot participate in the management of the company.
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Maturity
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Common stocks do not have specified maturity.
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Generally, bonds have specified maturity period.
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Convertibility
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Common stocks cannot be convert into bonds.
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Bonds, the can convert in common stock.
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Priority
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Common stock holders get last priority to get the dividend. It means before distributing dividend, the fixed amount of interest should be paid to bond holders.
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Bonds holders are the credit of organization and get the first priority on return. Interest amount are first paid to bond holders on company net profit before common dividends are paid.
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Difference between common stock and preference shares.
Basis
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Common Stock
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Preference Shares
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Rate of dividend
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The rate of dividend on common stock may vary from year to year and depending upon the availability of profit.
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Preference shareholders are paid dividend at a fixed rate.
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Voting rights
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Common stock holders have voting right. They cast their votes in annual general meeting of shareholders to elect directors.
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Preference shareholders do not have the right to cast their vote and to participate in the management of the company.
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Redemption
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Common stock cannot be redeemed except under a scheme involving reduction of capital.
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Preference share can be redeemed as provided by the articles and terms of issue.
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Cumulative dividend features
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Common stocks have not cumulative dividend features. It means common stock holders cannot get the arrears of past dividends.
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Holders of cumulative preference shares can get the arrears (unpaid) of past dividends.
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Payment of dividend
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Payment of dividend common stock is made only after paying to preference shares.
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Preference shares have a preferential right to receive dividend before any dividend is paid on common stock.
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Convertibility
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Common stocks are not converted in preference shares.
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Preference share are converted in common stock or equity shares
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5. Retained Earnings
Meaning of Retained earnings:
Retained earnings is an important source of financing. This source is mainly used by the established and profitably running firms. Retained earnings refer to the portion of net income which is retained by the corporation rather than distributed to its owners as dividends. In other words, the retaining of some portion of the profit earned by the firm and using that fund in the firm itself is called retained earnings. It is also called internal financing, self-financing and corporate saving.
Advantages of Retained earnings:
Following are the advantage of Retained earnings:
a) Cheapest source of finance: The use of retained earnings for the growth and expansion of the firm is regarded as the best and cheapest source of finance because no expenses are incurred when capital is available from this source.
b) Increase in credit worthiness: Since retained earnings increase the wealth of owners. It increases creditworthiness of the firm. On the other hand, if this fund is used to redeem debt, the firm becomes free of the anxiety to pay interest.
c) Financial stability: A company which has enough reserves can face up and down in business. Such companies can continuous with their business even in depression, thus building up its goodwill.
d) Benefit to shareholders:The shareholders receive long term benefit even if they have to lose dividend in the short run. The increase in retained earning leads to an increase in market price of shares. The shareholders can get, benefit by selling shares at high price.
e) No need of collateral:Using Retained earnings of the firm doesn't requires collateral and the company would direct invest its retained earning with approval of shareholders.
Disadvantages of Retained earnings:
The disadvantages of retained earnings are as follows:
a) Limited sources: There is limited and no high expectation of sources. Retained earnings doesn’t satisfied the huge investment.
b) Highly variable: Retained earnings are highly variable from year to year. A retained earnings is dependent upon the performance of firm and its expense and income.
c) Fear of over capitalization:While making capitalization by retained earnings, the company may be over capitalized. The over capitalized cannot use capital efficiently. The management is encouraged to misuse the fund. There is possibility to waste of fund from it.
d) Uncertain sources:Sometimes, firms may have no retained earnings due to some expenses, loses and other activities. Economic of the country also hamper retained earnings, and it is uncertain.
6. Capital Structure
Concept of Capital structure:
The capital structure is an important concept of the theory of finance. Capital structures refers to the mix of long term sources of fund such as debentures, long term debt, preference share capital and common stock or equity share capital share capital including reserves and surplus. In other words. Capital structure is the combination of debt and equity securities that comprise a firm's financing of its assets. The optimal capital structure in general is that mix of sources of long–term fund that maximizes that value of share and minimizes the overall cost o capital. Capital structure includes only long–term source of fund, it does not include the short–term funds or current liabilities.
Factor Affecting Capital Structure:
The following factors should be considered by firm when they making capital structure decision. They are described below:–
a) Management attitudes:Management can exercise its own judgment about the capital structure. Some management tends to be more conservation than others, and thus less debt than the average firm in their industry, whereas aggressive management uses more debt in the quest for higher profits.
b) Size of a firm: There is a positive relation between the capital structure and size of a firm. The large firms are more diversified, have easy access to the capital market receive high credit ratings for debt issues and pay lower interest rate on debt capita. Largest firms tend to use more debt capital than smaller firms.
c) Economic policies of the government: The capital structure depends also on the economic policies, particularly tax policy of government. The government affects the finance of a firm by regulation and taxation income. Generally, the interest on debt is given facility of deducting from taxable Income. It makes debt financing more attractive than stocks. So, such things should be taken into account while preparing capital structure decision.
d) Business risk: Without using debt also there is business risk. In future the business risk may arise due to the cost of operating activities of a firm. If there is more business risk than it is good to take less debt or if there is less business risk than it is good to take debt capital as a sources. In this way, business risk also affects the capital structure decision.
e) Control on corporation:The shareholders wish that they should not lose control on control on corporation. Hence, not to lose the control, they try to raise capital from debt instead of equity. The capital structure also depends on the age, experience self-confidence etc. of the management.
f) Other factors
· Sales stability
· Assets Structure
· Growth rate
· Nature of Investors
· Condition of the firm, etc.
7. Computation of Book value of Equity
Concept of Book Value:
The shareholders' equity is the sum of paid u[p capital, additional paid in capital and retained earnings. The total shareholder's equity is also called Net worth.
The book value per share of common stock is the shareholders' equity share divided by the number of share outstanding.
Calculation of shareholders' Equity Account.
Particulars
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Rs.
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Common stocks
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×××
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Additional Paid in capital (Share Premium)
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×××
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Retained Earning
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×××
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Total
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×××
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Less: Treasury stock (if any)
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×××
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Shareholders' equity or Net worth
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×××
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Alternatively,
Net Worth = Common stock + Share premium + Retained Earning - Treasury stock
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