3 Main Types of Long Term Financing

This article throws light upon the three main types of long term financing. The types are: 1. Equity Shares 2. Preference Shares 3. Debentures.

Type # 1. Equity Shares:

It is the most important sources of finance for fixed capital and it represents the ownership capital of a firm. The salient features of this issue are that the equity shareholders are to bear all losses or run risks that may arise as owner of the company.

They are entitled to the residue (surplus) that is left after the fixed rate of preference dividend and debenture interest is paid of course, the dividend so received depends on recommendation made by the directors Since they are the owners of the company they enjoy the rights and exercise control.

As raising of funds by the issue of shares has certain distinct advantages over other sources, especially the borrowed capital, once procured, is non-refundable except in case of liquidation, does not create any charge or any encumbrance on the assets of the company, and does not impose any fixed charge on its use.

It is advantageous for a firm to finance its fixed working capital requirements out of the proceeds of the issue of shares which in common parlance goes by the name of ownership capital.

Rights issue, however, represent the issue of equity shares among the existing sharehold­ers in the form of a fixed proportion, e.g., “one for four”, etc. The price is less than the market price and the rights may be sold if required. The rights are issued since the expenses of making an offer are avoided and, secondly, it ensures the sale of the shares.

Advantages of Owned Capital:

(i) It does not impose any burden 011 the economic activities of the company since no dividend is declared and paid if there is no sufficient profit.

(ii) The company can acquire fixed assets which may be utilized throughout its life by issuing such shares. On the contrary, it is non-refundable (expect in case of liquidation) and does not create any charge.

(iii) Long-term loans can be taken by pledging fixed assets which are acquired by the issue of equity shares.

(iv) Controlling power will remain in the hands of the equity shareholders if the equity share capital is greater than other loan/debt capital As a result, instability is decreased.

(v) Equity shareholders earn more dividend than preference shareholders if there is sufficient profit.

Disadvantages Owned Capital:

(i) If the entire capital structure consists of equity shares only, the equity shareholders may try to control the entire undertaking which may be inimical to the interests of the latter.

(ii) If excess capital is invested in the business by way of equity shares, the same may result in idle capital which increases cost and at the same time leads to over-capitalisation.

(iii) The investors who do not want to take any risks or who want to be assured regarding the rate of return on their investments do not like to prefer equity shares since the return on investments is not guaranteed.

(iv) Trading on equity is not possible if the entire capital structure is composed of equity shares.

Type # 2. Preference Shares:

These are called Preference Shares since the preference shareholders are entitled to receive a fixed rate of dividend before the dividend is received by the equity shareholders as also to priority of repayment of capital before the equity shareholders in the event of liquidation.

Firms may resort to this technique as long-term capital owing to the above advantages. Since they have no voting rights, they do not have to take any risk and, hence, ownership is not affected.

Advantages Preference Shares:

(i) It does not cause any economic burden on the company.

(ii) The rate of equity dividend can be increased by the issue of such shares as fixed rates of dividend is paid on these shares (which is less) and the surplus may be declared in the form of dividend or the retention may be increased, i.e., the benefit of trading on equity is possible.

(iii) Controlling right is not transferred since preference shareholders have no voting rights.

(iv) The investors prefer this type of share since the rate of dividend is fixed and have got priority as regards repayment of capital.

(v) These shares are helpful for raising funds for a long period since they do not create any charge over the assets.

Disadvantages Preference Shares:

(i) The dividend paid on Preference Shares in not an allowable deduction at the time of computing taxable income. As a result, cost of capital is increased in comparison with Debenture and others.

(ii) The promoters — by investing a smaller part of capital through equity shares — can control the entire undertaking by issuing these shares.

Types of Preference Shares:

The different types of preference Shares are discussed below:

a. Redeemable:

These shares are redeemed at the end of the stipulated period. In India, according to Section 80 of the Companies Act, 1956, these shares are redeemed either out of fresh issue of equity shares or by creating Capital Redemption Reserve Fund out of Profit and Loss Account and/or General Reserve, a sum equal to the face value of the shares.

But premium on redemption of preference shares, if any, is to be adjusted against Share Premium Account and/or Profit and Loss Account.

b. Irredeemable:

These shares are non-refundable to the holders during the lifetime of the firm.

c. Cumulative:

If, in any year, the dividend on Preference Shares is not paid due to insufficient profit or loss, the arrear dividends, together with the current one, will be paid at a time out of sufficient profits in subsequent years, i.e., arrear dividends will accumulate.

d. Non-Cumulative:

Dividend, if it is not paid due to insufficient profit in any year, cannot be claimed by the shareholders, i.e., arrear dividends will not accumulate. But they are to be treated at par with other preference shareholders regarding repayment of capital.

e. Convertible:

Convertible Preference Shares are those which can be converted into equity shares within a stipulated period of time.

f. Non-Convertible:

Preference Shares which are not converted into equity shares are called Non-Convertible Preference Shares.

g. Participating:

In spite of having a fixed rate of dividend, these shareholders share in the surplus of the company which may influence an investor to invest in this type of Preference Shares.

h. Non-Participating:

It is nothing but the Ordinary Preference Shares which carry only the fixed rate of dividend.

Type # 3. Debentures:

In India, u/s 2(12) of the Companies Act, 1956, Debentures include Debenture Stocks, Bonds and other securities of a company whether or not constituting a charge on the assets of the company.

In other words, a Debenture may be defined as an instrument executed by a company under its common seal acknowledging indebtedness to some person to persons or secure the sum advanced Debentures are called Creditor-ship Securities as these constitute borrowed and/or loan capital of the company.

A Debenture may be issued at par, at a discount or at a premium, i.e., these are issued in the same manner as shares. The Debentures is one of the important sources of raising finance for a company. In order to meet the initial needs, a company can issue Debentures to secure long-term finance.

Advantages of Debentures:

(i) It is desirable to raise a part of long-term finance by issuing Debentures since they can help Trading on equity.

(ii) Control of ownership and management in the firm is not at all affected since Debenture-holders have no voting rights.

(iii) Interest paid on Debentures is an allowable deduction in computing total taxable income under the Income Tax Act.

(iv) Flexibility in the capital structure is possible when Debentures are redeemed out of surplus fund (i.e., from Reserve or Undistributed Profits).

(v) Since a fixed rate of interest is paid every year, the cautious investors prefer to invest the money in Debentures rather than in shares.

Disadvantages of Debentures:

(i) The heavy stamp duty, duty on transfer, commission and brokerage add up to a big amount which makes the cost of raising capital very high.

(ii) If it is found that the rate of Debentures interest is higher than that of return on equity capital, the issue of Debentures is not justified, since, in that case, the rate of return on equity share capital will be reduced.

Types of Debentures:

The different types of Debentures are discussed below:

a. Redeemable:

Redeemable Debentures are those which are redeemed either at par or at a discount or at a premium after the expiry of the stipulated period. The same can be re-issued even after redemption if not cancelled.

b. Irredeemable:

These Debentures are not redeemed until and unless the company goes into liquidation.

c. Convertible:

Sometimes Debentures can be converted into Preference shares or Equity shares at a fixed rate of exchange after a certain period. Such Debentures are called Convertible Debentures.

d. Bearer:

These Debentures are just like negotiable instruments and are transferable by simple delivery, i.e., transfer of Debentures is not to be registered with the company. Interest is paid at the end of the stipu­lated period to the person who will possess them, i.e., interest is paid to the holders irrespective of identity.

e. Registered:

Here, the transfer of Debentures will be effected on execution of a transfer deed or interest is payable or the repayment of Debentures is made to that person whose name is registered in the books of the company.

f. Mortgage:

When Debentures are secured by a charge on the assets of the company, these are known as Mortgage Debentures.

g. Naked:

When Debentures are issued without any security (i.e., Unsecured Debentures) in respect of interest or the repayment of the principal, they are called Naked Debentures. Solvency of the company is the only security.