Unit-2 Sources of Finance:

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. Meaning of
capitalization – Theories of capitalization.
Equity Shares”
Issue of shares is the main source of long-term finance. Shares are issued by joint stock
companies to the public. A company divides its capital into units of a definite face value, say
of Rs. 10 each or Rs. 100 each. Each unit is called a share. A person holding shares is called a
shareholder.
Preference Shares:
Preference Shares are the shares which carry preferential rights over the equity shares. These
rights are (a) receiving dividends at a fixed rate, (b) getting back the capital in case the
company is wound-up. Investment in these shares are safe, and a preference shareholder also
gets dividend regularly.
Preference shares are securities issued by a company which typically have no voting rights. It
is similar to a fixed deposit in that it comes with a fixed tenure and a fixed dividend. Sebi said
the proposed regulations will provide a framework for public issuance of non-convertible
redeemable preference shares and also listing of privately-placed redeemable preference
shares.
Considering the risks involved in the instrument, certain requirements like minimum tenure
of the instruments (three years), minimum rating ("AA-" or equivalent) etc. have been
specified in case of public issuances. For listing of privately-placed non-convertible
redeemable preference shares, the minimum application size for each investor is fixed at 10
lakh.
Companies are allowed to issue redeemable preference shares with a maximum tenure of 20
years as per the Companies Act.

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.
The shares with Differential Voting Rights (DVRs) in a company means those shares that
give the holder of the shares the differential rights related to voting, i.e., either more voting
rights or less voting rights compared to the ordinary shareholders of the company.
The company issues DVRs in order to improve their capital structure without diluting or
losing control or management affairs of the company. This enables the promoters to retain
their control over the Company even when new investors are introduced. The issue of normal
equity shares means one share one voting right
No par value stocks:
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 on the open market. The advantage of no-
par value stock is that companies can then issue stock at higher prices in future offerings.
Sweat Equity Shares
Sweat equity shares are shares issued by a company to its employees or Directors, either at a
discount or for consideration other than cash. Sweat equity shares are often issued for
providing the know-how or creation of valuable intellectual property rights or key value
additions to the company.
Creditorship Securities:
Creditorship Securities also known as debt finance which means the finance is. mobilized
from the creditors. Debenture and Bonds are the two major parts of the Creditorship
Securities.
Debentures
A Debenture is a document issued by the company. It is a certificate issued by the company
under its seal acknowledging a debt. According to the Companies Act 1956, “debenture
includes debenture stock, bonds and any other securities of a company whether constituting a
charge of the assets of the company or not.”
Whenever a company wants to borrow a large amount of fund for a long but fixed period, it
can borrow from the general public by issuing loan certificates called Debentures.These are
offered to the public to subscribe in the same manner as is done in the case of shares. A
debenture is issued under the common seal of the company. It is a written acknowledgement
of money borrowed. It specifies the terms and conditions, such as rate of interest, time
repayment, security offered, etc.
Types of Debentures : • Debentures may be classified as: • a) Redeemable Debentures and
Irredeemable Debentures • b) Convertible Debentures and Non-convertible Debentures.
Corporate Bonds:

Corporate bonds are bonds issued by companies. Companies issue corporate bonds to raise
money for a variety of purposes, such as building a new plant, purchasing equipment, or
growing the business.

Corporate bonds are debt obligations of the issuer—the company that issued the bond. With a
bond, the company promises to return the face value of the bond, also known as principal, on
a specified maturity date. Until that date, the company usually pays you a stated rate of
interest, generally semiannually. A corporate bond does not give you an ownership interest in
the company—unlike when you purchase the company's stock.

Bonds are debt financial instruments issued by large corporations, financial institutions and
government agencies that are backed up by collateral or physical assets. Debentures are debt
financial instruments issued by private companies, but any collateral or physical assets do not
back them up.
Zero Coupon Bonds/Zero Interest Bonds:
Zero coupon bonds are bonds that do not pay interest during the life of the bonds. Instead,
investors buy zero coupon bonds at a deep discount from their face value, which is the
amount the investor will receive when the bond "matures" or comes due.
Callable Bond:
A callable bond, also known as a redeemable bond, is a bond that the issuer may redeem
before it reaches the stated maturity date. A callable bond allows the issuing company to pay
off their debt early. A business may choose to call their bond if market interest rates move
lower, which will allow them to re-borrow at a more beneficial rate. Callable bonds thus
compensate investors for that potentiality as they typically offer a more attractive interest
rate or coupon rate due to their callable nature.
Deep Discount Bond:
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
profiles.

A deep-discount bond trades at a market price that is 20% or lower than its par or face value.
These discounts may reflect underlying credit concerns with the issuer, increasing the yields
on these bonds to junk level as the risk of default increases.
Ploughing Back Of Profits:

The ‘Ploughing Back of Profits’ is a technique of financial management under which all
profits of a company are not distributed among the shareholders as dividend, but a part of the
profits is retained or reinvested in the company. This process of retaining profits year after
year and their utilization in the business is also known as ploughing back of profits.

It is actually an economical step which a company takes, in the sense, that instead of
distributing the entire earnings by way of dividend, it keeps a certain percentage of it to be re-
introduced into the business for its development. Such a phenomenon is also known as ‘Self-
Financing’; ‘Internal Financing’ or ‘Inter- Financing’.

Factors affecting ploughing back of profits:

a. Earning Capacity:

Ploughing-back of profits depends largely upon the earning capacity of the company. If a
concern does not earn sufficiently, there is no possibility of ploughing-back of profits.
Usually, greater is the earning capacity of a company, larger is the possibility of ploughing-
back of profits.
b. Desire and Type of Shareholders:

The policy of ploughing back of profits is also affected by the desire and type of its
shareholders. If shareholders largely belong to the class of retired persons, and other
economically weaker persons, they may desire maximum distribution of profits as dividend.
On the other hand, a wealthy investor may not mind if the company retains a portion of
profits for future development.

c. Future Financial Requirement:

Future financial requirements of the company also affect the policy of ploughing back of
profits. If a company has highly profitable investment opportunities for future development, it
may plough back its profits more successfully.

d. Dividend Policy:

The re-investment of profits depends to a great extent upon the dividend policy of the
company. If a company desires to plough back profits it cannot follow a policy of a very high
dividend payout.

e. Taxation Policy:

The taxation policy of the Government also affects the re-investment of profits. A high or low
rate of business taxation affects the net earnings of the company and thereby its re-investment
policy.

Merits and Demerits of Loan Financing:

Borrowing and lending have become common in businesses in recent years, and bank loans
are an essential part of this system. Various types of bank loans are available to meet
individual and business financial needs. As with any other product, there are advantages and
disadvantages of bank loans.

Merits:

Purchase without Liquidity

A major goal of a bank loan is to lend to people who do not have ready cash. A bank loan can
help an individual or a business buy something as simple as a car or a home for which he
doesn’t have a corpus, or it can help businesses buy machinery or set up big units for which it
doesn’t have money. The scope of a bank loan is vast, and the borrower can borrow as per
their capacity depending on their creditworthiness.

Driver of Growth

Bank loans are major drivers of growth, especially for public and private sector companies.
Very few companies may have enough cash flow to finance huge expansion. However, in
today’s fast-track economy, expansion is the only way to have sustainable profitability. This
is where bank loans come into the picture. Suppose Company A wants to expand its
production, for which it needs to invest in machinery. If the cost of machinery is 5 times the
company’s yearly net income, Company A does not have to wait for 5 years to expand. It can
borrow a term loan from the bank to fund its expansion plans and repay it over the next 5
years, thereby accelerating growth.

Provides Capital for Daily Operations

The banks have special loans that can help a company fund its day-to-day operational capital
and cash cycle. The working capital bank loans are major bank loans that are used for the
purpose. This allows companies to be flexible about their debtor and creditor agreement.
Suppose Company X has purchased goods worth USD 1000.00, the payment of which has to
be made in 10 days, whereas it sells these goods in USD 1200.00, which it will receive in 30
days. In such a situation, Company X can borrow USD 1000.00 from the bank for 20 days
and repay the USD 1000.00 to the bank after receiving the payment of USD 1200.00 from the
debtor. A major advantage of such a loan is that the company has to pay interest only for the
amount and the number of days for which it has borrowed.

Better Interest Rates

Before a century, the borrower would borrow money from unorganized money lenders. The
money lenders would usually exploit the borrowers by asking for exorbitant interest rates and
abnormal collateral demands. With the rise of organized banking from the beginning of the
1900s, these troubles have vanished. Organized and systematic bank loans are provided to
borrowers with minimal interest rates. Furthermore, bank loans are cheaper than other loans
from other financial institutions such as NBFCs.

Flexibility

Bank loans provide an element of flexibility to the borrower, which can be very beneficial in
the long term. The borrower can choose the duration of the loan and the amount of EMI,
whereas the amount of loan and interest rates are negotiable. For example, if an individual
takes a home loan from the bank, he can decide if he wants to repay the loan in 5, 10, or 20
years.

Accounting & Tax Advantages

The interest on bank loans is deductible from taxable income. This is an advantage to the
borrower in the form of tax savings. In addition, the borrower gets the advantage of
budgeting and planning for monthly loan expenses. This is especially true for fixed-rate
loans, although a simple model can be prepared for changes in floating-rate loans.
Ownership Remains with Borrower

With an ownership perspective, bank loans can be a great funding source for companies. If a
company decides to raise funds, it has many alternatives such as issuing equity shares, raising
private equity, including venture capital, etc. However, in all these methods, the company
may have to lose some part of the ownership share. Whereas in a bank loan, the company can
raise funds and keep the ownership.

Cash Discount

Since most creditors allow cash discounts, the benefit of which can only be derived when you
have funds available to pay. A bank limit can support a business for such opportunities.
Before making a cash payment and availing of the cash discount, business people must
analyze the pros and cons. The benefit derived from the cash discount should be more than
the cost involved in terms of interest on the funds. Only then the cash payment would be
beneficial.

Demerits of Bank Loan

Additional Burden on Cost of Goods

One of the biggest disadvantages of bank loans is that the borrower pays way more than the
product’s purchase price when he uses a loan to buy a product. Suppose an individual wants
to buy a smartphone for USD 800.00; he decides to use his own USD 300.00 and borrow the
rest of USD 500.00 by bank loan at 10% interest per annum. After one year, he repays his
loan, whereby he has to pay the principal amount of USD 500.00 + interest payment of USD
50.00 (10% of USD 500.00). Thus in total, he paid USD 850.00 for a product priced at USD
800.00. This seems a minor amount but imagine the principle going in hundreds of thousands
of dollars; then it can be quite expensive.

Security Needs and Creditworthiness

It is very difficult to obtain a bank loan unless an individual or a corporate has a sound credit
score or valuable collateral. Banks are careful to lend money, and they only give loans to
borrowers who have the ability and willingness to repay the loan. Small companies who are
new to the business and have not taken any bank loans in the past find it even more difficult
to obtain a bank loan.

Partial Funding Requirement

In the case of term loans, every bank has its own set of criteria as to partial payment
requirements from the borrower. The partial payment may range from 10% up to 40% in
some cases. For example, if a company wants to borrow USD 10,000.00 to buy a new office,
then the bank may require that the company invests USD 1000.00 of its own. If the borrower
doesn’t have sufficient funds for partial payment, the bank may reject the loan application.

Strict Repayment Schedule

Bank prescribes a very strict repayment schedule to the borrower, which must be adhered to.
Failure to do so may reduce borrowers’ credit scores and future credibility. The stringency to
stick to the repayment schedule sometimes creates a burden on the borrower.

Prepayment Penalties and Charges

Most banks charge borrowers for early repayment, which is a lose-lose situation for the
borrower. Some financial institutions apply heavy prepayment penalties and charges. It is
quite ideal for a prospective borrower first to check if the agreement of loan contains any
prepayment penalties. If yes, the borrower should double-check his need for a loan and the
tenure for which he needs it.

Capitalization and theories of Capitalization:

Introduction

The objective of every business is to maximize the value of the business. In this respect the
finance manager, as well as individual investors, want to know the value created by the
business. The value of business relates to the capitalization of the business.

The need for capitalization arises in all the phases of a firm’s business cycle. Virtually
capitalization is one of the most important areas of financial management.

Concept of Capitalization:

Capitalization refers to the valuation of the total business. It is the sum total of owned capital
and borrowed capital. Thus it is nothing but the valuation of long-term funds invested in the
business. It refers to the way in which its long-term obligations are distributed between
different classes of both owners and creditors. In a broader sense it means the total fund
invested in the business and includes owner’s funds, borrowed funds, long term loans, any
other surplus earning, etc. Symbolically:

Capitalization = Share Capital + Debenture + Long term borrowing + Reserve + Surplus

earnings.

Different authors have defined capitalization in different ways but the theme of those
definitions remains almost same. Some of the important definitions are presented below:

According to Guthmami and Dougall, ‘capitalization is the sum of the par value of the
outstanding stocks and the bonds’.
In the words of Walker and Baughen, ‘capitalization refers only to long-term debt and capital
stock, and short-term creditors do not constitute suppliers of capital, is erroneous. In reality,
total capital is furnished by short-term creditors and long-term creditors’.

Bonneville and Deway define capitalization as ‘the balance sheet values of stocks and bonds
outstanding’.

Hence capitalization is the value of securities and may be defined as the par value of various
obligations of a firm distributed over various classes of stocks, bonds, debenture and
creditors.

Theories of Capitalization:

We have seen that capitalization refers to the determination of the value through which a firm
is to be capitalized. In the context of capitalization there are two popular theories: Cost
Theory and Earning Theory.

i. Cost Theory:

This theory is focused on the cost of acquiring assets. The total value of capitalization under
the Cost Theory is the sum total of costs of acquiring both fixed and current assets. Under
this theory the costs incurred for issue of shares and other securities are also included in
capitalization.
Hence capitalization is the sum of land and building, plant and machinery and other fixed
assets, stock of raw materials, debtors and other current assets and preliminary expenses.
This theory is best used by a new firm as it helps to find the total amount of capital needed
for establishing the business.
The theory suffers from the following limitations:

a) It highlights only the cost aspect but not the capacity of the assets;

b) It remains silent about time when the asset becomes obsolete; and
c) For a firm having fluctuating earnings, the theory loses its importance.
i. Earning Theory:
Under this theory the earning capacity of the business is considered as the basis of
capitalization. According to this theory the capitalized value of earning of the firm is the
amount of capitalization. Industry’s representative rate of return is taken as the rate of
capitalization.
The value of capitalization is calculated thus:
Capitalization = Average Annual Future Earnings / Capitalization Rate x 100
This theory also suffers from the following limitations:
A.Estimation of future earning for a new company is very difficult;
B.Rate taken for capitalization may not be proper representative of the firm; and
C. Mistake committed at the time of estimating the earnings will directly influence the
amount of capitalization.
Watered Stock
Watered stock referred to shares of a company that were issued at a much greater value than
the value implied by a company's underlying assets, usually as part of a scheme to defraud
investors. The last known case of watered stock issuance occurred decades ago, as stock
issuance structure and regulations have evolved to put a stop to the practice.
This term is believed to have originated from ranchers who would make their cattle drink
large amounts of water before taking them to market. The weight of the consumed water
would make the cattle deceptively heavier, enabling the ranchers to fetch higher prices for
them.
Thus:
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.
Watered stock, once revealed for what it is, becomes difficult to sell, and if sold, is typically
done so at a much lower price than originally obtained.

Over-Capitalization: Concept, Causes and Remedies

Concept of Over-Capitalization:
Over-Capitalization might be defined as follows:
Over-capitalization is that state of financial affairs of a company, in which the real value of
company’s assets is much less than their book value; leading to a permanent decline in the
earning capacity of the company.
Illustration:
Suppose the book value of the assets of a company is Rs. 25, 00,000 (represented by a
capitalization of 25, 00,000, consisting of equity capital, preference capital and debentures).
However, suppose, the real value of assets as warranted by their earning capacity is only Rs.
15, 00,000. There is, then, over-capitalization in the company, to the extent of Rs. 10,
00,000.
Now, in the company, earnings are done only with Rs. 15, 00,000; whereas the earnings of
the company have to be distributed over a capitalization of Rs. 25, 00,000.
An over-capitalized company has an excess of capital; but only in a superficial sense. The
excess of Rs. 10,00,000 as per illustration given above, represents idle funds – not producing
any benefits or profits, for the company.Over-capitalization is a chronic financial disease. It
is discovered only when a company has worked for several years.
Causes of Over-Capitalization:
Following are the main causes leading to over-capitalization of a company:
(i) Assets Acquired at Inflated Prices:
When assets are acquired at inflated prices from promoters, the result is over capitalization;
because in this case, the excess price paid for assets does not bear any relationship with the
earning capacity of those assets.
(ii) Issue of Excessive Finances – that could not be Profitably used:
Sometimes, promoters are tempted by a favourable market sentiment; and resort to an issue
of excessive finances, which cannot be profitably employed by the company. The result is
over- capitalization; as a large part of excessive finance is non-earning. Raising excessive
finances by promoters leading to over capitalization is something like eating too much good
food; when it is available free-of-cost. This excessive intake of good food, then, is likely to
lead to various stomach troubles, later on.
(iii) Huge Borrowings at High Rates of Interest:
Sometimes the company might resort to raising too high borrowings, through debentures etc.
at very high rates of interest. In such a case, a large part of earnings have to be paid, by way
of interest; leaving little surplus to pay a fair rate of return on equity. The result is over-
capitalization.
(iv) Liberal Dividend Policy:
When a company follows a liberal dividend policy; it does not have many earnings left for
reinvestment purposes. This hampers growth of the company; leading to a gradual but
permanent decline in its earning capacity and producing over-capitalization.
(v) High Rates of Corporate Taxes:
In the present day times, the corporate taxes are quite high. These leave little profits in the
hands of management for reinvestment purposes, and for paying a fair rate of return on the
equity. This also leads to over-capitalization.

Consequences (or Effect of Over-Capitalization):

1) Consequences for the Company:
(i) An unsatisfactory rate of return on the equity leads to a poor market value of the
company’s shares. There is thus, considerable loss of goodwill to the company.
(ii) Investors’ confidence in the company is lost; as to them, the future of the company
seems to be gloomy and uncertain.

(2) Consequences for the Members:

(i) Members of the company are losers; as the dividend payable to them is both reduced an
uncertain, and
(ii) There is a capital loss to the members; as a result of the poor market value of their
shares.
(3) Consequences for the Workers:
(i) Because of reduced profitability, workers might be required to suffer a cut in their wages.
(ii) If an over-capitalized company is liquidated untimely due to this financial disease;
workers lose their employment.
(4) Consequences for the Society:
(i) The poor functioning of an over-capitalized company implies wastage of nation’s
precious economic resources; as the same amount of resource might be profitably employed
elsewhere, to produce more.
(ii) Closure of an over-capitalized company hits the society adversely; in terms of loss of
production, generation of unemployment, etc.