Based upon the time, the financial resources may be classified into long term and short term sources of finance. Long term sources of finance are those that are needed over a longer period of time – generally over a year.
A business requires funds to purchase fixed assets like land and building, plant and machinery, furniture etc. These assets may be regarded as the foundation of abusiness. The capital required for these assets is called fixed capital. A part of the working capital is also of a permanent nature. Funds required for this part of the working capital and for fixed capital is called long term finance.
The sources from which a finance manager can raise long-term funds are discussed below:
1. Issue of Shares
The amount of capital decided to be raised from members of the public is divided into units of equal value. These units are known as share and the aggregate values of shares are known as share capital of the company. Those who subscribe to the share capital become members of the company and are called shareholders. They are the owners of the company. Hence shares are also described as ownership securities.
Issue of Equity Shares
The most important source of raising long-term capital for a company is the issue of equity shares. In the case of equity shares there is no promise to shareholders a fixed dividend. But if the company is successful and the level profits are high, equity shareholders enjoy very high returns on their investment. This feature is very attractive to many investors even through they run the risk of having no return if the profits are inadequate or there is loss. They have the right of control over the management of the company and their liability is limited to the value of shares held by them.
From the above it can be said that equity shares have three distinct characteristics:
- The holders of equity shares are the primary risk bearers. It is the issue of equity shares that mainly provides ‘risk capital’, unlike borrowed capital. Even compared with preference capital, equity shareholders are to bear ultimate risk.
- Equity shares enable much higher return sot be earned by shareholders during prosperity because after meeting the preference dividend and interest on borrowed capital at a fixed rate, the entire surplus of profit goes to equity shareholders only.
- Holders of equity shares have the right of control over the company. Directors are elected on the vote of equity shareholders.
From the company’ point of view; there are several merits of issuing equity shares to raise long-term finance.
- It is a source of permanent capital without any commitment of a fixed return to the shareholders. The return on capital depends ultimately on the profitability of business.
- It facilities a higher rate of return to be earned with the help borrowed funds. This is possible due to two reasons. Loans carry a relatively lower rate of interest than the average rate of return on total capital. Secondly, there is tax saving as interest paid can be charged to income as a expense before tax calculation.
- Assets are not required to give as security for raising equity capital. Thus additional funds can be raised as loan against the security of assets.
Although there are several advantages of issuing equity shares to raise long-term capital.
- The risks of fluctuating returns due to changes in the level of earnings of the company do not attract many people to subscribe to equity capital.
- The value of shares in the market also fluctuate with changes in business conditions, this is another risk, which many investors want to avoid.
Issue of Preference Shares
Preference shares have three distinct characteristics. Preference shareholders have the right to claim dividend at a fixed rate, which is decided according to the terms of issue of shares. Moreover, the preference dividend is to be paid first out of the net profit. The balance, it any, can be distributed among other shareholders that is, equity shareholders. However, payment of dividend is not legally compulsory. Only when dividend is declared, preference shareholders have a prior claim over equity shareholders. Preference shareholders also have the preferential right of claiming repayment of capital in the event of winding up of the company. Preference capital has to be repaid out of assets after meeting the loan obligations and claims of creditors but before any amount is repaid to equity shareholders. Holders of preference shares enjoy certain privileges, which cannot be claimed by the equity shareholders. That is why; they cannot directly take part in matters, which may be discussed at the general meeting of shareholders, or in the election of directors.
Depending upon the terms of conditions of issue, different types of preference shares may be issued by a company to raises funds. Preference shares may be issued as:
- Cumulative or Non-cumulative
- Participating or Non-participating
- Redeemable or Non-redeemable, or as
- Convertible or non-convertible preference shares.
In the case of cumulative preference shares, the dividend unpaid if any in previous years gets accumulated until that is paid. No cumulative preference shares have any such provision.
Participatory shareholders are entitled to a further share in the surplus profits after a reasonable divided has been paid to equity shareholders. Non-participating preference shares do not enjoy such right. Redeemable preference shares are those, which are repaid after a specified period, where as the irredeemable preference shares are not repaid. However, the company can also redeem these shares after a specified period by giving notice as per the terms of issue. Convertible preference shows are those, which are entitled to be converted into equity shares after a specified period.
Many companies due to the following reasons prefer issue of preference shares as a source of finance.
- It helps to enlarge the sources of funds.
- Some financial institutions and individuals prefer to invest in preference shares due to the assurance of a fixed return.
- Dividend is payable only when there are profits.
- If does not affect the equity shareholders’ control over management
The limitations of preference shares relates to some of its main features:
- Dividend paid cannot be charged to the company’s income as an expense; hence there is no tax saving as in the case of interest on loans.
- Even through payment of dividend is not legally compulsory, if it is not paid or arrears accumulate there is an adverse effect on the company’s credit.
- Issue of preference share does not attract many investors, as the return is generally limited and not exceed the rates of interest on loan. On the other than, there is a risk of no dividend being paid in the event of falling income.
Methods of Issuing Securities
The firm after deciding the amount to be raised and the type of securities to be issued, must adopt suitable methods to offer the securities to potential investors. There are for common methods followed by companies for the purpose.
- When securities are offered to the general public a document known as Prospectus, or a notice, circular or advertisement is issued inviting the public to subscribe to the securities offered thereby all particulars about the company and the securities offered are made to the public. Brokers are appointed and one or more banks are authorized to collect subscription. This process is termed as Initial Public Offer (IPO).
- Some times the entire issue is subscribed by an organization known as Issue House, which in turn sells the securities to the public at a suitable time.
- The company may negotiate with large investors of financial institutions who agree to take over the securities. This is known as ‘Private Placement’ of securities.
- When an exiting company decides to raise funds by issue of equity shares, it is required under law to offer the new shares to the existing shareholders. This is described as rights issue of equity shares. But if the existing shareholders decline, the new shares can be offered to the public.