Long- Term Sources of Finance

Learning Objectives

Understand the features of ordinary/equity shares

Evaluate ordinary shares as A long term source of finance

Focus on right sharesLearn about preference sharesStudy the features and benefits of debt

financingExplore term loan as long term source of

financing

Topics Covered

Equity Shares/Ordinary SharesPreference ShareDebentures (Bonds)Term loan

Equity Shares or Ordinary Shares

Equity mean “Equality” among shareholdersOrdinary shares represent the ownership position

in a companyShareholders are the legal owners of the companyEquity shareholders provide permanent source of

capital or “Sine Die”It is also known as variable income securityEquity shareholders have the maximum risk

“Equity shareholders are the first to contribute to the capital and the last to receive any return”

Features of Ordinary shares

Claim on incomeClaim on assetsRight to controlVoting rightPre-emptive rightLimited liabilityNegotiable

Advantages of Ordinary Shares from Company’s view point

Permanent CapitalDividend payment discretionBorrowing base

Advantages from the shareholder’s view pointHigher returnVoting rightRight to controlLimited liability

Disadvantages of Ordinary shares from company’s view point

High cost:-Dividends are not tax deductibleHigher floatation costHigher expected return

Disadvantages from the shareholder’s view point

Earning dilutionOwnership dilutionNo fixed returnHigh Risk

Preference Shares: Hybrid Security

Commonalities between Ordinary Share & Preference Share:-

Dividends are non tax deductibleNon payment of dividend does not leads to

insolvencyIrredeemable preference shares have no

fixed date of maturity

Preference Shares: Hybrid Security

Commonalities between Debenture & Preference Share :-

Rate of Dividend is fixedPriority claim on income and assets over

ordinary shareholdersNo voting rightUsually do not share residual earnings

Preference Shares: Features

Preference over equity shareholders:- In dividend payment In asset realization (during liquidation)

Preference dividend is not tax deductibleFixed rate of dividendNo voting rights (exceptions are there)Claim on income and assetsPermanent/Temporary source of capitalHybrid Security

Voting Right of Preference Shares

Preference shareholders may be entitled to contingent or conditional voting right:-

They have a right to vote only on resolutions that directly affect the rights attached to preference shares e.g. Winding up, repayment or reduction of share capital

There are arrears in dividend for two or more years in case of cumulative preference shares;

Preference dividend is due for a period of two or more consecutive preceding years; or

In the preceding six years including the immediately preceding financial year, the company has not paid the preference dividend for a period of three or more years

In all the above situations the preference shareholders can nominate a member on the board of the company.

Types of Preference Shares

Cumulative and Non-Cumulative preference share

Redeemable and Irredeemable/Perpetual preference share

Convertible and Non-Convertible preference share

Participating and Non-Participating preference share

Advantages of Preference Share from Company’s view point

Limited Voting RightLimited amount of dividendDividend PostponabilityNon payment of dividend does not result in

insolvencyLess Costly

Disadvantages of Preference Share from Company’s view point

Non Tax deductibility of dividendLimited dividend Postponability

Right Issue

A right issues involves selling securities in the primary market by issuing rights to the existing shareholder. When a company issues additional equity capital, it has to be offered in the first instance to the existing shareholders on a pro rata basis. This is required under section 81 of the companies Act, 1956.

The shareholder, however, may by a special resolution forfeit this right, partially or fully, to enable the company to issue additional capital to public.

Features of Rights

The number of rights that a shareholders gets is dependent on the number of shares held by him

The number of right acquired to subscribe to an additional share is determined by the issuing company.

The price per share for additional equity, called the subscription price, is left to the discretion of the company

Rights are negotiable. The holder of the right can sell them

Rights can be exercised only during a fixed period and at fixed price only.

Conditions w.r.t. Right Shares

Existing shareholders, who exercise their rights in full, are given an opportunity to apply for additional shares

Existing shareholder who renounce their rights, wholly or partially, are not entitled to apply for additional shares

Share which becomes available, due to non-exercise of rights by some shareholders are allotted to shareholders who have applied for additional shares in proportion to their shareholding

Any balance left after meeting requests for additional shares by the existing shareholders are disposed of at the ruling market price or the issue price, whichever is higher

Right Issue: Impact on Shareholder’s Wealth

The following data pertains to XYZ limited:-

Ordinary Shares 30,00,000Market Price of share Rs. 65/share

Additional share to be issued10,00,000

Proposed Subscription Price Rs. 40/share

Right Issue: Impact on Shareholder’s Wealth

Number of rights required (N)= Existing Share New Shares= 30,00,000 10,00,000= 3 rights

OR 3:1, that means you need to have 3 shares to buy a new share.

Value of a right

R = P0- Ps

N + 1

= 65-40 4

= Rs. 6.25/right= Rs. 6.25 x 3= Rs. 18.75/new share

Value of a share after right issues

Px = So x Po + S x Ps

So + S

Where Px = Price of share after right

So = Number of Existing Shares

S = New sharesPo = Price of share before right issues

Ps = Subscription price of a share

Price of Share after right issue

Px = So x Po + S x Ps

So + S

= (30,00,000 x 65) + (10,00,000 x 40)30,00,000+ 10,00,000

= 19,50,00,000 + 4,00,00,000 40,00,000

= Rs. 58.75/share

Px = N x R + Ps

= 3 x 6.25 + 40

= 58.75/share

Effect of Right issue on the Wealth of SH

There are three options available to the shareholders:- Exercise his right Sell his right Allow rights to expire

Option 1: Exercise Right

Before Right Issue After right Issue

300 shares @ 65/share = 19,500

400 shares @ Rs. 58.75 = 23,500

100 shares @ 40/share = 4,000

Wealth of shareholder = 23,500

Wealth of shareholder = 23,500

Option II: Sell Rights

Before Right Issue After Right Issue

300 shares @ 65 = Rs. 19,500

300 shares @ Rs. 58.75 = Rs. 17,625

100 Shares’ rights @ Rs. 18.75/share =Rs. 1875

Wealth of Shareholder = Rs. 19,500

Wealth of Shareholder = 19,500

Option III: Allows Rights to expire

Before Right Issue After right issue

300 shares @ Rs. 65 = 19,500 300 share @ Rs. 58.75 = 17,625

Wealth of shareholder = Rs. 19,500

Wealth of shareholder = Rs. 17,625