Unit 4 Sources of Finance

8/9/2019 Unit 4 Sources of Finance

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UNIT 4

CLASSIFICATION OF SOURCES OF FINANCE

A source of finance can be classified under different categories mentioned as follows

(A) Classification according to periodIn this case a source of finance is classified based on the time period for which it is arranged.It is further classified into short term medium term and long term source of finance.

1) Short term sources of FinanceIt is the finance available from 1 day upto 1 year. Such a source of finance has to be returned

bac within one year. It is therefore also termed as sources of finance in order to meet theworing capital re!uirement. ".g.

# $rade Credit# Commercial paper# %ublic &eposits# Advance from &ealers

') edium term sources of FinanceA medium term sources of finance is available for more than one year but upto or * years. Itcan be use for financing short to medium purposes. ".g.# Company fi+ed deposits raised from public# edium $erm ,oans- etc.

) ,ong term Sources of FinanceA long term sources of finance is a source available for more than * or years. It may rangeto 1/ or */ years also. It is used to meet the funding needs oflong term re!uirements such as

purchase of fi+ed assets- funding e+pansion- diversification etc. ".g.

# Capital aret 0 Stoc aret# ,ease Financing# enture Capital Financing

(2) Classification according to ownership

According to ownership a source of finance may be classified into ownership funds andborrowed funds.

1) 3wned FundsSuch funds are contributed by the owners in a business and they are available- in most of thecases- till the winding up of the business. 3wners funds act as a base on which its borrowingability depends. ".g.# "!uity Share Capital# %reference Share Capital# 4etained "arning

') 2orrowed FundsIt is the loan funds which the business firm has arranged in order to meet its re!uirement.

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2orrowed funds may be for short term or long term. ".g.# &ebentures# ,ong $erm ,oans

(C) Classification according to source of generation

1) Internal SourceInternal Source is a source of funds arranged internally within the business organi5ation.Such a source does not bring in the cash but it conserves the cash outflows (generated fromsales) within the business firm. ".g.# 4etained %rofits# &epreciation

') "+ternal SourceAn "+ternal Source of funds actually brings in the cash within the business firm. Such a

source may be raised by way of owner6s funds or borrowed funds as well as for short term orlong term basis. ".g.# "!uity Share Capital# $erm ,oans# Commercial %aper# %ublic &eposits

(D)Classification on the basis of convenience

1. Security financing (shares- debentures etc)-

'. Internal financing (&epreciation funds- retained earnings- reserves etc)-

. ,oan Financing (short term loans- medium term loans and long term loans)

SECURITY FINANCING

Security7 A document8 historically- a physical certificatebut increasingly electronic- showingthat one owns a portion of a publicly#traded companyor is owed a portion of a debt issue.Securities are tradable.

Securities are broadly categori5ed into7

&ebtsecurities (such asbannotes-bondsand debentures)-

Shares- e.g.- e!uity and preference shares 8 and-

&erivativecontracts- such as forwards-futures- optionsand swaps.

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http://financial-dictionary.thefreedictionary.com/Certificatehttp://financial-dictionary.thefreedictionary.com/Publicly-Traded+Companyhttp://financial-dictionary.thefreedictionary.com/Tradablehttps://en.wikipedia.org/wiki/Debthttps://en.wikipedia.org/wiki/Banknotehttps://en.wikipedia.org/wiki/Banknotehttps://en.wikipedia.org/wiki/Bond_(finance)https://en.wikipedia.org/wiki/Debenturehttps://en.wikipedia.org/wiki/Derivative_(finance)https://en.wikipedia.org/wiki/Forward_contracthttps://en.wikipedia.org/wiki/Futures_contracthttps://en.wikipedia.org/wiki/Futures_contracthttps://en.wikipedia.org/wiki/Option_(finance)https://en.wikipedia.org/wiki/Option_(finance)https://en.wikipedia.org/wiki/Swap_(finance)http://financial-dictionary.thefreedictionary.com/Publicly-Traded+Companyhttp://financial-dictionary.thefreedictionary.com/Tradablehttps://en.wikipedia.org/wiki/Debthttps://en.wikipedia.org/wiki/Banknotehttps://en.wikipedia.org/wiki/Bond_(finance)https://en.wikipedia.org/wiki/Debenturehttps://en.wikipedia.org/wiki/Derivative_(finance)https://en.wikipedia.org/wiki/Forward_contracthttps://en.wikipedia.org/wiki/Futures_contracthttps://en.wikipedia.org/wiki/Option_(finance)https://en.wikipedia.org/wiki/Swap_(finance)http://financial-dictionary.thefreedictionary.com/Certificate


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&ebenture7 A type of long#term secured0unsecured bond (loan)- taen out by a company-

which it agrees to repay at a specified future date. $he company will usually pay a fi+ed rate

of interest to debenture holders each year until maturity- and if it fails to pay either the

interest or the principal amount of the loan when the time comes- the debenture holders can

force the company into li!uidation and try to recover- along with other creditors- their moneyfrom a sale of its assets.

"!uity shares7 "!uity shares are issued to the owners of a company.

%reference shares7 %reference shares have a fi+ed percentage dividend before any dividend is

paid to the ordinary shareholders.

LOAN FINANCING

1. Short term loansa. $rade credit

b. ,oan from commercial bansc. %ublic depositsd. ,oan from finance companies

i. ,easing and hire purchaseii. erchant baning

e. Accrual accountsf. Indigenous banersg. Advances from customersh. iscellaneous sources eg loan from directors or sister concerns.

'. ,ong term loans from financial institutions- bans etc.

Short term loans:-

(a) $rade Credits7# form of short term source of finance- generally made available to thebuyer on an informal basis without creating any charge on assets. $rade creditarrangements usually carry stipulations of allowing a cash discount to the buyer for

prompt payment.(b) Commercial bans7# 2ans provide following facilities to the customers

(1) ,oans(') Cash Credits() 9ypothecation(:) %ledge(*) 3verdrafts() 2ills discounted and purchase

(c) %ublic &eposits7 # %ublic deposits are deposits of money accepted by companies inIndia from the public for specified period ranging between months and months. $hese deposits are accepted within the limit and sub;ect to terms prescribedunder Companies (Acceptance of &eposits) 4ule- 1


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(c) 2usiness finance companies7 # there are the companies established for providing shortterm and medium term loans to firms nown to them- Since these firms have limitedfinancial resources- their lending is also limited only to the firms which are ofmedium and small si5e. ainly provide finance for special purpose eg financing ofcustomer durables- financing of transport vehicles etc.

(d) Accrual accounting7# $he most commonly accrual accounts are wages and ta+es. Inboth the cases the amount become due but not paid immediately. >sually the date isfi+ed for the payment. Similarly the payment of ta+ is created out of the profit of thecompany but the ta+ is paid only after the assessment is finali5ed. $hus the time lag

between the receipt of income and maing payment for the e+penditure incurred inearning that income helps the business in meeting some of its short term financialre!uirements.

(e) Advances from customers7# $his is cost free source of finance- and really useful forthose businesses where it has become customary to receive advance payment from the

customers.

(f) isc sources7# ,oans from sister concerned- and other business units.

Lon term so!r"es o# #$nan"e7# $he term loans is used for both medium as well as long termloans. edium#term loans are for periods ranging from 1 to * years while long term financeare for the period from * to 1/ or 1* years.

LOAN SYNDICATION

It is the process of involving several different lenders (bans or financial institutions) in

providing various portions of a loan. ,oan syndication most often occurs in situations where

a borrower re!uires a large sum of capital that may either be too much for a single lender to

provide- or may be outside the scope of a lender?s ris e+posure levels. $hus- multiple lenders

will wor together to provide the borrower with the capital needed- at an appropriate rate

agreed upon by all the lenders.

,oan syndication is common in mergers- ac!uisitions and buyouts- where borrowers often

need very large sums of capital to complete a transaction- often more than a single lender is

able or willing to provide.

ethods of loan syndication

%& $he borrower may approach or mae an application to a lead financial institution

which in turn gets in touch with other financial institutions.'& $he borrower may approach merchant ban to arrange for a loan syndication for him.

Steps in loan syndication

1. %reparation of pro;ect report

'. %reparation of loan syndication application.. Selection of financial institutions for loan syndication.

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:. 4eceipt of sanction letter or letter of intent from the financial institutions.*. Compliance of terms and conditions of the loan agreement by the borrower.. &ocumentation=. &isbursement of loan.

OO UILDING

Corporates may raise capital in the primary maret by way of an initial public offer- rights

issue or private placement. An Initial %ublic 3ffer (I%3) is the selling of securities to the

public in the primary maret. $his Initial %ublic 3ffering can be made through the fi+ed price

method- boo building method or a combination of both.

2oo building is actually a price discovery method. It is the process by which an underwriter

attempts to determine at what price to offer an I%3 based on demand from institutionalinvestors. An underwriter @builds a boo@ by accepting orders from fund managers indicating

the number of shares they desire and the price they are willing to pay.

$he issue price is not determined in advance rather the issue price is determined after the bid

closure based on the demand generated from investors at various prices.

In this method- the company doesn?t fi+ up a particular price for the shares- but instead gives

a price range- e.g. 4s /#1//.

Bhen bidding for the shares- investors have to decide at which price they would lie to bidfor the shares- for e.g. 4s /- 4s


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various price levels. $he boo runners and the Issuer decide the final price at which the

securities shall be issued.

G!$,el$nes #or oo+ !$l,$n

4ules governing 2oo building are covered in Chapter I of the Securities and "+change2oard of India (&isclosure and Investor %rotection) Duidelines '///. 2S"?s 2oo 2uilding

System offers a boo building platform through the 2oo 2uilding software that runs on the

2S" %rivate networ. $his system is one of the largest electronic boo building networs in

the world- spanning over */ Indian cities through over =/// $rader Bor Stations via leased

lines- SA$s and Campus ,AES.

*ROECT FINANCING

&efinition of ?%ro;ect Finance? by the International %ro;ect Finance Association (I%FA) as the

following7

$he financing of long#term infrastructure- industrial pro;ects and public services based upon anon#recourse or limited recourse financial structure where pro;ect debt and e!uity used tofinance the pro;ect are paid bac from the cash flow generated by the pro;ect.

%ro;ect finance is especially attractive to the private sector because they can fund ma;or

pro;ects off balance sheet based on the cash flows of the pro;ect. $he financiers usually have

little or no recourse to the non#pro;ect assets of the borrower.

e. "hara"ter$st$"s o# *ro/e"t F$nan"$n

1. Financing of long term infrastructure and0or industrial pro;ects using debt and e!uity.'. &ebt is typically repaid using cash flows generated from the operations of the pro;ect.

,imited recourse to pro;ect sponsors. ( 9igher ris pro;ects may re!uire the

surety0guarantees of the pro;ect sponsors). &ebt is typically secured by pro;ect6s assets- including revenue producing contracts.

First priority on pro;ect cash flows is given to the ,ender.

Consent of the ,ender is re!uired to disburse any surplus cash flows to pro;ect

sponsors

A,0antaes o# *ro/e"t F$nan"$n

1. "liminate or reduce the lender6s recourse to the sponsors.'. %ermit an off#balance sheet treatment of the debt financing.. a+imi5e the leverage of a pro;ect.:. Avoid any restrictions or covenants binding the sponsors under their respective

financial obligations.*. Avoid any negative impact of a pro;ect on the credit standing of the sponsors.. 3btain better financial conditions when the credit ris of the pro;ect is better than the

credit standing of the sponsors.

=. Allow the lenders to appraise the pro;ect on a segregated and stand#alone basis.. 3btain a better ta+ treatment for the benefit of the pro;ect- the sponsors or both.

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D$sa,0antaes o# *ro/e"t F$nan"$n

1. 3ften taes longer to structure than e!uivalent si5e corporate finance.'. 9igher transaction costs due to creation of an independent entity.. %ro;ect debt is substantially more e+pensive due to its non#recourse nature.

:. "+tensive contracting restricts managerial decision maing.*. %ro;ect finance re!uires greater disclosure of proprietary information and strategic

deals.

Staes $n *ro/e"t F$nan"$n

I. %re Financing Stage

%ro;ect identification

4is identification minimi5ing

$echnical and financial feasibility

II. Financing Stage

"!uity arrangement

Eegotiation and syndication

Commitments and documentation

&isbursement.

III. %ost Financing Stage

onitoring and review

Financial Closure 0 %ro;ect Closure

4epayments Subse!uent monitoring.

NE1 FINANCIAL INSTITUTIONS AND INSTRU2ENTS:

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CO22ERCIAL *A*ERS (C*):Commercial %aper (C%) is an unsecured money maret

instrument issued in the form of a promissory note. It was introduced in India in 1sance %romissory Eote- for funds deposited at a ban or other

eligible financial institution for a specified time period. Duidelines for issue of C&s are

presently governed by various directives issued by the 4eserve 2an of India- as amended

from time to time.

Feat!res:

1. C&s can be issued by7

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$hese are a class of investment which allows international investors to own shares in foreign

companies where the foreign maret is hard to access for the retail investor- and without

having to worry about foreign currencies and ta+ treatments. Glo3al Deos$tar. Re"e$ts are

issued by international investments bans as certificates (the GDR) which represents the

foreign shares but which can be traded on the local stoc e+change. For e+ample a >Hinvestor may be able to buy shares in a ietnamese company via a D&4 issued by a >H

investment. $he D&4 will be denominated in D2 %ounds and will be tradable on the ,ondon

Stoc "+change. $he investment ban taes care of currency e+change- foreign ta+es etc. and

pays dividends on the D&4 in D2 %ounds.

$he concept originally started in the >SA with the creation of American &epositary 4eceipts

which were created so that >S retail investors could buy shares in a foreign company without

having to worry about foreign e+change- or foreign ta+es.

Chara"ter$st$"s o# GDRs:

1. It is an unsecured security

'. A fi+ed rate of interest is paid on it

. It may be converted into number of shares

:. Interest and redemption price is public in foreign agency

*. It is listed and traded in the share maret

Several international bans issue D&4s- such as %organ Chase- Citigroup- &eutsche 2an-$he 2an of Eew Jor ellon. D&4s are often listed in the Franfurt Stoc "+change-

,u+embourg Stoc "+changeand in the ,ondon Stoc "+change.

2a$n 3ene#$ts o# GDRs $ss!an"e to the "oman. are:

1. increased visibility in the target marets- which usually garners increased research

coverage in the new marets8'. a larger and more diverse shareholder base8 and. $he ability to raise more capital in international marets.

STOC IN5EST

Stoc invest instrument was introduced by the govt. on the suggestion made by the S"2I. It is

an additional facility available to an investor for payment of shares application money against

the shares applied by him. It is lie an account payee che!ue where investors actually could

buy them from an issuing ban that was participating in a primary maret issue. $he money

remained in the investors account until the allotments were made and only then were the

investors? accounts debited. $he stoc invest scheme has been discontinued by S"2I w.e.f.

Eov*- '//.

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http://www.finance-investment-business-glossary.com/definitions/american_depositary_receipt_adr.shtmlhttp://en.wikipedia.org/wiki/JPMorgan_Chasehttp://en.wikipedia.org/wiki/Citigrouphttp://en.wikipedia.org/wiki/Deutsche_Bankhttp://en.wikipedia.org/wiki/Deutsche_Bankhttp://en.wikipedia.org/wiki/The_Bank_of_New_York_Mellonhttp://en.wikipedia.org/wiki/Frankfurt_Stock_Exchangehttp://en.wikipedia.org/wiki/Frankfurt_Stock_Exchangehttp://en.wikipedia.org/wiki/Luxembourg_Stock_Exchangehttp://en.wikipedia.org/wiki/London_Stock_Exchangehttp://www.finance-investment-business-glossary.com/definitions/american_depositary_receipt_adr.shtmlhttp://en.wikipedia.org/wiki/JPMorgan_Chasehttp://en.wikipedia.org/wiki/Citigrouphttp://en.wikipedia.org/wiki/Deutsche_Bankhttp://en.wikipedia.org/wiki/The_Bank_of_New_York_Mellonhttp://en.wikipedia.org/wiki/Frankfurt_Stock_Exchangehttp://en.wikipedia.org/wiki/Luxembourg_Stock_Exchangehttp://en.wikipedia.org/wiki/London_Stock_Exchange


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DE*OSITORIES

a"+ro!n,

$he earlier settlement system on Indian stoc e+changes was very inefficient as it was unable

to tae care of the transfer of securities in a !uic0speedy manner. Since- the securities werein the form of physical certificates8 their !uic movement was again difficult. $his led to

settlement delays- theft- forgery- mutilation and bad deliveries and also to added costs.

$o wipe out these problems- the &epositories Act 1


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4iss that are associated with physical certificates such as bad delivery and fae

securities- theft mutilation- forgery are absent

4educes transaction cost G Eo stamp duties

&irect transmission of securities by the &% to avoid correspondence with companies

4ecords any corporate actions automatically#eg dividend declaration

Deos$tor$es $n In,$a

$here are ' depositories in India

$he Eational Securities &epository ,imited KES&,L

Central &epository for Securities ,imited KC&S,L

Nat$onal Se"!r$t$es Deos$tor. L$m$te, (NSDL)

ES&, is the first depository to be set up in India. It was registered by S"2I on une =-

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4eliance Capital

>$I

Jes 2an

CREDIT RATING INSTITUTIONS

$he Indian credit rating industry has evolved over a period of time. Credit rating agencies

play an important role in most modern capital marets. &espite their ubi!uity in the financial

marets- credit ratings are often misunderstood. $he rating represents an independent

professional and impartial opinion as to the lielihood that the borrower or issuer will meet

its contractual- financial obligations as they become due and is not a recommendation to buy

or sell a security. It also does not address maret li!uidity or volatility ris.

$herefore credit ratings are not7

A comment on the issuer?s general performance

An indication of the potential price of the issuers? bonds or e!uity shares

Indicative of the suitability of the issue to the investor

A recommendation to buy0sell0hold a particular security

A statutory or non#statutory audit of the issuer

An opinion on the associates- affiliates- or group companies- or the promoters-

directors- or officers of the issuer

Role o# "re,$t rat$n aen"$es

1. 4educing information asymmetry or nowledge gap- between borrowers (issuers) andlenders (investors) by providing independent opinions of creditworthiness.

'. Improving maret function and efficiency by reducing the ability of one investor tooutperform another by maing better ;udgments about creditworthiness. In this view-ratings act as an e!uali5er in the fi+ed#income capital marets- helping to putinvestors on more e!ual footing.

3. Credit ratings serve as an unbiased, independent "second opinion"

that an investor can use to conr! or reute his or her o#n ana$%sis.

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4. Credit rating reduces uncertaint% about credit#orthiness o anissuer, thus he$ping hi! achieve $o#er costs o borro#ing than it#ou$d other#ise have.

5. & $arger ro$e or credit ratings is in the or! o pro!oting nancia$

stabi$it% or preventing asset bubb$es and nancia$ crises.

In,$an "re,$t rat$n $n,!str.

Indian credit rating industry mainly comprises of C4ISI,- IC4A- CA4"- 3EIC4A- FI$C9

S"4A.

CRISIL: C4ISI, is the largest credit rating agency in India- with a maret share of greater

than /M. It was established in 1


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In a broader sense- it refers to the commitment of capital as shareholding- for the

formulation and setting up of small firms speciali5ing in new ideas or newtechnologies.

2ean$n o# 5ent!re "a$tal

enture capital is long#term ris capital to finance high technology pro;ects which involveris but at the same time has strong potential for growth. enture capitalists pool theirresources including managerial abilities to assist new entrepreneurs in the early years of

pro;ect. 3nce the pro;ect reaches the stage of profitability- they sell their e!uity holdings athigh premium.

$hus a venture capital company is defined as Na financing institution which ;oins anentrepreneur as a co#promoter in a pro;ect and shares the ris and rewards of the enterprise.O

Feat!res

P enture capital usually in the form of e!uity participation. It may also tae the form ofconvertible debt or long term loanP Investment is only made in high ris but high growth potential pro;ects.P enture capital is available only for commerciali5ation of new ideas or new technologies.P enture capitalist ;oins the entrepreneur as a co#promoter in pro;ects and shares the rissand rewards of the enterprise.P $here is continuous involvement in business after maing an investment by the investor.P 3nce the investor has reached the full potential- the venture capitalist sells his holdingseither to the promoters or in the maret. $he basic ob;ective is not profit but capitalappreciation at the time of disinvestment.P enture capital is not ;ust in;ection of money but also an input needed to set up the firm-

design its maret strategy and organi5e and manage it.P Investment is usually made in small and medium scale enterprise.

5C #!n,s $n In,$a

%& Those romote, 3. the Central Go0ernment "ontrolle, ,e0eloment #$nan"e

$nst$t!t$ons. For e+ample7 # ICICI enture Funds ,td.- IFCI enture Capital Funds

,td (ICF)-SI&2I enture Capital ,td (SC,)'& Those romote, 3. State Go0ernment "ontrolle, ,e0eloment #$nan"e

$nst$t!t$ons&For e+ample7 # %un;ab Infotech enture Fund - Du;arat enture Finance

,td (DF,) - Herala enture Capital Fund %vt ,td.7& Those romote, 3. !3l$" 3an+s&For e+ample7 # Canban enture Capital Fund-

S2I Capital aret ,td4& Those romote, 3. r$0ate se"tor "oman$es& For e+ample7 # I,FS $rust

Company ,td - Infinity enture India Fund8& Those esta3l$she, as an o0erseas 0ent!re "a$tal #!n,. For e+ample7 # Balden

International Investment Droup- 9S2C %rivate "!uity management auritius ,td

FACTORING

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De#$n$t$on: Factoring is a financial transaction whereby a business sells its accountsreceivable (i.e.- invoices) to a third party (called a factor) at a discount. $he factoringcompany (factor) pays the business a percentage of the value of the accounts receivable anddeducts a fee for the cost of collections. $hen the factor collects the receivables.

!"ne way to look at factoring is that a business is outsourcing its recei#ables collectionsprocess.$

Factoring may broadly be defined as the relationship- created by an agreement- between theseller of goods0services and a financial institution called the factor- whereby the later

purchases the receivables of the former and also controls and administers the receivables ofthe former.

(Factoring allows you to leverage your invoices to gain immediate access to cash)

For e+ample- assume a factor has agreed to purchase an invoice of Q1 million from Clothing

anufacturers Inc.- representing outstanding receivables from 2ehemoth Co. $he factor may

discount the invoice by say :M- and will advance Q='/-/// to Clothing anufacturers Inc.

$he balance of Q':/-/// will be forwarded by the factor to Clothing anufacturers Inc. upon

receipt of the Q1 million from 2ehemoth Co. $he factor?s fees and commissions from this

factoring deal amount to Q:/-///.

Eote that the factor is more concerned with the creditworthiness of the invoiced party #

2ehemoth Co. in the e+ample above # rather than the company from which it has purchased

the receivables (Clothing anufacturers Inc. in this case).

Factoring is designed for businesses that want to improve their cash flow by not waiting /-:*- / days for a customer to pay. Bidely accepted as an alternative financing source-accounts receivable funding is used in almost every industry that sells business#to#business or

business#to#government. Factoring is not a loan and differs from borrowing in that theaccounts receivable are sold at a discount rather than merely offered as collateral.

1h. 6o!l, a "oman. sell the$r re"e$0a3les9Companies that encounter a recurring cash flow problem often can6t afford to have cash tiedup in receivables for /#/#


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Fle+ible G business can choose which invoices it wants to offer for sale.... and within

limits- when.

2usiness can receive credit reports on prospective customers-

Continuous monitoring of the credit status of current customers.

>nlimited source of operating cash G it grows as sales grow

Fa"tor$n Coman$es $n In,$a

1. Canban Factors ,imited'. S2I Factors and Commercial Services %vt. ,td. $he 9ong Hong and Shanghai 2aning Corporation ,td:. Foremost Factors ,imited*. Dlobal $rade Finance ,imited. "+port Credit Duarantee Corporation of India ,td=. Citiban EA-

. India Small Industries &evelopment 2an of India (SI&2I)

Documents

Unit 4 Sources of Finance