Different Sources Of Raising Capital
Financial Market Practice / Education

Different Sources Of Raising Capital

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Sources For Raising Capital

There are different sources for raising capital. Equity Capital represents ownership capital as equity holders represents as owners of the company and enjoy the rewards (dividends) and bear the risk (decrease in the market price of the shares) of ownership. From the corporate perspective, there is no fixed obligation of funds to be paid to the equity shareholders. It is perpetual in nature. If the shareholders require funds, they can sell the shares in the secondary markets. Exception: a company may buy back the shares. A company may buy back its shares without shareholders’ resolution, to the extent of 10% of its paid up equity capital and reserves. However, if a company intends to buy back its shares to the extent of 25% of its paid up capital and reserves, then the same has to be approved by Shareholders Resolution as specified in Section 77A of Companies Act, 1956.

  • Authorized: Amount of capital a company can potentially issue.
  • Issued: Amount of capital offered to the investor.
  • Subscribed: Capital actually subscribed by the investor.
  • Paid-up: Actual amount paid up by the investor to the issuing company.

The obligations of companies towards their shareholders are as follows:

  • Income Distribution: The income left after paying the claims of all other investor (e.g. debt) belongs to the equity shareholders. Dividends once declared, should be distributed among the shareholders.
  • Indirect Control: Shareholders elect Board of Directors who in turn selects the management of the company.
  • Liquidations: Shareholders have residual claim on the assets of the company in case of liquidation.
  • Need to maximize shareholders wealth.

Preference shares are called quasi equity (having characteristic of both equity and debt). They behave partly like shares and partly like debt instruments. Preference share holders get Dividend, which is fixed and paid before anything is paid to equity holders & Capital appreciation, if any. But they do not have voting rights. In case a company fails to pay the stated dividends, they may acquire the voting rights in certain circumstances. The investors can claim stake over the residual assets, at the time of liquidation of the company, before the equity holders and after the debt holders.

They behave like debt instruments because they offer the dividends to the shareholders without any obligation on the company.

 

Obligations Of Companies Towards Preference Share Holders

  • Income Distribution: Most of the preference shares carry a cumulative feature with respect to dividend where unpaid dividends are carried forward and paid in the future.
  • Liquidation: Shareholders have claim on the assets of the company, prior to the claim of equity shareholders, in case of liquidation.

Debentures as was discussed in Debt Markets In India, are instruments for raising debt finance. Debentures holders are the creditors of the company. Debt provides the capital to a company with fixed cost liability (Interest to be paid either annually / semiannually). Debentures holders get Interest paid as the Payment of interest is an obligation on the company. But they do not have voting rights which equity shareholders have. They can claim over the assets of the company before the equity holders.

Obligations of the company issuing debentures includes establishing a Trustee through a trust deed. The trustee, usually a bank or financial institution is supposed to ensure that the company fulfils its contractual obligations. Secondly, as Debentures are backed by mortgages / charges on the immovable properties of the companies. Debentures are redeemable in nature. With maturity greater than 18 months, company has to create Debenture Redemption Reserve ( with a reserve of 50% of the amount of issue before the redemption begins ). Company has to pay the pre-decided fixed or floating interest rate to the debenture holders.

A company can also sources long-term and medium-term loans from financial institutions like the Industrial Finance Corporation of India (IFCI), State level Industrial Development Corporation, etc. These financial institutions can grant loans for a maximum period of 25 years against approved schemes or projects. Loans agreed to be sanctioned must be covered by securities by way of mortgage of the company’s property or assignment of stocks, shares, gold, etc. The corporate also has option of sourcing medium-term loans from commercial banks against the security of properties and assets. Funds required for modernization and renovation of assets can be borrowed from banks. This method of financing does not require any legal formality except that of creating a mortgage on the assets.

Alternatively, company can source funds by inviting the general public to deposit their savings with the company. Public deposits can be raised by companies to meet their medium-term as well as short-term financial needs. The increasing popularity of public deposits is due to:

  • The rate of interest the companies have to pay on them is higher than the interest from bank fixed deposits, but lower than interest charged by banks and financial institutions lending to the corporate.
  • These are an easier method of mobilizing funds than banks, especially during periods of credit squeeze.
  • They are unsecured.
  • Unlike commercial banks, the company does not need to satisfy credit-worthiness for securing loans.

Example: Tata Motors has tapped the market to grab nearly a quarter of the public deposit space. The firm that launched its scheme announced that it had collected Rs 175 Crore (Rs. 1.75 Billion) within a month. There was a tremendous response once the scheme opened. Some investors who would have invested in other companies opted for Tata Motors. But Tata Motors had a statutory limit of Rs 2700 Crore (Rs 27 Billion) for raising deposit from the public. The company did not disclose the exact amount that it plans to raise or the date till which it will offer the scheme. The automobile manufacturer turned to public deposits after facing difficulties in raising finance for its acquisition of Jaguar and Land Rover, the two marquee brands of Ford Motors, in the UK for $2.3 billion.

Reinvestment of Profit involving transfer of surplus to reserves instead of distributing the surplus to the shareholders in form of the dividends is another method of sourcing capital. This may be regarded as reinvestment of profits. Retention of profits is a sort of self financing of business.

When is the corporate is facing dilemma on the method to raise capital, it has to analyze the advantages and disadvantages of raising capital using different methods. The corporate also usually calculates its total debt to equity ratio. It may also try to analyze the weighted average cost of capital while exploring different options to raise capital. Following is a snapshot of the advantages and disadvantages in raising capital by different means.

 

Constraint In Equity Financing

Raising adequate equity finance tends to be the most challenging aspect of as equity typically shoulders the greatest level of operational, financial and market risk.

Factor considered as constraints:

  • Market Scenario: During bearish scenario, the market risk increase. So raising funds becomes challenging.
  • Investor Sentiments: Investor sentiments are affected due to market crash. So investor may not commit funds to new issues.
  • Regulatory Constraints In Terms Of Eligibility: As there are specific eligibility criteria, some companies become ineligible to raise funds though public IPOs.
  • Company Past History And Future Projections: Financial risk increases based on negative future projections.
  • Exit Options In Case Of Private Placement: Operational risk increases in case of private placements.

 

Constraints In Debt Financing

  • Firm-specific factors such as leverage, growth opportunities and cash holdings are related with the convertibility, maturity and security structure of issued bonds.
  • Economy-wide factors, in particular the state of the macro economy, affect the quality distribution of securities offered in particular, during recessions, firms issue fewer poor quality bonds than in good times but similar numbers of high-quality bonds.
  • Controlling for firm characteristics and economy-wide factors, project specific factors appear to influence the types of securities that are issued.

 

Advantages And Disadvantages Of Sourcing Capital Through Different Means For Shareholders/Lenders.

    • Equity Advantages: Shares are easily transferable. Limited Liability to the extent of the face value of the share. Share in the profit of the company (dividends).
    • Equity Disadvantages: Ownership equity is the last or residual claim against assets, paid only after all other creditors are paid.

 

    • Preference Shares Advantages: Prior claim on the assets and earning of the company as compared to the equity holders.
    • Preference Shares Disadvantages: No legal obligation on the company to preferential dividend. No voting rights.

 

    • Debentures Advantages: The company is liable to pay interest even if there are no profits.
    • Debentures Disadvantages: No voting rights.

 

    • Loans From Financial Institutions Advantages: The company is liable to pay interest/principal amount.
    • Loans From Financial Institutions Disadvantages: No voting rights.

 

    • Loans From Commercial Banks Advantages: The company is liable to pay interest/principal amount.
    • Loans From commercial Banks Disadvantages: No voting rights.

 

    • Public Deposits Advantages: The company is liable to pay interest/principal amount.
    • Public Deposits Disadvantages: No voting rights.

 

    • Reinvestment Of Profit Advantages: Not applicable.
    • Reinvestment Of Profit Disadvantages: Not applicable.

 

For Issuers/Borrowers

    • Equity Capital Advantages: Equity Capital has no maturity date, hence the firm has no obligation to redeem. Larger the equity base, greater the creditworthiness of the company. 
    • Equity Capital Disadvantages: Cost of issuing equity shares is generally higher than the cost of issuing other securities. Cost involves underwriting commission, issue expenses, brokerage cost.

 

    • Preference Shares Advantages: It is regarded as part of net worth hence enhance the creditworthiness of the firm. No voting rights, hence no dilution of control.
    • Preference Shares Disadvantages: Though there is no legal obligation to pay preference dividends, skipping them effect the image of the company.

 

    • Debentures Advantages: More flexible as compared to loans in terms of maturity, interest rate, repayment.
    • Debentures Disadvantages: Need to follow strict regulations like appointment of debenture trustee, creating a reverse for redemption (Debenture Redemption Reverse).

 

    • Loans From Financial Institutions Advantages: Loans can be customized in terms of repayments and maturity. 
    • Loans From Financial Institutions Disadvantages: Financial institutions impose restrictive conditions on the borrowers. 

 

    • Loans From Commercial Banks Advantages: Loans can be customized in terms of repayments and maturity.
    • Loans From Commercial Banks Disadvantages: Banks impose restrictive conditions on the borrowers.

 

    • Public Deposits Advantages: These are an easier method of mobilizing funds than banks, especially during periods of credit squeeze.
    • Public Deposits Disadvantages: Restrictive conditions on the borrowers in terms of max amount and period of borrowing.

 

    • Reinvestment of Profits Advantages: It reduces the dependence on external sources of finance. It increases the credit worthiness of the company. It enables the company to withstand difficult situations. It enables the company to adopt a stable dividends policy.
    • Reinvestment of Profits Disadvantages: Shareholders may demands dividends. Hence board of director need to justify the rationale behind investing the profits into the company.

 

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