FINANCIAL MANAGEMENT

MODULE 4: SOURCES OF
FINANCING

FACULTY: DR. SHALNI H S

ACHARYA BANGALORE B-SCHOOL
Contents
• Shares, Debentures, Term loans, Lease financing, Hybrid financing,
Venture Capital, Angel investing and private equity, Warrants and
convertibles (Theory Only).
• Cost of Capital: Basic concepts. Cost of debenture capital, cost of
preferential capital, cost of term loans, cost of equity capital
(Dividend discounting and CAPM model) - Cost of retained earnings -
Determination of Weighted average cost of capital (WACC) and
Marginal cost of capital (Theory & Problems).
SOURCES OF LONG TERM
FINANCE
Need for long term Finance
• Long term vs. short term(working capital) funds requirements
• For modernization, expansion, diversification huge quantities of
funds are required, for long term, irreversible decision
• Asset-liability mismatch, interest rate risk, liquidity risk will arise
if long term requirements are met by short term funds
Equity Capital
• Authorized, Issued, Subscribed and Paid up capital
• Par/face value, Issue Price, Book value and Market Value
• Rights of equity shareholders
-Right to Income :PAT less preferred dividends
-Right to Control: voting rights
-Pre-emptive Right: for additional issues, rights issue in the same
proportion
-Right in liquidation: residual claim over assets
Pros and cons of equity Capital
Advantages Disadvantages
• Dilution of control of existing
• No fixed maturity, no owners
obligation to redeem • High Cost: rate of return expected
• No compulsion to pay dividends by equity holders higher than
debtholders
• Provides leverage capacity • Dividends are not tax deductible:
• Dividends tax exempt for hence cost is higher
investors • Issue costs higher: underwriting,
brokerage, other issue expenses
• Higher servicing costs: hold AGMs,
post annual reports etc.
 Internal Accruals
Consists of retained earnings and depreciation charges

Pros Cons
• Readily available, no talking to • Quantum very limited
outsiders • High Opportunity costs: dividends
• Effectively additional equity capital, forgone by equity holders
however no issue costs of loss due to • Requires careful attention to NPV of
under pricing projects
• No dilution of control
• No expansion in equity base, hence no
dilution of EPS, BV per share etc.
Source of long term capital
Source Notions used

Equity Ke

Preference Kp

Debenture Kd

Term loan/ Secured loan KTL

Retained earnings Kѐ
Cost of equity
• Equity finance can be obtained in two ways:
1. Retention of earnings
2. Issue of additional equity
Dividend growth model approach

OR
Calculation of growth rate
g = br
Where b = Retention rate
r = return on equity/investment
Problem 1
• Calculate the annual growth rate in dividends:

Year Div
1 3
2 3.5
3 4
4 4.25
5 4.75
Answer 1
Year Div Rupee change % growth
1 3 - -
2 3.5 0.5 16.7
3 4 0.5 14.3
4 4.25 0.25 6.26
5 4.75 0.5 11.76
Answer 1
• 12.26%
Floatation costs
• Also called issue expenses
• Calculated per share basis
• It includes all expenses such as issuing prospectus,
underwriting commission, listing fees etc.
Problem 2
• Gama Ltd. Raises Rs. 100 lakhs through issue of external equity
and Rs. 100 lakhs through retained earnings. The face value is Rs.
100, the expected return on equity is 18% and the dividends are
expected to grow at a rate of 5% p.a. a) Estimate the cost of
external equity if the flotation costs are 5% on issue. b) Estimate
the cost of the retained earnings
Answer 2
• 23.95%
EPS based approach
Problem 3
• A company has raised Rs. 10,00,000 through issue of equity shares.
The shares of Rs. 10 were issued at a premium of Rs. 90. The
company earned PAT of Rs. 80,000. The current MPS is Rs. 125.
Find out the cost of equity.
Answer 3
• 6.4%
CAPM approach
• It is a market based approach wherein an equity
investment is linked to market return and risk free
rate
• An investment should earn above the risk free rate
Problem 4
• If the risk free rate in the market is 7% and return on market is
11%. The beta of the stock is 0.8. Find out the return on X stock.
Answer 4
• 10.2%
Cost of retained earnings

• Where Ea = Dividend issued to the shareholders,

TR = Tax rate, P = Market price of the share
Problem 5
• The market price of a share is Rs. 255. A company anticipated
earnings of Rs. 3,00,000 to be distributed among 30,000
shareholders. The tax rate is 30%. Find out the cost of internally
generated retained earnings?
Answer 5
• 3.33%
Calculation of cost or equity for two
stage growth model

• Where gs = super normal growth rate

Ke = Cost of equity
gn = Normal growth rate
Div = Dividends
Problem 6
• The X company share is selling at Rs. 134. Current
dividends are Rs. 3.5 per share. It is expected to grow
at 15% over next 6 years, and then at a rate of 8%
forever. Calculate the cost of equity.
Answer 6
• 12%
Problem 7
• ABC company declared a dividend of Rs. 4 per share and is
expected to grow at a rate of 12% p.a. for next 5 years and
then at a rate of 6% forever. If the price of the stock is
Rs. 137.09/-, calculate the cost of equity?
Answer 7
• 10%
Preference Capital
• Is a hybrid form of financing, payment after debt but before equity
• Equity features:
-out of distributable profits
-not an obligatory payment
-dividends not tax deductible
• Debt features:
-dividend rate is fixed
-capital is redeemable
-normally no right to vote
• Can have other features like cumulative, convertible, participating…..
 Preference Capital
Pros Cons
• No obligation to pay dividend, no • Expensive source since dividends are not tax
bankruptcy or legal action for non payment deductible
• Financial distress of redemption obligation • Though no legal consequences, liability to
not very high pay dividends stands, can spoil company’s
• Part of net worth, hence increases its image
creditworthiness/ leverage capacity • Can acquire voting rights in some cases
• No dilution of control • Have claim prior to equity holders
• No pledging of assets required
Cost of Irredeemable Preference
Share
Redeemable Preference Share
 Term Loans
• Provided by FIs/banks
• Can be in domestic/foreign currency, liability on FC loans translated to rupees
for payment
• Are typically secured against fixed assets/ hypothecation of movable
properties, prime security/ collateral security
• Definite obligations on interest and principal repayment; interest paid
periodically; based on credit risk and pegged to a floor rate
• Carry restrictive covenants for future financial and operational decisions of the
company, its management, future fund raising, projects, periodic reports called
for.
 Term Loans
Pros Cons
• Interest on debt is tax deductible • Entails fixed obligation for interest and
principal, non payment can even lead to
• Does not result in dilution of control
bankruptcy/ legal action
• Do not partake in value created by the firm
• Debt contracts impose restrictions on firm’s
• Issue costs of debt is lower financial and operational flexibility
• Interest cost is normally fixed, protection • Increases financial leverage, excess raises
against high unexpected inflation cost of equity to the firm
• Has a disciplining effect on management • If inflation rate dips, cost of debt higher
than expected
 Debentures
• Like promissory notes, are instruments for raising Long Term debt
• More flexible compared to term loans as they offer variety of choices as regards maturity,
interest rate, security, repayment and other special features
• Interest rate can be fixed/floating/deep discount
• Convertibility : Can be FCDs, NCDs, PCDs
• Warrants : Can have warrants attached, detachable or non detachable, detachable traded
separately
• Option : Can be with call or put option
• Redemption: Bullet payment or redeemed in installments
• Security: Secured or unsecured
• Credit rating: Need to have a credit rating by a credit rating agency
• Trustee: Need to appoint a trustee to ensure fulfillment of contractual obligations by company
• DRR: Company needs to create a DRR if maturity more than 18 months
 Cost of Debt Issued at Par
• The before-tax cost of debt (kd) is the rate of return required by
lenders. It is easy to compute before-tax cost of debt issued and to
be redeemed at par; it is simply equal to the contractual (or coupon)
rate of interest
 Other forms of Finance
• Leasing: asset leased out in lieu of lease rentals, title not transferred, only economic
use of assets given; can be financial lease or operating (service) lease
• Hire Purchase: ownership transferred to the buyer after all the installments paid up
• Securitization: assets involving financial claims pooled and financial instruments
created, thus creating cash out of receivables
• Government Subsidies: central and state govts offer cash subsidies to units in
backward areas, classified in three categories
• Sales tax deferments and exemptions: payment deferred for a fixed period, like
interest free loan; or exemptions given for certain number of years
• Suppliers credit: available from suppliers of machinery, other fixed assets, terms
devised to defer payment, or pay in installments over a period of time
 Leasing vs. Hire Purchase
Leasing Hire-Purchase
• Ownership not transferred to lessee • Ownership transferred to hirer on payment of all
installments
• Depreciation benefit to lessor
• Depreciation shield available to hirer
• Maybe for smaller value capital goods
• Magnitude of funds high, for big ticket items
• Some down payment reqd
• No margin money/down payment required
• Maintenance of asset by lessor in operating lease
• Maintenance cost borne by hirer
• Tax benefits of depreciation taken by lessor; lessee gets
tax shield on lease rentals
• Considered off balance sheet mode of financing, as no • Hirer allowed depreciation claim and finance charge for
asset or liability figures in balance sheet taxation; seller may claim interest on amount borrowed
to acquire asset
• Asset figures in balance sheet on complete of purchase
 Initial Public Offer
Pros Cons
• Access to larger amount of funds
• Pricing may have to be attractive to
• Further growth limited companies not using this lure investors
route
• Listing: provides exit route to promoters; ensures • Loss of flexibility
marketability of existing shares
• Higher accountability
• Encash on value created in the firm
• Recognition in market
• More disclosure requirements to be
met
• Stock prices provide useful indicators to
management • Visibility in market
• Sometimes stipulated by private investors in the
company
• Cost of making a public issue quite
high
Steps in an IPO
• Approval of BOD
• Shareholders’ approval
• Appointment of lead manager(s)
• Due diligence by LM
• Appointment of intermediaries like registrars, printers, bankers, advertisers
• Prepare draft prospectus
• Filing with SEBI
• Listing applications filed alongwith draft prospectus
• Agreement with registrars and depositories
• Appoint underwriters (if reqd.)
• Make changes in draft prospectus as per SEBI observations, SE suggestions
Contd…
• File prospectus with Registrar Of Companies
• Issue marketing exercise commences
• Application forms dispatched
• Issue opened
• Basis of allotment finalized
• Allotments made, refunds posted, shares listed on SEs
Other aspects of a public issue
• Eligibility criteria defined: net worth, track record of profitability, issue in
same year; secondary issues have no such restrictions
• Book Building process: process of tendering quantities at prices within a band
• Issue expenses: underwriting, brokerage commissions, fees to managers to the
issue, registrars, printers, advertisers, listing fees, stamp duty
• Issue pricing: free pricing, disclose basis for issue price
• Public issue of debt: appointment of debenture trustee, creation of DRR,
credit rating reqd., security to be created
Rights Issue
• Issue of capital to existing shareholders
• Offer made on a pro rata basis
• Offer document called Letter of Offer
• Option given to apply for additional shares
• Rights renunciation: are tradeable, may be sold off in the market
• Value of a share after rights:
(NP0+S)/(N+1); N=no. of existing shares required for rights; P0 =cum rights MP per share;
S= subscription price of rights issue
• Value of a right= (P0 –S)/(N+1)
• Comparison with Public issue: with familiar investors, hence likely to be more successful;
less floatation costs since no underwriting; but lower pricing to benefit shareholders
Private Placement
• Sale of securities directly to wholesale investors like FIs, banks, MFs, FIIs,PE funds etc.
• Called private placement in equity/equity related instruments, in unlisted companies and in all
cases of debt
• Called preferential allotment in case of unlisted companies for equity/equity related
instruments
• Different from reservations made for such QIBs out of a public issue
• Subject to SEBI regulations on pricing, lock in period, open offer to be made to public
• QIB placement guidelines recently issued by SEBI for compliance and disclosures
Private Placement
Pros Cons
• Less expensive mode • Does not qualify for listing in an unlisted
company
• Lesser SEBI and other regulations
• Easier to market the issue to a few investors • Restrictive covenants may be imposed by the
investors
• Entry of wholesale financially sophisticated
investors in company’s profile • May call for management participation
• Issue pricing more tight
• May use this route until IPO decision taken
• Less administrative maintenance
Venture Capital/Private Equity
• Equity finance to potentially high growth companies
• Reasonably long to medium term commitment
• Hands on management approach, active participation in management
• Considered value add investor
• VC: primarily high risk high return investment esp. in technology oriented/ knowledge intensive businesses
with long development cycles, greenfield ventures
• Can be in unlisted or listed (PIPES) Companies
• Exit route to be defined at the time of investment
• Restrictive clauses on promoters’ holding sell off and other financial/operational issues
• Detailed memorandum/business plan on company, its financials to be prepared
• Shareholders agreement to be signed by both parties
• Valuation of Company key issue
• Leads to dilution of control by existing promoters
 Obtaining a Term Loan

• Submission of loan application: a project report containing complete details of the project given
to the FI/Bank
• Initial processing of loan application: prepare flash report to decide if project worth an
appraisal or not
• Project Appraisal: Detailed appraisal done to decide if project taken or not, in terms of market,
technical, financial, managerial appraisal
• Issue of Letter of Sanction: to the borrower containing amount sanctioned and terms and
conditions thereto
• Acceptance of terms and conditions by the borrowing unit: thru a board meeting and conveyed
to the FI/Bank
• Execution of loan agreement: signed by both parties
• Disbursement of loan: in tranches based on progress of the project, tie up of means of finance
• Creation of security: formalities to be completed within a timeframe
• Monitoring: at implementation and operational stage thru periodic progress reports, site visits
etc.
 Hybrid Financing
• Hybrid Financing can be defined as a combined face of equity and
debt. This means that the characteristics of both equity and bond
can be found in Hybrid Financing.
• There are several forms of Hybrid Financing like preference capital,
convertible debentures, warrants, innovative hybrids and so on.
 Purpose of Hybrid Financing

• The concept of Hybrid Financing has been developed to enjoy the

positive factors of both the equities and debt instruments.
• The residual claim is related to the equities. If someone is holding shares
of a particular company then it is obvious that the person would enjoy
some special rights regarding the cash flow and the assets.
• At the same time, the shareholder of the company is also entitled to
play an important role while making business decisions.
• Debt instruments are totally different from equities. These instruments
are used by the major companies to arrange a kind of loan for the
development of the company.
 Contd…
• The debt instruments do not provide the right to take part in the
management of the particular company.
• But at the same time, the debt instruments confirm a permanent claim
on the assets of the company.
• Now these two are totally different and the purpose of Hybrid
Financing is to combine the qualities of both these investment
instruments and to develop something better for the investors.
Types of Hybrid Financing
• Preference Capital
• This capital is always preferred at the time of distribution of the
dividends. Again, preference capital is paid first when the company
is winding up its activities. The equity capital always comes next.
 Types of Hybrid Financing
• Warrant:
• Warrant is a kind of hybrid financing and it is very close to security
options. Any person who is holding a warrant is guaranteed to be
provided with specific number underlying instruments and the prices
for that instruments are fixed previously.
• This means that if the value of the particular instrument is going up
the investor can make good amount of profit and if the market is not
favorable, the warrant-holder is not bound to use the warrant.
• Like securities market, here also both the call and put warrants are
available.
Convertible Debenture
• Convertible debentures are those that can be transformed into the
shares of the same company. These debentures are also known as
convertible bonds. The ratio of conversion from bond to share is
fixed by the company and the bonds are usually converted to
common stocks.
End of module 4