External Sources of Finance

  • Post last modified:21 April 2021
  • Reading time:17 mins read
  • Post category:Corporate Finance
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External Sources of Finance

  1. Equity Shares
  2. Preference Shares
  3. Debentures and Bonds
  4. Venture capital
  5. Term Loans
  6. Lease financing

Equity Shares

Every company has a statutory right to issue shares to raise funds. Also known as ordinary shares are issued to the owners of a company. Ordinary share have a nominal or face value.

Dividend on these shares is paid after the fixed rate of dividend has been paid on preference shares, if any amount is left. The rate of dividend on equity shares is not fixed and depends upon the profits available and the intention of the board to distribute dividend among shareholders.

In case of winding up of the company, equity capital can be paid back only after every other claim including the claim of preference shareholders has been settled. The most outstanding feature of equity capital is that its holders control the affairs of the company and have an unlimited interest in the company’s profits and assets.

Equity shareholders enjoy voting right on all matters relating to the business of the company and are considered real owners of the business.

Advantages of equity shares financing

  • Permanent Capital: Equity shares are a good source of long-term finance. A company is not required to pay-back the equity capital during its lifetime and therefore, it is a permanent source of capital for the business.

  • No Fixed Burden: Equity shares are also called residual equity and it is not mandatory to give dividends to the equity shareholders. Because the dividend on these shares is subject to the availability of profits and the intention of the board of directors. They may not get the dividend even when a company has profits. Thus they provide a cushion of safety against unfavorable development.

  • Voting rights: Every equity shareholders has the right to vote on every resolution placed before the general body of shareholders. Voting rights of each shareholder is in proportion to his or her share of the paid-up capital of the firm.

  • Claim on income and on asset: The shareholders have a residual claim on the income and assets of the firm.

  • Credit worthiness: Issuance of equity share capital creates no change on the assets of the company. A company can raise further finance on the security of its fixed assets.

Preference Shares

Preference shares as those shares which carry preferential rights as the payment of dividend at a fixed rate and as to repayment of capital in case of winding up of the company.

Thus, both the preferential rights viz.

  • Preference in payment of dividend and
  • Preference in repayment of capital in case of winding up of the company must attach to preference shares.

The rate of dividend on these shares is fixed and the dividend on these shares must be paid before any dividend is paid to ordinary shares

Types of Preference shares

  • Cumulative and Non-cumulative Preference shares: Cumulative preference shares enjoy the right to receive the dividend in arrears for the years in which company earned no profits or insufficient profits, in the year in which company earns profits.

    In other words, dividend on these shares will go on accumulating until it is paid in full with arrears before any dividend is paid on equity shareholders.

    In case of non-cumulative preference shares dividend does not accumulate and therefore, no arrears of dividend will be paid in the year of profits. If the company does not have any profits in a year, no dividend will be paid to non-cumulative preference shareholders.

  • Redeemable and Irredeemable Preference Shares: Redeemable preference shares can be redeemed on or after a period fixed for redemption under the terms of issue or after giving a proper notice of redemption to preference shareholders. The companies Act, however, impose certain restrictions for the redemption of preference shares. Irredeemable preference shares are those shares which cannot be redeemed during the life-time of the company.

  • Convertible and Non-convertible preference shares: Where the preference shareholders are given a right to convert their holding into ordinary shares, within a specified period of time, such shares as known as convertible preference shares. The holders of non-convertible preference shares have no such right of conversion.

  • Participating and Non-participating Preference Shares: The holders of participating preference shares have a right to participate in the surplus profits of the company remained after paying dividend to the ordinary shareholders and preference shareholders at a fixed rate. The preference shares which do not have such right to participate in surplus profits are known as non-participating preference shares.

Advantages of Preference shares financing

  • Lower cost: The dividend payable on preference shares is fixed that is usually lower than that payable on equity shares. Thus they help the company in maximizing the profits available for dividend to equity shareholders.

  • No dilution of control: Preference shareholders have no voting right on matters not directly affecting their right hence promoters or management can retain control over the affairs of the company.

  • Flexibility in Capital Structure: The Company can maintain flexibility in its capital structure by issuing redeemable preference shares as they can be redeemed under terms of issue.

Debentures and Bonds

Debentures and Bonds are a fixed-interest, fixed term investment. They are offered by finance and industrial companies which are referred to as issuers.

They usually offer a higher return than is available from other fixed interest investments. Returns are based on a combination of official interest rates and loan rates depending on the issuer’s lending practices. They are not risk-free investments.

Types of Debentures

  • Registered Debentures: These are the debentures that are registered with the company. The amount of such debentures is payable only to those debenture holders whose name appears in the register of the company.

  • Bearer Debentures: These are the debentures that are not recorded in a register of the company. Such debentures are transferable merely by delivery. Holder of bearer debentures is entitled to get the interest.

  • Secured or Mortgage Debentures: These are the debentures that are secured by a charge on the assets of the company. These are also called mortgage debentures. The holders of secured debentures have the right to recover their principal amount with the unpaid amount of interest on such debentures out of the assets mortgaged by the company.

  • Unsecured Debentures: Debentures which do not carry any security with regard to the principal amount or unpaid interest are unsecured debentures. These are also called simple debentures.

  • Redeemable Debentures: These are the debentures which are issued for a fixed period. The principal amount of such debentures is paid off to the holders on the expiry of such period. These debentures can be redeemed by annual drawings or by purchasing from the open market.

  • Non-redeemable Debentures: These are the debentures which are not redeemed in the lifetime of the company. Such debentures are paid back only when the company goes to liquidation.

  • Convertible Debentures: These are the debentures that can be converted into shares of the company on the expiry of the pre-decided period. The terms and conditions of conversion are generally announced at the time of issue of debentures.

  • Non-convertible Debentures: The holders of such debentures cannot convert their debentures into the shares of the company.

Advantages Debenture Financing

  • Benefit of Tax: Issuing of debentures would attract interest expense for the company. As per normal tax laws, interest is a tax-deductible expense. On the contrary, the dividends paid to equity shareholders are not tax-free. They are paid out of divisible profits i.e. profits remaining after all the expenses and taxes well known as profit after tax (PAT).

  • Cheaper Source of Finance: As discussed above, the interest cost incurred on debentures enjoys a tax shield which indirectly makes the cost of debenture low as compared to preference and equity shares. For example, effective cost of a 12% debenture with current tax rate of 30% is 8.4% {12% * (1-30%)}.

  • Dilution of Ownership Control: Debentures don’t have any effect on the control of the existing shareholders of the company. If the same fund is raised using equity finance, the control of existing shareholders would dilute accordingly.

  • No Dilution in Share of Profits: Opting for debentures over the equity as a source of finance saves the profit shares of existing shareholders. Debenture holders do not share profits of the company except that they are liable to receive the agreed amount of interest only.

Venture capital

The term ‘venture capital’ represents financial investment in a highly risky project with the objective of earning a high rate of return. Venture capital (VC) is financial capital provided to early-stage, high-potential, high risk, growth start-up companies.

The venture capital fund makes money by owning equity in the companies it invests in, which usually have a novel technology or business model in high technology industries, such as biotechnology, IT and software. While the concept of venture capital is very old the recent liberalisation policy of the government appears to have given a fillip to the venture capital movement in India.

In real sense, venture capital financing is one of the most recent entrants in the Indian capital market. Venture capital companies provide the necessary risk capital to the entrepreneurs so as to meet the promoters’ contribution as required by the financial institutions. In addition to providing capital, these VCFs (venture capital firms) take an active interest in guiding the assisted firms.

Features of Venture capital

  • High Degrees of Risk: Venture capital represents financial investment in a highly risky project with the objective of earning a high rate of return.

  • Equity Participation: Venture capital financing is invariably, an actual or potential equity participation wherein the objective of venture capitalist is to make capital gain by selling the shares once the firm becomes profitable.

  • Long Term Investment: Venture capital financing is a long term investment. It generally takes a long period to recover the investment in securities made by the venture capitalists.

  • Participation in Management: In addition to providing capital, venture capital funds take an active interest in the management of the assisted firms.

    Thus, the approach of venture capital firms is different from that of a traditional lender or banker. It is also different from that of an ordinary stock market investor who merely trades in the shares of a company without participating in their management.

    It has been rightly said, “venture capital combines the qualities of banker, stock market investor and entrepreneur in one”.

Term Loans

Term loans are provided to the industrial sector by commercial banks, development financial institutions, state level financial institutions and investment institutions.

Terms loans are secured or unsecured loans obtained by the company. The company has to pay interest on these term loans. The shareholders do not lose ownership control of the company by obtaining term loans.

Term loans represent long- term debt with a maturity of more than one year. Term loan is one of the most common methods of financing by companies in India.

Feature of Term Loans

  • Term Loan is normally extended for acquisition of Land, Building and machinery, purchase of vehicles etc. and also along with working capital finance as composite loans.

  • Term Loan is given both for industrial and non-industrial borrowers i.e. both for projects/activities involved in manufacture/processing/repairing and business/trading activities etc. The project needs to establish technical feasibility and economic viability.

  • Term loan is extended in different forms such as all rupee loans, foreign currency loans and Deferred Payment Guarantees (DPG) / acceptance facilities (other than foreign currency loans obtained from the foreign banks or branches of Indian Banks abroad without the back-up of DPGs issued by Banks in India).

  • Repayment schedule for term loans would be stipulated based upon Debt Service Coverage Ratio, cash generation and repayment capacity. Repayment would be by way of periodic installments with an appropriate repayment holidays during the implementation of the project.

  • Rate of interest on term loans depend upon various factors like nature of the project, quantum of loan, risk rating, repayment period and structure of the debt. • Securities for term loans per se would be as per general lending norms of the banks and also depends on the risk perception of the individual account.

Lease financing

Lease financing is important method for companies who don’t have access to capital market. A lease is a contract granting use or occupation of property during a specified period in exchange for a specified rent. A lease is a method of obtaining the use of assets for the business without using debt or equity financing.

It is a legal agreement between two parties that specifies the terms and conditions for the rental use of a tangible resource such as a building and equipment. Lease payments are often due annually. The agreement is usually between the company and leasing or Financing organization and not directly between the company and the organization providing the assets. When the lease ends, the asset is returned to the owner, the lease is renewed, or the asset is purchased.

A lease may have an advantage because it does not tie up funds from purchasing an asset. It is often compared to purchasing an asset with debt financing where the debt repayment is spread over a period of years. However, lease payments often come at the beginning of the year where debt payments come at the end of the year.

So, the business may have more time to generate funds for debt payments, although a down payment is usually required at the beginning of the loan period. The variables of a lease contract are lessor, lessee and lease rental. The lessor is actual owner of the asset who permits the use of the asset to the other party called lessee.

The lessee acquires the right to use the asset on agreed terms on payment of the periodic amount. The lease rental is the periodic amount paid to the lessor by the lessee for using the asset.

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