Long-term Sources of Funds for a Joint Stock Company — notes

Equity shares represent ownership of a company. Features: ownership and voting rights; residual claim on income and assets; dividend not fixed; permanent capital (repaid only on winding up, apart from a buy-back); limited liability; highest risk.

Advantages to the company: no fixed burden of dividend; permanent capital; no charge on assets; a strong equity base improves creditworthiness; suits investors willing to take risk.

Disadvantages: dilution of control; costlier than debt (higher expected return, dividend not tax-deductible); high floatation cost and formalities; risk of over-capitalisation; may encourage speculation in the shares.

Preference shares carry a preferential right to a fixed dividend and to return of capital on winding up, before equity. Their voting rights are restricted to matters directly affecting them, but extend to all resolutions if their dividend is unpaid for two years or more (Companies Act, 2013).

Types: cumulative / non-cumulative; participating / non-participating; convertible / non-convertible; redeemable. Under the Companies Act, 2013 a company may not issue irredeemable preference shares; they must be redeemed, normally within twenty years.

Advantages to the company: no dilution of control; fixed dividend allows trading on equity; no charge on assets; attracts cautious investors. Disadvantages: dividend is not tax-deductible, so costlier than debt; arrears burden on cumulative shares; fixed dividend reduces what is left for equity.

Equity versus preference: dividend (variable / fixed); priority (last / first); voting (full / restricted); risk (high / lower); redemption (no / yes); arrears (none / possible).

• Bonus shares: free shares to existing shareholders by capitalising reserves (free reserves or securities premium). No fresh funds.
• Rights issue: new shares offered to existing shareholders in proportion to their holdings, usually below market price; the right can be renounced.
• ESOP (employee stock option plan): an option to employees to buy shares at a pre-determined price after a vesting period.
• Sweat equity shares: shares issued to directors or employees at a discount or for non-cash consideration such as know-how, intellectual property or value addition.
• QIP (qualified institutional placement): a listed company issues shares or convertible securities to qualified institutional buyers (mutual funds, banks, insurers and similar), quickly and without a full public issue.

Bonus versus rights: funds (none / fresh cash); payment (free / paid); renunciation (not possible / possible); source (reserves / shareholders' cash).

Retained earnings (ploughing back of profits) are the part of net profit kept in the business. It is an internal source of owners' funds.

Merits: permanent; no floatation cost; no dilution of control; improves credit standing; provides a cushion that helps keep dividends steady. Demerits: low dividends may cause dissatisfaction; uncertain, because it depends on profit; opportunity cost may be ignored, leading to careless use; possible misuse by management.

A debenture is a written acknowledgement of debt by a company, carrying a fixed rate of interest. Holders are creditors with no vote.

Kinds: secured / unsecured; redeemable / irredeemable; fully convertible / partly convertible / non-convertible; registered / bearer.

Advantages to the company: no dilution of control; interest is tax-deductible, so cheaper; fixed cost permits trading on equity; can be redeemed when funds are no longer needed; suits cautious investors. Disadvantages: fixed interest burden even in a loss year; charge on assets reduces further borrowing capacity; redemption must be provided for; risky when earnings are unstable.

Shares versus debentures: status (owner / creditor); return (dividend / interest); loss-year payment (no / yes); tax (not deductible / deductible); voting (yes / no); security (none / usually secured); priority on winding up (after creditors / before shareholders).

Term loans from commercial banks are given for more than a year, usually against security, and repaid in instalments. Financial institutions (development banks and state-level corporations) provide medium- and long-term project finance, often with technical and managerial advice.

Advantages: long-term funds without a public issue; confidentiality; no dilution of control; flexible repayment in instalments; advice from institutions; available when markets are depressed. Disadvantages: security required; lengthy appraisal and documentation; restrictive conditions such as a nominee director or limits on dividends and further borrowing; fixed repayment burden.