Ch.3 Sources of Finance for a Joint Stock Company

Question 1

A joint stock company requires …

Answer 1

A joint stock company requires two types of finance: (i) long-term finance and (ii) short-term finance

Long-term finance can be raised by issue of shares, issue of debentures, retained earnings, loans from commercial banks and loans from financial institutions.

Short-term finance can be raised through public deposits, commercial banks, trade credit, customer advances factoring, intercorporate deposits and instalment credit.

Question 2

Write a short note about long-term and short-term funds with diagram

Answer 2

Long-term funds are required to purchase fixed assets such as land and buildings, plant and machinery, furniture and fixture etc.

Both long-term and short-term funds can be raised from two types of sources: (a) owned funds and (b) borrowed funds or loan capital.

Owned funds consist of equity shares, preference shares and retained earnings. These funds belong to the owners.

Borrowed funds belong to creditors or lenders. For example, debentures, trade credit, loans, public deposits. These funds are repayable after a specified time period.

Question 3

Equity shares note with definition

Answer 3

Issue of shares is the most important method of raising long-term funds.

Shares are ownership securities and share capital represents ownership capital.
The capital of a company is divided into a number of equal parts which are known as shares.

According to the Companies Act, “a share is a share in the share capital of a company, and includes stock except where a distinction between stock and shares is expressed or implied.

A public company limited by shares can issue two types of shares:
1. Preference shares
2. Equity shares

Shares which carry no preference rights or priority in the payment of dividend and in the repayment of capital are called equity shares or ordinary shares.

Dividend on equity shares is paid after paying dividend on preference shares.

Question 4

Features of equity shares

Answer 4

i) Equity shares are issued prior to preference shares and debentures
ii) These shares carry no preferential rights in the payment of dividend.
iii) Equity share capital is repaid in the last in the event of winding up of the company
iv) Holders of equity shares generally enjoy voting rights.

Question 5

Advantages of Equity shares - Company’s POV

Answer 5

1. No burden on earnings - Equity shares pose no burden on the company’s resources because the dividend on such shares is payable only at the discretion of the management based on the availability of adequate profits.
2. Permanent capital - Equity share capital is refunded only at the time of winding up of the company. Therefore, equity capital. remains with the company forever.
3. No charge on assets - Equity shares do not create any charge or mortgage on the assets of the company.
4. Source of strength - A company with a large amount of equity shares has the ability to borrow large amounts of money due to high credit worthiness.
5. Small nominal value - The face value of an equity share is generally very low. Therefore, equity shares have a wide appeal even among people who belong to low income groups.

Question 6

Advantages of equity shares - From investors’/shareholders’ point of view

Answer 6

i) Equity shareholders enjoy voting rights and have controlling power over the company
ii) The liability of the equity shareholders is limited to the face value of the shares subscribed by them.
iii) Equity shareholders have the right to subscribe to new shares. These are called ‘Right Shares’.
iv) Shareholders are not required to pay income tax on dividends received from the company.

Question 7

Disadvantages of equity shares - From company’s POV

Answer 7

1. Manipulation of control - Equity shares carry full voting rights. This gives rise to many undesirable practices by persons who seek to gain control over the company.
2. No trading on equity - When the entire share capital is raised through equity shares, the benefit of trading on equity is not available.
3. Costly - The cost of issuing equity shares is higher than the cost of issuing other types of securities.
4. Inflexible - A company cannot issue shares in excess of its authorised capital as stated in the Memorandum of Association.

Question 8

Disadvantages of equity shares - Investors’/shareholders’ POV

Answer 8

1. Perpetuation of control by few - Any new issue of equity shares has to be first offered to the existing shareholders. Ordinary and small shareholders remain owners in name only.
2. High risk - Equity shareholders sink or swim with the company. Dividend and refund of capital are both uncertain.
3. Unhealthy speculation - Very often there is unhealthy speculation in the price of equity shares. This is more apparent during boom when prices are rising.

Question 9

Preference shares meaning/features

Answer 9

Preference shares are the shares which carry certain privileges or preferential rights - both regarding the dividend and return of capital.
First, dividend at a fixed rate must be paid on preference shares before any dividend is paid on equity shares.
Secondly. in the event of winding up of the company, preference shareholders must be paid back their capital before equity shareholders.
Generally, preference shares do not carry any voting rights except when the dividends is outstanding for more than two years (three years in case of non-cumulative preference shares.

Like equity shares, dividend on preference shares is payable only when there are profits.

Like debentures, preference shares carry a fixed rate of dividend and enjoy priority over equity shares but no voting rights.

Question 10

Types of preference shares

Answer 10

1. Cumulative and non-cumulative preference shares - In case of cumulative preference shares, dividends are not paid in a particular year but are carried forward to the next year. However, non-cumulative preference dividend shares do not accumulate. In case the company does not have adequate profits in any year, the right to dividend in respect of that year is lost forever.
2. Participating and non-participating preference shares - Participating preference shares give the holder the right to share in the profits left after the payment of dividend to preference and equity shareholders. The holders of non-participating preference shares do not enjoy the right to share in the surplus profits.

3.Convertible and non-convertible preference shares - Holders of convertible preference shares can get such shares converted into equity shares after a fixed period. Non-convertible preference shares refers to preference shares which cannot be converted into equity shares.

4. Redeemable and irredeemable preference shares - The holders of redeemable preference shares can be refunded their capital after the expiry of a specified period or at the discretion of the company as stated in the Articles of Association. Non-redeemable preference shares cannot be redeemed before the winding up of the company.

Question 11

Advantages of preference shares - company’s POV

Answer 11

1. Appeal to cautious investor - Preference shares are greatly appealed by those investors who seek reasonable safety of their capital along with a fixed but higher return.
2. No burden on profits - Preference shares do not put a fixed burden on finances as dividends are payable only out of profits.
3. No interference in management - Generally preference shares do not carry voting rights.
4. No charge on assets - Issue of preference shares does not involve any charge on the assets of the company.
5. Flexibility - In case of redeemable preference shares the amount can be repaid as and when the company does not need it.

Question 12

Advantages of preference shares - investors’/shareholders’ POV

Answer 12

i) Rate of dividend is fixed
ii) The risk involved is comparatively less because preference share capital is payable before equity share capital on the winding up of the company.
iii) Preference shareholders can expect to get back their investment after a certain time period .

Question 13

Disadvantages of preference shares - company’s POV

Answer 13

i) Costly source - The cost of raising finance through preference shares is greater than that of debentures.

ii) Permanent burden - Dividend on preference shares has to be paid at a fixed rat before any dividend is paid on equity shares.

iii) Legal formalities - Redemption of preference shares involves several legal restrictions.

iv) Low appeal - Preference shares have little appeal to investors.

Question 14

Disadvantages of preference shares - shareholders’ POV

Answer 14

i) Lack of voting rights - Preference shares do not carry voting rights in the normal course of the business enterprise.

ii) Fear of being shown the door - The company raises capital from holders of redeemable preference shares when it needs funds as soon as possible . But once its purpose is served, it bids goodbye to them by paying back their money.

iii)No capital appreciation - Preference shareholders do not get benefit of appreciation in their investment. They do not share in the excess profits of the company during boom period.

iv) No guarantee of dividends - Payment of dividend on preference shares is not guaranteed. Rate of dividend is generally modest.

Question 15

Preference shares may be a useful source of capital for a company under the following conditions:

Answer 15

1) When the assets are not acceptable as sufficient collateral security for issuing debentures

2) When higher interest will have to be paid by issuing debentures against assets which are already mortgaged

3) When the company’s promoters want to retain control without creating fixed obligation as to payment

4) When the company needs funds for medium term it can issue redeemable preference shares

Question 16

Distinction between preference and equity shares

Answer 16

Table

Question 17

Bonus shares or bonus issue meaning

Answer 17

Sometimes, a company may have a large undistributed profits which it wants to distribute among its shareholders. Instead of distributing these profits as dividend, the company issues fully paid up shares to them free of charge in proportion tot their existing shareholdings.

These shares are called ‘bonus shares’.
Issue of bonus shares is also known as ‘bond issue’ or ‘capitalisation of the undistributed profits’ of the company.

Question 18

A company must comply with the following conditions before issuing bonus shares:

Answer 18

i) Articles of Association of the company must authorise the issue of bonus shares

ii) It has, on the recommendation of the Board, been authorised in the general meeting of the company

iii) The bonus issue is made out of free reserves built out of the genuine profits or shares premium collected

iv) The bonus share shall not be issued in lieu of dividend

Question 19

Right shares or rights issue

Answer 19

A public company limited by shares may, at anytime, increase its subscribed capital by issuing new shares. But the directors of the company cannot offer the new shares to any persons at their discretion.

Section 62 of the Companies Act, 2013 provides that whenever a company proposes to increase its subscribed capital through a further issue of shares, it should offer such shares to the existing members are called ‘Right Shares’ and the right of members to be offered is called ‘Right of Pre-Emption’.

Question 20

(=>Right shares) A company need not offer further shares to the existing shareholders in the following cases:

Answer 20

i) Where a special resolution is passed by the company in the general meeting
ii) Where the company passes an ordinary resolution and gets the approval of the Central Government.
iii) Where all existing shareholders decline the offer

Question 21

Distinction between right shares and bonus shares

Answer 21

Table

Question 22

Employee Stock Options Plans (ESOP) meaning

Answer 22

An employee stock option plan is a scheme under which an employee of the company is given the right to purchase a specified number of its shares at a stipulated price (usually below the market price) during a given period of time. The employees who exercise the option may be allowed to pay the money in instalments or by way of deduction from his/her monthly salary.

Question 23

Merits and demerits of ESOP

Answer 23

Merits:
i) It encourages the employees to work even better
ii) It creates a sense of ownership and responsibility among the employees
iii) This scheme boosts morale and team effort among employees

Demerits:
i) This scheme can be used only be profit-making companies
ii) Share prices do not always reflect fundamentals
iii) Failing share prices result in loss to employees

Question 24

Sweat Equity Shares meaning

Answer 24

Sweat Equity Shares are the shares issued by a company under Section 79A of the Companies Act, 1956 to employees and directors (i) at a discount or (ii) for consideration other than cash or (iii) for providing know-how or making available intellectual property rights.

Question 25

Following conditions are prescribed for issue of Sweat Equity:

Answer 25

(a) The issue of sweat equity shares is authorised due to a resolution that was passed by the company in the general meeting
(b) The resolution specifies the number of shares, the value and the classes of directors or employees to whom such equity shares are to be issued
(c) These must be of a class of shares and must have already been issued by the company

Question 26

Every holder of shares in a company may at any time nominate in the prescribed manner of shares upon the production of such evidence as many requited by the Board may:

Answer 26

(a) Register himself as holder of the shares
(b) Transfer of the shares as the deceased share holder could have been made

Question 27

Retained earnings meaning

Answer 27

Retained earnings or ploughing back of profits refers to the process of retaining a part of the net profit year after year and reinvesting the same in business.
This source is also called self-financing as it is an internal method of finance.
The amount of retained earnings in a company depends on several factors.
Generally, when the amount of net profit is large, the capacity to plough back profits is greater.
In addition, the dividend policy of the company determines the extent to which profits can be retained for reinvestment in business.
Also, the age of the company affects the practice of self-financing.

Question 28

Merits of retained earnings - company’s POV

Answer 28

(i) It is the most convenient and economical method of finance
(ii) The financial structure of the company remains fully flexible
(iii) It raises further finance by floating new securities in the market

Question 29

Merits of retained earnings - Shareholders’ POV

Answer 29

(i) Shareholders of a company having large reserves and surplus get the benefit of safety of investment
(ii) Shareholders will receive regular dividends as deficiency of one year will be made good out of the undistributed profits of previous years
(iii) Ploughing back of profits will add to the earning capacity of the company

Question 30

Demerits of retained earnings

Answer 30

Excessive ploughing back of profits may result in:
(i) The management of a company may not always use the retained earnings in the best interest of the shareholders.
(ii) It is an unstable source as profits may not remain the same in future years
(iii) The practice of ploughing back of profits may be used to manipulate share prices of stock exchange.

Question 30

Merits of retained earnings - society’s POV

Answer 30

(i) Corporate savings accelerate the rate of capital formation in the country
(ii) Surplus makes the economy more stable
(iii) Business enterprises can produce better quality goods at lower costs

Question 31

Debentures meaning

Answer 31

Debentures denote borrowing by a company and represent its loan capital. Debenture holders are the creditor of the company. A debenture is a document or certificate issued by a company as proof of the money lent to it by the holder.

A debenture is a certificate issued by a company under its common seal as acknowledgment of debt with or without a charge on the company’s assets.
Interest on debenture is paid at a fixed rate rate and it is payable periodically until the maturity and repayment of debentures.
Debentures carry no voting rights.

According to Evelyn Thomas, “a debenture is a document under the company’s seal, which provides for the payment of a principal sum and interest thereon at regular intervals, which is usually secured by a fixed or floating charge on the company’s property or undertaking and which acknowledges a loan to the company”.

Question 32

Characteristics/features of debentures

Answer 32

1. Debentures represent borrowed funds
2. Interest on debentures is paid at a fixed rate
3. Interest is payable every year irrespective of whether there are profits or not
4. Debentures generally carry no voting rights
5. Debentures generally involve a charge on the assets of the company

Question 33

Distinction between shares and debentures

Answer 33

Table

Question 34

Kinds of debentures

Answer 34

1. Naked and mortgage debentures - Naked or simple debentures are not secured as no property is pledged or mortgaged on their issue. There are more promises to pay.
   However, mortgage or secured debentures are issued by creating a fixed or floating charge on the company’s assets.

A fixed charge is created on specific and existing assets of the company. Whereas, a floating charge is created on both the existing and future assets of the company.
Any change created by a company in the form of debenture holders must be registered.

2. Redeemable and irredeemable debentures - Redeemable or callable debentures are repayable on a predetermined date or at any time prior to their maturity at the option of the company. But irredeemable or perpetual debentures are repayable only at the time of winding up of the company.
3. Bearer and registered debentures - Bearer debentures can be transferred by mere deliveries as no record of such debentures is kept in the Register of Debenture holders. No legal formalities are required. But registered debentures are recorded in the Register of Debenture holders. Such debenture can be transferred only by transfer deed or intimation to the company and not mere delivery
4. Convertible and non-convertible debentures - In case of convertible debentures, he debenture holders are given the option to convert their debentured into equity shares after a specified period and on certain conditions. Non-convertible debentures do not carry any right to be converted into equity shares.

Question 35

Advantages of debentures - debenture holders’ POV

Answer 35

1. Appeal to cautious investors - Large amount of finance can be raised by issuing debentures from cautious investors who prefer safety of investment and a fixed return.
2. Regular return - Debenture holders are paid interest at a fixed rate and periodical intervals, irrespective of profits.
3. Safety of investment - Debentures are usually secured by a charge on the company’s assets.

Question 36

Advantages of debentures - company’s’ POV

Answer 36

1. Freedom of management - Debentures do not carry voting rights. The management retains its independence as there is no interference from debenture holders.
2. Trading on equity - When the earnings of the company increase, the rate of dividend on equity shares can be increased. This is known as trading on equity.
3. Flexibility - Funds are available for a fairly long period and can be repaid out of earnings.

Question 37

Disadvantages of debentures - company’s POV

Answer 37

1. Permanent burden of interest - Interest on debentures has to be paid every year irrespective of profits.
2. Charge on assets - Debentures usually involve mortgage of fixed assets. A company cannot raise funds easily through debentures unless it has enough fixed assets.
3. Reduction in dividend - During times of low earnings, very little profit might be left after payment of interest on debentures.

Question 38

Disadvantages of debentures - debenture holders’ POV

Answer 38

1. No voting rights - Debenture holders have no voting rights in the management of the company.
2. High unit price - The unit price of debentures is generally higher than that of shares.
3. Unattractive - Debentures of new companies do not appeal to the investors since they want a high return.

Question 39

Loans from commercial banks meaning

Answer 39

Commercial banks usually provide short-term finance because most of their deposits are short-term deposits. However, in some cases, commercial banks also provide term loans for medium and long periods especially to small scale and medium enterprises (SSMEs).

Question 40

Loans from commercial banks advantages

Answer 40

(i) Funds are available for the specified period
(ii) Loans from commercial banks provide the benefit of trading on equity
(iii) Repayment can be made out of future earnings

Question 41

Loans from commercial banks disadvantages

Answer 41

(i) Assets may have to be pledged or mortgaged for raising bank loans
(ii) Several time-consuming formalities are involved in raising loans from commercial banks
(iii) Interest on bank loans has to be paid irrespective of profits

Question 42

Loans from financial institutions meaning

Answer 42

The Government of India had set up several special institutions in the country to provide long-term and medium-term finance to buisness enterprises. These institutions or development banks have become a major source of finance. They provide finance both in the form of equity and debt.

IFCI (Industrial Finance Corporation of India), IDBI (Industrial Development Bank of India), ICICI (Industrial Credit and Investment Corporation of India), SIDBI (Small Industries Development Bank of India) are well-known development banks in the country.

In addition, LIC, General Insurance Corporation, SFCs( State Financial Corporations), NIDC, NSIC, UTI and so on also help provide finance to the industry.

Question 43

Loans from financial institutions advantages

Answer 43

1. Both risk as well as loan capital is available
2. New companies which may find it difficult to raise finances from the public can get finance from these institutions
3. As these institutions carry out thorough investigations before granting assistance helps to increase the creditworthiness of the company.
4. The rate of interest and repayment procedures are convenient and economical

Question 44

Loans from financial institutions disadvantages

Answer 44

1. The concern requiring finance from special financial institutions has to submit itself to a thorough investigation
2. Many deserving concerns may fail to get assistance for want of security and other conditions laid down by these institutions
3. Sometimes these institutions place restrictions on the autonomy of management

Question 45

Sources of short-term finance

Answer 45

1. Public deposits - They refer to the deposits of money made by the public with non-banking companies. These deposits represent loans from the public including employees and shareholders of the company. Companies find it cheaper than loans from banks and financial institutions.

Advantages: (i) Economical - The interest payable on public deposits is lower the interest charged by banks and special financial institutions. (ii) Simple - The procedure of inviting public deposits is simple. (iii) Trading on equity - As the rate of interest is fixed by the company and it provides the benefits of trading on equity. (iv) No charge on assets - The public deposits generally do not involve a charge on the assets of the company (v) Medium term - Funds are available for a longer period than bank loan.

Disadvantages: (i) Unreliable - Public deposits are an unreliable source of finance. (ii) Risk to investors - Depositors face high risk as they do not get any security for their investment. (iii) Not available to new concerns - Public deposits are generally not available to new companies and those with uncertain earnings (iv) Restrict growth of capital market - Widespread use of public deposits restricts the growth of a healthy capital market. (v) Speculation - Management of the company may be tempted to indulge in over-trading and speculation with the help of surplus deposits.

2. Commercial banks (bank credit) -
   (a) Loans and advances - A loan is a direct advance made
   in lumpsum which is credited to a separate loan
   account in the name of the borrower. The borrower
   withdraws the full amount in cash immediately and
   undertakes to repay it in one, or more instalments.
   The borrower is required to pay the interest on the
   whole amount from the date of sanction. Loans may
   be secured or unsecured.
   (b) Cash credits - It is a formal credit agreement under
   which a borrower is allowed to borrow up to a certain
   limit. Cash credit is of two types. When the cash
   credit is not backed up security, it is known as clean
   cash credit. Under it, the borrower submits a
   promissory note which is signed by two or more
   sureties. In case of secured cash credit, the borrower
   is required to give security in the form of tangible
   assets or guarantees.
   (c) Bank overdrafts - It is a kind of temporary financial
   accommodation extended by a bank to its regular
   customers. Under this arrangement, a customer
   having a current account with the bank is allowed to
   overdraw his account up to a specified amount.
   Interest is charged on the amount actually overdrawn
   and not on the amount sanctioned by the bank.
   (d) Discounting of bills - This implies procuring cash
   from a cash from a bank in exchange for credit
   instruments. Banks charge some commission for this
   service by paying a price lower than the face value of
   the credit instrument.

          Bank credit has the following advantages:(i) It is 
          flexible and can be repaid whenever desired (ii) 
          Banks maintain secrecy of the borrower's affairs
   
           Disadvantages: (i) The borrower has to perform 
           several legal formalities (ii) Banks grant loans 
           generally against some security

3. Trade credit - Trade credit is the credit extended by one business firm to another due to the sale or purchase of goods and services. It is also known as mercantile credit. It does not include consumer credit or instalment credit. Trade credit is usually granted for periods ranging from 15 days to three months.
   Trade credit may be extended in two forms: (a) open account where the buyer does not sign any formal debt instrument. (b) bills payable where the buyer has to give a written promise to pay the amount of invoice at a fixed date in the future.

Advantages: (i) Trade credit is very simple (ii) No interest is payable

Disadvantages: (i) He requires a larger working capital to supply goods on credit (ii) The buyer loses cash discounts.

4. Instalment credit - Instalment credit refers to the facility of buying machinery, equipment and other durable goods on credit. The buyer has to pay a part of the price of the asset at the time of delivery and the balance is payable in a number of instalments. The supplier charges interest on the balance due and the interest is included in the amount of instalment itself.
5. Accounts receivable financing (Factoring) - Factoring implies raising finance through the sale or mortgage of book debts. Finance companies or factors provide finance to business concerns through outright purchase of accounts receivable. The finance companies generally make advances up to 60% of the accounts receivable pledged with them.
6. Customer Advances - The customers advance represent a part of the price of the goods ordered/booked by the customers to be supplied at a later date. This arrangement is used in case of products which are in short supply or which involve a waiting period for delivery. Eg. automobiles and telephone.
7. Inter-corporate deposits - When a comp0any borrows funds for a short period from another company which has surplus funds, it is called inter-corporate deposit (ICD). The ICDs are generally unsecured and are arranged by a financier. These deposits are very convenient and popular because no legal formalities are involved.