Chapter 5

SOURCES OF
FINANCE-I
LEARNING OBJECTIVES
After studying this chapter, you should be·able t~:
♦ Understand the financial requirements of a business.
1

+ Understand the sources of finance available to a business.

+ Understand the concept of shares, equity shares and preference shares, as a source of Finance.
❖ Understand the meaning of ploughing back of profits, zero interes
t bonds and equity warrants. _

meet the financial

A financial manag er has to acquire funds from different sources to
nt operat ion of business.
requirements of business. Adequate finance is necessary for the efficie
sion is possible without
Neither any business can be established nor its development and expan
ss can be Jivide d into
adequate finance. On the basis of time, financial requirements of a busine
three parts:
(1) Long-terrri Requirements of Funds
(2) Mediu m-term Requirements of Funds ··------ '--
(3) Short- term Requirements of Funds -,
(1) Long-term Requirements of Funds: The requirements of funds
for more than five or
ement s of
seven years are called long term requirements of funds. Long-term requir
ed for the
funds should be met from long-term sources. Long term funds are requir
and payme nt of
purch ase of fixed assets, arrang ement of perma nent working capital
nery, furnit ure
preliminary expenses. Fixed assets include land, building, plant & machi
business for a
and fittings, patents, goodwill, livestock, etc. Fixed assets are used in the
ters at the
long period to earn profits. Preliminary expenses are incurr ed by the promo
for the business.
time of promo tion ofcompany. Similarly, working capital is also neede d
Working capital is of two types:
(a) Perma nent Working Capital, and
(b) Temp orary Working Capital
in curren t assets.
(a) Permanent Working Capital is neede d for minimum investment
l is not
Therefore, it should be acquired from long term sources. Long term capita
time of
only needed at the time of establishment of business, but also at the
l in a
expansion and development of business., The requir ement of fixed capita
ss, size of
business, depends upon a numb er of factors including nature of busine
 Fina nct
al Management

busi ness , com plex ity of prod ucti•on proces s ' prel imin ary expe nses , viewp 1•
. h
man agem ent. All the~e facto rs h ave b ee n discu ssed m c apte r 3 . ° nt Of
( 2) M echu •
m-te rm Req uire men t.9 of Fun d s: M e d 1. um term requ irem ent fund s occur £
·
pen od of one to five or seve n year s. S uc h fu n ds a re requ ired for such uses whics hor a
•

.
neit her of fixe d natu re nor of curre nt na ture The se fund s are need ed fo · are
. ry
· .
•a or h eavy imp rove men ts m . r the
rep lacem ent of mac hme and equi· pmenl.J . them "
rese arch and deve lopm ent and heav y exp endi , ,or
ture o n adve rtise men t, etc.
(3 ) Sho rt-te rm Req uire men t of Fun ds: Sho
rt-te rm fund s are need ed for a peri od of l~!
than one year . Sho rt tenn fund s are need ed for
expe nses of rout ine natu re like purc hase
of good s, paym ent of sala ry, wag es, rent, etc.
The refo re, ~rra nge men t of adeq uate
wor king capi tal has to be mad e und er shor
t term fina nan g. Sho rt term financial
requ irem ents shou ld be met from shor t term
sour ces.
In the abov e disc ussi on, natu re oflo ng-t erm, med
ium -term and shor t term requ irem ent of
fund s has been exp lain ed. It is wor th noti ng
that long-term financial requ irem ents shou ld
from the long -term sour ces, med ium tenn be met
requ irem ents from the med ium -term sour ces
shor t-ter m requ irem ents from the shor t-ten and
n sour ces. The refo re, a fina ncia l man ager
mai ntai n prop er bala nce in the long -term must
, med ium -term and shor t-ter m sour ces of
Som etim es, it is diffi cult to diffe rent iate in funds.
the long -term and med ium -term sour ces. Cert
busi ness es use the fund s acqu ired from the shor ain
t-ter m sour ces for the purc hase offixe d asse ts.
is not cons ider ed prop er as per the prin ciple But it
s of finan cial man agem ent beca use it decr ease
liqu idity ofbu sine ss and the prob lem of prom s the
pt paym ent may arise . Simi larly , if the fund s acqu
from the long -term sour ces are used for fulfi lling ired
shor t-ter m requ irem ents , it will be misu tilisa tion
fund s as the fund s of busi ness will rem ain of
unut ilise d whic h will redu ce prof itabi lity. Fina
rnan age- r shou ld also mai ntai n prop er bala ncia l
nce in own ed capi tal and borr owe d capi tal.
requ irem ents of busi ness can be met out of ff all
equi ty capi tal and rese rves and surp lus, it will
dep rive d of the bene fits of trad ing on equity. be
If on the othe r hand , all finan cial need s are met
borr owe d capi tal, ther e will be fixed burd en of by
inte rest on busi ness . The refo re, to-su m up, it can
said that , thro ugh finan cial plan ning , prop er be
bala nce betw een own ed capi tal and borr owe d
and amo ng long -term , med ium -term and shor capit al
t-ter m sour ces shou ld be esta blish ed.
~o ur ce s of Fin anc e
1/ The sour ces of fina nce- long -term , med ium
Diff eren t sour ces of fina nce can be outl ined
-term and shor t-ter m are diffe rent for busi ness
.
as und er:
Sou rces of Lon g-te rm Fina nce: Sou rces of
long -term fina nce can be divi ded into two
part s: (i) Own ed Cap ital and (ii) Borr owe d Capi
tal.
Ow ned Cap ital is prov ided by the ~~~rs
of ~in ess and inclu des ·ordi nary sh~ .
pre f ere n ee shar es and r~_ es. On the othe
r hand , Borr owe d Cap ital is raise d as long term
from the ~ wers . Mai n 5?ur ces ?f ~rro wed ~a~i tal_inc~ ude loan
de~ res , bond s, leas e finan cing
and Jong term Joan s. In I_ndia, spe ~bs ed fi~a n~al
msu tuuo ns have been esta blish ed forp rovi ding
long term Joa ns whi ch will be expl aine d bne~
y m the next chap ter.
Sou rces of Med ium -ter m_Loa ns: Med mm
-ten n loan s can be mad e avai lable from vario us
ediu m-t erm sour ces mclu de loan s from
sour ces. M finan cial insti tutio ns, rede ema ble pref eren ce
~

58
 5 Sources of Finance-I

Hire Purchase System and

shares, redeem able deben tures, public deposits, purchases under
chapter.
accumulated profits. All these sources have been explained later in this
e bank loans, public
Sources of Short-term Funds: Sources of short-term funds includ
ses, commercial papers ,
deposits, advances from customers, provision for taxes and credit purcha
etc.

■ Shares
ing shares is called owned
. Shares ~re a source oflon ,.s:-te ~funds. The capital raised _b4-issu
of Indian Companies Act,
capital. Share 1s a part of the capital of company. Under Section 2(46)
es stock excep t where
1956- - "Shar"e· means share in the share capital of a compa ny and includ
distinc tion betwe en stQd..and share is expres sed or implied".
given certificate to the
Share holde rs are the owne;s of the company. Each shareh older is
, their serial numb ers and
shareh older for the shares held by him. It indicates the numb er of shares
'
their face value.
• Characteristics of Shares
olders. Some of the
Shares of compa ny affec_f the interests of the company and the shareh
main ch,l\;acteristics of shares are as under :
e)I Permanent Capital: Comp any can acquire perma nent capita!J?_y issuing shares and
gemen t is not
mana geme nt can use these funds till the business is contin uing. Mana
invest ment, he
worri ed to repay this capital. If a shareh older wants to get back his
is liquid ated, the
can do so by selling these shares to other person s. When a compa ny
shareh olders are refund ed the left out funds.
e~nt to- pay
~ o Obligation to Pay Dividends: It is not necessary fqr ~e m~ag
its profits in the
~ divide nd every year on the. shaJ;:es. Manageinent can reinvest all
- ~ - . _ _.
company. - ·
issuing shar~s.
d£) No Secur ity is Requi red: No security ~s r~qui~~d to ~~se the ~pi_tal by
no obligation
~ No Oblig ation to Refun d Capital: As alr~ady said, the company is under
to refund the capital to its shareh olders during its lifetime.
dividend out of the
(5) Resid ual Claims to Incom e and Pl!)perty: Shareholders are paid
rly, at the time
residu_al income of the comp ~y afte~ paying intere ;t <?n debentures. Simila
after payin g the
of liquidation their capita l is paid after payin g off all credit ors. If
t.
credit ors, there is no balanc e, the shareh olders will not get any amoun
value of shares
Limited Liability:_!he liability of ea~ shareh older is li~ited upto the
E'rui~i"'io'
~

l..2)).
held by him. ·_
~f~ r Shares: Shareholders can sell th_e!r -~li~res. and can invest the
~ ,,.,mo unt so received elsewhere. .. ...... ____ . ___ _________ _
~ g h t to M~ag e the Company: Shareholders are the ~~~-;~s- ·;f
~e company. They
ors as their
have full rights to mana ge the compa py. They appom t direct
repres entati ves to manag e the company.
• -- - - - - 4 .. ~
-· - ---

59
 Financial Management

■ Difference between Share and Stock

· I tock Share is a part of the capital of
It 1s essential to know the difference between s1iare am s · · . ·
• I d k A 11 y company can convert. its fully
the company. The share capital as a whole 1s cal e st.oc · . ff II .
· k ti e collect:Jve sum o u y paid up
. ·
paid up share
.
capital into stock.
. . .
Therefore, stoc means 1. . .
f . d ~ mmatton . It 1s not necess,1ry that all
shares which can be subd1v1ded mto small parts o ,my eno II
'k I . ti e small parts are not a ottec1serial
these small parts should be of the same amount. Li es ,mes, · les • . II
d . st k O f ~IO a 1t 110ug11 11e ongma y had
numbers. For example, a shareholder may be hol mg· oc ' . . f
· 11 any part of 1t but m case o shares he
shares of~ 100. In case of stock shareholder hast l1e opuon to se ' b
- f· s kd not have any face va 1ue ut shares·
had to sell the whole of a share and not a part o it. toe oes
• • · t 't egistered for transfer. But share can
have. Stock is not a bearer security and 1t 1s necessary toge 1 r .
·
be a bearer secunty. To convert the share capita mto
· l · s t oc k , informatlon
. . be sent to the
must
·
Registrar. St_ock can be reconverted mto· ' sh ares,are more ·m pracuce than the stock ·
shares. I n I n d 1a,

■ JYpes of Shares
·J , Under S e ~ f the Indian Company Act, 1956, a company can issue two types of shares:
(i) Equity Shares, and
(ii) Preference Shares
Before the implementation of this Act, companies could issue deferred shares al~o. But under
the Companies Act, 1956 no public company can now issue such type of shares. Fully mdependent
private companies can issue such shares. In the following pages, we will explain only Equity and
Preference Shares.

r:
uity Shares . · ,
I ·,
Equity shares have an important place in the capital structure of a company. Ordinary share
ca ·ta1 is the base debt and preference share capital. drctmary shareholders are the actual owners of
the comp~y and have full voting rights}fhey take part in the management of the company through
the appointment of directors. They have unlimited interest in the incomes and assets ' of the
company. The main objective of the company is to maximise the value of shares held by
shareholders. Ordinary shareholders bear all the risk. There is no predetermined rate of dividend
for them. Ordinary shareholders have the right on that income which is left after payment ofinterest
and preference dividend. Similarly@.liquidatiorl!h,ey have the right on those assets which are left
after payment_of all liabilities and preference share capit~
Therefore, following are the main characteristics of equity shares:
(I) Maturity: From the ordinary shares, company gets fixed capital, which the c~mpany is
not ~ound t~ p~y d~ring its life_timeQ'_he shareholders c;; demand their capital only at
the ume ofhqmdat!o~. At the time ofhquiqatioq, they will get their capital b~ck only if,
there is any balance l_eft aft~r pay-off otha-ijabilities. Company c ~ t bind its
shareholders to sell the1r holdmgs. • -.
(2) Claims on Income: Equity sha~eholders of the company are 'd ', : f' i e
. . . res1, ua1owners o mcom
of the company
.
e1r nght on mcome arises only when th
d . .· & • . r. r.
ere 1s any mcome 1eit aiter
, fi
Payment of mt~st an preference d1v1dend · Even if th e ,company has pro Its,
1
shareholders cant wrce t 1e company to pay dividend to th Wh f fi
c . · · d em. o1e o the pro its can
be ploughed back 1or expansion, eve Iopment and strength . h . ..
enmg t e financial posiuon

60
 5 Sources of Finance-I

of th e company. In actual practice, the company pays dividend at a reasonable rate in

th e even~ ~f adequate earnings so that sharehol ders may have faith in the company /No
!s
rate of dividend fi:,_cfd . It depend~ on the po~cy of the managem ent and quantum of
• • .. , .
profits.)

~ Claims on Assets: Being the residual ownen@ e ordinary sha~d ers have last cbirn
r on th e assets of the company. At the time o(liquida tion, the assets of company are sold
a nd ~rst of all the claims of crediLots and preferen ce sharehol ders are settled without
makmg any pay1i1ent to the ordinary shareholder&,. Whateve r the balance is left,
ordinary sharehol ders have full right on it and it is distributed among them in
proporti on to their holdings. Ordinary share capital provides safety to the interests of
creditors .
(4) Control: Ordinary sharehol ders have fuJl right of managem ent aod control of the
' i company. Each sharehol der has voting right m the meetings of the company in
proporti on to his holdings in the company. For the operatio n and control of the
company, they appoint directors who act as their representatives. They have right to •
remove the directors also. If a sharehol der can't present himself in the meetings of the
company, he can use proxy.
(5) Right of Pre-emption: Although the ordinary sharehol ders can't force the company
to
, J distribut e dividend , yet they have been given right to have proporti
onate interest in the
assets, income and control of the company. For this purpose, they have got preferen tial
right to purchase the new shares issued by the company. It is the statutory obligation of
the company that it should present new shares to the existing sharehol ders first. This
right of the ordinary sharehol ders is called Right of Pre-emp tion. Each sharehol der can
exercise this right in proporti on to the shares held by him. For example , if a sharehol der
~as 200 shares and company has total issued capital of2,000 shares, he will have right to
, purchase I 0% of the new shares of the company. ·
The number of rights needed to buy a new share can be calculated by using following
formula: ·
. Old Shares
Number of Rights needed to buy a New Shar e=--- --
. New Shares
Funds to be Raised
Num bers of Sh ares=
Subscription Price

■ Determination of Value of a Right

When the new shares are presente d to the existing shareholders, they get previlege to
purchase them at a cost lower than the market price. This right can be sold in the market, as a result
of which it becomes necessary to determin e the value of this right.
The value of right can be determin ed as under:
R = Mo-S
N+I

61
r

Financial Management

where R = Value of one right

M0 = T he rnrrent market prire of a 11hare
S = Sub~cription prire of share
N = Number of rights needed tu bny one share.
• Illustration 1. .
If the market price of a share is, 10 and subs~ription pr.ice is f 8, and it requ ires to buy 8 rights
to buy an additional share, calculate the value of the right.
• Solution:
Calculation the value of the right:
R = M0 ~ - S = ,10 - f8 = , 0_22
.... N + 1 8 +1

■ Advantages of Equity/Ordinary Shares

(A) Advantages to the Company: The company has following advantages from equity shares:
(i) From the equity shares company gets fixed capital which it can use during its lifetime and
is not bound to repay it. ·
(ii) Company is not bound to pay dividend. No rate of dividend can be fixed and the amount
of divide~d depends on the income of the company and its plan for growth and
expansion. Company can reinvest its entire profits, if it desires.
(iii) By issuing equity shares, the debt capacity of company increases. For the ordinary
shares, the assets of the company need not be pledged. More equity share capital
provides safety to the creditors.
(iv) Equity shareholders bear the maximum risk on the basis of which the management can
face financial crisis.
(v) Equity capital is a cheap source of finance.
(B) Advantages to Investors:
(i) At the time ofincrease in profits, there is a possibility ofincreasing the rate ofdividend.
(ii) Equity shareholders have right to participate in the management of the company. By
using their voting rights, they can appoint directors and remove them.
(iii) With the incre~se in profits of company and reinvestment of these profits, the market
value of shares mcreases. Shareholders can earn capital gains by selling their holdings.
(iv) For the investors who are enterprising and ready to bear risk, it is a good avenue to
invest.
As compared to fixed assets investment in equity shares is liquid. Shareholders can get their
money back at the time of need. . . .

■ Disadvantages of Equity Shares

• (1) for the Company
(i) By issuing only equity shares, the cor~pany cannot take the advantage of trading on
equity. For taking the advantage of tradmg on equity, it is essential to issue debentures.

~ 62
 ,f!Jl fl'~-----------
_________
5 Sources of Finance-I

(ii) SIlare I1 olders have the voting right. Shares can be purchased and sold in the stock
market. T~1 erefore, sometimes some persons purchase the shares to keep control of the
company m their hands. Thus, the control of company is centralised in a few hands.
(iii) I n case of over-capitalisation, to correct the situation it becomes difficult to reduce the
value of share or their number, whereas the debentures and preference shares can be
redeemed.
(iv) Equity shareholders bear the maximum risk and the rate of dividend for them is also not
fixed. It encourages speculation which affects the goodwill of the company.
• (2) For the Investors
(i) Income on equity shares is irregular because dividend is neither paid regularly nor at a
fixed rate. Amount of dividend depends on the income of the company. In case of more
profits, more dividend is paid and in case ofless profits, less dividend is paid. Thus, the
investors desiring fixed income get disappointed.
(ii) Income on ordinary shares is uncertain. In case of no profit, no dividend is paid. In case
of profits too, it is not necessary that board of directors will certainly declare the
dividend. Whole of the profits can be used for the growth and expansion of the business.
(iii) During depression, the shareholders have to bear capital loss due to fall in market value
of shares.
(iv) The persons who don't have the capacity to bear more risk, investment in ordinary
shares is not the best alternative for them.
(v) At the time ofliquidation, shareholders have to bear the risk ofloss in assets. The equity
shareholders are paid at the end after payment to . all creditors and preference
shareholders. Sometimes, the ordinary shareholders are unable to get back any amount
due to low value of assets.
Despite these disadvantages, equity shares are the most important source of finance for the
company.

■ Analysis of Equity Shares

- .

For the comparative study of different sources of capital, three factors-<ontrol, risk and
income should be analysed. The quantum of control, risk and income of all the sources of finance is
different. Investors viewpoint is also different towards control, risk and income. Some investors
want to invest in those securities which yield regular and fixed income. Contrarily, some investors
are more ambitious and ready to bear risk, whether their income is irregular and uncertain. In
relation to equity share capital, risk, control and income can be analysed as under:
(1) Control: In actual practice the control of company remains centralised in a few hands.
These persons hold a major part of the ordinary share capital. Only a small part of the
equity share capital is held by a large number of the shareholders who are spread all
over the country and are unorganised. They can't make use of their voting power
effectively. They don't have any say to change the policies of the company. They are,
therefore, interested mostly in the risk and income rather than control. These
shareholders do not use proxy for voting until the controlling shareholders do not
encourage them to do so. Such companies do not want to issue new equity shares for

63
Financial Management

raising additional capital so that the control of company remains in th eir hands. They
meet the requirement of additional. capital br issuing debentures or preference shares.
(2) Risk Every im·estment in capital has less or more risk. Every inv_eSl~r not only expects a
reasonable return on his in\'estment but also wants that his capttal is safe. If the capital
employed is represented by assets of the similar amount, the capital empl~yed is safe.
But continuous losses first of all decrease the funds of company and the capital. It gives
rise to a situation that the company is unable to pay its liabilities in time and the
liquidation of company becomes compulsoqr. In case of liquidati~n, the creditors are
paid first, then preferential shareholders and in the end, the eqmty shareholde~ are
paid. Thus, equity shareholders have residual claim only and they hear the maxunwn
risk as compared to creditors and preference shareholders.
Even if there is no liquidation, equity shareholders bear the ma.."'<.imum risk. Due to
continuous losses, the market value of share falls. In case of profits or reinvestment of
profits, the market value of share rises and the shareholders enjoy capital gains.
(3) Income: The nature and quantum of investment depend on the amount of income
accruing from iL Investors want a fair return on the amount invested by them alongwith
the safety of their investment. The amount invested in equity share capital and the
income expected on it have greater degree of risk because equity shareholders are paid
dividend out of the income left after paying interest on debentures and dividend on
preference capital. Despite of adequate income, it is not necessary that equity
shareholders will be paid dividend because the board of directors may recommend the
reinvestment of profits for the financial soundness of the company and for its growth
plans. But in actual practice, the board of directors try to pay dividend to the
shareholders because in the absence of it, the company may face difficulties to raise
funds in future. Besides, the equity shareholders are the owners of the company and the
long term objective of the company is to maximise their wealth. By following the policy
of trading on equity management can increase ~e rate of return on equity share capital.
By using stable dividend policy, uncertainly about dividend can be reduced to some
extent.
To clear the concep_t ~fincome on equity shares, it becomes essential to analyse. Earnings
Per Share (EPS), D1V1dend Per Share (DPS), Pay-out Ratio, Earning Yield and Dividend
Yield.
A brief description of these ratios is as under:
(i) Earnings
. · th
Per Share (EPS): Equity shareholders have thei·r ·m 1erest m e reSI"d ual
mcome
. ·
of the. company. The rate of dividend depends O n th"1s mcome b eSI"d es o th er
things. Eqmty •
shareholders are the claimants of th"1s res1"d ua l mcome f1
(a ter
.
payment of mterest and preference dividend) If wh 0 l f th • .
· · d d. ·d d . · e o e mcome 1s not
distribute as 1v1 en , the balance 1s retained in the b • . .
• h usmess. Agam the eqmty
h h
sharehol d ers ave t e ng t on these retained earning T. ' .
. s. ,o ca1cu1ate Earnmgs Per
ft
Share, profit a er mterest and preference dividend is d' ·d db .
ivi e y number of equny
sh ares.
Profit after Interest Ta d
Earnings Per Share = ' x, an Preference Dividend
Number of Equity Shares

64
 5 Sources of Finance-I

For example , if the income of a company is ,60,000 after payment of interest, tax
a nd preferen ce dividend and the number of equity shares issued by it are
I 0,000, Earnings Per Share will be ~ GO,OOO = ?6 per share.
~ 10,000

(ii) D_i~dend Per Share (DPS): Equity sharehol ders are more intereste d in the
dividend per share rather than earnings per ~hare. If company retains woole of its
• profits and does 1\ot pay any dividend , the sharehol ders will be dissatisfied and
they will not be intereste d in any future investme nts in that company . Therefor e,
the company declares dividend at a rate which is prevalen t in other compani es of
similar type.
If a company declares dividend @I 0% and its each share is off I 00 (fully paid up),
dividend per share will be f I 0. '·

(iii) Pay-out Ratio: Pay-out ratio is the proporti on of dividend pe_r share to earnings
per share. With its help it is ascertain ed which part of residual il)come is distribut ed
by the company as dividend . It can be ascertain ed by using following formula:
. Dividend Per Share x I 00
Pay O u t Rat10 =- ---------
Earnings Per Share

For example , if the earning per share (EPS) is f 5 and dividend per share (DPS) is
1
t 3 the pay-out ratio will be x I 00 = 60%
5
It means that company retains 40% of its incorrie.
(iv) Earning s Yield: This ratio explains the relations hip of earii.i~gs per share to the
market price per share. It is also called Price Earning Ratio. It {:an be calculate d as
under:
Earnings Per Share x I 00
Earnings Yield = - - - - - - - - - -
Market Price Per Share •.

For example , if a company earns t 3 per share and the market_value ofits share is
f 15, the Earnings Yield will be l_ x 100 = 20% .
15
It means that the market price of the share is five times ofits ear?ings per share.
(v) Dividend Yield: This ratio is calculate d by dividing the Divide~d Per Share (DPS)
by market price per share. ,'
~ ,
Dividend Per Share x I 00
Dividend Yield
Market Price Per Share

For example , if a company declares dividend @ f2 per sha.re and the market
price of the share is f 16, the dividend yield will be ) .

.! X 100= }25% · I'

16 :J,
l
All these ratios have been explaine d in the Chapter on Ratio Analysis.
' 4j,,
l
l'.1
\ 65
 ,_ _ __ _ __ 1111-.,IWillllftt!llJlf/fl/TlfJf/fl[ffPrfDff'I _ _ _ _ _ _ __

Financial Management

■ American and Global Depository Receipts

Liberalisation and globalisation took place in India in 1991 . After this, Indian capital market
has widened scope to include international capital markets as well. Today, Indian firms have easier
access to international capital markets than what it was in the past. Now, Indian firms are able to raise
finance through ADR and GDR from the international capital markets.
GDR is an instrument in the form of a depository or a certificate issued by the Overseas
Depository Bank and Issued outside the country to non-residents against ordinary shares of the
issuing company. An Indian company seeking to raise fund through Depository Receipts is required
to take permission from the Department of Economic Affairs, Ministry of Finance, Government of
India. Indian companies are not allowed by law to list Indians rupee-dominated shares directly in
foreign stock markets. Hence, the companies issue the shares to a depository which has an office in
India. These shares remain in India with a custodian. Against these shares, the depository issues
foreign currency denominated receipts to the foreign investors. The foreign investors can seU these
receipts either in the foreign exchange or to the depository and get the Indian rupee-denominated
shares which can be sold in Indian markets.

■ Advantages
(i) Lower cost of raising equity funds from the international capital market.
(ii) ~nhancement of the image of the issuer company.
(iii) Broading shareholder base.
(iv) Listing and trading in international stock exchanges.
(v) Reduction in foreign exchange risk.
(vi) Excellent liquidity.

■ ADR
AD~, similar to GDR, are negotiable receipts, denominated in US dollars, and issued by the
US Depository Bank. .US Depository · · company
. bank also certify that the shares of an I n d'1an 1ssumg
are held by the depository's custodian bank in India. ADR are q' uoted in US d o11ars. Th e company
·d d d'
sen d s di vi en s · irectly ·
to the depository (in Indian rupees). The depository issues
US d ll
d'1v1'den d fi gures
to ADR h old ers m o ars.

■ Venture Capital
A form of equity financing designed specially for funding hi g h ns· k d h' h ·
· kn 'Vi c · 1, . an 1g reward proJeCts
• fi . . .
IS own as enture apita . Venture capital plays an importa n t ro le m nanc1al hi-tech proJeCts
· h d d
an d h eIpmg researc an evelopment project to turn them · . .
· · h d . mto commercial producuon In
deve Iope d countnes, it as assume great importance as it has fi d h' . . ·
.h h b nance 1ghly mnovauve new and
risky ventures wh 1c ave ecome a great commercial succes U l'k ' . .
10
developing countries like India, venture capital is in its beginn:~ s:: ; ~:eloped_ n_auo~s,_
opularity as a source of finance due to opening of worldwide e g _g · wever, It IS gammg
P conom1es.

66
 5 Sources of Finance-I

• preference Shares ~
~eference s~are capital is ano ·her source of rovidi n long term fi nance., Preference shares
are those shares which ]~ave preferential rights regardin g th e payment of 1v1dend and repayment
of cap~ over the equity shareholders . Equi ty shareholders can't be paid any di vidend unless
dividend at a fi xed rate is pai? to preference shareholders. In other wi,rds, they are paid the
dividend o.u~ of the _e ar~ings ~fter .interest and taxes but befo re any dividend to equity
shareholders. Similarly, at the time of liquidation repayment of capital to the preference
shareholders is made after settling the claims of creditors and debentures but before making any
payment to equity shareh~lders . Due to these two preferential rights, these shares are called
Preference Shares. T he mam characteristics of preference shares are outlined below:
(1) Maturity: The company gets fixed capital from the preference shares like the equity
share~nd it is not bound to repay it@ut many time_s the ~ompanies.issue red~able
preference &hares _a nd fix the time of their redemption under the terms of issue. Such
shares are called Redeemable Preference Shares. Redeemable preference shares are
redeemed at the option of the company but according to the terms ofissue. Sometimes,
the companies issue convertible preference shares also. As a result, the preference
shareholders have the option to convert their shares in the equity shares of the
company. The ratio in which these shares can be converted into equity shares is
explained by the articles of the co~pany@ e main objsctive of issuing conv<:rtible OT
redeemable preference shares is to make the capital structure of company more
flexible) · · · ·
(2) Claims on Income: Preference shareholders have the preference in relation to
dividend over the equity shareholder l'They are paid a fixeJ;;te of dividend on the
basis of predetermin ed term~uity¥areholders can't be paid any dividend before
making any payment to preference shareholder y But it does not mean that it is
statutory' obligation to pay dividend to the preference shareholders. Even in case of
income, they can't legally compel the company to pay them the dividend. The
distribution of dividend depends upon the decision of the Board of Directors. But if the
decision for distribution of dividend has been taken, dividend the preference
shareholders will have to be paid dividend prior to equity shareholders.
Sometimes, the preference shareholders are offered to participate in the additional
income of the company, over and above their fixed rate of dividend. Such shares are
called Participating Preference Shares. As already said that in case there are
inadequate profits or the company suffers losses, it is possible that no dividend is paid
on preference shares. But many companies ar~ange for paying the amount of dividend
of such years in the coming years. Such shares are called Cumulative Preference
Shares. If at the time of issue of the shares, it is not cleared whether these shares are
cumulative or non-cumulative and no provision has been made in the Articles, these
shares will be considered as Cumulative Preference Shares. The main objective of the
Cumulative Preference Shares is to attract the investors to invest in the company.
(3) Claims on Assets: Although assets of the company are not kept as security with
the preference shareholders , yet their claims on assets are better to the equity
shareholders . &_the time of liquidation of the co~pany, the capital of preference
shareholders will be paid hack ta them before making payro~nt to equity shareholders .
• • ' I
I

!i 67
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Financial Management

(4) Controlling Powe~r mally, the preference shar~hold~rs do not have right to
participate in the manageme nt of company because they don t have any v2tmg rights for
the appointme nt of directors)m d on allied mat1crs. But uacler Section 87 of the
. to vote on some spe c·i·-,..•l -"sues
company Act, they have nght ~ · which directly affect th ern .
1'

■ Types of Preference Shares

The following are the various types of preference shares:
(1) Redeemable and Non-redeemable Preference Shares: Redeemab le preference share~
are the preference shares which can be redeemed at the option of th e company after a
fixed period of time. The terms for the redeemabl e preference shares a~e determined at
the time of their issue. Contrarily, if the amount of pr~~~~ence shares is not to be paid
back to the shareholde rs during the lifet'i'ine of the company, such preference shares are
called Non-redee mable Preference sii~res. When a company needs additional capital
of
for a fixed period time, the compaiiy"issues'i-~de~mable preference shares. After the
redemptio n of these shares company can be free from the liability of fixed dividend.
(2) Cumulative and Non-cumulative Preference Shares: In case of cumulativ e preference
shares, the shareholde rs have the right to recover the arrears of dividend in the
coming years. If a company is unable to pay the dividend on preference shares in a year
due to inadequac y of profits -or losses in that year, the cumulativ e preference
shareholde rs have the right to cla'im the dividend of that year ~n th~ subsequen t years.
In·
the s·ubsequen f years, first of all the arrears of dividend will be paid and then the
dividend for the current year. On the other hand, the holders for non-cumulative
preference shares do not have any·right to recover their arrears of dividend of any year
- - -- in the next years: Whetiier the shares·of the company are cumulativ e or non-cumulative,
it must be made clear under the terms of issue or in th~ Articles o"t'the company. If the
Articles of company do not contain anythingabout the cumulativ e or non-cumulative
character of the shares, the shares are said to be cumulative .
(3) Participa ting and Non-part icipating Preferenc e Shares: If the preference
sharehol_d~rs have the right to get a share in the additional profits alongwith the fixed
rate of d1v1dend, such shares are called participati ng preferenc e shares. In such case,
firstly, the preference sharehold ers will be paid dividend at a fixed rate and then the
equity shareholde rs will be paid a fair rate of return. If still any balance of profit is
left, the p~efere_n_ce shar_e~older~ will get some more pre-determ ined dividend. The
rate of this add1t1onal d1v1dend 1s determine d at the time of issuing the preference
sha~~s. But in case, preference shareholde rs do not have any right to participate in the
add1t1onal profits, such shares are called non-participati"ng
sh ares.
c.
pre,erence
(4) Convertib~e and Non-convertib~e Preference Shares: If the sharehold ers have the right
to get their shares converted mto equity shares after fi d . d f .
. a xe per10 o ume, su ch
P reference shares are said to be convertible preference sh Th . · n
. • b . ares.
and convers10n ratio must e made clear m the Articles ofAs . .e penod of convers10 s
soc1at1on or under the term
of issue.
O n the other hand, .the preference
c.
shares which can't b . .
e converted mto eqmty shares ar
e
called non-conve rtible pre,erence shares. . . :

68
 5 Sources of Finance-I

On conversion ofp·1~efi .
fi d d ' 'd d erence s11ares, company hecomes free form th e burden of paymg
_xel ivi lefnl · Shareholders become th e owners of th e company and they get voting
ng 1ts too. · t 1e fin (:ancial · · o rt1le compan y ts
" p osit1on
· 'd en cl
• sound , th ey can get more dm
. fi
111 uture. In the absence of f:clVottra11
. .• C' • f · h
1 econ(1111ot1s ror th e issue o equtty s ares, t e
h
company can issue the p reference shares.
(5) Guaranteed and ~on-guannteed Preference Shares: Th e preference sha res on which
the fixed rate of dividend is guaranteed are ca lled Guara nteed Prefe re nce Shares.
The preference shares on which no such guarantee is gi ven a re called Non-guaranteed
Preference Shares.
(6) Cumul~tive Convertible Preference Shares: The Gove rnm e n t of India made
declaratI?n for these shares in its budget session in March 1985. Public Limited
Compa_m es are ~ll~wed to . issue such shares for the establishment of new projects,
exp~sion ~f existmg projects, modernisation, diversification and management of
w_o~kmg capital. The par value of such shares will be normally , I 00 each and the rate of
dividend will be 10%. These shares will be converted into equity shares in three years or
five years at the option of the company.

■ Advantages of Preference Shares

• (1) Advantages to the Company
Company has following advantages on issuing preference shares: .
(i) By issuing preference shares, the company is able to get capital from such persons who
are more alert and do not want to bear much risk and give preference to low but certain
mcome.
(ii) Like the ordinary shares, management can use the capital raised from preference
shares till the liquidation of the company. Unless there is a provision in the agreement,
it is not the statutory obligation of the company to repay ~~e preference share capital.
(iii) Company does not need to mortgage its assets for issuing preference shares. As a result,
it can get additional capital in future easily by pledging such assets.
(iv) By issuing preference shares, company does not have a fixed liability of paying
dividend. Although the rate of dividend on these shares is fixed but it does not mean
that company is bound to pay dividend every year. Even in case of adequate profit~ the
directors can decide to reinvest whole of these profits and the preference shareholders
can't bind the company to pay them dividend. Thus, the company gets funds for future
growth and expansion and it has also .not to pay dividend at a very higher rate.
(v) The companies which do not have adequate fixed assets to issue debentures, preference
shares are a easy source of finance.
(vi) By using preference shares, the company can take the advantages of leverage. After
paying dividend on preference shares at a fixed rate, the balance income is available for
the equity shareholders. As a result, their rate of dividend can be increased.
(vii) By issuing preference shares, the capital structure of the company can be made flexible
in which company can make adjustments as per its needs. At the time of over
capitalisation, it can redeem its redeemable preferenc~ shares.
(viii) Because of absence of voting power on preference shares, their holder's can't interfere
in the management and control of the company.

69
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Financial Management

• (2) Advantages of Investors '~.,,

I nvestors get the followmg . advantages b . · m · preference shares:
y 111vest111g
(i) The investors get regular and fixed rate of return .
.. )
(u c
Preference shareholde rs have pre1erent1a · I · )1 ts over equity shareholde rs in r
ng espeq
of income and assets of the company.
(iii) In preference shares the investment is less risky.
· depression• also they get fixe d
(iv) Dunng rate of d tv
' 1'dend despite lower
. . rate of inte rest.
(v) Although the preference shareholders do not have general votmg nght but they have
voting right to protect their interests. They ha~e a right t~ vote on all such proposals of
the company which affect their interests dITe~tly fm example, th e. p~opos~l for
liquidation of the company or for reducing capital of. the _c?mpany. Similarly, if the
cumulative preference shareholde rs have not been pa1d _dividend for two years and
non-cumulative preference shareholde rs for two c?nsecuuv e years or for 3 years out of
6 years prior to the conclusion oflast general meetmg, the preference shareholders get
the voting right on every proposal of the company.

■ Disadvantages of Preference Shares

• (1) For the Company
(i) In case of low profits, the equity shareholde rs have lesser availability of profit after
paying dividend to preference shareholders at a fixed rate.
(ii) Because the dividend on preference shares has to.be paid at a fixed rate, it creates a fixed
burden on the company.
(iii) For determinin g income-tax, interest paid on debentures is subtracted from the income
of the company but the dividend on preference shares is not subtracted . As a result, the
actual cost of preference shares is more than the cost of debentures .
(iv) If under the artic}~s, the provisions has been made that for issuing additional share
capital or ·debentures the permission of existing preference shareholde rs has to be
taken, the company faces difficulty-to raise·additional capital
(v) If the company earns a rate less than the rate of di~idend for preference shareholders,
the equity shareholde rs do not get the advantages of financial leverage.
• (2) For Shareholders
The preferentia l shareholde rs have following disadvantages by investing in these shares:
(i) Because the·y are paid dividend at a fixed rate, they are deprived of a share in the
increased earnings in the years of growth and progress of the company.
(ii) They do not hav~ right to vote on general matters of the company. Therefore, they
cannot take part m the control and manageme nt of the company.
(iii) In case .of redeemabl e preference shares the redempti'o n fth
, ' o ese s h ares d epe nds at
the opuon of the company. They cant be assured of the redemptio n.
(iv) No guarantee is given for dividend on preference shares.

■ Analysis of Preference Shares

Preference share capital has an important place in the long term fi f h oue
. of fin · · il nance o t e company.
to fixed rate of dividen d ' th is sou~ce ance is s1~ a~ to debentures which also bear fixed rate of
interest. But the main difference m these two secunt1es is that interest on debenture s is a chargeable

70
 5 Sources of Finance-I

e"pense while d~t~rmining income-lax, whereas payment of dividend is not considered as an ·

e"pens~. ~ atller it is treated as distributio n of income. Due to this reason, the cost of preference
shares is highe~· th an the_ cost of debentures . From the view poin t of preference, the preference
shares have th~ir plac~ prior to the equity shares bu t after the debentures. T herefore, manageme nt
should ascertam tha~ 1~ has at least such an amount of pro fi t after payment of interest and tax which
is adequate to pay dividend on the preference shares. If adequate profits will not be available, the
managemen t should not issue these shares.
Before issuing ~he preference shares, financial manager should take into account aJJ those
circumstances deter~nme whether the issue will be highly profitable. If during the previous years
the level of sales and mc~~e had been ir regular but the average rate of return had been higher than
the rate of preference d1v1dend, preference shares can be issued by the company. If company does
not have adequate fixed assets for mortgage, it can issue preference shares. Similarly, if the company
has taken more debts and the debentureh olders demand more interest, these shares can be issued.

■ Ploughing Back of Profits ....

-----. '-·

We have already discussed Equity Shares and Preference Shares as long term sources of
finance. Besides, ploughing back of profits is considered as an important internal source of finance.
When a company does not distribute whole ofits profits and wishes to reinvest a part ofif, it is called
ploughing back of Profits or retention of earnings. Because ploughing back of profits generates
financial sources, it is called self financing or internal financing. Retention of earnings is made in the
form of various reserves and funds, such as General Reserve, Dividend Equalisation Fund, etc.
Therefore, every year after payment of tax on the income and distribution of a part ofit as dividend,
the balance is retained in business. Retained earnings can be used to meet both long term and short
term requirements of capital. It is an easy and cheap source of finance which can be used for the
expansion and modernisa tion of business. These accumulated profits can be used to issue bonus
shares. The increase in these accumulated profits increases book value of shares. Besides, a
company can follow stable dividend policy due to these accu.rp.ulated profits and business can save
itself from business fluctuations . Debts can be paid easily and the efficiency of company increases.
However, retention of profits depends upon the total earnings, dividend policy, tax policy of the
government, need for growth, availability of other sources of finance, nature of business of
company and the attitude of manageme nt, etc.

I Zero Interest Bonds/Debentures

Zero Interest Bonds have been brought in India by some companies in modern time. Infact
this is convertible debenture s on which no interest is earned. Due to no availability to interest to
investors that loss occurs is compensated by converting this debenture into equity shares. By doing a
company can provide better service to equity shareholders. No interest paid on these debentures
and these debentures are converted into equity shares after definite period of time. Due to
non-payment of interest the cost of projects normally less.
Equity Warrants:
Equity warrant is an instrumen t which is attached with this bonds or preference shares. This
gives a right to the holder to purchase in future a pre-determ ined equity shares at a pre-determ ined
price. Equity warrants helps in planning debentures. When these are issued, there is no fixed price
and the market value of equity shares increases above the fixed price. Then there equity shares
become profitable and attractive but equity shares are given to the investors at the fixed price.
Securities Premium Notes with detachable Warrants:
The payment for this is made after the lock-in-period of these notes. These detachable
Warrants are converted into equity at a right time of the applicant company sells the security
71
 Financial Management

pre~ um notes durin g Lock-in-Period, no interest is paid

on them. The applica_nt converts these
prem ium ~otes into equit y share s only when these
have been allott ed fully. fhese should be
conv erted ma defin ite perio d indicated by the company.
Debe nture with Warrants:
A ·warr ant is call optio n sold by the company. They c~rry
the r_ight to purch ase equity shares of
the comp any at a prede term ined price after a prede termi
ned perto d. .
Difference betw een Debentur~s with Warrants and Conv
ertible debe ntures _is that in case of
first one the holde rs of these warra nts is requi red to inves
t additionaj cash, whe~eas 1~ case of secenct
the conver'lible debe nture s are to be coiwerted in to equit
y share a~ter a specified time.
(I) Non- conv ertib le Debentures with Detachable Warr
ants
The debe nture s as such are non-convertible but they
carry detac hable warra nts which
provi des optio n to the debe nture holde rs to acquire
equity share s at a pre-fix~d price after
pre-d eterm ined lock-in perio d. Warr ants being detachable
can be trade d separ ately m the market.
Debe nture holde rs not inten ded to exercise the optio n
himself. .
(II) Partly Convertible Debentures with Detachable Warr
ants · ·
Thes e debe nture s have two parts:
(A) Convertible into equity shares at pre-fixed rate.
(B) Unconvertible (Red eeme d as per the terms oflss ue)
Detachable Warr ants which can be trade d indep enden tly
in the mark et. The warr ant holder
1• becomes entitl ed to receive equit y shares as per the price
deter mine d.by the comp any.

---------~---------------------------------~----·
I. Wha t are diffe rent financial requi reme nts of a co~p any?
Expl ain equit y share s as a
sourc e oflon g-ter m finance and give their merits and deme
rits.
2. ~-at do you mean by prefe rence shares? What
are their vario us types? Expla in them
cnuca lly as a source oflon g-ter m finance. .
3. Wha t is the difference between equity
shares and prefe rence share s? Unde r what
cir~u ms~c es each is considered a suitable source oflon
g-ter m finan ce?
4. Wnte bnef notes on the following:
(i) Ploug hing back of Profits.
(ii) Righ t of Pre-e mptio n.
5. Wha t is mean t by long-term finance? Explain the fact
long- term fimanc e. ors d eterm ·mmg
· t h e size
· of

HI

72