Corporate Finance EFIN542 PDF

Corporate Finance EFIN542 Edited by: Dr. Nitin Gupta Corporate Finance Edited By Dr. Nitin Gupta  CONTENTS Unit 1: Financial Management 1 Atif Ghayas, Lovely P...

Corporate Finance EFIN542 Edited by: Dr. Nitin Gupta Corporate Finance Edited By Dr. Nitin Gupta  CONTENTS Unit 1: Financial Management 1 Atif Ghayas, Lovely Professional University Unit 2: Sources of Finance 15 Atif Ghayas, Lovely Professional University Unit 3: Money Market Instruments 31 Atif Ghayas, Lovely Professional University Unit 4: Time Value of Money Concept 47 Atif Ghayas, Lovely Professional University Unit 5: Investment Decisions - 1 65 Atif Ghayas, Lovely Professional University Unit 6: Investment Decisions -2 78 Atif Ghayas, Lovely Professional University Unit 7: Cost of Capital 104 Atif Ghayas, Lovely Professional University Unit 8: Financing Decisions 122 Atif Ghayas, Lovely Professional University Unit 9: EBIT - EPS Analysis 142 Atif Ghayas, Lovely Professional University Unit 10: Dividend Decisions 163 Atif Ghayas, Lovely Professional University Unit 11: Forms of Dividend 186 Atif Ghayas, Lovely Professional University Unit 12: Working Capital Management 198 Atif Ghayas, Lovely Professional University Unit 13: Corporate Governance 228 Atif Ghayas, Lovely Professional University Unit 14: Economic outlook and Business Valuation 255 Atif Ghayas, Lovely Professional University  Notes Atif Ghayas, Lovely Professional University Unit 01: Financial Management Unit 01: Financial Management CONTENTS Objectives Introduction 1.1 Classification of finance 1.2 Corporate Finance 1.3 Evolution of finance 1.4 Finance Functions 1.5 Role of a finance manager 1.6 The Basic Goal: Creating Shareholder Value 1.7 Organization of Finance Functions 1.8 Agency issues 1.9 Business ethics and social responsibility Summary Keywords Self-Assessment Answers for Self Assessment Review Questions Further Readings Objectives After studying this unit, you will be able to:  Understand the meaning of Corporate Finance  Understand the evolution of Finance  Understand the finance functions  Outline the role of a finance manager  Analyse the basic goal of a firm  Understand the Agency problem in business  Understand the concept of Business ethics  Explain the concept of Social Responsibility Introduction Finance reference to the Management of large amounts of money, especially by governments or large companies. It may also mean providing funding for a person or an enterprise. The term Finance is derived from a French wordfinance,meaning an end, settlement, or retribution. It is used in the context of ending or settling a debt or a dispute. After adapting to English, the word is used to define any type of management of money. 1.1 Classification of finance The discipline of Finance can be categorized into three parts: Public Finance Lovely Professional University 1 Notes Corporate Finance This type of finance is related to states, municipalities, provinces in short government required finances. It includes long term investment decisions related to public entities. Public finance takes factors like distribution of income, resource allocation, economic stability in consideration. Funds are obtained majorly from taxes, borrowing from banks or insurance companies. Corporate Finance Corporate Finance is about funding the company expenses and building the capital structure of the company. It deals with the source of funds and the channelization of those funds like the allocation of funds for resources and increasing the value of the company by improving the financial position. Corporate finance focuses on maintaining a balance between the risk and opportunities and increasing the asset value. Personal Finance Personal Finance is managing the finance or funds of an individual and helping them achieve the desired goals in terms of savings and investments. Personal Finance is specific to individuals and the strategies depend on the individuals earning potential, requirements, goals, time frame, etc. Personal finance includes investment in education, assets like real estate, cars, life insurance policies, medical and other insurance, saving and expense management. 1.2 Corporate Finance Imagine that you are planning to start your own business, you would have to answer three questions: What long-term investments should you take on? Where will you get the long-term financing to pay for your investment?How will you manage your everyday financial activities?Corporate finance is all about thestudy to answer these questions Corporate finance deals with the capital structure of a corporation, including its funding and the actions that management takes to increase the value of the company. Corporate finance also includes the tools and analysis utilized to prioritize and distribute financial resources. The ultimate purpose of corporate finance is to maximize the value of a business through planning and implementation of resources, while balancing risk and profitability. “Corporate Finance is concerned with the efficient use of an important economic resource, namely capital funds” - Solomon Ezra & J. John Pringle. “Corporate Finance is the operational activity of a business that is responsible for obtaining and effectively utilizing the funds necessary for efficient business operations”- J.L. Massie. The three Important Activities that Govern Corporate Finance: 1. Investments & Capital Budgeting 2. Capital Financing 3. Dividends and Return of Capital 1.3 Evolution of finance The stages in the evolution of finance discipline can be categorized into three phases: Traditional Phase Transitional Phase Modern Phase 2 Lovely Professional University  Notes Unit 01: Financial Management Finance, as capital, was part of the economics discipline for a long time. So, financial management until the beginning of the 20th century was not considered as a separate entity and was very much a part of economics Traditional phase: This phase started from 1920 and lasted till 1940. During this phase focus was mainly on below aspects:  Arranging, formation, issuance of funds.  Business expansion, merger, reorganization, and liquidation during the life cycle of the firm.  The instruments of financing, the institutions and procedures used in capital markets, and the legal aspects of financial events. Transitional phase This phase started from early 1940 and lasted till early 1950. During this phase focus was mainly on below aspects:  Nature of financial management was similar to same as Traditional phase.  But more emphasis was put on financial problems faced by managers in day-to-day operations hence leading to increased focus on working capital management. Modern Phase This phase started in middle of 1950 and has witnessed an accelerated pace of development with the infusion of ideas from economic theories and applications of quantitative methods of analysis. During this phase focus was mainly on below aspects:  The scope of financial management got broadened.  A well-managed Finance department came into existence.  Role of Financial manager got defined, which include acquisition of funds required in the business at the least possible cost, investing the funds obtained in an optimum manner so as to maximize returns and taking decisions relating to distribution of profits i.e., deciding the dividend policy and retention of profits. 1.4 Finance Functions Finance function is the most important function of a business. Finance is closely connected with production, marketing and other activities. In the absence of finance, all these activities come to a halt. In fact, only with finance, a business activity can be commenced, continued and expanded. Finance functions or decisions are divided into long-term and short-term decisions: Long-term financial decisions can be further classified into three categories: Long-term Financial Decisions Investment Decision Financing Decision Dividend Decision Lovely Professional University 3 Notes Corporate Finance Investment Decisions: Investment decision deals with the decisions related to the allocation of capital to long-term assets that would yield benefits in the future like Plant and machinery, Building etc. This decisionrelated to allocation of capital or commitment of funds to long-term assets that would generate cash flows in the future. It involves the evaluation of the prospective profitability of new investments.The Future benefits of investments are difficult to predict with certainty. The Risk in investment arises because of the uncertain returns. Hence, investment proposals should, therefore, be evaluated in terms of both expected return and risk and while, making these kinds of decisions, the financial manager must weigh the costs and benefits of each investment. Financing Decisions: Financing decisions are other important decisions to be made by the finance manager of firm, these decisions essentially relate with the arrangement of funds to fulfil the requirements of the firm. These decisions answer the question: from where and how to acquire funds to meet the Firm’s Investment needs. The Financial Manager must decide whether to raise more money by equity or debt or by a combination of these finance sources. Use of each type of finance has certain costs and benefits attached with it. The main concern while selecting the finance source is its cost to the firm. Firm should select an optimum capital structure, it’s the capital structure at which the cost of the capital is lowest for the firm. Dividend Decisions: These decisions are related to the distribution of earnings. The financial manager must decide whether the firm should distribute all profits, or retain them, or distribute a portion and retain the balance. The proportion of profits distributed as dividends is called the dividend-payout ratio and the retained portion of profits is known as the retention ratio. Like the debt policy, the dividend policy should be determined in terms of its impact on the shareholders’ value. The optimum dividend policy is one that maximizes the market value of the firm’s shares.The financial manager should also answer the questions of dividend stability, bonus shares and cash dividends in practice. Short-term Financial Decision: Liquidity Decision Management of current assets that affects a firm’s liquidity is yet another important finance function. Investment in current assets affects the firm’s profitability and liquidity. Current assets should be managed efficiently for safeguarding the firm against the risk of illiquidity. A trade-off exists between profitability and liquidity while managing current assets. If the firm does not invest sufficient funds in current assets, it may become illiquid and therefore, risky. On the other hand, it would lose profitability, as idle current assets would not earn anything. Thus, a proper trade-off must be achieved between profitability and liquidity. 1.5 Role of a finance manager A financial manager is a person in a firm who main responsibility is to carry out the finance functions.In a modern enterprise, the financial manager occupies a key position. He or she is one of the members of the top management team, The role of finance manager is becoming more important day by day. Finance manager performs a lot of tasks, some of his/her important responsibilities are giver below: Funds Raising Funds Allocation Profit Planning Understanding Capital Markets 4 Lovely Professional University  Notes Unit 01: Financial Management Fund Raising The traditional approach placed emphasis on raising of funds. It neglected the issues relating to the allocation and management of funds. Raising of funds to meet the firm’s requirement is one of the important responsibilities of the finance manager. It was during the major events, such as promotion, expansion or diversification that the financial manager was asked to raise funds. Otherwise, In the day-to-day activities, his or her only significant duty was ensure that the firm had sufficient cash to meet its requirements. Fund Allocation In the modern firm, the emphasis shifted from raising of funds to efficient and effective use of funds. Hence, financial manager, in the new role is concerned with the efficient allocation of funds.Thus, in a modern enterprise, the basic finance function is to decide about the expenditure decisions and to assess the requirement of capital for these expenditures. In other words, the financial manager, new role, is more concerned with the efficient allocation of funds. Profit Planning The functions of the financial manager may be broadened to include profit-planning function. It refers to the operating decisions in the areas of pricing, costs, volume of output and the firm’s selection of product lines.Profit planning means the decisions in the areas of pricing, costs, volume of output and other operating decisions. Profit planning is, therefore, a prerequisite for optimizing investment and financing decisions. Understanding Capital Markets Capital markets bring investors (lenders) and firms (borrowers) together.Hence the financial manager has to deal with capital markets. He or she should fully understand the operations of capital markets and the way in which the capital markets value securities. 1.6 The Basic Goal: Creating Shareholder Value (a)Profit Maximisation Wealth Maximisation a) Profit Maximization Profit Maximization is the capability of the firm in producing maximum output with the limited input, or it uses minimum input for producing stated output. It is termed as the foremost objective of the company.Profit maximization is considered as an important goal in financial decision- making in an organization. It ensures that firm utilizes its available resources most efficiently under conditions of competitive markets. But in recent years, profit maximization is regarded as unrealistic, difficult, inappropriate goal. Favorable Arguments for Profit Maximization The main aim of a firm is to earn profit. Profit is the indicator of success of the business operation. Sufficient profitsreduce risk of the business concern. Profit is the main source of finance for a firm in the form of internal equity. Profitability meets the social needs of a business also. Lovely Professional University 5 Notes Corporate Finance Criticism of Profit Maximisation Profit maximization is vague concept as the term profit is not defined precisely. Profit may be short term or long-term profit; it may be before tax profit or after-tax profit. Profit maximization does not consider the time value of money or the net present value of the cash inflow. Profit maximization does not consider risk of the business concern. Risks may be internal or external which will affect the overall operation of the business concern. The goal of profit maximization may lead to the exploitation of workers and consumers. Profit maximization may create immoral practices such as corrupt practice, unfair trade practice, etc. (b) Wealth Maximization The prime objective of a business entity is to maximize value for its owners, equity shareholders. Therefore, the ultimate objective of financial management should be wealth maximization.Wealth maximization means maximizing the ‘net present value’ of a course of action or investment project. The net present value of a course of action is the difference between the present value of its benefits and the present value of its costs. It is the versatile goal of the company and highly recommended criterion for evaluating the performance of a business organization. Favorable Arguments for Wealth Maximization Contrary to profit maximization objective, wealth maximization is based on cash flows, and not on profits. The objective of wealth maximization focuses on the long run picture. Wealth maximization considers the time value of money. Wealth-maximization criterion considers the risk and uncertainty factor. Profit Maximization V/s Shareholder Wealth Maximization The objective of wealth maximization is generally preferred over profit maximization because of the following reasons: It considers wealth for the long-term. Wealth-maximization criterion considers the risk and uncertainty factor. It considers the timing of returns 1.7 Organization of Finance Functions Responsibility of carrying out the finance functions lies with the top management. Financial Department may be created under the direct control of the board of directors. The executive heading the finance department is the firm’s Chief Finance Officer (CFO). However, the exact nature of the organization of the financial management function differs from firm to firm depending upon factors such as size of the firm, nature of its business type of financing operations, ability of financial officers and the financial philosophy, and so on. Similarly, the designation of the chief executive of the finance department also differs widely in case of different firms. In some cases, they are known as finance managers while in others as vice-president (finance), director (finance), and financial controller and so on. He reports directly to the top management. Various sections within the financial management area are headed by managers such as controller and treasurer. 6 Lovely Professional University  Notes Unit 01: Financial Management Controller Chief Financial Officer Board of Chief Executive Treasurer Directors Officer Chief Operating Officer The Financial Functions Within a Corporation Chief Executive Officer(CEO) He or she is a member of the Top Management and is closely associated with the formulation of policies and making decisions for the firm. The Treasurer and Controller operates under CFO’s supervision. Treasurer Treasurer is a manager responsible for financing, cash management, and relationships with financial markets and institutions. His/her duties include forecasting the financial needs, administering the flow of cash, managing credit, floating securities etc. Controller Controller is an officer responsible for budgeting, accounting and auditing.The functions of the controller relate to the management and control of assets. 1.8 Agency issues The agency problem is a conflict of interest inherent in any relationship where one party is expected to act in another's best interests.The relationship between stockholders and management is called an agency relationship. Understand this though an example. Suppose that you want to sell your old bike and for that purpose you hire someone to sell it. You agree to pay the agent a flat fee when he/she sells the bike. This is an example of Principal-Agent Relationship. The agent’s motive in this case is to make the sale, no guarantee that to get you the best price. This is an example of Agency Problem Now, if you offer a commission instead of the flat fee, let’s say, 3% percent of the sales price instead of a fixed amount, then this problem may be resolved.The agency problem is a conflict of interest inherent in any relationship where one party is expected to act in another's best interests. The relationship between stockholders and management is a form of agency relationship. The conflict between the principal and the agent emerges when the agents who is entrusted with the task, choose to use their authority for personal benefit.It is a common problem and it can be notices in any organization Like any club, company or any government institution. Lovely Professional University 7 Notes Corporate Finance Delegates Authority Principal Conflict of Interests Agent Acts and Makes Decisions Types of Agency problem: Stockholders v/s Management Stockholders v/s Creditors Stockholders v/s other Stakeholders Agency Cost Agency cost is the costs of the conflict of interest between stockholders and management. This cost can be indirect or direct. Suppose a firm is planning a new project. This project is expected to increase the share value for the shareholders, but it’s risky. Now, the firm's owners or the shareholders may like to make the investment, but firms management may not, since there's a chance the project will fail and management’s jobs will be lost.Thus, if management does not take the investment, then the stockholders may lose a good opportunity. This is one example of an indirect agency cost. Direct agency costs are of two types. The first type is some sort of expenditure that will benefit firm’s management but at the cost of the stockholders for e.g., purchase of expensive cars and corporate jets. The second type of direct agency cost are expenses incurred on monitoring managerial actions. For example, paying outside auditors to assess the accuracy of financial statement information. Solving Agency issues Incentives: incentivizing an agent to act in better accordance with the principal's best interests like a manager can be motivated to act in the shareholders' best interests through incentives such as performance-based compensation. Regulations:agency issues can be reduced through instituting measures like tough screening mechanisms, penalizing for poor performance etc. 1.9 Business ethics and social responsibility Business ethics: The word ‘ethics’ has its origin in the Greek word ‘ethics’ meaning character; norms, ideals or morals prevailing in a group or society. Ethics is concerned with what is right and what is wrong in human behavior. It is judged on the basis of a standard form of conduct approved by society. Ethics can also refer to codes or other system for controlling means so that they serve human ends. business ethics are the moral principles that act as guidelines for the way a business conducts itself and its transactions. A few examples of business ethics are: charging fair prices from customers, using fair weights for measurement of commodities, giving fair treatment to workers and earning reasonable profits.Ethical business behavior improves public image, earns people’s confidence and trust, and leads to greater success.Ethics and profits go together in the long run. An ethically responsible enterprise develops a culture of caring for people and environment and commands a high degree of integrity in dealing with others. 8 Lovely Professional University  Notes Unit 01: Financial Management Elements of Business Ethics  Top management commitment: The (CEO) and other higher-level managers need to be openly and strongly committed to ethical conduct. They must give continuous leadership for developing and upholding the values of the organization.  Publication of a ‘Code’:Businesses that have effective ethics programmes write out the standards of behavior for the entire organization in written documents known as the "code” covering areas such product safety and quality; health and safety in the workplace; conflicts of interest etc.  Establishment of compliance mechanisms:In order to ensure that actual decisions and actions comply with the firm’s ethical standards, suitable mechanisms should be established.  Involving employees at all levels:It is the employees at different levels who implement ethics policies to make ethical business a reality. Therefore, their involvement in ethics programmes becomes a must.  Measuring results: Although it is difficult to accurately measure the end results of ethics programmes, the firms can certainly perform audit to monitor compliance with ethical standards. Social Responsibility Social responsibility of business refers to its obligation to take those decisions and perform those actions which are desirable in terms of the objectives and values of our society.Business is part of society. It should fulfill the aspirations of society, and respect the values and norms of society. Thus, social responsibility relates to the voluntary efforts on the part of the businessmen to contribute to the social wellbeing. Social responsibility is broader than legal responsibility of business. Legal responsibility may be fulfilled by mere compliance with the law. Social responsibility is more than that. It is a firm’s recognition of social obligations even though not covered by law. Arguments for Social Responsibility Justification For Existence and Growth: Profit should be looked upon as an outcome of service to the people. The prosperity and growth of business is possible only through continuous service to society Long-term Interest of The Firm: When members of society — including workers, consumers, feel that business enterprise is not serving its best interest, they will tend to withdraw their cooperation to the enterprise concerned. The public image of any firm would also be improved when it supports social goals. Avoidance of Government Regulation: it is believed that businessmen can avoid the problem of government regulations by voluntarily assuming social responsibilities. Maintenance of Society: laws cannot be passed for all possible circumstances. People who feel that they are not getting their due from the business may resort to anti-social activities, not necessarily governed by law Availability of resources with business: business institutions have valuable financial and human resources which can be effectively used for solving problems. Converting problems into opportunities: business with its history of converting risky situations into profitable deals, can not only solve social problems but it can also make them effectively useful by accepting the challenge. Better environment for doing business: business system should do something to meet needs before it is confronted with a situation when its own survival is endangered due to enormous social illnesses. Lovely Professional University 9 Notes Corporate Finance Holding business responsible for social problems: some of the social problems have either been created by business enterprises themselves. pollution, unsafe workplaces. so, it is the moral obligation of business to get involved in solving these problems. Arguments Against Social Responsibility Violation of profit maximization objective: According to this argument, business exists only for-profitmaximization. Therefore, any talk of social responsibility is against this objective. Burden on consumers: undertaking the social responsibility is very costly for the business and often require huge financial investments. Lack of social skills: All social problems cannot be solved the way business problems are solved so businesses should not be expected to solve the social problems. Lack of broad public support: business cannot operate successfully because of lack of public confidence and cooperation in solving social problems. Reality of Social Responsibility Threat of public regulation: governments today are expected to act as welfare states whereby they have to take care of all sections of society. Thus, where business institutions operate in a socially irresponsible manner, action is taken to regulate them for safeguarding people’s interest. Pressure of labor movement: labour movement for extracting gains for the working class throughout the world has become very powerful. Impact of consumer consciousness: Development of education and mass media and increasing competition in the market have made the consumer conscious of his right and power in determining market forces Development of social standard for business: New social standards consider economic activity of business enterprises as legitimate but with the condition that they must also serve social needs. Development of business education: Development of business education which has made more and more people aware of the social purpose of business. Relationship between social interest and business interest: Business enterprises have started realising the fact that social interest and business interest are not contradictory. Instead, these are complementary to each other Development of professional, managerial class: Professional management education in universities and management institutes have created a separate class of professional managers who have got a different attitude towards social responsibility as compared to the earlier class of manager. Kinds of Social Responsibility: Economic responsibility: A business enterprise is basically an economic entity and, therefore, its primary social responsibility is economic. Legal responsibility:Every business has a responsibility to operate within the laws of the land. Since these laws are meant for the good of the society, a law-abiding enterprise is a socially responsible enterprise as well law-abiding enterprise. Ethical responsibility:This includes the behaviour of the firm that is expected by society but not codified in law. For example, respecting the religious sentiments and dignity of people while advertising for a product. Discretionary responsibility:This refers to purely voluntary obligation that an enterprise assumes, for instance, providing charitable contributions to educational institutions or helping the affected people during floods or earthquakes. 10 Lovely Professional University  Notes Unit 01: Financial Management Social Responsibility: Towards Different Interest Groups Towards the shareholders or owners:A business enterprise has the responsibility to provide a fair return to the shareholders on their capital investment and to ensure the safety of such investment. Towards the workers:Management of an enterprise is also responsible for providing opportunities to the workers for meaningful work. It should try to create the right kind of working conditions so that it can win the cooperation of workers Towards the consumers:Supply of right quality and quantity of goods and services to consumers at reasonable prices constitutes the responsibility of an enterprise toward its customers. Towards the government and community:Enterprise must respect the laws of the country and pay taxes regularly and honestly. It must behave as a good citizen and act according to the well accepted values of the society. It must protect the natural environment Summary  Corporate finance deals with the capital structure of a corporation, including its funding and the actions that management takes to increase the value of the company. Corporate finance also includes the tools and analysis utilized to prioritize and distribute financial resources.  Evolution of finance discipline is generally classified in three phases: Traditional phase which lasted till 1940 and focused on certain episodic events like formation, issuance of capital, expansion, merger, reorganization and liquidation. Transitional phase - from early 1940 to 1950- and focused on financial problems faced by managers in day-to-day operations, leading to increased focus on working capital management and modern phased which started in mid of 1950 and focused on rational matching of funds to their uses so as to maximize the wealth of the shareholders.  Finance function can be classified into long-term and short-term decisions: Under long- term decision comes Investment decisions which deals with the allocation of funds, Financing decisions which deals with the sourcing of funds and dividend decisions which relates with the distribution of earnings. Short-term decisions primarily relate with the management of current assets and liquidity.  Role of finance manager mainly consists of funds raising, funds allocation, profit planning and understanding capital markets.  Broadly there are two alternative objectives of a firm. Profit maximization vs Wealth maximization. Profit maximization objective primarily considers earning profits as the main objective of a firm. This objective has several criticisms. On the contrary,wealth maximization objective considers maximization of shareholdersvalue as the main objective and is generally preferred over the profit maximization objective.  The agency problem is a conflict of interest inherent in any relationship where one party is expected to act in another's best interests.  Ethics is concerned with what is right and what is wrong in human behavior judged on the basis of a standard form of conduct/behavior of individuals. business ethics are the moral principles that act as guidelines for the way a business conducts itself and its transactions.  Social responsibility of business refers to its obligation to take those decisions and perform those actions which are desirable in terms of the objectives and values of our society. Lovely Professional University 11 Notes Corporate Finance  A firm has social responsibility towards different stakeholders. It has responsibilities towards shareholders or owners, workers, consumersandtowards the government and community. Keywords Corporate finance, Financial Management, Finance Functions, Profit maximization, Wealth maximization, Agency issues, Business Ethics, Social responsibility. Self-Assessment 1. The structure in which there is separation of ownership and management is called A. Sole proprietorship B. Partnership C. Company D. All business organizations 2. Profits do not have to be shared in which of the following organization type A. Partnership B. Sole proprietorship C. Company D. None of the above 3. ________is the limitation of Traditional approach of Financial Management. A. More emphasis on long term problems B. Ignores allocation of resources C. One-sided approach D. All of the above 4. Financial decisions of an individual like planning application of income, deciding on mode of saving etc. relates to A. Personal Finance B. Corporate Finance C. Public Finance D. None of the above 5. Which of the following option/s is/are true about Corporate Finance: A. It deals with the decisions of a firm related to investment, financing and dividend. B. It is subset of finance C. The primary goal of is to maximize shareholder value D. All of the above 6. Which one of the following is a short-term financial decision? A. Investment decision B. Financing decision C. Dividend decision D. Liquidity decision 12 Lovely Professional University  Notes Unit 01: Financial Management 7. The main goal of financial management is A. profit maximization B. fund transfer C. Maximum Returns D. Wealth Maximization 8. Finance function involves A. procurement of finance only B. expenditure of funds only C. safe custody of funds only D. procurement and effective utilization of funds 9. Which of the following is/are the roles of the finance manager? A. Funds Raising B. Funds Allocation C. Profit Planning D. All of the above 10. The criticism of the Profit maximization goal is/are? A. It is vague concept. B. It ignores timing of returns. C. It ignores the risk factor. D. All of the above 11. Agency is the result of agreement between whom? A. Principal and creditor B. Principal and agent C. Principal, agent and the third party D. Principal and debtor 12. Example/s of the agency relation is/are A. Stockholders and Management B. Stockholders and Creditors C. Stockholders and other Stakeholders D. All of the above 13. Agency cost consists of A. Unnecessary expenditure by the management B. Monitoring C. Auditing cost D. All of the above 14. Examples of business ethics are: A. charging fair prices from customers, Lovely Professional University 13 Notes Corporate Finance B. using fair weights for measurement of commodities, C. giving fair treatment to workers D. All of the above 15. Social Responsibility is needed for: A. Long-term interest of the firm B. Maintenance of society C. Better environment for doing business D. All of the above Answers for Self Assessment 1. C 2. B 3. D 4. A 5. D 6. D 7. D 8. D 9. D 10. D 11. B 12. D 13. D 14. D 15. D Review Questions 1. Define corporate finance. 2. Which objective of financial management is superior? 3. What is the difference between profit maximization and wealth maximization objectives? 4. State the agency cost to prevent agency problem. 5. List the stages of evolution of financial management. Further Readings 1.Khan, M. and Jain, P., 2011. Financial management. 1st ed. New Delhi: Tata McGraw- Hill. 2. Pandey, I.M. (2015). Financial Management (10th Ed). New Delphi, India, Vikas Publishing 3.Berk, Jonathan. &DeMarzo, Peter. & Harford, Jarrad. & Ford, Guy. &Mollica, Vito. (2017). Fundamentals of corporate finance. Melbourne, VIC : Pearson Australia Web Links 1. https://corporatefinanceinstitute.com/resources/knowledge/finance/corporate- finance-industry 2. https://corporatefinanceinstitute.com 3. https://www.investopedia.com/terms/b/business-ethics.asp 14 Lovely Professional University  Notes Atif Ghayas, Lovely Professional University Unit 02: Sources of Finance Unit 02: Sources of Finance CONTENTS Objectives Introduction 2.1 Classification of sources of funds 2.2 Long-Term Sources of finance 2.3 Short-Term Sources of finance 2.4 International Financing 2.5 Factors Affecting the Choice of The Source of Funds 2.6 Equity Shares 2.7 Preference Shares 2.8 Types of Preference Shares 2.9 Debentures 2.10 Types of Debentures 2.11 Debt v/s Equity Financing Summary Keywords Self-Assessment Answers for Self Assessment Review Questions Further Readings Objectives After studying this unit, you will be able to:  understand the concept of Business Finance  classify various sources of Finance  examine the factor affecting Source of Finance  examine Equity and Preference shares as sources of finance  evaluate the merits and limitations of Equity and Preference shares  classify the various types of preference shares  examine Debenture as a source of Finance.  classify the types of debentures.  compare equity Vs Debt financing. Introduction Business requires money for carrying out various activities.The finance required by business to establish and run its operations is known as business finance. No business can function without adequate amount of funds for undertaking various activities. Business finance is called the life blood fora business. The funds may be required for several purposes like purchasing fixed assets, for running day-to-day operations, and for undertaking growth and expansion plans in a business organization Lovely Professional University 15 Notes Corporate Finance Fixed Capital Requirement: For starting any business, funds are required in order to purchase fixed assets for example, building, land, plant and machinery, and furniture and fixtures. The main feature of these fund is that the funds required in fixed assets remain invested in the business for a long period of time. Working Capital Requirements: Other than fixed assets, funds are required for short-term also. Working capital of a business firm is used for holding current assets, such as raw material stock, finished goods, bills receivables and for paying salaries, wages, taxes, and rent. 2.1 Classification of sources of funds The funds required for an enterprise can be sourced from various sources. The funds available to a business can be classified according to three main criteria, which are: (i) Time period (ii) Ownership (iii) Source of generation. On the Basis of Time Period Long-Term Sources: Those sources of finance which fulfills the financial need of an enterprise for a period exceeding five years are known as long-term sources. Medium-Term Sources: The sources of finance which provides funds to an enterprise for more than one year but less than five years are known as medium-term sources. Short-Term Sources: Short-Term sources as those which fulfills the financial requirements of a business firm for a period not exceeding one year. On the Basis of Ownership Owner’s funds: the financial requirement of an enterprise can be met through own funds or through the borrowed funds. Owner funds are the funds that are provided by the owners of an enterprise, which can be sole proprietor, partners in a partnership firm or shareholders of a company. Borrowed funds: Borrowed funds are those funds which are borrowed from outside the enterprise and raised through loans or debentures. These funds have to paid back after a specific period of time along with the interest. On the Basis of Generation Internal sources of funds: Funds sources from inside the business enterprises are known as Internal sources of funds. External sources of funds:These sources are external to the business enterprise such as suppliers, lenders, and investors. 16 Lovely Professional University  Notes Unit 02: Sources of Finance 2.2 Long-Term Sources of finance Long-Term Sources Retained Ordinary Preference Financial Debentures Earnings Shares Shares institutions Retained Earnings Generally, a company does not distribute all the earnings to the shareholders. The portion of the net earnings of the company that is not distributed as dividends is known as retained earnings. The amount of retained earnings available depends on the dividend policy of the company. It is a source of internal financing or self-financing or ploughing back of profits. Ordinary Shares Equity shares is the most important source of raising long term capital by a company. Equity shares represent the ownership of a company and thus the capital raised by issue of such shares is known as ownership capital or owner’s funds. The earning on these shares is fluctuating in nature. As the equity shares are the owners of the firm, they have a say in the management of a company. Preference Shares Preference shares are similar to the equity shares but they differ on some grounds. They get the preferential right to the shareholders with respect to payment of earnings and the repayment of capital. That means, while distributing the earnings, these shareholders get the return before the equityshareholders. The preference shareholders get steady income as return on these shares are fixed in nature. Debentures Debentures are an important source of long-term debt capital. Debentures bear a fixed rate of interest. The debenture issued by a company is an acknowledgment that the company has borrowed a certain amount of money, which it promises to repay at a future date. It represents the loan capital of a company. These are the fixed charged funds that carry a fixed rate of interest. It is suitable in the situation when the sales and earnings of the company are stable. Financial institutions Loans from financial institutions is another source for getting external funds. Governments have established a number of financial institutions to provide industrial finance to companies. They are also called development banks. They are suitable when large funds are required for expansion, reorganization and modernization of the enterprise. Lovely Professional University 17 Notes Corporate Finance 2.3 Short-Term Sources of finance Short-Term Financing Loan from Commercial Trade Credit Factoring Banks Papers Trade Credit Trade credit is source of short-term finance. Trade credit is the credit extended by one trader to another for purchasing goods or services. Trade credit facilitates the purchase of supplies on credit. The terms of trade credit vary from one industry to another and are specified on the invoice. Such credit appears in the records of the buyer of goods as ‘sundry creditors’ or ‘accounts payable’. Factoring Factoring is a financial service under which the ‘factor’ renders various services such as discounting of bills, providing information about credit worthiness of prospective client’s etc. Factor is responsible for all credit control and debt collection from the buyer. Itprovides protection against any bad-debt losses to the firm. The factor charges fees for the services rendered. Loan from Banks Banks loans another source of short-term finance for a business firm. Banks provide short and medium-term loans to firms of all sizes. The rate of interest charged by a bank depends upon factors including the characteristics of the borrowing firm and the level of interest rates in the economy. Commercial Papers Commercial papers is an unsecured promissory note issued by a firm to raise funds for a short period. The maturity period of commercial paper usually ranges from 90 days to 364 days. The amount raised by CP is generally very large. As the debt is totally unsecured, the firms having good credit rating can issue the CP. 2.4 International Financing Apart from the sources discussed above, there are various other international sources through which firms can get funds. With liberalization and globalization of the economy, Indian companies have started generating funds from international markets. Include foreign currency loans from commercial banks, financial assistance provided by international agencies and development banks. Global Depository Receipts (GDR’s) The local currency shares of a company are delivered to the depository bank. The depository bank issues depository receiptagainst these shares. Such depository receipts denominated in US dollars are known as Global Depository Receipts (GDR). GDR is an instrument issued abroad by an Indian company to raise funds in some foreign currency and is listed and traded on a foreign stock exchange. 18 Lovely Professional University  Notes Unit 02: Sources of Finance American Depository Receipts (ADRs) American Depository Receipts are similar to a Global Depository Receipts. ADRs are bought and sold in American markets, like regular stocks. It can be issued only to American citizens and can be listed and traded on a stock exchange of USA. Indian Depository Receipt (IDRs) Indian Depository Receipt is a financial instrument denominated in Indian Rupees in the form of a Depository Receipt. It is created by an Indian Depository to enable a foreign company to raise funds from the Indian securities market. Foreign Currency Convertible Bonds (FCCBs) Equity linked debt securities that are to be converted into equity or depository receipts after a specific period.The FCCB’s are issued in a foreign currency and carry a fixed interest rate which is lower than the rate of any other similar nonconvertible debt instrument. FCCB’s are listed and traded in foreign stock exchanges. 2.5 Factors Affecting the Choice of The Source of Funds The selection of a source of capital is dependent on a number of factors making it a very complex decision for the business. The factors that affect the choice of source of finance are briefly discussed below: Cost: Both the types of cost viz. cost of procurement of funds and cost of utilizing the funds should be taken into account while deciding about the source of funds. Strength and Stability: The business should be in a healthy financial position so as to be able to repay the principal amount and interest on the borrowed amount. Thus, Financial Strength and Stability of Operations is an important factor affecting this decision. Form of Organization: The choice is also based on the type of organization i.e., Sole proprietorship, Partnership firm or a company.A partnership firm, for example, cannot raise money by issue of equity shares as these can be issued only by a joint stock company. Risk Profile: Business should evaluate each of the source of finance in terms of the risk involved as the risk associated with each type of the source is different. Control:A particular source of fund may affect the control and power of the owners on the management of a firm. Thus, business firm should choose a source considering the preference of the equity shareholders. Credit Worthiness:The dependence of business on certain sources may affect its credit worthiness in the market. For example, issue of secured debentures may affect the interest of unsecured creditors of the company and may adversely affect their willingness to extend further loans as credit to the company. Purpose and Time Period: Business should plan according to the time period for which the funds are required. Similarly, the purpose for which funds are required need to be considered so that the source is matched with the use. Tax Benefits: Various sources may also be weighed in terms of their tax benefits. For example, while the dividend on preference shares is not tax deductible, interest paid on debentures and loan is tax deductible Flexibility and Ease:Flexibility and ease of obtaining funds is another factor affecting the choice. For e.g., restrictive provisions, detailed investigation and documentation in case of borrowings from banks and financial institutions for example may be the reason that a business organisation may not prefer it. Lovely Professional University 19 Notes Corporate Finance 2.6 Equity Shares Equity share capital is the most important source of raising long term capital for a company.The capital of a company is divided into small units or parts called as shares. The person holding the share is known as shareholder.Equity shares represent the ownership of a company and the holders of these shares are called as owners of the company. This capital is the prerequisite for the creation of a company. Equity shares are also known as Ordinary shares. Features of Equity Shares: The key features of the equity shares are discussed below: Nofixed dividend:Equity shareholders are not entitled to get any fixed dividend or fixed interest. Their earning depends on the company’s earning as well as the dividend policy of the firm. Residual owners: They are known to as ‘residual owners’ as they receive what is left after all other claims on the company’s income and assets have been settled. Bear the risk: Equity shareholders bear the risk in their investment also as the dividend is not fixed on their investment. Liability is Limited:The liability of the shareholders is limited to the extent of capital contributed by them in the company. Right to Participate:The equity shareholderare the owners of the company. Through their right to vote, these shareholders have a right to participate in the management of the company. Merits: The merits of equity share capital as a source of finance are as follows: i. Equity share capital is the permanent Source of Finance. ii. The payment of dividend on the equity share capital is not fixed. iii. The usage of equity share capital opens the chances of borrowing for the company. iv. Equity capital helps in retained the earnings for future use. v. Democratic control over management of the company is maintained due to voting rights of equity shareholders. Limitations: Equity share capital comes with some limitations also which are discussed below: i. While issuing equity capital, floatation cost is incurred by the company which increases the cost of the capital. ii. Due to the high risk involved in the equity capital, the return demanded by the equity shareholders is also high. iii. Equity capital is taxable unlike debt capital. Hence, Interest on debentures are tax deductible expenses but dividends are not. iv. Issuance of new equity shares dilutes the control of existing shareholders. Terms Related to Equity Shares Various terms related to the equity shares are defined below: Authorized Share Capital: It is the maximum amount of capital which a company can issue. The companies can increase it from time to time. Issued Share Capital: It is that part of authorized capital which the company offers to the investors. Subscribed Share Capital: 20 Lovely Professional University  Notes Unit 02: Sources of Finance It is that part of issued capital which an investor accepts and agrees upon. Paid-up Capital:It is the part of the subscribed capital, which the investors pay. Normally, all companies accept complete money in one shot and therefore issued, subscribed and paid capital becomes one and the same. Rights Shares: Right shares are those shares which a company issues to its existing shareholders. The purpose of issuing these kinds of shares in order to protect the ownership rights of the existing investors. Bonus Shares: Sometime company issues share to the existing shareholders in place of cash dividends. These shares are known as bonus shares. Sweat Equity Share: Sweat equity shares are issued to theexisting employees or directors of the company for their performance. Various prices of Equity Shares: Various prices of equity shares are defined below: Par or Face value: Par or face value of a share is the value of shares which is recorded in the books of accounts. Issue Price: Issue price is the price which a company offers to the investors. Share Premium/Discount: When issuance of shares is at a price higher than face value, this excess amount is known as premium. On the other hand, when the issuance of shares is at a price lower than face value, this deficit amount is known as discount. Book Value: This is the balance sheet value of shares.The calculation of the book value is the sum of paid-up capital and reserve and surplus less any loss divided by the total number of equity shares of the company. Market Value: In the case of companies listed on stock exchanges, the market value of the share is the price at which they are currently sold in the market. This price is determined by the demand and supply of the shares in the stock market. 2.7 Preference Shares Preference shares also commonly known as preferred stock. It is a special type of share where dividends are paid to the shareholders before the equity stock dividends.The preference shareholders get preference over equity shareholders in two ways:They receiving a fixed rate of dividend out of the earning of the company and, receiving their capital (after the claims of the company’s creditors have been settled) at the time of liquidation. Unlike ordinary shares, the holders of these shares do not enjoy any voting rights. Features: The key features of the preference shares are discussed below: Fixed Dividends: The preference shareholders get fixed dividends as return on their capital due to this reason they resemble debentures. Preference over Equity: While distributing the earning of the company, the preference shareholders is given preference over ordinary shareholders. Lovely Professional University 21 Notes Corporate Finance No Voting Rights: The preference shareholders do not enjoy voting rights in the meeting and thus they do not have any control over the firm. Fixed Maturity: These preference shares are issued for a fixed period, after which the preference share capital is paid back to the holders. Merits i. Although the preference shareholders have to be paid fixed dividend regularly, however, there is no legal obligation for the company to pay the dividend. ii. Just like equity share capital, preference share capital also improves borrowing capacity of a company. iii. As the preference shareholders do not have any voting rights the issuance of equity capital do not results in the dilution of control of the equity shareholders. Limitations i. Preference share capital is costlier source of finance than the debt capital. ii. Although a company can skip paying the dividend in a year, generally skipping dividend disregard market image of the company. iii. The preference shareholders have the preference in claims on the company in case of liquidation over equity shareholders. 2.8 Types of Preference Shares a) Cumulative and Non-Cumulative b) Participating and Non-Participating c) Convertible and Non-Convertible a) Cumulative and Non-Cumulative Cumulative preference shares are the preference shares which enjoy the right to accumulate unpaid dividends in the future years, in case the same is not paid during a year. On Non-cumulative shares, dividend is not accumulated if it is not paid in a particular year. b) Participating and Non-Participating Participating shares are those shares which have a right to participate in the further surplus of a company shares, which after dividend at a certain rate has been paid on equity shares.The non- participating preference are such which do not enjoy such rights of participation in the profits of the company. c) Convertible and Non-Convertible Convertible preference shares are those preference shares that can be converted into equity shares within a specified period of time. On the other hand, non-convertible shares are such that cannot be converted into equity shares 2.9 Debentures Debentures arethe debt instrument issued by companies to raise money for medium to long-term duration. The debenture holders are paid return y company ata specified rate of interest. Debentures of a written contract specifying the repayment of the principal and the interest payment at the fixed rate. Generally, a debenture is not secured by any collateral and is only backed by the reputation of the issuer.An alternative form of debenture in India is a bond. Public issue of debentures requires that the issue be rated by a credit rating agency like CRISIL. 22 Lovely Professional University  Notes Unit 02: Sources of Finance Features of Debentures: Some of the features of the debentures are discussed below: Interest Rate:The interest rate on a debenture is fixed. It indicates the percentage of the par value of the debenture that will be paid out annually in the form of interest. Maturity: Debentures are issued for a specific period of time. The maturity of a debenture indicates the length of time until the company redeems (returns) the par value to debenture holders. Redemption:Mostly debentures are redeemable. Redemption of debentures can be accomplished either through a sinking fund or buy-back (call) provision. Security:Debentures are classified as secured debentures and unsecured debentures. Secured debentures are secured by some immovable assets of the company. On the other hand, the unsecured assets are issued based on the general credit of the company. Indenture:It is also known as debenture trust deed and is a legal agreement between the company issuing debentures and the debenture trustee. It is the responsibility of the trustee to protect the interests of debenture holders by ensuring that the company fulfils the contractual obligations. Merits i. Debentures are cheaper source of finance for the company. The investors consider debentures as a relatively less risky investment and therefore, require a lower rate of return. Other major benefit with the debentures is that the interest payments on debentures are tax deductible. ii. Company has to pay debenture holders a fixed Interest regularly as the payment for return on their investment. iii. Debenture-holders do not have voting rights. Thus, debenture issue does not cause dilution of ownership of the equity shareholders. iv. There is disciplinary effect of debenture capital on the management of the company due to theburden of interest despite business profit or loss which makes the entrepreneur cautious. Limitations i. There is an obligatory payment for the firm to pay the interest regularly and the principal amount to the debenture holders. If not paid, can force the company into liquidation. ii. It increases the firm’s financial leverage and hence, the financial risk also. It may be disadvantageous to a firm having volatile sales and earnings. iii. The principal amount has to be paid on maturity. Hence, at some points, they involve substantial cash outflows from the company. iv. Debenture indenture or the agreement may contain several restrictive conditions which may limit the company’s operating flexibility in future. 2.10 Types of Debentures There are different types of debentures which a firm can issue. On the basis of security: a) Secured Debentures: secured debentures are the debentureswhich are secured fully or partly by a charge over the assets of the company. Lovely Professional University 23 Notes Corporate Finance b) Unsecured Debentures:Unsecured debentures are those debentures which are not secured fully or partly by a charge over the assets of the company. On the basis of Convertibility: a) Convertible Debentures:Convertible debenture are the debentures, which are convertible into equity shares or preference shares at the option of the holders, after a certain period. b) Non-Convertible Debentures:The non-convertible debenturesare not convertible into equity shares. On the Basis of Redeemability a) Redeemable Debentures:Redeemable debentures are the debentures which are repayable by the company after a certain period. These debentures can be redeemed by the company on demand by the holders or by the company. b) Irredeemable Debentures:Irredeemable Debenturesare the debentures, which are not repayable during the life time of the company. The company may repay the money at the time of liquidation. On the Basis of Registration a) Registered Debentures:In case of registered debentures, the names of the holders of these debentures with details of the number, value and type of debenture held are recorded in the register of debenture holders. b) Bearer Debentures:In case of the bearer debentures, the register of debenture holders does not have the names of the debenture holder recorded. They are transferable by mere delivery. On the Basis of Priority a) Preferred Debentures:These debenturesare paid first at the time of winding up of the company. These debentures are also called first debentures. b) Ordinary Debentures:Ordinary debenturesare paid only after the preferred debentures during the liquidation or winding up of a company. 2.11 Debt v/s Equity Financing Companies mainly have two types of financing options, equity financing and debt financing. Mostly companies use a mixture of debt and equity financing. The comparison of these financing options is given below: Equity Financing: Equity financing is also called ownership capital. This source of capital does not placeany additional financial burden on the company. Moreover, there is no obligation to repay the money acquired through it.Equity financing involves selling a portion of a company's equity or ownership in return for capital. Debt Financing: Debt financing is other option to finance the requirements of the company. Debt financing involves the borrowing of money and paying it back with interest. The debt provider has no voting right or control over the company. It’s a cheaper source of finance than the equity capital due to the lesser risk involved as well as due to the interest tax shield. 24 Lovely Professional University  Notes Unit 02: Sources of Finance Example:Equity Financing v/s Debt Financing Company XYZ is planning to build a new factory. It determines that it needs to raise Rs. 50 Lacs in capital to fund this expansion.To obtain this capital, the company decides to offer a combination of equity financing and debt financing. It can issue 100% equity or 100% debt, or 50% equity and 50% debt or any other combination. If the company decides to raise capital with just equity financing, the owners would have to give up more ownership.On the other hand, if they decided to use only debt financing, their monthly expenses would be higher.Businesses must determine which option or combination is the best for them. Summary  Business requires money for carrying out various activities. The finance required by business to establish and run its operations is known as business finance.  The funds required for an enterprise can be sourced from various sources. The funds available to a business can be classified according to three main criteria, which are: o Time period o Ownership o Source of generation  The main long-term sources of finance are o Retained Earnings o Ordinary Shares o Preference Shares o Debentures o Financial institutions  The main short-term financing source of capital available for a company are: o Trade Credit o Factoring o Loan from Banks o Commercial Papers  Apart from the sources discussed above, there are various other international sources through which firms can get funds. With liberalization and globalization of the economy, Indian companies have started generating funds from international markets. o Global Depository Receipts (GDR’s) o American Depository Receipts (ADRs) o Indian Depository Receipt (IDRs) o Foreign Currency Convertible Bonds (FCCBs)  Factors Affecting the Choice of The Source of Funds: The selection of a source of capital is dependent on a number of factors making it a very complex decision for the business. The factors that affect the choice of source of finance are briefly discussed below: o Cost of capital o Strength and Stability o Form of Organization o Risk Profile o Control o Credit Worthiness o Purpose and Time Period o Tax Benefits o Flexibility and Ease Lovely Professional University 25 Notes Corporate Finance  Equity share capital is the most important source of raising long term capital for a company.The capital of a company is divided into small units or parts called as shares. The person holding the share is known as shareholder. Equity shares represent the ownership of a company and the holders of these shares are called as owners of the company.  Preference shares also commonly known as preferred stock. The preference shareholders get preference over equity shareholders in two ways: They receiving a fixed rate of dividend out of the earning of the company and, receiving their capital (after the claims of the company’s creditors have been settled) at the time of liquidation.  Types of Preference Shares o Cumulative and Non-Cumulative o Participating and Non-Participating o Convertible and Non-Convertible  Debentures arethe debt instrument issued by companies to raise money for medium to long-term duration. The debenture holders are paid return by company ata specified rate of interest. Debentures of a written contract specifying the repayment of the principal and the interest payment at the fixed rate.  There are different types of debentures which a firm can issue. o On the basis of security:  Secured Debentures  Unsecured Debenture o On the basis of Convertibility  Convertible Debentures  Non-Convertible Debentures o On the Basis of Redeemability  Redeemable Debentures  Irredeemable Debenture o On the Basis of Registration  Registered Debentures  Bearer Debentures o On the Basis of Priority  Preferred Debentures  Ordinary Debentures  A firm can choose between equity or debt source of capital. However, there are certain benefits and limitations with both of these sources. If the company decides to raise capital with just equity financing, the owners would have to give up more ownership. On the other hand, if they decided to use only debt financing, their monthly expenses would be higher.Businesses must determine which option or combination is the best for them. Keywords Capital, Source of capital, Equity, Debt, Preference shares, Retained Earning. Self-Assessment 1. Which among the following is not a long-term source of finance? 26 Lovely Professional University  Notes Unit 02: Sources of Finance A. Retained Earnings B. Ordinary Shares C. Preference Shares D. Trade Credit 2. _____________is a form of long-term finance. A. Retained Earnings B. Trade Credit C. Loan from Banks D. Commercial Papers 3. Internal sources of capital are those that are A. Generated through outsiders such as suppliers B. Generated through loans from commercial banks C. Generated through issue of shares D. Generated within the business 4. Debenture means A. Taking Loan B. Taking Capital C. Taking Venture capital D. None of the above 5. Commercial paper is a type of A. Fixed coupon Bond B. Unsecured short-term debt C. Equity share capital D. Government Bond 6. Equity shareholders are called A. Owners of the company B. Partners of the company C. Executives of the company D. Guardian of the company 7. The share capital which has preference of dividend and capital is known as Lovely Professional University 27 Notes Corporate Finance A. Equity share B. Preference share C. Debenture D. Term loan 8. Which is not true for Equity Shares capital? A. Permanent Source of Finance B. No obligatory dividend payments C. Open Chances of Borrowing D. Fixed interest payments 9. To whom dividend is given at a fixed rate in a company? A. To equity shareholders B. To preference shareholders C. To debenture holders D. To promoters 10. Issue of shares at a price lower than its face value is called: A. Issue at a Loss B. Issue at a Profit C. Issue at a Discount D. Issue at a Premium 11. A company cannot issue A. Debentures with Voting rights B. Share C. Debentures D. None of the above 12. Which of the following is False? A. Debentures is written instrument acknowledgment a debt under the common seal of the company. B. Debentures is a part of owned capital. C. The payment of interest on debentures is a charge on the profit of the company. D. Redeemable debentures are those debentures, which are payable on the expiry of the specific period. 28 Lovely Professional University  Notes Unit 02: Sources of Finance 13. Debenture holders are the: A. Owners of the company B. Creditors of the company C. Money lenders D. None of the above 14. ____________Debentures have to be redeemed within a fixed period of time. A. Convertible B. Redeemable C. Participating D. None 15. Debentures are usually A. Secured B. Unsecured C. Assets D. Loss. Answers for Self Assessment 1. D 2. A 3. D 4. A 5. B 6. A 7. B 8. D 9. C 10. C 11. A 12. B 13. B 14. B 15. A Review Questions 1. Explain why do a business need funds? 2. Explain the sources of raising long-term and short-term finance. 3. Explain the difference between Equity and preference share capital. 4. Explain what are the preferential rights which are enjoyed by preference shareholders. 5. Explain briefly the different types of debentures. Further Readings 1.Khan, M. and Jain, P., 2011. Financial management. 1st ed. New Delhi: Tata McGraw- Hill. 2. Pandey, I.M. (2015). Financial Management (10th Ed). New Delphi, India, Vikas Publishing Lovely Professional University 29 Notes Corporate Finance 3.Berk, Jonathan. &DeMarzo, Peter. & Harford, Jarrad. & Ford, Guy. &Mollica, Vito. (2017). Fundamentals of corporate finance. Melbourne, VIC : Pearson Australia Web Links https://efinancemanagement.com/sources-of-finance https://www.investopedia.com/terms/e/equity.asp 30 Lovely Professional University  Notes Atif Ghayas, Lovely Professional University Unit 03: Money Market Instruments Unit 03: Money Market Instruments CONTENTS Objectives Introduction 3.1 Indian Money Market 3.2 Participants of Money Market 3.3 Functions of Money Market 3.4 Treasury Bills 3.5 Commercial Paper 3.6 Certificate of Deposit 3.7 Treasury Management 3.8 External Commercial Borrowings 3.9 Micro Small and Medium Enterprise 3.10 Financing for MSMEs: 3.11 Equity funding Summary Keywords Self Assessment Answers for Self Assessment Review Questions Further Readings Objectives After studying this unit, you will be able to:  define Money Market,  identify various money market instruments,  evaluate merits and limitations of these money market instruments.  understand the concept of Treasury Management in corporations,  analyse External Commercial Borrowings,  identify the Financing options available for MSMEs. Introduction Whilethe capital market handles the medium term and long-term credit needs of the firms, the Money Market is a market for lending and borrowing of short-term funds. It deals in funds and financial instruments having a maturity period of one day to one year. It covers money and financial assets which are close substitutes for money. The instruments in the money market are of short-term nature and highly liquid. Money market does not deal in cash or money as such but simply provides a market for credit instruments such as bills of exchange, promissory notes, commercial paper, treasury bills, etc. Lovely Professional University 31 Notes Corporate Finance Financial Market Money Market Capital Market Money market refers to the whole networks of financial institutions which deals in the short-term funds, that provides an outlet to lenders and a source of supply for such funds to borrowers. Most of the money market transactions take place on telephone, fax or Internet. 3.1 Indian Money Market The Indian money market consists of Reserve Bank of India, Commercial banks, Co-operative banks, and other specialized financial institutions.The Reserve Bank of India is the leader of the money market in India. Some Non-Banking Financial Companies (NBFCs) and financial institutions like LIC, GIC, UTI, etc. also operate in the Indian money market. 3.2 Participants of Money Market There are many institutions which participates in the India money market which are as follows:  Reserve Bank of India  Commercial banks  Central and State Government  Public sector undertaking  Private sector companies  Non-banking financial institutions  Mutual funds  Insurance companies 3.3 Functions of Money Market The important functions of the money market are discussed below: Financing Trade:The main function of the money market is to provides financing to the traders who need short-term funds. It provides a facility to discount bills of exchange, and this provides immediate financing to pay for goods and services. Central Bank Policies:As we know, the central bank is responsible for guiding the monetary policy of a country. With the help of money market, the central bank can perform its policy-making function efficiently.For example, the short-term interest rates in the money market represent the prevailing conditions in the banking industry and can guide the central bank in developing an appropriate interest rate policy. Growth of Industries:The money market fulfills short-term needs of the firm and helps to finance its working capital requirements. Although money markets do not provide long-term loans, it influences the capital market and can also help businesses obtain long-term financing. The capital market benchmarks its interest rates based on the prevailing interest rate in the money market. 32 Lovely Professional University  Notes Unit 03: Money Market Instruments Commercial Banks Self-Sufficiency:Money market provides commercial banks with a market where they can invest their excess reserves and earn interest which can easily be converted to cash to support customer withdrawals.When faced with liquidity problems, they can borrow from the money market on a short-term basis. Money Market Instruments Money Market instruments mainly include Government securities, securities issued by private sector and banking institutions: 3.4 Treasury Bills In simple terms, a treasury bill is actually a promissory note issued by the Government under discount for a specified period stated therein which does not exceed one year. It is a short-term borrowing instrument issued by the govt. of India. The Government promises to pay the specified amount mentioned therein to the bearer of the instrument on the due date.The Treasury bill rate of discount is fixed by the RBI from time-to-time. It is the lowest one in the entire structure of interest rates in the country because of short-term maturity and degree of liquidity and security. The difference between the issue price and the redemption value indicates the interest on treasury bills, call as a discount. For example, a 91-day Treasury bill of Rs.100/- (face value) may be issued at say Rs. 98.20, that is, at a discount of say, Rs.1.80 and would be redeemed at the face value of Rs.100. This means that you can get a hundred-rupee treasury bill at a lower price and can get Rupees hundred at maturity. These are the safest investment instrument of its category, as the risk of default is negligible. Further, the date of issue predetermines, as well as the amount also fixed. Features of Treasury Bills The main features of the treasury bills are given as under:  Form: The treasury bills are issued by government in physical form as a promissory note or dematerialized form.  Eligibility: The investment in the treasury bills can be made byIndividuals, firms, companies, trust, banks, insurance companies, provident funds, state government, and financial institutions.  Issue price:The T-bills are issued at a discount but redeemed at par.The difference between the issue price and the redemption value indicates the interest on treasury bills, call as a discount  Repayment:The repayment of the T-bill is made at par on the maturity of the term.  Availability:The T-bills are available in both primary as well as secondary financial markets.  Method of the auction:the method of auction is uniform price auction method for 91 days T-bills, whereas multiple price auction method for 364 days T-bill. Types of T-bills The three types of Treasury bills are: Lovely Professional University 33 Notes Corporate Finance 91 days T-bills 182 days T-bills 364 days T-bills a) 91-Days T-Bills:The tenor of these bills completes on 91 days. These are an auction on Wednesday, and the payment makes on the following Friday. b) 182 days T-bills:These treasury bills get matured after 182 days, from the day of issue, and the auction is on Wednesday of non-reporting week. Moreover, these are repaying on following Friday, when the term expires. c) 364 days T-bills:The maturity period of these bills is 364 days. The auction is on every Wednesday of reporting week and repay on the following Friday after the term gets over. Merits  Safety:Investments in T-bills are very safe as the payment of interest and principal are assured by the Government. They carry zero default risk since they are issuing by the RBI for and on behalf of the Central Government.  Liquidity: T-bills are also highly liquid because they can convert into cash at any time at the option of the investors.  Ideal Short-Term Investment:Idle cash can profitably invest for a very short period in T- bills. T-bills are available on top throughout the week at specified rates. Financial institutions can employ their surplus funds on any day.  Ideal Fund Management:T-billsare available on top as well through periodical auctions. They are also available in the secondary market. T-bills help financial managers to manages the funds effectively and profitably.  Statutory Liquidity Requirement:As per the RBI directives, commercial banks have to maintain SLR (Statutory Liquidity Ratio) and for measuring this ratio of investments in T- bills takes into account. T-bills are eligible securities for SLR purposes. Moreover, to maintain CRR (Cash Reserve Ratio). TBs are very helpful.  Source of Short-Term Funds:The Government can raise short-term funds for meeting its temporary budget deficits through the issue of T-bills. It is a source of cheap finance to the Government since the discount rates are very low.  Non-Inflationary Monetary Tool:T-bills enable the Central Government to support its monetary policy in the economy. For instance, excess liquidity, if any, in the economy can absorb through the issue of T-bills.  Hedging Facility:T-bills can use as a hedge against heavy interest rate fluctuations in the call loan market. When the call rates are very high, money can raise quickly against T- billsand invest in the call money market and vice versa. T-bills can use in ready forward transitions. 34 Lovely Professional University