Instruments of Long Term Finance

INSTRUMENTS OF LONG TERM FINANCE

LONG TERM FINANCE

• Shares• Debentures • Term Loans• Convertible debentures• Warrants• Zero Interest Debentures• Deep Discount Bonds• Secured Premium Notes

LONG TERM FINANCE (2)

Asset Based Financing

• Lease• Hire Purchase• Project Financing

Venture Capital Finance

Shares

Features of Ordinary Shares• Claim on Income: Residual ownership claim• Claim on Assets: Residual claim• Right to control• Voting rights• Pre-emptive rights• Limited Liability

Shares (2)

Pros and cons of equity Financing

Advantages:

• Permanent capital

• Borrowing Base

• Dividend payment discretion

Shares (3)

Disadvantages

• Cost

• Earnings dilution

• Ownership dilution

Issue of Equity

• Public Issue of equity

Underwriting of issues

• Private Placement

• Rights Issue of equity shares

Preference Shares

Features• Claims on income and assets• Fixed dividend• Cumulative dividends• Redemption: Sinking fund & Call• Participation feature• Voting rights• Convertibility

Pros and Cons of Preference Shares

Advantages• Riskless Leverage• Dividend postponability• Fixed dividend• Limited voting rights

Limitations• Non-deductibility of dividends• Commitment to pay dividend

Debentures

Features• Interest Rate• Maturity• Redemption

Sinking Fund

Buy-back (call) provision• Indenture: Debenture trust deed• Security• Yield• Claims on assets and income

Types of Debentures

• Non-convertible Debentures

• Fully-convertible Debentures

• Partly-convertible Debentures

Pros and cons of Debentures

Advantages• Less costly• No overall dilution• Fixed payment of interest• Reduced real obligation

Limitations• Obligatory payment• Financial Risk• Cash Outflows• Restricted covenants

Term Loans

Features• Maturity• Direct negotiation• Security• Restrictive covenants• Convertibility• Repayment schedule

Convertible Debentures

Why issue convertible debentures• Sweetening fixed-income securities

• Deferred equity financing

• Avoiding earnings dilution

• Raising low cost capital

Warrants

A warrant entitles the purchaser to buy a fixed number of ordinary shares at a particular price during a specified time period.

Characterisitics• Exercise price• Exercise ratio• Expiration date• Detachability• Right

Warrants

Why issue warrants

• Sweetening debt

• Deferred equity financing

• Cash inflow in future

Other Types of Debentures

• Zero interest debentures

• Deep–discount bonds

• Secured premium notes

Lease

Lease is a contract between the lessor, the owner of the asset, and a lessee, the user of the asset.

Some Terms:• Up-front lease• Back-ended lease• Primary lease• Secondary lease

Types of Leases

• Operating lease

• Financial lease

• Sale and lease back

Cash Flow Consequences of a Financial Lease

• Avoidance of the purchase price

• Loss of depreciation tax shield

• After-tax payment of lease rentals

Advantages of Leasing

• Convenience and flexibility

• Shifting the risk of obsolescence

• Maintenance and Specialized services

Hire Purchase FinancingDifference between Leasing and Hire

PurchaseHire Purchase Financing

Lease Financing

Depreciation: claimed by the hirer

Lessee is not entitled to claim depreciation

HP Payments: Hirer can charge only interest portion of payment as expenses for tax purposes

Lessee can charge the entire lease rental as expenses for tax purposes

Salvage Value: Hirer becomes owner after payment of last installment

Lessee does not become the owner of the asset

Project Financing

• In project financing, the project, its assets, contracts, inherent economics and cash flows are separated from their promoters or sponsors in order to permit credit appraisal and loan to the project independent of the sponsors.

• The assets of the specific project serve as collateral for the loan, and all loan repayments are made out of the cash flows of the project.

Characterisitics of Project Financing

• A separate project entity is created that receives loans from lenders and equity from sponsors.

• The component of debt is very high in project financing. Thus project financing is a highly leveraged financing.

• The project funding and all its cash flows are separated from the parent company’s balance sheet.

Characteristics of Project Financing (2)

• Debt services and repayments entirely depend on the project’s cash flows. Project assets are used as collateral for loan repayments.

• Project financiers’ risks are not entirely covered by the sponsor’s guarantees.

• Third parties like suppliers, customers, government and sponsors commit to share the risk of the project.

Project Financing Arrangements

• Build-Own-Operate-Transfer (BOOT)

• Build-Own-Operate (BOO)

• Build-lease-Transfer (BLT)