Sources of Finance for a Joint Stock Company

Flashcards for review of lecture notes on equity shares, preference shares, bonus shares, ESOPs, sweat equity shares, retained earnings, debentures and short term sources of finance.

Equity Shareholders

The real owners of the company; have voting rights but no priority in dividend payment or capital repayment. Shares known as ordinary shares; considered high risk with potentially high rewards.

Features of Equity Shares

• Voting rights

• Permanent capital (no maturity)

• Dividend = profit after tax – preference dividend

• Claim on remaining assets

• Limited liability (only up to share value

Advantages of Equity Shares (Company Perspective)

• Permanent source of funds

• No fixed obligation (dividend paid only if profit)

• Easy fund mobilisation from small investors

• No charge on assets

Advantages of Equity Shares (Shareholder Perspective)

• Possibility of high returns (in profitable years)

• Ownership rights and control

• Limited liability

• Right to get right shares

• Easy to sell in capital markets

Disadvantages of Equity Shares (Company Perspective)

• Costly to issue (advertising, SEBI, legal)

• Possibility of management control being affected

• Overcapitalisation risk

• Dividends not tax-deductible

• No trading on equity possible

Disadvantages of Equity Shares (Shareholder Perspective)

High risk

concentrated control

speculation.

Preference Shares

Shares with preferential rights regarding dividend and capital repayment before equity shareholders.

Cumulative Preference Shares

Unpaid dividends accumulate and are carried forward.

Non-Cumulative Preference Shares

Unpaid dividends are not carried forward.

Participating Preference Shares

Shareholders have right to share in left over profit after dividends to preference and equity shareholders.

Non-Participating Preference Shares

Shareholders do not share in leftover profit.

Convertible Preference Shares

Shares convertible into equity shares after a fixed period.

Non-Convertible Preference Shares

Shares that cannot be converted into equity shares.

Redeemable Preference Shares

Shares repaid by the company after a fixed period.

Irredeemable Preference Shares

Shares not repaid during the company's lifetime, only at liquidation.

Advantages of Preference Shares (Company Perspective)

• No charge on assets

• No interference in management (no voting)

• Flexibility in Servicing Capitals

• Good for trading on equity

• Promoters maintain control

• Raising long term funds

Advantages of Preference Shares (Shareholder Perspective)

Stable return rate

higher rate of dividend

lower risk compared to equity shares

and suitable for conservative investors

Arrears on dividend on cumulative shares

Disadvantages of Preference Shares (Company Perspective)

Costly source of funds

permanent burden

legal formalities for redemption

lack of creditworthiness.

Disadvantages of Preference Shares (Shareholder Perspective)

Restricted voting rights

fixed return with risk

no certainty of dividend

no capital appreciation

lower liquidity.

Bonus Shares

Fully paid-up additional shares issued free to existing shareholders from reserves or surplus profits. In proportion to their existing shareholding.

Reasons for Issuing Bonus Shares

To reward shareholders without paying cash dividends

capitalize undistributed profits

increase the number of shares in the market.

in case of high profit and low cash

Conditions for Issuing Bonus Shares

Only fully paid-up shares

Articles of Association must allow

no default on interest/ principal

no default on employee dues

bonus shares cannot be issued from revaluation reserves.

any partly paid up capital must be full paid

bonus shares cannot be issued in the place of dividend

they can be issued from free reserves

bonus shares must be issued within 6 months from Board’s approval.

Rights Issue

Offer of new shares to existing shareholders in proportion to their holdings.

ESOP (Employee Stock Option Plan)

Scheme where employees can buy company shares at a discounted price as a part of their compensation package.

Key Features of ESOPs

Given only to employees

discounted price

vesting period

non-cash reward

potential for long-term growth.

Why Companies Use ESOPs

Attract talent

retain employees,

motivate for company growth

give employees a sense of ownership.

Merits (Advantages) of ESOPs

Motivates employees

reduces turnover,

builds loyalty,

effective retention,

creates a market for shareholders, diversification of wealth.

Demerits (Disadvantages) of ESOPs

Fall in share price leads to employee loss

only for well-performing employees,

cash crunch for the company,

and sacrifice in salary or perks.

Sweat Equity Shares

Equity shares issued to employees or directors at a discount or for non-cash consideration, for their special Contribution

Features of Sweat Equity Shares

• Issued to employees/directors

• For value creation (ideas, IPR, skills)

• Issued at a discount or even free

• No cash exchange

• Legally allowed under Section 54

• Based on contribution, not investment.

Retained Earnings

Net profits kept in the business for reinvestment, expansion, or debt repayment.

Uses of Retained Earnings

• asset purchase

• Plant modernisation

• Business expansion

• Repaying debt

• Working capital needs

Features of Retained Earnings

• No floatation cost

• No legal formalities

• Internal source of finance

• No dilution of control

• Flexible to use

• Has opportunity cost (loss of dividend

Cost of Retained Earnings

Shareholders lose dividends, so it has an opportunity cost, and companies may neglect paying them out

Merits of Retained Earnings

• Very economical (no interest, no issue expense)

• Best for expansion and growth

• Flexible use

• Ensures stable dividend payments

• Improves financial strength

• Supports capital formation

• Useful for repaying debt

• Promotes reinvestment

Demerits of Retained Earnings

• May be misused (wasteful spending)

• Overcapitalisation risk

• Shareholders may get lower dividends

• Management monopoly possible.

Debenture

A debenture is a debt instrument used by a company to raise medium or long-term funds from the public, with a promise to pay fixed interest and repay the principal after a specified period.

Charges on Debentures

Fixed charge on specific assets, floating charge on current assets.

Debenture Redemption Reserve (DRR)

Reserve created to ensure repayment to debenture holders at redemption.

Features of Debentures

Specified maturity period,

long-term instrument,

fixed interest rate,

no voting rights.

Advantages of Debentures (Company Perspective)

• Trading on equity is possible

• Lower cost of funds (lower interest rate)

• Interest is tax-deductible

• Flexible (fixed repayment date)

• No dilution of control.

Advantages of Debentures (Debenture Holder Perspective)

• Fixed return (even if company makes no profit)

• Safer investment (secured by company assets)

• Suitable for conservative investors

Disadvantages of Debentures (Company Perspective)

• Compulsory interest payment

• Asset charge reduces future flexibility

• Lowers company’s credit rating

• Reduces profit available for shareholders

Disadvantages of Debentures (Debenture Holder Perspective)

• No voting rights

• May be expensive for small investors

• Interest earned is taxable

Debentures Based on Transferability

Registered and bearer debentures.

Debentures Based on Repayment

Redeemable and irredeemable debentures.

Debentures Based on Security

Unsecured/naked and secured/mortgage debentures.

Debentures Based on Convertibility

Convertible and non-convertible debentures.

Debentures Based on Interest Rate

Fixed rate and floating rate debentures.

Zero Coupon Bonds

Issued at a discount and redeemed at face value without interest payments.

Loans from Commercial Banks

Loans from commercial banks refer to funds borrowed by a business from a bank, usually for short, medium, or long-term purposes. These loans are given against security (collateral) and carry a fixed or variable interest rate. The loan must be repaid over time in installments along with interest.

Advantages of Loans from Commercial Banks

• Available for long-term needs

• Repayment from future earnings

• Interest is tax-deductible

• Lower cost than overdrafts

• Promoters retain full profit (no equity sharing)

Disadvantages of Loans from Commercial Banks

• Requires collateral/security

• Interest payment even in losses

• Limits future borrowing capacity

• If floating rate, interest may fluctuate.

Loans from Financial Institutions

Medium and long-term funds from government-established institutions to promote industrial development.  These institutions offer finance through share subscriptions, debentures, loans, and guarantees.

Advantages of Loans from Financial Institutions

• Low interest rates (sometimes subsidised)

• Long-term funding for large projects

• Easy repayment in instalments

• Increases credit image

• Expert advice and support

• No collateral in some cases

• No flotation cost

• Flexibility (can give loans, equity, debentures)

Disadvantages of Loans from Financial Institutions

• Interference in management

• May reduce ownership/control

• Right to appoint directors

• Long approval time (slow process)

• Can be costly (charges, interest)

• Strict conditions and monitoring

• Restricted use (only for stated purpose)

Lease Financing

Using assets owned by another party by paying regular rent.

Bank Overdraft

Facility to withdraw more money than the balance in a current account.

Cash Credit

Short-term loan against security with a sanctioned limit.

Bill Discounting

Bank pays the business before the maturity of a bill, deducting a discount.

Revolving Credit Agreement

Pre-approved loan agreement where funds can be borrowed, repaid, and borrowed again.

Public Deposits

Unsecured deposits from the public for a short period with higher interest.

Trade Credit

Credit extended by suppliers to delay payment for purchases.

Factoring

Selling a company’s accounts receivables to a factor for immediate cash.

Inter-Corporate Deposits (ICDs)

Short-term unsecured loans extended by one company to another.

Installment Credit

Allows buying goods immediately and paying in regular installments.

Customer Advances

Payments in advance for goods or services to be delivered later.

Advantages of Public Deposits

Convenient, no charge on assets, fixed interest, no control dilution, tax benefits.

Disadvantages of Public Deposits

Uncertain funds, legal limits, risk of speculation, short-term use only.

Advantages of Trade Credit

Simple, no paperwork, no interest if timely, cheap.

Disadvantages of Trade Credit

Only for reputed firms, costly if late, startups not eligible.

Advantages of Factoring

Immediate cash, avoid bad debts, no collateral, quick funds.

Disadvantages of Factoring

Fees reduce profit, may get refused, high cost.

Advantages of Inter-Corporate Deposits

No legal hassle, secrecy, low cost.

Disadvantages of Inter-Corporate Deposits

Unregulated, legal lending limit.

Advantages of Installment Credit

Boosts sales, better living standard, increases market.

Disadvantages of Installment Credit

Expensive, legal formalities, leads to overspending.

Advantages of Customer Advances

Cheap working capital, better demand forecasting.

Disadvantages of Customer Advances

Inflation risk, delay may lead to penalties.