Long-Term Sources of Finance - Essay Example

Long-term Sources of Finance Businesses need fixed assets like factory and office buildings, plant and machinery, and vehicles for which funds on large scale are required. Besides, funds for Research and development, patent and copy rights, advertisement for products launch are required on long-term basis. It is not desirable to use short term funds because of higher rate of interest and because of their limited availability. If the short term funds are diverted for long-term purposes, business will suffer for want of working capital required for inventory, bills receivable and operating expenses. Hence to meet the requirement of long-term capital, there are long-terms sources of finance which the business should seek for ensuring viability in their operations. Main sources are equity, debt and derivatives. While equity comes from share capital from the public and promoters, debt finance and derivatives can be procured in the form of debentures,, convertible notes, warrants etc. Share capital Ordinary shares Funds required for capital purposes are collected through instrument called share (also known as equity share) by offering to public by advertisement or private placement. The share holders acquire right of ownership in the company by which they are entitled to share of profits, to vote in general meeting to elect and remove directors and pass or reject important resolutions concerning the company's management. In case of liquidation of company due to loss, the share holders may lose their money invested the shares of the company or in part in accordance with the company's liquidity position. Ordinary share form bulk of the company's capital having no special rights over the other shares. As already mentioned, in case of liquidation, the ordinary share will rank last for being paid after all other liabilities of the company are met. The management of the company may decide not to pay dividends in any one or more years for reasons of losses or any such reason. Most important feature of share form investment is that the share holders' liabilities are limited to the value of their shares and they will not be called upon to pay more than that in case of losses incurred by the company... Preference Shares This type of shares carries a right of dividend over ordinary share holders above discussed. The dividend is generally a fixed amount every year whether there is profit or not earned by the company. At the time of liquidation also, the preference share holders are paid before ordinary share holders. Preference share holders do not have voting rights but it may be exercised in case of failure to pay dividends to them. Several types of preference shares as follows. a) Participating preference shares. These share are entitled to additional dividends which may fluctuate as per profits earned by the company. b) Cumulative preference shares. If in any particular year, dividends are not paid, they are carried over and cumulative of such dividends is paid in subsequent years. c) Non-cumulative preference shares. They are so called as are not entitled to accumulate arrears of dividends. d) Redeemable preference shares. Company can redeem these shares and pay the owners a redemption price usually set above the par value in order to compensate them for untimely redemption. e) Convertible preference shares. Holders of theses shares have an option to convert them into other types of shares usually ordinary shares. This form of investment being less risky, carries lesser returns than ordinary shares which may be eligible for higher dividends in case of abnormal profits. Practical example of above said shares is taken from the Annual Report of M/S Reckittenkisser, Uk for 2004-05. The Annual Report says that parent company holds 4,500,000 nos 5% cumulative preference shares. The rights and restrictions of these shares are mentioned in note 16 to the report. Number of ordinary shares at the book price of m76 as at 31 December 2005, is mentioned as 722,160,934. as against an authorised capital of 945,500,000 nos of ordinary shares and unclassified shares valued at m 100. ( Recitbenkisser.2005) Retained Earnings In companies not all profits need be distributed to share holders. The company can retain the profits earned in full or part ad reinvest in the business. Thus after tax profits not distributed as dividends shown as retained earnings under the equity can also serve as long term source of funds. Companies tend to accumulate retained earnings just to avoid taxes on it which the tax authorities of U.K. take adverse notice of. Other sources of long-term funding are balance in share premium account, reserve resulting out of revaluation, general and specific reserves. Apartment from the above sources traceable to owners of the company, which may not be sufficient or for strategic reasons of avoidance of higher dividend burden etc, the company decides not to have more of capital funds and instead decides to have debts for long-term capital requirements. Capital Gearing Capital gearing is understood by the degree to which a company's activity is financed by owners funds and borrowed funds. Capital gearing is the general term indicating a financial ratio that compares owners' capital to borrowed funds. The higher the degree of leverage, the more risky is the company's financial position. ." As for most ratios, an acceptable levelis determined by its comparisonto ratios ofcompanies in the same industry.The best known examples of gearing ratios include the debt-to-equity ratio (total debt / total equity), times interest earned (EBIT / total interest), equity ratio (equity / assets), and debt ratio (total debt / total assets)" (investopedia) A company of high gearing ratio is more prone to be affected by business cycles as it has to continue servicing its debt regardless of its sales revenue. A greater amount of equity will lower the rate of gearing and act as cushion against uncertainties and prove to be a measure of financial health of the company. The above table would show that the company is capital gearing ratio is less than 1 and is considered a lesser rate. As such the company is not considered to be in risky position. The figures shown above have been taken from the Annual of the company for the year 2005. The following are few sources that a company can resort for long-term funding Loans from Financial Institutions.: Long-term loans can be availed from Financial Institutions which specialise in funding for acquisitions of plant and machinery and building constructions. Usually these loans are available for 5 years and more depending up on the company's project viability and repayment projections. Interest burden will be cheaper than dividend burden through equity financing and hence to maximise profits, company may resort to term loan funding. Fixed deposits Depending on the company's long term needs, fixed deposits are invited from the public carrying a certain amount of interest. The deposits are usually repayable over a period of 3 to 5 years. This type of deposits is a simple form of funds sourcing and companies resort to this frequently. At the time of repayments, companies usually make repeat collections so that the members of the public are retained as good-will ambassadors of the company while they enjoy prompt payment of interest. Debentures Debentures are issued by the company just as shares are issued. Instead of dividend, interest is offered for the investment made in debentures. Debentures are issued when a company is faced with huge capital requirements which are not easily available from term lending institutions except on complying with various security requirements as collateral to the loan. Debenture holders though will have prior right over share holders, issue of debentures will not be as much cumbersome as availing of term loans. Venture Capital For high risk projects, venture capital firms provide seed money or ground floor financing. The venture capital is usually provided in stages depending up on progress stage by stage. This serves as a powerful motivators for the project owners. Although there is large demand for capital, venture capital sources are very limited. More over it very expensive. Usually venture capital providers demand share in equity as much as 40%.. These groups of investors are also called angel investors because of their tendency to support highly risky projects. They are ultimately absorbed as regular share holders at the appropriate time. Convertibles It is a security in the form of Bond or a preferred stock capable of being converted into altogether a different security. As a long term source of finance, companies issue such securities to raise funds in the market. In such cases conversion formula is fixed by which security issued can be converted into common stock at a fixed price. "Both investors and companies should understand that market price based convertible security deals can affect the company and possibly lower the value of its securities. Here's how these deals tend to work and the risks they pose: The company issues convertible securities that allow the holders to convert their securities to common stock at a discount to the market price at the time of conversion. That means that the lower the stock price, the more shares the company must issue on conversion. The more shares the company issues on conversion, the greater the dilution to the company's shareholders will be. The company will have more shares outstanding after the conversion, revenues per share will be lower, and individual investors will own proportionally less of the company. While dilution can occur with either fixed or market price based conversion formulas, the risk of potential adverse effects increases with a market price based conversion formula. The greater the dilution, the greater the potential that the stock price per share will fall. The more the stock price falls, the greater the number of shares the company may have to issue in future conversions and the harder it might be for the company to obtain other financing" (US SEC) Warrants It is a security issued for a lesser period than that of convertible bonds. It can also be detached from the securities cash can be demanded." The Black-Scholes option valuation formula may be used to place a value on warrants, but care must be taken to allow for the effects of dividends and changes in the number of shares outstanding. Warrants are frequently issued with private placement bonds and occasionally with public bond issues. They are also occasionally used as compensation for investment bankers and as part of restructuring packages for firms reorganizing after bankruptcy." (Brealey Meyers) Financial derivatives In chemistry, term derivative means a substance that can be made from another substance. Derivatives in finance also work on the same model. These finance instruments promise payoffs from the underlying asset. For example derivatives available with payments linked to the S & P stock index, the temperature at Kennedy air port, and number of bankruptcies among a group of selected companies. Presently market for derivatives is estimated to be in the region of $ 270 trillion Options are a form of derivatives by which a contract is entered into giving the buyer a right to buy or sell an asset at chosen price at the appointed time. For example if A buys an option to sell a share of a company on 31 December 2009, for 15 by paying a premium of 2, he can exercise that option on that day when the actual price may be only 10 and earn a profit of 15-10-2 = 3 pounds by buying the stock at 10 pounds from the open market and sell it at 12 pounds and pay the option. Suppose the price does not fall below 15 pounds on the fixed day, then A cannot exercise that option and hence the premium he pays per share will be his loss. "Options or futures are different kinds of contracts where one party agrees to pay a fee to another for the right to buy or sell something to the other. For example, a person worried that the price of his Microsoft stock may go down soon just before he plans to sell it may pay a fee to another person who agrees to buy the stock from him at today's price. The person in this example is using an option or future to manage the risk that his stock may go down, while the person he pays a fee to might be using the option as a way to speculate that Microsoft's stock will actually increase, and if so would earn more money then if he were to simply buy Microsoft's stock." (Wikipedia) Swaps In the case of Swaps, one party agrees to swap a thing with another on certain circumstances." For example, one person desiring a fixed rate loan for his business-1, finding that all banks only offer him a variable rate, enters into an agreement with business-2 to have business-2 pay business-1 when rates go up and business-1 must pay business-2 when rates go down, effectively creating a fixed rate for business-1 and possibly saving business-2 money or helping it to convert some of its fixed rate debt into variable rate. Since both of these types of contracts were between two parties, and could be used for risk management or speculation, these contracts became commonly known as "derivatives' " ( wikipedia) The underlying asset can be commodity, equity or bond, interest rate, exchange rate or stock market index. Leasing This facilitates companies to pay a nominal sum periodically for the plant and machinery and buildings instead of being purchased at a huge prices blocking their capital which otherwise be used more beneficially. The lease amount paid every year is deductible from profits though depreciation is not allowed on the leased assets. This greatly helps companies to avoid .unremunerative investment. As assets are used over a period of time, leasing is considered an alternative source of long term source of financing. When the lease period expires, the leased assets are returned to the lessor. Hire purchase In hire purchase transactions, the company in need of assets acquires it by paying periodical hire charges till the contract period ends. At the end of the contract period, the company acquires ownership rights over the assets so purchased. Here also the company can charge to profit and loss account, the hire charges so paid. If the company defaults in payment of hire, the asset can be taken back by the owner and hire charges paid by the company will not be refunded. Conclusion The long-term sources of finance would give a bird's eye view of the availability and implications of each source to a company. Companies should cultivate ploughing back of profits every year so that long term sources of funds are available readily and without cost. References Brealey Meyers, http://highered.mcgraw-hill.com/sites/0072467665/student_view0/chapter23/ accessed on 5 December 2006 Reckittbenkiser, http://www.reckittbenckiser.com/investor/annual_report_2005/rb_annual_report_2005.pdf accessed on 5 December 2006 US SEC http://www.sec.gov/answers/convertibles.htm accessed on 5 December 2006 Wikipedia, http://en.wikipedia.org/wiki/Derivative_ (finance) accessed on 5 December 2006 Read More