They do not carry voting rights and are secured against the companys assets. (B) Disadvantages or Dangers of Excessive Ploughing Back: (i) Misuse of Retained Earnings It is not necessary that the management may always use the retained earnings to the advantage of shareholders. When businesses need to use the money in the long term (more than five years), this creates the need for long-term finance. Huge Collection of Essays, Research Papers and Articles on Business Management shared by visitors and users like you. They carry a fixed interest rate and give the borrower the flexibility to structure the repayment schedule over the tenure of the loan based on the companys. The common practice in India is the repayment of principal in equal instalments and payment of interest on the outstanding loan. It is required by an organization during the establishment, expansion, technological innovation, and research and development. (c) Financial institutions may insist the borrower to convert the term loans into equity. The money raised from the market does not have to be repaid, unlike debt financing which has a definite repayment schedule. Covenants may also include the appointment of nominee director by financial institutions to safeguard their interests. (v) Safety from the Risk of Obsolescence In a lease contract, the lessor being the owner of the leased asset bears the risk of obsolescence. ii. At the end of lease period, the lessee is usually given an option to buy or further renew the lease contract for a definite period. The following sources are considered major sources of finance for major corporations. Non-Convertible Debentures Refer to the debentures that have no right to get converted into the equity shares during their maturity period. Personal savings is money that has been saved up by an entrepreneur. A debenture is a form of financial instrument that provides long-term debt to an organization. If a company wants to raise money privately, it may approach the major debt investors in the market and borrow from them at higher interest rates. Debentures are one of the frequently used methods by which a company raises long-term funds. As a result, the lender has a regular and steady income. This article shall discuss major sources of long-term debt financing for most corporations. In other words, the extent of profitability after tax, the size of dividend payments and the amount of depreciation provided for along with the reserves and surplus all contribute to the sources of internal funds. This is particularly important in the case of assets where the income tax laws provide for accelerated depreciation. The term loans may be converted into equity at the option and according to the terms and conditions laid down by the financial institutions. A debenture is a certificate issued by a company under its seal acknowledging a debt due by it to its holders. The real position of lessor is not renting of asset but lending of finance and hence lease financing is, in effect, a contract of lending money. For availing the benefit of trading on equity, it is essential to issue debentures or preference shares with fixed yields lower than the earning rate of the company. Failure to meet these payments raises a question mark on the liquidity position of the borrower and its existence may be at stake. In addition, they can be issued at discount, par, and premium. In case of any default in debenture interest payment, the debenture holders can sell the companys assets and recover their dues. (v) Loss on Liquidation In case of liquidation, equity shareholders have to bear the maximum risk. The less the firm relies on external sources of funding, more is the retention of the ownership of the firm. The organization pays the dividend on preference shares before paving dividend to equity shareholders. They are designed to meet the long-term funds requirement of the issuer and investors who are not looking for immediate return. The interest on term loans is a definite obligation that is payable irrespective of the financial condition of the firm. You can learn more about excel modeling from the following articles: . The capital profits emerging out of retained earnings may be preferred because of taxation considerations. These units are known as share and the aggregate values of shares are known as share capital of the company. However, the use of internal accruals as opposed to new shares or debentures avoids costs that are associated with fresh issues. Cookies help us provide, protect and improve our products and services. The characteristics of preference shares are as follows: i. The dividend policy of the company is determined by the directors. Firstly, as compared to interest, dividends cannot be deducted from the income of the company while calculating taxes. (ii) Direct Negotiation Terms and conditions of such loans are directly negotiated between the borrower and the financial institution providing the loan. Loans from banks are however less flexible. The lessee pays a fixed rental to the lessor at the beginning or at the end of a month, quarter, half year, or year. Debt Capital 9. Internal and external sources of finance (AO2) Short-term and long-term external sources of finance (AO1) The appropriateness of sources of finance for a given situation (AO3) 3.2 Costs and revenues. Help in collecting funds at the right time, iv. These funds are normally used for investing in projects that will generate synergies for the company in the future years. Equity financing is the process of the sale of an ownership interest to various investors to raise funds for business objectives. Some of the long-term sources of finance are:- 1. Limiting the liability of equity shareholders to the amount of shares they hold, iv. Content Filtration 6. On the balance sheet of the company, equity share capital is listed as stockholders equity or owners equity. Report a Violation 11. Login details for this Free course will be emailed to you, Leasing is an arrangement in which the asset's right is transferred to another person without transferring the ownership. Since, both debenture and term loan are a type of debt financing, they share basic characteristics of a debt and hence their pros and cons are also similar. (Nickels, McHugh, McHugh, N.D.) Long-Term Finance Depending upon the intrinsic value of shares, the market value fluctuates. The holder of a zero-coupon bond only receives the face value of the bond at maturity. (ii) Increase in Rate of Dividends In case of higher profits in the company, these shareholders are handsomely rewarded in the form of higher dividends. Out of the realised value of assets, first the claims of creditors and then preference shareholders are satisfied, and the remaining balance, if any, is paid to equity shareholders. His position is akin to that of a person who uses the asset with borrowed money. The advantage of having internal accruals like depreciation and retained earnings is clearly seen in their characteristics. Interest is computed on the amount of the unpaid balance of the loan at each payment period. The amount borrowed is paid back in installments over a predetermined agreed period of time usually 10, 20 or 30 years. It is a standard clause of the bond contracts and loan agreements. (iii) Increase in Market Value Usually a portion of the profits is ploughed back into the business which results in enhanced earning power of the company and increase in the market value of its shares. The main advantage is that it is not been paid immediately or within shorter time duration. For example, in India, dividends are free from tax liability for shareholders; however, the organization pays tax on dividend before its distribution at the rate of 12.5%. The amount of capital decided to be raised from members of the public is divided into units of equal value. Equity Shares 2. 3) Long-term Sources of finance. Here, we discuss the top 5 sources of long-term financing, examples, advantages, and disadvantages. (iii) Creation of Monopolies Continuous ploughing back of profits over a long time may lead a company to grow into a monopoly. The advantages and disadvantages of term loans from the lenders and borrowers point of view are discussed below: (a) Term loans are provided by banks and other financial institutions against security because of which the term loans are secured. Definition: Long term, either debt or equity, refers to the time period of more than five years. Internal sources of finance examples (v) Dissatisfaction among the Shareholders Excessive ploughing back of profits may create dissatisfaction among the shareholders since the rate of dividend is quite low in relation to the earnings of the company. Funds required for a business may be classified as long term and short term. Financial Management, Company, Finance, Sources, Sources of Long-Term Finance. Involve less cost in raising funds than equity shares, ii. Loan from Public Financial Institutions 3. 19.2 Objectives. This method of financing is also known as self-financing or internal financing. Here we discuss the two types of external sources of finance: long-term financing (equity, debentures, term loans, preferred stocks, venture capital) and short-term financing (bank overdraft and short-term loans). The main characteristics of retained profits are that there is no compulsory maturity like term loans and debentures and they are not characterized by fixed burden of interest or installment payments like borrowed capital. Do not require any security from the organization. vi. v. Redeemable Preference Shares Refer to the shares that are repaid by the organization. Lenders normally lend in proportion to the amount of shareholders funds. IPO is a means of raising capital for companies by allowing them to trade their shares on the stock exchange.read more or opt for a private investor to take a substantial stake in the company. In addition, the lessee is not free to make alterations to the leased asset. iii. Allow shareholders to receive dividend after payment is made to each and every stakeholder. The long term sources of finance are shown below: 1. Preference Shares 3. However, prime basis on which a share is valued is the price at which it is expected to be sold. Allow preference shareholders to receive dividends out of profit earned by the organization, iv. The disadvantages of debentures are as follows: i. Compel an organization to pay interest even if there is no profit or loss. Long term 2; Basics Long term finance - Funding obtained exceeding three years in duration. The companys credit rating also plays a major role in raising funds via long-term or short-term means. There exists a controversy whether depreciation should be taken as a source of finance. They can be redeemable, irredeemable, convertible, and non-convertible. Paying dividend on equity shares is not an obligation for an organization when there is less profit or loss, ii. Internal finance includes the funds generated within the corporate unit irrespective of the nature of source. Each type of shares has a different set of characteristics, advantages, and disadvantages. An equal instalment schedule is comprised of a decreasing interest payment and an increasing principal payment. In simple terms, it means giving the asset on hire or rent. ii. Bonds 7. International Sources. It may come from different sources such as equity, debt, hybrid instruments, or internally generated retained earnings. These funds may be used to finance the cost of acquisition of fixed assets that are needed for expansion, modernization and diversification programmes of the company. Further, this provision has been incorporated in the corporate laws by section 43(a) (ii) of Companies Act, 2013. Raising funds through equity shares for long-term investment as these shares are repaid during the lifetime of the organization, iii. Make organizations more focused on profitable projects, as they have to pay interests on quarterly, half yearly, and annual basis, vi. Capital Markets 6. These are called covenants. (vi) Repayment Schedule Such loans have to be repaid according to predetermined schedule. In other words, bonus shares are issued when an organization has sufficient profit but is in need of more working capital at that particular time. These are the profits the company has kept aside over time to meet the companys future capital needs. Discounts and premiums on shares are calculated from their par value or face value. The holders of these shares are the legal owners of the company. This is more likely to occur when other companies find it difficult to procure finance from the market whereas an existing concern continues to grow through its retained earnings. The borrowing organization has to submit audited annual accounts report to the lender or financial institution, v. Details of fixed assets purchased from the loan. From Managements (Borrowers) Point of View: (a) Yearly interest payment and repayment of principal is obligatory on the part of borrower. You are free to use this image on your website, templates, etc., Please provide us with an attribution linkHow to Provide Attribution?Article Link to be HyperlinkedFor eg:Source: Long-Term Financing (wallstreetmojo.com). Long-term finance generally helps businesses in achieving their long-term strategic goals. Debentures normally carry a fixed interest rate and a certain date of maturity. Preference share capital is another source of long-term financing for a company. (a) They are cheap although they have an opportunity cost, that is, the return they could have obtained elsewhere. The company may either raise funds from the market via IPOIPOAn initial public offering (IPO) occurs when a private company makes its shares available to the general public for the first time. There is a lock-in period for SPN during which no interest will be paid for an invested amount. After discussing the characteristics and types of equity shares, let us look at their following advantages: i. Public Deposits 4. For example, the Rs.12,000 loan may be divided by the 12 payment periods each resulting in a principal payment of Rs.1,000 per loan payment. Long-term sources of finance are those which help in getting funds for longer period that is more than one year. The maturity period of term loans is typically longer, in case of sanctions by financial institutions, in the range of 6-10 years in comparison to 3-5 years of bank advances. Cumulative Preference Shares Refer to the shares for which dividends get accumulated over a period of time. The control of the company may change to new shareholders who may reap the benefits of the companys prosperity and progress. Debentures are usually secured by a charge on the immovable properties of the company. (iv) Flexibility in Fixing the Rentals Lease rentals are fixed in such a way that the lessee is able to pay them from the cash flows generated from his business operations. Share capital or Equity shares Short-Term Finance Short-term finance is an amount of money, which is borrowed, will be repaid in one year. (iii) High Profitability Leasing business is highly profitable to the lessor because the rate of return is more than what the lessor pays on his borrowings. The warrant gives a right to the debenture holder to obtain equity shares specified in the warrant after the expiry of a certain period at a price not exceeding the cap price specified in the warrant. After the maturity of the financed the borrower needs to return the financier the real amount with some profit and interest. 2) Amazon raised $54 million via the IPO route to meet the long-term funding needs of the company in 1997. Do not consider the term loan providers as the owners of the organization. (b) If the purpose for utilization of retained earnings is not clearly stated, it may lead to careless spending of funds. These shares carry a fixed rate of dividend and such dividend must be paid in full before the payment of any dividend on equity shares. Convertible Debentures Refer to the debentures that have right to get converted into the equity shares after a specific period of time. The value of equity capital is computed by estimating the current market value of everything owned by the company from which the total of all liabilities is subtracted. Long-term funds are paid back during the lifetime of an organization. Save an organization from unnecessary interference of preference shareholders as they do not enjoy any voting right, v. Prevent preference shareholders from claiming f or the assets of the organization. The volatility of markets is a major factor that should be considered to determine the price of a share in the market at a particular point of time. (a) The terms and conditions of term loans are negotiable between borrowers and lenders and as a result, it may sometimes affect the interest of lenders. Result in overcapitalization if more than required equity shares are issued. As the legal owner, it is the lessor (and not the lessee), who will be entitled to claim depreciation on the leased asset. It is usually done for big projects, financing, and company expansion. The payment of dividend depends on the availability of divisible profits and the discretion of directors. (e) Debt financing by term loan has fixed installments till the maturity of the loan. In case of sole-proprietary concerns and partnership firms long term funds are generally provided by the owners themselves or by their retained profits. Despite the above disadvantages, the ploughing back of profits is a popular source of long-term finance and is widely used by most of the companies. Make the repayment of preference shares possible during the existence of the organization, iii. The equity shareholders collectively own the company and enjoy all the rewards and the risks associated with the ownership. When a company does not distribute whole of its profits as dividend but reinvests a part of it in the business, it is known as ploughing back of profits or retention of earnings. (iv) Bonus Shares Equity shareholders have a claim on the residual income of the company. This has been a guide to what external sources of finance are. These covenants may be in respect of maintaining a minimum current ratio, not to create further charge on assets, not to sell fixed assets without the lenders approval, restrain on taking additional loan, reduction in debt-equity ratio by issuing additional shares etc. Companies can also raise internal finance by selling off assets for cash. Therefore, it has become essential for the issuer to innovate and introduce new financial instruments to cater to the different needs of the issuers and investors. (iv) Ownership Dilution If the new shares are issued to the public, it may dilute the ownership and control of the existing shareholders. SBA 7 (a) loans, for example, range from $25,000 . Allow an organization to raise secured loans. However, term loan providers are considered as the creditors of the organization. Generally used for financing big projects, expansion plans, increasing production, funding operations. It is also referred to as ploughing back of profit. They have mostly securedloans offered by banks against strong collaterals provided by the company in the form of land and building, machinery, and other fixed assets. The interests of the debenture holders are protected by a trustee (generally bank or an insurance company or a firm of attorneys). Issuing bonus shares is beneficial for both the organization as well as the shareholders. 3) Apple raises $6.5 billion in debt via bonds. The companys management needs to be assured about creating a mix of short-term and long-term financing sources. Prohibited Content 3. On the other hand, the holder of a conventional bond not only receives the face value of the bond at maturity but is also paid regular interests at the coupon rate over the life of the bond. Sources of Long-term Finance. Debentures 5. (iii) Helpful in Following a Balanced Dividend Policy Such a company can follow the policy of paying regular and balanced dividends because it can use retained earnings for paying dividends in the years when there are inadequate profits. A bond that is sold at a discount on its par value and has a coupon rate significantly less than the prevailing rates of fixed-income securities with a similar risk profile. Long-term finance Personal savings Personal savings is money that has been saved up by an entrepreneur. Generally, the financial institutions charge an interest rate that is related to the credit risk of the proposal, subject usually to a certain minimum prime lending rate (PLR) or floor rate. There is a lock-in period up to which no interest will be paid. Tax liability on dividends differs in different zones, states, and countries. This includes short-term working capital, fixed assets, and other investments in the long term. Debentures refer to long-term debt instruments issued by a government or corporation to meet its financial requirements. This makes employees feel that they are owners of the organization and motivate them to demonstrate dedication in their work. It involves financing for fixed capital required for investment in fixed Assets. However, there are certain disadvantages of using internal accruals as a source of finance. There are generally two types of loan repayment schedules: In equal principal payment schedule, the size of the principal payment is the same for every payment. (c) Zero Interest Fully Convertible Debentures (FCD): The investors in zero-interest fully convertible debentures are not paid any interest. Whatever may be the outcome of such controversy, the fact remains that the depreciation is a sum that is set apart out of profits and retained within the business. Registered debenture holders cannot transfer their debentures without giving prior information to the organization. But an amendment in the Companies Act, 2000 permitted companies to issue equity shares with differential voting rights. There is a dilution in the ownership and the controlling stake with the largest equity holder in, The equity holders have no preferential right in the, Preference shareholders carry preferential rights over equity shareholders in terms of receiving dividends at a fixed rate and getting back, They are entitled to a fixed interest payment per the agreed-upon terms mentioned in the. It is recorded as expenditure in the accounting system of a firm. For example, a ZCB offered by a financial institution has a face value of Rs.20,000 but will be issued to the subscribers as part of this offer at Rs.11,980. Dividends refer to the portion of business earnings paid to the shareholders as gratitude for investing in the companys equity. This is known as retained earnings. Market value is the value at which the shares are traded on the stock exchange. Following points explain the type of debentures in brief: i. Create pressure on an organization to make profit at any cost as the interests on these loans are very high and may be paid on quarterly and half yearly basis, iv. and is accumulated from the capital market. A holder of a zero-coupon bond does not receive any coupon or interest payments. Equity Shares, also known as ordinary shares, represent the ownership capital in a company. You are free to use this image on your website, templates, etc., Please provide us with an attribution link. However, they rank behind the companys creditors. It is allowed to be deducted while arriving at the net profits of the firm subject to adherence of the percentages of allowable depreciation fixed under the tax laws. The subscription price at which the right shares are offered to them is generally much below the shares current market price. Higher amount of shareholders funds provides higher safety to the lenders. To conclude, equity shares are the most convenient and popular source of long-term finance for a company. It is required by an organization during the establishment, expansion, technological innovation, and research and development. Facilitate debenture holders to be paid back during the lifetime of an organization, iv. The advantages of debentures are as follows: i. Covenant refers to the borrower's promise to the lender, quoted on a formal debt agreement stating the former's obligations and limitations. For example, if an expansion or acquisition is allowed with venture capital, the investor might demand part ownership of the firm, rather than simply a share in the profits, including a say in management. 1) Funds raised by an NBFC named NeoGrowthCredit Pvt. This residual income is either directly distributed to them in the form of dividend or indirectly in the form of bonus shares. Maturity refers to the last day of paying the financier the real amount of finance. The holders of convertible preference shares have to pay conversion price at a given date for converting their shares into equity shares. Financial Institutions 6. Internal sources of finance come from inside the business, meanwhile, external sources of finance come from outside the business. Term loans, also referred to as term finance, represent a source of debt finance, which is generally repayable in less than 10 years. Some of the long-term sources of finance are:- 1. There are a number of sources of short-term finance which are listed below: 1. An additional disadvantage from borrowers viewpoint is that the loan contracts contain certain restrictive covenants which restrict the managerial freedom. China's population fell in 2022 for the first time in decades, a historic shift that is expected to have long-term consequences for the domestic and global economies. Because the unpaid balance of the loan decreases with each principal payment, the size of the interest payment of each loan payment also decreases. The management is free to utilise such capital and is not bound to refund it. (ii) Tax Benefits The lessor is entitled to claim the depreciation of leased asset and thus reduces his tax liability. They are employed to finance acquisition of fixed assets and working capital margin. In India, a number of special financial institutions have been established by the Government at the national level and state level to provide medium-term and long-term loans to the industrial undertakings. These various sources are described below. They have unrestricted claim on income and assets of the company and possess all the voting power in the company. ii. Sources of Long Term Finance Definition: The Sources of Long Term Finance are those sources from where the funds are raised for a longer period of time, usually more than a year. The conversion of detachable warrants into equity shares will have to be made within the time limit notified by the issuing company. The holders of these shares are the real owners of the company. These various sources are described below. Preference Shares 3. The amount of dividend may vary from one financial year to another. Ploughing Back of Profits 4. It just requires a resolution to be passed in the annual general meeting of the company. iv. However, unlike the sole proprietor or the partner of a firm, the risk of the shareholders in case of insolvency is limited to their capital contribution. The recipient of a long-term bank loan incurs a debt and is liable to pay interest . SBA Loans. Equity capital represents the ownership capital. Equity Share Capital: Equity shares, also known as ordinary shares or common shares represent the owners' capital in a company. The borrowing company needs to follow a repayment schedule for paying back the term loan to the financial institution. Trade credit 2. As the foreign capital plays a constructive role in a countrys economic development, it has led to a progressive reduction in regulations and restraints that had earlier inhibited the inflow of foreign capital. Also, the use of retained earnings does not require compliance of any legal formalities. (v) Convertibility Financial institutions usually insist on the option of converting their loans into equity shares of the company. A company does not generally distribute all its earnings amongst its shareholders as dividends. (iii) No Real Control over the Company There are a number of shareholders and most of them are scattered and unorganised. 3.3 Break-even analysis. (i) Economical Method It is very economical method of financing. But, in case of companies Before uploading and sharing your knowledge on this site, please read the following pages: 1. The firms that choose to finance through the external sources can retain internal funds to cover the company in an emergency. Long-term sources are those sources that are required to be Re-paid after 5 years. An equity investor is that person or entity who contributes a certain sum to public or private companies for a specific period to obtain financial gains in the form of capital appreciation, dividend payouts, stock value appraisal, etc. A financial plan is typically considered long-term when its goals span more than a year into the future. A company can reinvest whole of its income, if it so desires. The foreign capital may be provided by foreign government, institutions, banks, business corporations or individual investors. Hence, improving the companys credit rating might help the organizations raise long-term funds at a much cheaper rate. Bank credit - Loans and advances - Cash credit - Overdraft - Discounting of bills 3. There are different vehicles through which long-term and short-term financing is made available. (iv) Manipulation in the Value of Shares Ploughing back of profits provides the management an opportunity to manipulate the market value of its shares.
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