2. Issue of Debentures
When a company decides to raise loans from the public, the amount of loan is dividend into units of equal. These units are known as debentures. A debenture is the instrument or certificate issued by a company to acknowledge its debt. Those who invest money in debentures are known as ‘debenture holders’. They are creditors of the company. Debentures are therefore called ‘creditor ship’ securities.
Debentures carry a fixed rate of interest, and generally are repayable after a certain period, which is specified at the time of issue. Depending upon the terms and conditions of issue there are different types of debentures. There are:
- Secured or unsecured Debentures and
- Convertible of Non convertible Debentures.
It debentures are issued on the security of all or some specific assets of the company, they are known as secured debentures. The assets are mortgaged in favor of the debenture holders. Debentures, which are not secured by a charge or mortgage of any assets, are called unsecured debentures. The holders of these debentures are treated as ordinary creditors.
Sometimes under the terms of issue debenture holders are given an option to covert their debentures into equity shares after a specified period. Or the terms of issue may lay down that the whole or part of the debentures will be automatically converted into equity shares of a specified price after a certain period. Such debentures are known as convertible debentures. If there is no mention of conversion at the time of issue, the debentures are regarded as non-convertible debentures.
Debentures issue is a widely used method of raising long-term finance by companies, due to the following reasons.
- Interest payable on Debentures can be fixed at low rates than rate of return on equity shares. Thus Debentures issue is a cheaper source of finance.
- Interest paid can be deducted from income tax purpose; there by the amount of tax payable is reduced.
- Funds raised for the issue of debentures may be used in business to earn a much higher rate of return then the rate of interest. As a result the equity shareholders earn more.
- Another advantage of debenture issue is that funds are available from investors who are not entitled to have any control over the management of the company.
- Companies often find it convenient to raise debenture capital from financial institutions, which prefer to invest in debentures rather than in shares. This is due to the assurance of a fixed return and repayment after a specified period.
Debenture issue as a source of finance has certain limitations too.
- It involves a fixed commitment to pay interest regularly even when the company has low earnings or incurring losses.
- Debentures issue may not be possible beyond a certain limit due to the inadequacy of assets to be offered as security.
3. Loans from financial Institutions
Government with the main object of promoting industrial development has set up a number of financial institutions. These institutions play an important role as sources of company finance. Besides they also assist companies to raise funds from other sources. These institutions provide medium and long-term finance to industrial enterprises at a reason able rate of interest. Thus companies may obtain direct loan from the financial institutions for expansion or modernization of existing manufacturing units or for starting a new unit. Often, the financial institutions subscribe to the industrial debenture issue of companies and also subscribe to the share issued by companies. All such institutions also underwrite the public issue of shares and debentures by companies. Underwriting is an agreement to take over the securities to the extent there is no public response to the issue. They may guarantee loans, which may be raised by companies from other sources.
Loans in foreign currency may also be granted for the import of machinery and equipment wherever necessary from these institutions, which stand guarantee for re-payments. Apart from the national level institutions mentioned above, there are a number of similar institutions set up in different states of India. The state-level financial institutions are known as State Financial Corporation, State Industrial Development Corporations, State Industrial Investment Corporation and the like. The objectives of these institutions are similar to those of the national-level institutions. But they are mainly concerned with the development of medium and small-scale industrial units. Thus, smaller companies depend on state level institutions as a source of medium and long-term finance for the expansion and modernization of their enterprise.
4. Retained Profits
Successful companies do not distribute the whole of their profits as dividend to shareholders but reinvest a part of the profits. The amount of profit reinvested in the business of a company is known as retained profit. It is shown as reserve in the accounts. The surplus profits retained and reinvested may be regarded as an internal source of finance. Hence, this method of financing is known as self-financing. It is also called ploughing back of profits.
Since profits belong to the shareholders, the amount of retained profit is treated as ownership fund. It serves the purpose of medium and long-term finance. The total amount of ownership capital of a company can be determined by adding the share capital and accumulated reserves.
This source of finance is considered to be better than other sources for the following reasons.
- As an internal source, it is more dependable than external sources. It is not necessary to consider investor’s preference.
- Use of retained profit does not involve any cost to be incurred for raising the funds. Expenses on prospectus, advertising, etc, can be avoided.
- There is no fixed commitment to pay dividend on the profits reinvested. It is a part of risk capital like equity share capital.
- Control over the management of the company remains unaffected, as there is no addition to the number of shareholder.
- It does not require the security of assets, which can be used for raising additional funds in the form of loan.
However, there are certain limitations on the part of retained profit.
- Only well established companies can be avail of this sources of finance. Even for such companies retained profits cannot be used to an unlimited extent.
- Accumulation of reserves often attract competition in the market,
- With the increased earnings, shareholders expect a high rate of dividend to be paid.
- Growth of companies through internal financing may attract government restrictions as it leads to concentration of economic power.
5. Public Deposits
An important source of long/medium–term finance which companies make use of is public deposits. This requires advertisement to be issued inviting the general public of deposits. This requires advertisement to be issued inviting the general public to deposit their savings with the company. The period of deposit may extend up to three yeas. The rate of interest offered is generally higher than the interest on bank deposits. Against the deposit, the company mentioning the amount, rate of interest, time of repayment and such other information issues a receipt.
Since the public deposits are unsecured loans, profitable companies enjoying public confidence only can be able to attract public deposits. Even for such companies there are rules prescribed by government limited its use.
Source: Financial Management-MGU KTM
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