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Sources of Finance

Debts and Equity Contractual set of cash flows ( P+I) I paid are tax deductible Debts have a fixed maturity Debtors plays a passive role to protect interest.

Sources of Finance

Classification of Sources

According to period
Long Terms Sources Shares, Debentures, LT Loans etc Short Terms Sources- Loan from bank, Trade Credit, Customer advances, Public Deposits etc

According to Ownership
Own Capital- Shares, RE, Surplus Borrowed Capital-Debentures, Public Deposits

According to Source of Generation


Internal Sources- RE, Depreciation funds etc External Sources- Shares, Debentures, Loans etc

Ms. Jyothi P.T Dept of Managment Science MESCE

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General Classification

Security Financing- Financing through Shares and Debentures Internal Financing- Depreciation funds and RE Loan financing- Short Term and Long Term

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Ms. Jyothi P.T Dept of Managment Science MESCE

Security Financing
Issue of SharesOne of the units into which the share capital of a company has been divided. It is a share in the capital of a company and includes stock except where a distinction between stock and share is expressed or implied. It is the most common method of raising long term capital.
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Ordinary SharesFeatures

Claim on Income Claim on Assets Right to Control Voting Rights Pre-Emptive Rights Limited Liability

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Ms. Jyothi P.T Dept of Managment Science MESCE

Types
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Preference Shares: These are the shares which carry a preferential right over the other classes of shares: 1. A preferential right in respect of a fixed dividend as a fixed amount or rate 2. A preferential right as to repayment of capital in the case of winding up of a company in priority to other class of shares. Types: Cumulative or Non Cumulative Participating or Non Participating Redeemable or Irredeemable

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Ms. Jyothi P.T Dept of Managment Science MESCE

Flexible arrangement since payment of dividend is not a legal obligation No final maturity date except for Redeemable PS and thus they are perpetual in nature. Additional to equity base to the company thereby increasing borrowing power Cushion to the Debenture holders as they save from paying higher interest rates Issue of Preference shares do not create any sort of charge against assets of the company
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Merits

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Fixed rate of dividend is paid and thus higher profit will enhance dividend to equity shareholders Cheaper than equity shares and higher return to investment for Preference share holders Demerits 1. It dilute the claim of the Equity Holders over the assets of the Company

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Ms. Jyothi P.T Dept of Managment Science MESCE

2. Equity Shares
These are shares which are not Preference shares. They do not carry any preference rights or any fixed returns. It is the most risky element in financing. Merits 1. Financing through Equity shares do not impose any burden on Company since payment of return is subject to availability of profit. 2. Sort of Perpetual loan in nature 3. Do not carry any charge on the assets of the company 4. Company have flexibility in operations and utilisation of the capital since neither capital or return on Equity Share is obligatory.

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Demerits
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2.
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High risk and hence high expectation of returns Control of company can be easily manipulated through the cornering of shares Reservation on issue of shares to new holders on account of loss of control Excessive reliance on equity share capital will reduce the capacity of the company to trade on equity, which may result in over capitalisation Cost of Share capital handling is high compared to others
Ms. Jyothi P.T Dept of Managment Science MESCE 10

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Debentures
It is a document issued by a company as an evidence of a debt due from the company with or without a charge on the assets of a company. It is a certificate issued by a company under its seal. Types: Naked Debentures: Which do not carry any charge on the assets of Company Mortgage Debentures: Secured by mortgage or charge on the whole or part of the assets of the company. Redeemable and Irredeemable Debentures Convertible and Non Convertible Debentures
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07/02/10

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Merits: 1 Specific period funding 2 Long term funding without dilution of control 3 Take advantage of the trading on equity and pay equity holders dividend at the rate higher than the overall return on investment 4 More suitable to investors who are conservative in nature and stable rate is looking with little or no risk Demerits 1. Raising fund through debentures is risky 2. Not suitable to companies whose income is fluctuating. 3. Debenture issue is considered to be issued at a not so better condition and hence debenture holders may ask for higher returns and subsequent sourcing of fund will be further difficult
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Merits and Demerits

Internal Sources
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2.

Depreciation as a source of finance Financing through Retained earnings or Ploughing Back of Profit

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Ms. Jyothi P.T Dept of Managment Science MESCE

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Loan Financing
1.

Short Term Loans and Credits Commercial Bank Loans Public Deposits Finance Companies Customer Advances Accrual Accounts- Wages and other accrual accounts whose payments are delayed on account of any reasons or whose funds earmarked are used at specific dates only. Term Loans Bridge Finance Loan Syndication Book Building- Method of Issue of Shares on price quotes Promoters Contribution
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Trade Credit Bank Credit or CC etc

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Special Features of Term Loans


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2.
3. 4. 5.

Specific Objectives Security Time Period Formal Agreements Participation or Syndication

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New Financial Institutions


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New Financial Institutions


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Venture Capital Funds Mutual Funds Factoring Companies Credit Rating Institutions OTC Exchange of India- Over the Counter Trading Exchange of India

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New Financial Instruments


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Commercial Papers: CP.


It is a form of usance promissory note negotiable by endorsement and delivery. It is normally issued by a High Net Worth company for meeting WC requirements, and not more than 1 year period is applicable to the CP. The maximum amount that can be raised should be 75 %.

2.

Certificate of Deposits- CD.


Issued for short term fund raising. No prescribed Rate of Interest and can be issued at face value or at a discount. It is a bearer document.

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New Financial Instruments


3.Securitisation of Debt: It is a financing technique whereby loans and receivables are packaged underwritten and sold in the form of asset backed securities. 4. SPN Secured Premium Notes with detachable warrants is redeemable after a notified period say 4-7 years. 5. NCD -Non Convertible Debentures with Detachable Warrants 6. ZCB- Zero Coupon Bonds. The bonds which are sold at a discount but do not carry any rate of interest 7. FCD Zero Interest Fully Convertible Debentures 8. Stock Invest- It is a form of additional facility available to an investor for availing Share Application Money for applying for Shares. It is a document issued by the Bank which can be used as Cheque or Cash for the Purpose.
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Depository Receipts ADR- American Depository Receipt. It is a Negotiable Instrument denominated in US $ and issued by a depository Bank representing ownership in non US Securities. It helps the US Investor to subscribe for the shares of a foreign company offered in his country or in International Market, in the form of Depository Receipts. 10. Euro Issues: An issue listed on a European stock Exchange. 1. Foreign Currency Convertible Bonds 2. EDR- European Depository Receipts issued only in Europe 3. GDR- Global Depository Receipts issued in Europe and US or Both 11. FRB- Floating Rate Bonds- Bonds issued without a Coupon Rate but linked to any benchmark rate. 12. Non voting Right Shares 13. Derivatives
9.

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Factoring
It is a financial service designed to help the firms to manage the receivables better. It involves an outright sale of receivables of a firm to a financial institution, called factor, which specialise in management of credit. Advantages: 1. Manufacturer of goods etc concentrates on the production and marketing and not on the collection 2. Reduction in the cost of maintenance and collection of book debts 3. Saving in time, manpower, etc 4. Monitoring of book debts and prevention of bad debts
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Functions of Factors
Credit recording 2. Credit administration 3. Credit protection 4. Credit financing Factoring Calculations: Cost of Factoring as Fee and Commission is judged against the Saving in cost due to factoring and increased collection of Money, lower Bad debts and Advance payment from the Factor Company.
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Leasing
Definition:

A contractual arrangement / transaction in which a party owing an asset / equipment (lessor) provides the asset for use to another / transfer the right to use the equipment to the user (lessee) over a certain / for an agreed period of time for consideration in form of / in return for periodic payment (rentals) with or without a further payment (premium)

No exclusive law / legislation/ act / regulation / direction/ to govern equipment leasing finance

Divorce of ownership from the economic use of an asset / equipment. Device of financing the cost of an asset / money lending. Lessor is the nominal owner Lessee has the possession and use of the asset on payment of the specified rentals over a predetermined period of time

Elements:

Parties to the contract :Individual & owner / Lessor & Lessee a. Individuals, Partnerships, Joint Stock companies, Corporations, Financial Institutions b. Joint Lessor/ Joint Lessee

C. Lease Broker : who acts as an intermediary in arranging lease

0.5% - 1%

Commission

Asset : Property / Equipment Automobile, P&M, L&B , Equipments , factory, Running business. 1. Ownership separated from user: Ownership vests with lessor and its use is allowed to lessee. On lease tenure , assets reverts to the lessor

Terms of Use : Period for which the arrangement of lease remains in operation.
Strech over the entire economic life of the asset Financial
Lease

Period shorter than useful life of the asset Operating Lease

Lease Rentals : The consideration which the lessee pays to the lessor for the lease transaction.

It is to ; Compensate the lessor ( depreciation, interest on investment , repair )

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Mode of terminating lease : Terminated at the end of lease period


The lease is renewed on a perpetual basis or for a definite period The asset reverts to the lessor The asset reverts to the lessor & the lessor sells it to a third party The lessor sells the assets to the lessee

Risk : Possibility of loss arising on account of under-utilization or technological obsolescence of the equipment.
Reward: The incremental net cash flows that are generated from the usage of the equipment over its economic life and the realization of anticipated residual value or expiry of the economic life.

Advantages of Leasing
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Permits alternate use of funds Arrange faster and cheaper Credits Increase the lessees capacity to borrow Protect against obsolescence Boom for small firms Tax shield

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Ms. Jyothi P.T Dept of Managment Science MESCE

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Securitization

Securitization is the process of pooling

and repacking of homogeneous long term illiquid financial assets and non-performing assets into marketable securities, which can be sold to investors
Securitization in India is regulated by the SARFAESI Act 2002- (Securitization & Reconstruction of Financial Assets & Enforcement of Security Interest).

Process of Securitization

Assets are originated through receivables, leases, housing loans/ any other form of debt by a company and funded on its balance sheet. (The company is normally referred to as the originator) Once a suitable large portfolio of assets has been originated, the assets are analyzed as portfolio and then sold to a third party, which is normally a Special Purpose Vehicle Company (SPV) formed for the purpose of funding the assets. SPV issues debt and purchases receivables from the originator. The SPV will be owned by a trust or the originator.

The administration of the asset is then subcontracted back to the originator by the SPV. It is responsible for collecting the principal amount and interest on the loans in the underlying pool of assets. The SPV issues tradable securities to fund the purchase of assets. The performances of these securities are directly linked to the performance of the assets. The investors purchase the securities (because they are satisfied that the securities would be paid in full and on time from the cash flow available from the asset pool). As cash flow of arise on the assets they are used by SPV to repay funds to the investors in the securities.

Advantages

It provides liquidity to the originators (NonBanking Finance Companies / Banks) Better Credit Rating is possible. Securitized debt is cheaper as the original investors can beat the ratings given by the rating agencies and thereby diversify their credit risk. Originators can plan their capital adequacy requirements by using securitization to reduce the risk of weighted assets and thereby improve their capital adequacy.

Process

Identifying and aggregating the receivables of originator Selling these receivables to SPV SPV borrows money from investor SPV makes payment to the originator at discount Receivables are collected on behalf of SPV Repayment of principal and interest by SPV to investor

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