PR Academy

FINANCIAL MANAGEMENT (FM)

Chapter 2: Types of Financing Weightage of Marks 6 - 8%

Financial Needs and Sources of Financing:

As seen in the last chapter, Finance plays an important role in every organisation, in
order meet its varied requirements. It can be classified into three different categories.
Long Term Financing requirements: Generally, for a period of 5 – 10 years. It
includes funds required for purchasing plants, machineries, and buildings. Furthermore,
permanent working capital will be service by these finances.
Medium Term Financing: This type of financing needs range between 3 – 5 years. It is
used for financing an expansion in the business.
Short Term Financing: This type of financing aides in financing the short-term
financing (not exceeding one year) needs of an organisation, for example Working Capital
Financing.
The above rules for financing are used, however, the nature of business and the level of
operation of the organisation also play a key role in financing decisions. For instance,
some large corporates may use short term financing for acquiring a Fixed Asset because
of the large amount of revenues it generates.
Classification of Financing Sources:

Sources of Finance

Based on Maturity of
Based on Sources
Payment

Internal External
Retained Medium Term Short Term
Long Term
Earnings Preference shares,
Equity, Preference Trade Credit,
Debentures, Bonds,
shares, Accrued
Medium Term
Debentures, bonds, loans, Expenses,
Debt or Borrowed Deferred income,
Capital Loans from Fin Public Depostis, Short term loans,
Share Capital corps and Banks, Leasing, ECBs, FD less than 1
1. Debentures VCs, Asset Euro Isssues,
1. Equity year Advances
2. Loan From Securitisation, & Foreign Currency
2. Preference Financial Euro Issue. bonds
Institutions
3. Others

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Long Term Sources of Financing:

Owner’s or Share Capital
Permanent – Owners of the company – Undertakes high risk – Receives dividend – Have
residual claim – Higher cost – Security to other capital providers.
Advantages:
Permanent Source – Increase the company’s capital base – Dividends can be suspended
– Can increase the share capital
Disadvantages:
Higher Costs – Riskier for Investors – Reduces earning per share – Dilution of Ownership
Preference Share Capital:
Have priority rights before Ordinary share capital providers towards payment of
dividend and capital repayment.
 Cumulative – Unpaid dividends gets accumulated
 Higher rate of return than debt providers
 Redeemable – must repaid after a specified period
 Hybrid - characteristics of both Debt and Equity
 Convertible Preference shares
 Can be redeemed before the specified date
Advantages:
No dilution of EPS – Fixed charge – No voting rights – No participation in excess profits
Disadvantages:
Preference dividend is not tax deductible – Dividend is cumulative in nature
Retained Earnings:
Accumulated Profits – Belongs to ordinary shareholders – No dilution of ownership
Debentures:
Loans raised by a public company from public.
Characteristics:
➢ Denominated in Rs.100s and Rs.1000s
➢ Issued based on Debenture Trust Deed
➢ Secured or unsecured
➢ Listed or unlisted
➢ Low cost of capital – Tax Benefit
➢ Obligatory to pay interest
➢ Long term capital – 3 – 10 years of maturity

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Types of Debentures
▪ Non-convertible debenture
▪ Fully convertible debenture
▪ Partly convertible debenture
Advantages:
Lower cost – No dilution of control – Fixed monetary outflow
Disadvantages:
Obligatory payment – Restrictive covenants – Large cash outflow during redemption
Public issue of debentures requires Credit Rating done by Rating Agencies
Bond: Fixed income security for raising funds, through public or private placements.
Types: Callable Bonds: Can be redeemed before maturity.
Puttable Bonds: Provides with right to sell the bond before maturity.
Various Bonds in Use:
FCCB: Low interest – Must have money during repayment
Plain Vanilla: No discounts – No options
Convertible Floating rate Notes: Specified Coupon/interest
Drop Lock bond: Interest becomes fixed after it fall a specified rate.
Variable Rate demand obligations: Can be sold back to trustee
Yield Curve Note: Used for hedging the interest rate.
Yankee bonds: US$ Bonds issued in US – LIBOR Rates used – Issued in Tranches –
Issued by Non-US Banks and Corporations
Euro Bonds: A Euro bond is denominated in a currency other than the home currency
of the country or market in which it is issued. These bonds are often grouped together by
the currency in which they are denominated, such as euro dollar or euro yen bonds.
Issuance is usually handled by an international syndicate of financial institutions on
behalf of the borrower, one of which may underwrite the bond, therefore guaranteeing
purchase of the entire issue.
Samurai Bonds: Yen Bonds issued in Japan – Used for funding Japanese Operations.
Bulldog Bonds: GBP bonds issued in UK – Accessing UK Capital.
Indian Bonds:
Masala Bond – Denominated in INR – Issued outside India.
Municipal Bonds: Issued for developing Urban Infrastructure.

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Government / Treasury Bonds: Issued by RBI & GOI.

Loans from Financial Institutions: IFCI, SFCs, IDBI, LIC, ICICI, UTI, IRBI & NIDC.
International Financial Institution: World Bank, IFC, ADB.
Loans from Commercial Banks: Long term and WC requirements
Bridge Finance: Short period loans issued by Banks before disbursing a sanctioned
loan by a Financial Institution through hypothecating, movable assets or guarantees.
Venture Capital Financing: Financing a high-risk project by inexperienced
entrepreneurs with good prospect of succeeding.
Characteristics: Equity financing the – Providing strategic inputs and management
expertise.
Methods: Equity Financing – It does exceed more than 49%
Conditional Loan: Repayable in the form of royalty (2% - 15%) – No interest
Income Note: Has both interest and Royalty.
Participating Debenture: Different phases has different interest rates.
Debt Securitisation: Securitisation is the procedure where an issuer designs a
marketable financial instrument by merging or pooling various financial assets into one
group.
Process: In securitisation, the company holding the assets—known as the originator—
gathers the data on the assets it would like to remove from its associated balance sheets.
For example, if it were a bank, it might be doing this with a variety of mortgages and
personal loans it doesn't want to service anymore. This gathered group of assets is now
considered a reference portfolio. The originator then sells the portfolio to an issuer who
will create tradable securities. Created securities represent a stake in the assets in the
portfolio. Investors will buy the created securities for a specified rate of return.
Leasing: A lease is a contract outlining the terms under which one party agrees to rent
property owned by another party. It guarantees the lessee, also known as the tenant, use
of an asset and guarantees the lessor, the property owner or landlord, regular payments
for a specified period in exchange. Both the lessee and the lessor face consequences if they
fail to uphold the terms of the contract.
Short Term Finances: Trade Credit, Accrued Income and Deferred Expenses, Advances
from Customers, Commercial Papers, Treasury Bills, Certificates of Deposits,
Bank Advances: It can be called back by banks when required. Few of the facilities
provided by Banks are, Short term loans, OD and Clean ODs, Cash Credit, Advances
against goods, Bills Purchased or Discounted.
Financing of Export Trade by Banks:

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Pre-Shipment Credits include Clean packing credits, Packing credit against pledge of
goods, ECGC Guarantee, Forward exchange contract.
Post Shipment Credits include Purchase/Discount of Documentary Export Bills, ECGC
Guarantees, Advance against export bills sent for collection, Advance against duty
drawbacks and cash subsidies.
Other Facilities to exporters include Letter of Credit, guarantees of waiver of export
duty, Providing economic intelligence on countries and deferred payment services.
Inter corporate deposits: Short period loan from other companies.
Certificate of Deposits: Like FDs, however, without prescribe interest rates.
Public Deposits: Deposits from public used to finance WC requirements.
Other Sources of Finances:
1. Seed Capital Assistance: Designed by IDBI, The Seed Capital Assistance is
interest free but carries a service charge of one per cent per annum for the first
five years and at increasing rate thereafter. Maximum Cost Rs. 2 crores and 50%
assistance will be given.
2. Internal Cash Accruals: Using accumulated reserves or cash profits.
3. Unsecured Loans: Provided by Promoters. Unsecured loans are considered as
part of the equity for the purpose of calculating of debt equity ratio.
4. Deferred Payment Guarantee: Provided by Bank for purchase of machineries
5. Capital Incentives: Lump sum subsidy provide in quantum as % of Fixed Capital.
6. Deep Discount Bonds: Sold at discounted value, face value is paid on maturity.
7. Secured Premium Notes: Detachable warrant with right to convert into Equity.
8. Zero Interest Fully Convertible Debentures
9. Zero Coupon Bonds
10. Option Bonds
11. Inflation Bonds
International Financing:
Commercial Banks: Barclays banks, SCB, Citibank etc
Development Banks
Discounting of Trade Bills
International Capital Markets: Four main systems viz, Euro-currency market, Export
credit facilities, Bonds issues, Financial Institutions. The eurocurrency market is the
money market in which currency held in banks outside of the country where it is legal
tender is borrowed and lent by banks.
Financial Instruments:
 External commercial borrowing (ECB) is an instrument used in India to
facilitate Indian companies to raise money outside the country in foreign currency.

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The government of India permits Indian corporates to raise money via ECB for
expansion of existing capacity as well as for fresh investments.
 Euro Bonds
 Foreign bonds
 Fully Hedged bonds
 Medium Term Notes: Several lots of bonds with varied characteristics are issued.
 Floating Rate notes
 Euro Commercial Papers
 Foreign Currency Options
 Foreign Currency Futures
 Foreign Euro bonds: E.g. Yankee, Samurai and bulldog Bonds
 Euro Convertible bonds: It is a debt instrument which gives the holders of the
bond an option to convert the bonds into a pre-determined number of equity shares
of the company.
 Euro Convertible Zero Bonds: No interest paid.
 Euro bonds with Equity Warrants: Warrants are detachable
 Euro Issues by Indian Companies: Indian companies are permitted to raise
foreign currency resources through issue of ordinary equity shares through Global
Depository Receipts (GDRs)/ American Depository Receipts (ADRs) and / or issue
of Foreign Currency Convertible Bonds (FCCB) to foreign investors i.e.
institutional investors or individuals (including NRIs) residing abroad. Such
investment is treated as Foreign Direct Investment.
1. An American depositary receipt (ADR) is a negotiable certificate
issued by a U.S. depository bank representing a specified number of
shares—or as little as one share—investment in a foreign company's stock.
The ADR trades on markets in the U.S. as any stock would trade.
2. A Global depositary receipt (GDR) is very similar to an American
depositary receipt (ADR). It is a type of bank certificate that represents
shares in a foreign company, such that a foreign branch of an international
bank then holds the shares. The shares themselves trade as domestic
shares, but, globally, various bank branches offer the shares for sale.
3. An Indian Depository Receipt (IDR) is an instrument denominated in
Indian Rupees in the form of a depository receipt created by a Domestic
Depository (custodian of securities registered with the Securities and
Exchange Board of India) against the underlying equity of issuing company
to enable foreign companies to raise funds from the Indian securities
Markets.
Question of Importance:
1. Debt Securitisation
2. Depository Receipts

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Madesh Kuppuswamy MSc (Edin)