FINANCIAL MANAGEMENT

Unit II: Sources of finance and Capitalization 9 Hrs

Ownership securities – Equity shares , Preference shares,
Deferred shares, No par stock/shares, Shares with differential
rights, Sweat Equity Creditorship securities – Debentures – Zero
coupon bonds, Zero interest bonds, Callable bonds, Deep
discount bonds Internal financing or ploughing back of profit –
factors affecting ploughing back of profits – merits and demerits
Loan financing – short term and long term sources. Startup
finance-Bootstrapping, Series Funding.
 OWNERSHIP SECURITIES
• Ownership securities mean that the investor is a part-owner of the
company. Equity shares are generally a part of ownership securities
meaning that the investor who owns equity shares is a part-owner of the
company and has a right to vote.
• Equity shares
• Preference shares
• Deferred shares
• No par stock/shares
• Shares with differential rights
• Sweat equity
 Equity shares
Equity shares are long-term financing sources for any company. These shares
are issued to the general public and are non-redeemable in nature. Investors in
such shares hold the right to vote, share profits and claim assets of a company.

Features:
• Equity share capital remains with the company. It is redeemed at the
time of liquidation.
• Equity Shareholders possess voting rights and participate in the
company's management.
• The dividend rate on the equity capital depends on the total earnings
of the firm.
 Types of equity shares
• Authorized Share Capital- This amount is the highest amount an organization can
issue. This amount can be changed time as per the companies recommendation and
with the help of few formalities.
• Issued Share Capital- This is the approved capital which an organization gives to
the investors.
• Subscribed Share Capital- This is a portion of the issued capital which an investor
accepts and agrees upon.
• Paid Up Capital- This is a section of the subscribed capital, that the investors give.
Paid-up capital is the money that an organization really invests in the company’s
operation.
• Right Share- These are those type of share that an organization issue to their
existing stockholders. This type of share is issued by the company to preserve the
proprietary rights of old investors.
• Bonus Share- When a business split the stock to its stockholders in the dividend
form, we call it a bonus share.
• Sweat Equity Share- This type of share is allocated only to the outstanding
workers or executives of an organization for their excellent work on providing
intellectual property rights to an organization.
 PREFERENCE SHARES
Preference shares, also known as preferred stock, is an exclusive
share option which enables shareholders to receive dividends
announced by the company before the equity shareholders.

Features of preference shares:

• Preferential dividend option for shareholders.
• Preference shareholders do not have the right to vote.
• Shareholders have a right to claim the assets in case of a wind
up of the company.
• Fixed dividend payout for shareholders, irrespective of profit
earned.
• Acts as a source of hybrid financing.
 TYPES OF PREFERENCE SHARES
Types of preference share are:
• Cumulative preference share: Cumulative preference shares are a special
type of shares that entitles the shareholders to enjoy cumulative
dividend payout at times when a company is not making profits.

• Non-cumulative preference shares: These types of shares do not

accumulate dividends in the form of arrears. In the case of non-
cumulative preference shares, the dividend payout takes place from the
profits made by the company in the current year.
• Participating preference shares: These types of shares allow the
shareholders to demand a part in the surplus profit of the company at
the event of liquidation of the company after the dividends have been
paid to the other shareholders.
• Non-participating preference shares: These shares do not yield the shareholders the
additional option of earning dividends from the surplus profits earned by the company.
In this case, the shareholders receive only the fixed dividend.

• Redeemable Preference Shares: Redeemable preference shares are shares that can be
repurchased or redeemed by the issuing company at a fixed rate and date. These types of
shares help the company by providing a cushion during times of inflation.

• Non-redeemable Preference Shares: Non-redeemable preference shares are those shares that
cannot be redeemed during the entire lifetime of the company. In other words, these
shares can only be redeemed at the time of winding up of the company.

• Convertible Preference Shares: Convertible preference shares are a type of shares that
enables the shareholders to convert their preference shares into equity shares at a fixed
rate, after the expiry of a specified period as mentioned in the memorandum.

• Non-convertible Preference Shares: These type of preference shares cannot be converted

into equity shares. These shares will only get fixed dividend payout and also enjoy
preferential dividend payout during the dissolution of a company.
DEFERRED SHARES
Features of Deferred Shares
Shares with no right to dividends either for a set period or
until certain conditions are met, for example, a certain level of
profitability is achieved.

Advantages of deferred shares

Large dividend payments are regularly sent to the owners of
deferred shares, although they are paid after other
shareholders.
eligible to receive all residual earnings once all the other
obligations have been satisfied.
 No-Par Value Stock
No-par stocks are those where the value of the stocks relies
completely on the market, not at all based upon any
guaranteed value (the par value) set at the issuance of the
stocks.

Advantages of No-Par Value stock

No-par value stock is issued without a par value. The value of no-
par value stocks is determined by the price investors are
willing to pay in the open market. The advantage of no-par
value stock is that companies can then issue stock at higher
prices in future offerings.
 Shares with differential rights
Equity shares with differential rights refer to shares that
provide specific rights or privileges to certain shareholders,
which differ from the rights enjoyed by other shareholders
holding the same class of shares.

Features
• Equity shares with differential voting rights (DVRs) are the
kind of shares issued by a company that offers shareholders
varying levels of the voting power.
• Some shareholders have more voting power than others and
this can significantly impact the control and decision-making
capabilities of the company.
 Benefits of Equity Shares with Differential Rights
• Flexibility in Capital Structure: Equity shares with
differential rights provide companies with the flexibility to
raise funds without diluting the control of existing
shareholders.
• Increased Voting Rights: Equity shares with differential
rights allow companies to provide their promoters or founders
with higher voting rights, enabling them to have better control
over the company’s affairs.
• Reduced Dividend Payout: Equity shares with differential
rights with lower dividend rights can help companies conserve
cash by reducing the dividend payout to shareholders.
 Sweat equity
• Sweat equity is a type of financial instrument that represents any form of
non-monetary equity that the owners or employees of a business receive
for their contribution to the venture. (start-ups)

Importance of sweat equity shares:

• Cost-effective compensation: In its initial stages, a company may not have
sufficient capital to pay high salaries to experts. Since these experts need
compensation for their services, companies pay them by providing
company shares which may rise significantly as the company expands.
• Retention of talent: This type of equity can be an effective tool for
companies to retain talented employees or service providers. They can have
company shares which may rise in value based on their contributions. The
hope for high profits in the long term ensures lower employee turnover.
 CREDITORSHIP SECURITIES

• Debentures
• Zero-coupon bonds
• Callable bonds
• Deep discount bonds
 Debentures
• Debentures are the debt instruments which can be used by government,
companies, organization for the purpose of issuing the loan.
• Based on the reputation of the corporates, loan is issued on fixed ROI (Rate
of Interest).
• When companies need financial support they borrow the money
for expansion or anything they need for at a fixed rate of interest.
 Features of Debentures
• Debentures are usually the unsecured form of bonds which are not backed
by any asset or collateral. Instead, the investors consider the
issuer’s creditworthiness as a primary parameter for the purchase.
• They have a fixed coupon rate, at which the investors receive interest at
specific intervals, i.e., monthly, quarterly, half-yearly or yearly. Some
investors also get accumulated interest on redemption.
• The issuing company pays off the interest as an expense before paying
the dividends. The interest is thus tax-deductible, bringing down
the taxable income.
• Some companies issue debentures, which after a specified period, can be
changed into equity stocks. In addition, the issuer enjoys low-cost
borrowing since they offer a lower interest rate than non-convertibles.
• Repayments can be attained either in installments payable yearly or all
at once. Thus, if the issuer pays off annual installments to the holders, it
may do so by making a redemption reserve. Else, the issuer can repay the
borrowed sum in a lump sum on the maturity of the debt.
 Types of Debentures

• Redeemable debenture : which can be redeemed on the expiry of a

certain period.
• Irredeemable debentures : not redeemable during the life time of the
company
• Convertible debentures : issued by a company and the debenture holders
are fixed an option to exchange the debentures into equity shares after the
lapse of a specified period.
• Zero interest bonds/debentures: it is a convertible debenture which yields
no interest. The company does not pay any interest on such debentures.
But the investor in a zero interest bonds is compensated for the loss of
interest through conversion of such bond into equity shares at a
specified future date.
 Zero coupon bonds
A zero-coupon bond, also known as an accrual bond, is a debt security
that does not pay interest but instead trades at a deep discount,
rendering a profit at maturity, when the bond is redeemed for its full face
value.

Features of zero coupon bonds

• Fixed maturity: The maturity date is fixed in Zero coupon bonds. The
investor will only be fully redeemed at face value on the specified
maturity date. Due to this, the investor finds it to be a very useful tool for
long-term investing.
• Interest payments: No periodic interest payments are given to the
investors in Zero coupon bonds. As well as they are sold at a discount to
their face value and then redeemed at face value when they mature.
• Interest rate risk: The interest rates generally fluctuate as per the market
condition, and the scenario is similar for tax-free bonds as well.
• Long-term investment: Zero coupon bonds
have a fixed maturity date and are treated as
long-term investment options. Because it
works on the principle of longer maturity,
higher interest rates, and provides a great
return on investments.
 Callable bonds
• Callable or redeemable bonds are bonds that can be redeemed or paid off
by the issuer prior to the bonds' maturity date.
• When an issuer calls its bonds, it pays investors the call price (usually the
face value of the bonds) together with accrued interest to date and at that
point, stops making interest payments.
• An issuer may choose to call a bond when current interest rates drop below
the interest rate on the bond.
• That way the issuer can save money by paying off the bond and issuing
another bond at a lower interest rate.
There are three primary types of call features, including:
• Optional Redemption: allows the issuer, at its option,
to redeem the bonds. Many municipal bonds, for
example, have optional call features that issuers may
exercise after a certain number of years, often 10 years.
• Sinking Fund Redemption: requires the issuer to
regularly redeem a fixed portion or all of the bonds in
accordance with a fixed schedule.
• Extraordinary Redemption: allows the issuer to call
its bonds before maturity if certain specified events
occur, such as the project for which the bond was
issued to finance has been damaged or destroyed.
Pros and Cons of callable bonds
 Deep-discount bonds
• A deep-discount bond is a bond that sells at a significantly
lesser value than its par value. In particular, these bonds sell
at a discount of 20% or more to par and has a yield that is
significantly higher than the prevailing rates of fixed-income
securities with a similar profile.
 Advantages of deep discount bonds
• There are chances of significant capital appreciation on the
purchase of these bonds. If you hold these bonds till maturity,
you are liable to receive the face value, although you
purchased them at low prices.
• These are fairly simple modes of investment, and you do not
require any assistance from underwriters or brokers thus
saving brokerage and commission costs.
• It is ideal for long-term financial goals as the maturity period
of these bonds is more than 5 years.
• The minimum investment on these bonds is quite low;
thereby, it is open to all types of investors.
• Moreover, the liquidity of these bonds is quite high, and you
can easily trade them in secondary markets.
 Dis-advantages of deep discount
bonds
• The credit risk profile of issuers is always a matter of
concern, and there is quite a high possibility of default.

• Some bonds, like zero coupon bonds, are not fixed-income

securities. You will not have the luxury of getting recurring
income.

• Capital gains arising from these are subject to taxation. It

may negate all or some of the gains that one has made.
 Internal financing / Ploughing back of profits
It is a technique under which all profits of a company are not
distributed amongst the shareholders as dividend, but a part of
the profits is retained or re-invested in the company.

Factors influencing ploughing back of profits

• Earning capacity
• Desire and type of shareholders
• Future financial requirement
• Dividend policy
• Taxation policy
 Merits of ploughing back of profits

To the company
• Absorb the shocks of economy
• Economical method of financing
• Aids in smooth and undisturbed running of the business
• Helps on following stable dividend policy
• Flexible financial structure
• Makes the company self-dependent
To the shareholders
• Increase in the value of shares
• Safety of investments
• Enhanced earning capacity
• No dilution of control
To the society or nation
• Increases the rate of capital formation
• Stimulates industrialization
• Increases productivity
• Decreases the rate of industrial failure
• Higher standard of living.
 De-Merits of ploughing back of profits
• Over-capitalisation
• Creation of monopolies
• Depriving the freedom of the investors
• Misuse of retained earnings
• Manipulation in the value of shares
• Evasion of taxes
• Dissatisfaction among the shareholders.
 Loan financing
Long term loans
• loan capital/long-term bank loans.
• share capital/equity finance.
• Government grants and subsidies.
• venture capital.
• business angels.
Short term loans
• Bank overdrafts
• Trade credit
• Debt factoring
• Leasing
• Medium term bank loan
 CAPITALISATION
Capitalization represents permanent investment in companies excluding long-
term loans.
Capitalization can be distinguished from capital structure.
Capital structure is a broad term and it deals with qualitative aspect of finance.
While capitalization is a narrow term and it deals with the quantitative aspect.

THEORIES OF CAPITALISATION
• The cost theory of capitalisation
• The earnings theory of capitalisation
 COST THEORY OF CAPITALISATION
• Under this theory, the capitalization of a company is
determined by adding the initial actual expenses to be
incurred in setting up a business enterprise as a going concern.
• It is aggregate of the cost of fixed assets (plant, machinery,
building, furniture, goodwill, and the like), the amount of
working capital (investments, cash, inventories, receivables)
required to run the business, and the cost of promoting,
organizing and establishing the business.
Merits:
(i) This theory is easy to understand.
(ii) It is useful to ascertain the capitalisation required for a new firm. It
enables the promoters to know the amount of capital to be raised.

Limitations:
(i) The amount of capitalisation calculated under this theory is based on
cost and not on earning capacity of a firm. The capitalisation will
remain the same irrespective of the earning capacity of the firm.
(ii) Since some assets are idle or become obsolete, the earning capacity
will be severely affected. But still the capitalisation will remain high as
it is based on the cost of assets.
 The earnings theory of capitalisation
• This theory assumes that an enterprise is expected to make
profit. According to it, its true value depends upon the
company’s earnings and/or earning capacity.
• Thus, the capitalisation of the company or its value is equal to
the capitalised value of its estimated earnings.
• To find out this value, a company, while estimating its initial
capital needs has to prepare a projected profit and loss
account to complete the picture of earnings or to make a
sales forecast.
Merits:
(i) The amount of capitalisation found under this method
represents the true worth of the firm.
(ii) The amount of capitalisation arrived at on the basis of
earnings can be used as a standard for comparison.

Limitation:
• Estimation of future earnings of a new firm is not easy. If
the earnings are not estimated correctly, the amount of
capitalisation would be misleading.
 Watered stock
• Watered stock is an illegal scheme to defraud investors by offering
shares at deceptively high prices. Watered stock is issued at a higher value
than it is actually worth; it is accomplished by overstating the firm's book
value.

Causes of watered stock

• It can create an inflated sense of the company’s value, leading to over-
investment.
• It can lead to insider trading, as insiders attempt to cash in on the
artificially high stock price.
• It is a sign that the company is in trouble and that its stock price does not
reflect its true value.
Advantages of watered stock
• By selling the equities at a significantly inflated price and realizing big
gains, smart investors may profit from the market’s misunderstanding of
the stocks.
• The company’s promoters often profit from this knowledge
asymmetry.

Disadvantages of watered stock

• The unknowing owners of the watered stocks are held responsible for the
lenders’ funds during the deception’s exposure.
• Watered stock is difficult to sell once its true nature is known, and when
it is, it usually sells for a significant discount to what it initially costs.
 Over capitalisation
• Overcapitalization occurs when a company has issued more debt and equity
than its assets are worth. The market value of the company is less than the total
capitalized value of the company.

• An overcapitalized company might be paying more in interest and dividend

payments than it has the ability to sustain long-term.

• According to Bonneville, Dewey and Kelly, “When a business is unable to earn a

fair rate of return on its outstanding securities, it is over-capitalized.”

• Gerstenberg opines that “a corporation is over-capitalized when its earnings are

not large enough to yield a fair return on the amount of stocks and bonds that
have been issued.”
 Causes of Over-Capitalization
• Promotion of a Company with Inflated Assets
• Company Promoted with High Promotion Expenses
• Over-estimating Earnings at the Time of Promotion
• Company Formed or Expanded during Inflationary Period
• Defective Depreciation Policy
• Liberal Dividend Policy
 Effects of over capitalisation
• Poor Credit-Worthiness
• Reduction in the Rate of Dividend
• Loss to Shareholders
• Loss to Employees and Labourers
• Loss to Creditors
 Remedies of over capitalisation
• Reduction in Bonded Debt
• Reduction of Fixed Charges on Debt
• Redemption of High Dividend Preferred Stock
• Reducing Par Value of Shares
• Reducing Number of Shares
 Under capitalization
• Undercapitalization occurs when a company does not have
sufficient capital to conduct normal business operations.
• When its earnings are exceedingly high in relation to other
similar firms in the industry, or when it has very little capital to
conduct its business.
• when the real value of assets are more than the book value, the
company is said to be under-capitalised.
 Causes of Under capitalization
• Acquisition of Assets during Recession
• Conservative Dividend Policy
• Maintaining High Standards of Efficiency
• Creation of Secret Reserves
 Effects of Under capitalization
• Conflict between labor and management
• Consumers’ feeling of exploitation - higher profits with higher prices of the
products.
• Manipulation in the value of shares – high profits – high prices of shares on
stock exchange .
• The management of the company may build up secret reserves and pay
lower taxes to the Government.
 Remedies of Under capitalization
• Splitting Stock - The shares may be splitted into shares of
small denomination leading to decrease in amount of
dividend per share.
 Over Trading
Overtrading refers to the excessive buying and selling of stocks
by either a broker or an individual trader.

Causes of over trading

• Over-excitement: When prices move quickly, traders open
positions without conducting thorough research and analysis.
• Greed: When traders make profits, they perform more
transactions to generate more returns.
• Vengeance: Traders often engage in excessive trading to
compensate for a significant loss or a series of small losses.
• Boredom: Staring at the screen all day without buying or
selling financial instruments can be difficult for some people.
They end up placing orders for the sake of trading.
 Under Trading
Under-trading is the reverse of over-trading.
It means keeping funds idle and not using them properly due to
the under employment of assets of the business, leading to the fall
of sales and results in financial crises.

Cause of Under trading

• Lack of confidence in the market,
• Lack of financing
• Failure to recognize opportunities for growth etc.,
 Capital structure
• All equity
• Equity with Debt
• Equity with preference
• Equity with Debt & Preference
• Optimum cap structure – max market value per
share & less cost of capital
• Profitability
• Solvency
• Flexibility
• Conservation – debt capacity of a firm to pay
its fixed charges & principal sum
• Control – no loss of control on the firm
 considerations
• Return on investment (ROI)
• Tax benefit
• Perceived financial risk – high debt financing
 Determinants
• Industry leverage ratios
• Seasonal variations
• Degree of competition
• Industry life cycle
• Agency cost
• Requirements of investors
• Purpose of finance
• Legal requirements