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Karnataka 1st PUC Business Studies Question Bank Chapter 8 Sources of Business Finance
1st PUC Business Studies Sources of Business Finance Text Book Questions and Answers
Multiple Choice Questions
Equity shareholders are called
(a) Owners of the company
(b) Partners of the company
(c) Executives of the company
(d) Guardian of the company
(a) Owners of the company
The term ‘redeemable’ is used for
(a) Preference shares
(b) Commercial paper
(c) Equity shares
(d) Public deposits
(b) Commercial paper
Funds required for purchasing current assets is an example of
(a) Fixed capital requirement
(b) Ploughing back of profits
(c) Working capital requirement
(d) Lease financing
(c) Working capital requirement
ADRs are issued in
Public deposits are the deposits that are raised directly from
(a) The public
(b) the directors
(c) The auditors
(d) The owners
(a) The public
Under the lease agreement, the lessee gets the right to
(a) Share profits earned by the lessor
(b) Participate in the management of the organisation
(c) Use the asset for a specified period
(d) Sell the assets
(c) Use the asset for a specified period
(a) Fixed capital of the company
(b) Permanent capital of the company
(c) Fluctuating capital of the company
(d) Loan capital of the company
(d) Loan capital of the company
Under the factoring arrangement, the factor
(a) Produces and distributes the goods or services
(b) Makes the payment on behalf of the client
(c) Collects the client’s debt or account receivables
(d) Transfer the goods from one place to another
(c) Collects the client’s debt or account receivables
The maturity period of a commercial paper usually ranges from
(a) 20 to 40 days
(b) 60 to 90 days
(c) 120 to 365 days
(d) 90 to 364 days
(d) 90 to 364 days
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
(d) generated within the business
Short Answer Questions
What is business finance? Why do businesses need funds? Explain.
Business is an economic activity directed towards producing, acquiring wealth through buying and selling of goods. It is a very wide term. Finance is the life blood of the business. Funds are required to commence and carry on business. All business activities such as planning, organizing, managing, controlling, purchasing, selling, directing, marketing etc cannot take place without finance.
Thus, we can say requirements of funds by business to carry out its various activities is called business finance. When an entrepreneur takes a decision to start business the need fo fund arises in order to meet the expenses of establishment of business, finance is required for purchasing fixed and current assets, for day-to-day operations, purchase of raw material, to pay salaries etc. Smooth functioning, expansion and growth of business is possible when it has sufficient funds.
List sources of raising long-term and short-term finance.
Sources of Long Term Finance:
- Equity Shares
- Retained earnings
- Preference shares
- Loans from banks and other financial institutions.
Sources of Medium Term Finance:
- Lease financing
- Public deposits
- Loans grom banks and other financial institutions.
Sources of Short Term Finance:
- Trade credit
- Commercial papers.
- Short term loans from banks
What is the difference between internal and external sources of raising funds? Explain.
Internal Sources of Finance:
- Internal sources of funds are those that are generated within the business.
- Examples of internal sources of finance are accelerating collection of receivables, disposing of surplus inventories and ploughing back of profit.
- The internal sources of funds can fulfill only limited needs of the business. Cost of internal funds is low.
- Business is not required to provide security while obtaining funds from internal sources.
External Sources of Finance:
- External sources of funds include those sources that he outside the organization, such as suppliers, lenders, and investors.
- Examples of external sources of finance are Issue of debentures, borrowing from commercial banks and financial institutions and accepting public deposits.
- Large amount of money can be raised through external sources. External funds are more costly.
- Business is required to mortgage its assets as security while obtaining funds from external sources.
What preferential rights are enjoyed by preference shareholders? Explain.
The following preferential rights are enjoyed by preference shareholders
- Receiving a fixed rate of dividend, out of the net profits of the company, before dividend is declared for equity shareholders.
- Preference over equity shareholders in receiving their capital after the claims of the company’s creditors have been settled, at the time of liquidation.
- In case of dissolution of the company preference share capital is refunded prior to the refund of equity share capital.
Name any three special financial institutions and state their objectives.
1. Industrial Finance Corporation of India (IFCI):
It was established in July, 1948 as a statutory corporation under the Industrial Finance Corporation Act, 1948. Its objectives include assistance towards balanced regional development and encouraging new entrepreneurs to enter into the priority sectors of the economy. IFCI has also contributed to the development of management education in the country.
2. State Financial Corporation’s (SFCs):
State Financial Corporations are established by the State Governments under the Financial Corporations Act, 1951 for providing medium and short term finance to industries which are outside the scope of the IFCI. Its scope is wider than IFCI as it covers not only public limited companies but also private limited companies, partnership firms and proprietary concerns.
3. Life Insurance Corporation of India (LIC):
LIC was set up in 1956 under the LIC Act, 1956 after nationalizing 245 existing insurance companies. It mobilizes savings in the form of the insurance premium and makes it available to industrial concerns in the form of direct loans and underwriting of shares and subscriptions to shares and debentures.
What is the difference between GDR and ADR? Explain.
Global Depository Receipts (GDR):
The depository receipts denominated in US dollars issued by depository bank to which the ” local currency shares of a company are delivered. GDR is a negotiable instrument and can be traded freely like any other security. In the Indian context, a GDR is an instrument issued abroad by an India company to raise funds in some foreign currency and is listed and traded on a foreign stock exchange.
American Depository Receipts (ADR):
The depository receipts issued b a company in the USA are known as American Depository Receipts ADRs are bought and sold in American markets like regular stocks. ADR is similar to a GDR except that it can be issued only to American citizens and can be listed and traded on a stock exchange of USA.
Long Answer Questions
Explain trade credit and bank credit as sources of short-term finance for business enterprises.
Trade credit is the credit extended by one trader to another for the purchase of goods and services. It facilitates the purchase of supplies without immediate payment and is commonly used by business organizations as a source of short – term financing. Trade credit appears in the records of the buyer of goods as ‘sundry creditors’ or ‘accounts payable’.
It is granted prudently to those customers who have reasonable amount of financial standing and goodwill The volume and period of credit extended depends on factors such as reputation of the purchasing firm, financial position of the seller, volume of purchases, past record of payment and degree of competition in the market.
Terms of trad ecredit may vary from industry to industry and from person to person. As we know, trade is the purchase and sale of goods on profit motive. So, trade credit strictly refers to the routine business activity. Bank Credit Commercial banks provide funds for different purposes and for different time periods to firms of all sizes by way of cash credits, overdrafts, term loans, purchase / discounting of bills, and issue of letter of credit.
The rate of interest charged by banks depends on various factors such as the characteristics of te firm and the level of interest rates in the economy. The loan is repaid either in lump sum or in installments. Bank credit is not a permanent sources of funds and is generally used for medium to short periods. The borrower is required to provide some security or create a change on the assets of the firm before a loan is sanctioned by a commercial bank.
Discuss the sources from which a large industrial enterprise can raise capital for financing modernization and expansion.
Financial institutions established by the central as well as State Governments all over the country to provide finance to business organizations are considered the most suitable source of financing when large funds for longer duration are required for expansion, reorganization and modernization of an enterprise.
These institution provide both owned capital and loan capital for long and medium term requirements and supplement the traditional financial agencies like commercial banks. In addition to providing financial assistance, these institutions also conduct market surveys and provide technical assistance and managerial services to people who run the enterprises.
The various Speicla Financial Institutions in India are as under:
1. Industrial Finance Corporation of India (IFCl):
It was established in July 1948 as a statutory corporation under the Industrial Finance Corporation Act, 1948. Its objectives Include assistance towards balanced regional development and encouraging new entrepreneurs to enter into the priority sectors of the economy. IFCI has also contributed to the.development of management education in the country.
2. State Financial Corporations (SFC):
The State Financial Corporations Act, 1951 empowered the State Governments to establish State Financial Corporations in their respective regions for providing medium and short term finance to industries which are outside the scope of the IFCI. Its scope is wider than IFCI, since the former covers not only public limited companies but also private limited companies, partnership firms and proprietary concerns.
3. Industrial Credit and Investment Corporation of India (ICICI):
This was established in 1955 as a public limited company under the Companies Act. ICICI assists the creation, expansion and modernization of industrial enterprises exclusively in the private sector. The corporation has also encouraged the participation of foreign capital in the country.
4. Industrial Development Bank of India (IDBI):
It was established in 1964 under the Industrial Development Bank of India Act, 1964 with an objective to coordinate the activities of other financial institutions including commercial banks. The bank performs three types of functions, namely, assistance to other financial institutions, direct assistance to industrial concerns, and promotion and coordination of financial-technical services.
5. State Industrial Development Corporations (SIDC):
Many state governments have set up State Industrial Development Corporations for the purpose of promoting industrial development in their respective states. The objectives of the SIDCs differ from one state to another.
6. Unit Trust of India (UTI):
It was established by the Government of India in 1964 under the Unit Trust of India Act, 1963. The basic objective of UTI is to mobilise the community’s savings and channelise them into productive ventures. For this purpose, it sanctions direct assistance to industrial concerns, invests in their shares and debentures, and participates with other financial institutions.
7. Industrial Investment Bank of India Ltd:
It was initially set up as a primary agency for rehabilitation of sick units and was known as Industrial Reconstruction Corporation of India. It was reconstituted and renamed as the Industrial Reconstruction Bank of India in 1985 and again in 1997 its name was changed to Industrial Investment Bank of India. The Bank assists sick units in the reorganisation of their share capital, improvement in management system, and provision of finance at liberal terms.
8. Life Insurance Corporation of India (LIC):
LIC was set up in 1956 under the LIC Act, 1956 after nationalising 245 existing insurance companies. It mobilises the community’s savings in the form of insurance premia and makes it available to industrial concerns, both public as well as private, in the form of direct loans and underwriting of and subscription to shares and debentures.
What advantages does issue of debentures provide over the issue of equity shares?
Debentures are long term debt instruments which bear a fixed rate of interest. The deenture issued by a company is an acknowledgment that the company has borrowed a certain amount of money, which it promises to repay at a fixture date. Debenture holders are paid a fixed amount of interest at specified intervals say six months or one year.
Issue of Zero Interest Debentures (ZID) which do not carry any explicit rate of interest. Has also become popular in recent years. In the case of ZIDs, the difference between the face value of the debenture and its purchase price is the return to the investor.
Merits of Debentures over Equity Shares:
- Debentures are preferred by investors who want fixed income at lesser risk.
- Debentures are fixed charge funds and do not participate in profits of the company.
- The issue of debentures is suitable in the situation when the sales and earnings are relatively stable.
- Financing through debentures does not dilute control of shareholders on management as debentures do not carry voting rights.
- Financing through debentures is less costly as compared to cost of equity capital as the interest payment on debentures is tax deductible.
State the merits and demerits of public deposits and retained earnings as methods of business finance.
The deposits that are raised by organisations directly from the public are known as public deposits. Rates of interest offered on publi^eoosits are usually higher than that offered on bank deposits. Any person who is interested in depositing money in an organisation can do so by filling up a prescribed form.
The organisation in return issues a deposit receipt as acknowledgment of the debt. Public deposits can take care of both medium and short-term financial requirements of a business. The deposits are beneficial to both the depositor as well as to the organisation.
While the depositors get higher interest rate than that offered by banks, the cost of deposits to the company is less than the cost of borrowings from banks. Companies generally invite public deposits for a period upto three years. The acceptance of public deposits is regu¬lated by the Reserve Bank of India.
Merits: The merits of public deposits are,
- The procedure of obtaining deposits is simple and does not contain restrictive conditions as are generally there in a loan agreement.
- Cost of public deposits is generally lower than the cost of borrowings from banks and financial institutions.
- Public deposits do not usually create any charge on the assets of the company. The assets can be used as security for raising loans from other sources.
- As the depositors do not have voting rights, the control of the company is not diluted.
Limitations: The major limitation of public deposits are as follows.
- New companies generally find it difficult to raise funds through public deposits;
- It is an unreliable source of finance as the public may not respond when the company needs money;
- Collection of public deposits may prove difficult, particularly when the size of deposits required is large.
A company generally does not distribute all its earnings amongst the shareholders as dividends. A portion of the net earnings maybe retained in the business for use in the future. This is known as retained earnings. It is a source of internal financing or selffinancing or ‘ploughing back of profits’. The profit available for ploughing back in an organisation depends on many factors like net profits, dividend policy and age of the organisation.
Merits: The merits of retained earning as a source of finance are as follows.
- Retained earnings is a permanent source of funds available to an organisation.
- It does not involve any explicit cost in the form of interest, dividend or floatation cost.
- As the funds are generated internally, there is a greater degree of operational freedom and flexibility.
- It enhances the capacity of the business to absorb unexpected losses.
- It may lead to increase in the market price of the equity shares of a company.
Limitations: Retained earning as a source of funds has the following limitations.
- Excessive ploughing back may cause dissatisfaction amongst the shareholders as they would get lower dividends;
- It is an uncertain source of funds as the profits of business are fluctuating;
- The opportunity cost associated with these funds is not recognised by many firms. This may lead to sub-optimal use of the funds.
Discuss the financial instruments used in international financing.
Various financial instruments used in international financing include:
1. Commercial Banks:
Commercial banks all over the world extend foreign currency loans for business purposes. They are an important source of financing non-trade international operations. The types of loans and services provided by banks vary from country to country. For example, Standard Chartered emerged as a major source of foreign currency loans to the Indian industry.
2. International Agencies and Development Banks:
A number of international agencies and development banks have emerged over the years to finance international trade and business. These bodies provide long and medium term loans and grants to promote the development of economically backward areas in the world.
These bodies were set up by the Governments of developed countries of the world at national, regional and international levels for funding various projects. The more notable among them include International Finance Corporation (IFC), EXIM Bank and Asian Development Bank.
3. International Capital Markets:
Modem organisations including multinational companies depend upon sizeable borrowings in rupees as well as in foreign currency. Prominent financial instruments used for this purpose are:
(a) Global Depository Receipts (GDR’s):
The local currency shares of a company are delivered to the depository bank. The depository bank issues depository receipts against these shares. Such depository receipts denominated in US dollars are known as Global Depository Receipts (GDR). GDR is a negotiable instrument and can be traded freely like any other security.
In the Indian context, a 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. A holder of GDR can at any time convert it into the number of shares it represents.
The holders of GDRs do not carry any voting rights but only dividends and capital appreciation. Many Indian companies such as Infosys, Reliance, Wipro and ICICI have raised money through issue of GDRs.
(b) American Depository Receipts (ADR’s):
The depository receipts issued by & company in the USA are known as American Depository Receipts. ADRs are bought and sold in American markets like regular stocks. It is similar to a GDR except that it can be issued only to American citizens and can be listed and traded on a stock exchange of USA.
(c) Foreign Currency Convertible Bonds (FCCB’s):
Foreign currency convertible bonds are equity linked debt securities that are to be converted into equity or depository receipts after a specific period. Thus, a holder of FCCB has the option of either converting them into equity shares at a predetermined price or exchange rate, or retaining the bonds.
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. FCCB ’s are very similar to the convertible debentures issued in India.
What is a commercial paper? What are its advantages and limitations.
Commercial Paper emerged as a source of short term finance in our country in the early nineties. Commercial paper is an unsecured promissory note issued by a firm to raise funds for a short period, varying from 90 days to 364 days. It is issued by one firm to other business firms, insurance companies, pension funds and banks.
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. Its regulation comes under the purview of the Reserve Bank of India.
The merits and limitations of a Commercial Paper are as follows:
- A commercial paper is sold on an unsecured basis and does not contain any restrictive conditions.
- As it is a freely transferable instrument, it has high liquidity.
- It provides more funds compared to other sources. Generally, the cost of CP to the issuing firm is lower than the cost of commercial bank loans.
- A commercial paper provides a continuous source of funds. This is because their maturity can be tailored to suit the requirements of the issuing firm Further, maturing commercial paper can be repaid by selling new commercial paper.
- Companies can park their excess funds in commercial paper thereby earning some good return on the same.
- Only financially sound and highly rated firms can raise money through commercial papers. New and moderately rated firms are not in a position to raise funds by this method.
- The size of money that can be raised through commercial paper is limited to the excess liquidity available with the suppliers of funds at a particular time.
- Commercial paper is an impersonal method of financing. As such if firm is not in a position to redeem its paper due to financial difficulties, extending the maturity of a CP is not possible.
1st PUC Business Studies Sources of Business Finance Additional Questions and Answers
One Mark Questions
Mention any one source of Business Finance.
Mention any one type of shares.
Give one merits of Equity shares.
Equity shares holders enjoy the limited liability.
State any one type of preference shares.
Cumulative preference shares.
State any one type of Debentures.
Mention any one sources of owner’s fund.
Mention any one type of Financial Institutions.
Industrial Finance Corporation of India.
American Depository Receipts.
Global Depository Receipts
Indian Depository Receipts.
Inter Corporate Deposit
Expand EXIM Bank.
Two Marks Questions
What is business finance?
Business finance is concerned with estimating, raising, allocating and managing of capital funds in meeting financial needs of the business.
What do you mean by fixed capital?
In order to start a business, funds are required to purchase fixed assests like land and building, plant and machinery, furniture and fixtures etc., is known as fixed capital.
Give the meaning of working capital.
The financial requirement of a business enterprise do not end with the procurement of fixed assets, it needs funds for its day to day operations. This is known as working capital,.
The total capital of the company is divided into small units. Each units is called as shares.
Give the meaning of ordinary shares.
Ordinary shares is a type of shares that are not preferred and don’t pay any type of predetermined dividend amount.
Give the meaning of preference shares.
Preference shares are shares of a company’s stock with dividends that are paid out to shareholders before common stock dividends are issued.
Debenture is an instrument issued by the company acknowledging the debt raised from general public.
Give the meaning of retained earnings.
A portion of earning is retained in the business in form of reserve for the use in future is called as retained earnings.
Give the meaning of public deposit.
Raising deposits by a company directly from public for a specific period at a specific rate of interest is known as public deposit.
What is discounting of bill?
The selling of bill to invoice discounting company before the due date of payment at a value which is less than the invoice amount.
What do you mean by trade credit?
A trade credit is an agreement where a customer can purchase goods on account (without paying cash), paying the supplier at a later date.
What do you mean by Bearer debentures?
The debentures which are payable to bearer and whose names do not appear in the register of debenture holders are known as “Bearer Debentures”.
Five Marks Questions
What are the metrits of Ordinary Shares?
- Equity shares are suitable for investors who are willing to assume risk for higher returns.
- Payment of dividend to the equity shareholders is not compulsory. Therefore, there is no burden on the company in this respect.
- Equity capital serves as permanent capital as it is to be repaid only at the time of liquidation of a company. As it stands last in the list of claims, it provides a cushion for creditors, in the event of winding up of a company.
- Equity capital provides credit worthiness to the company and confidence to prospective loan providers.
- Funds can be raised through equity issue without creating any charge on the assets of the company. The assets of a company are, therefore, free to be mortgaged for the purpose of borrowings, if the need be.
- Democratic control over management of the company is assured due to voting rights of equity shareholders.
What afe the Demerits of Ordinary Shares?
The major limitations of raising funds through issue of equity shares are as follows:
- Investors who want steady income may not prefer equity shares as equity shares get fluctuating returns.
- The cost of equity shares is generally more as compared to the cost of raising funds through other sources.
- Issue of additional equity shares dilutes the voting power, and earnings of existing equity shareholders.
- More formalities and procedural delays are involved while raising funds through issue of equity share.
What do you mean by ADR, GDR, IDR?
Modem organizations including multinational companies depend upon sizeable borrowings in rupees as well as in foreign currency. Prominent financial instruments used for this purpose are:
1. Global Depository Receipts (GDR’s):
The local currency shares of a company are delivered to the depository bank. The depository bank issues depository receipts against these shares. Such depository receipts denominated in US dollars are known as Global Depository Receipts (GDR).
2. American Depository Receipts (ADR’s):
The depository receipts issued by a company in the USA are known as American Depository Receipts. ADRs are bought and sold in American markets like regular stocks. It is similar to a GDR except that it can be issued only to American citizens and can be fisted and traded on a stock exchange of USA.
3. An Indian Depository Receipt (IDR):
It is a financial instrument denominated in Indian Rupees in the form of a depository receipt created by a Domestic Depository (custodian of securities registered with the Securities and Exchange Board oflndia) against the under tying equity of issuing company to enable foreign companies to raise funds from the Indian securities Markets.
Briefly explain the Different Methods of Raising Finance.
1. Equity 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. Equity share capital is a prerequisite to the creation of a company.
2. Preference Shares:
The capital raised by issue of preference shares is called preference share capital. The preference shareholders enjoy a preferential position over equity shareholders in two ways:
- Receiving a fixed rate of dividend, out of the net profits of the company, before any dividend is declared for equity shareholders.
- Receiving their capital after the claims of the company’s creditors have been settled, at the time Of liquidation.
In other words, as compared to the equity shareholders, the preference shareholders have a preferential claim over dividend and repayment of capital. Preference shares resemble debentures as they bear fixed rate of return.
These are an important instrument for raising long term debt capital. A company can raise funds through issue of debentures, which 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. Debenture holders are, therefore, termed as creditors of the company. Debenture holders are paid a fixed stated amount of interest at specified
4. Commercial Banks:
Commercial banks occupy a vital position as they provide funds for different purposes as well as for different time periods. Banks extend loans to firms of all sizes and in many ways, like, cash credits, overdrafts, term loans, purchase/discounting of bills, and issue of letter of credit.
The rate of interest charged by banks depends on various factors such as the characteristics of the firm and the level of interest rates in the economy. The loan is repaid either in lump sum or in instalments.
5. Financial Institutions:
The government has established a number of financial institutions all over the country to provide finance to business organizations. These institutions are established by the central as well as state governments. They provide both owned capital and loan capital for long and medium-term requirements and supplement the traditional financial agencies like commercial banks. As these institutions aim at promoting the industrial development of a country, these are also called ‘development banks’.
6. Global Depository Receipt (GDR), and American Depository Receipt (ADR):
Every publie company issues shares. These shares are listed and traded on various share markets. Companies in India issue shares which are traded on Indian share markets like BSE (Bombay Stock Exchange) and NSE (National Stock Exchange) etc.
Ten Marks Questions
What are the different types of Preference Shares.
As the name indicates, these shares have certain privileges and preferential rights distinct from those attaching to equity shares. The shares which carry following preferential rights are termed as preference shares.
- A preferential right as to the payment of dividend during the life time of the company.
- A preferential right as to the return of capital in the event of winding up of the company.
Holders of these shares have a prior right to receive the fixed rate of dividends before any dividend is paid to equity shares. The rate of dividend is prescribed in the issue.
1. Cumulative preference shares:
Cumulative preference shares are those shares on which dividend goes on accumulating until it is fully paid. This means, if the dividend is not paid in one or more years due to inadequate profit, then such unpaid dividend gets accumulated. The accumulated dividend is paid when company performs well.
The arrears of dividend are paid before making payment to equity shareholders. The preference shares are always cumulative unless otherwise stated in the Articles of Association. It means that if dividend is not paid in any year or falls short of prescribed rate, the unpaid amount is carried forward to next year and so on; until all arrears have been paid.
2. Non-cumulative preference shares:
Dividend on these shares does not accumulate. This means, the dividend on shares can be paid only out of profits of that year. The right to claim dividend will lapse, if company does not make profit in that particular year. If dividend is not paid in any year, it is lost.
3. Participating preference shares:
The holders of these shares are entitled to participate in surplus profit besides preferential dividend. The surplus profit which remains after the dividend has been paid to equity shareholders up to certain limit, is distributed to prefe rence shareholders.
4. Non-participating preference shares:
The preference shares are deemed to be non-participating, if there is no clear provision in Articles of Association. These shareholders are entitled only to fixed rate of dividend prescribed in the issue.
5. Convertible preference shares:
These shareholders have a right to convert their preference shares into equity shares. The conversion takes place within a certain fixed period.
6. Non-convertible preference shares:
These shares cannot be converted into equity shares.
7. Redeemable preference shares:
Shares which can be redeemed after a certain fixed period are called redeemable preference shares. A company limited by shares, if authorized by Articles of Association, issues redeemable preference shares. Such shares must be fully paid. These shares are redeemed out of divisible profit only or out of fresh issue of shares made for this purpose.
8. Irredeemable preference shares:
Shares which are not redeemable i.e, payable only on the winding up of the company are called irredeemable preference shares. As per Companies Act (Amendment made in 1988) the company cannot issue irredeemable preference shares.
What do you mean by Debentures and what are the types of Debentures.
Debentures have occupied a significant position in the financial structure of the companies. It is one of the main sources of raising debt capital to meet long term financial needs. Debentures represent borrowed capital. The debenture holders are creditors ofthe company. The debenture holder gets a fixed rate of interest as return on his investment.
Board of Directors has the power to issue debentures. The debentures can be of different kinds according to their terms of issue, conversion, provision of security, repayment etc. Let us discuss them in detail.
1. Secured debentures:
The debentures can be secured. The property of company may be charged as security for loan. The security may be for some particular asset (fixed charge) or it may be the asset in general (floating charge). The debentures are secured through ‘Trust Deed’.
2. Unsecured debentures:
These are the debentures that have no security. The issue of unsecured debenture is now prohibited by Companies (Amendment) Act, 2000.
3. Registered debentures:
Registered debentures are those on which the name of holders are recorded. A company maintains a register of debenture holders in which the names, addresses and particulars of holdings of debenture holders are entered. The transfer of debentures in this case requires the execution of regular transfer deed.
4. Bearer debenture:
Name of holders are not recorded on the bearer debentures. Their names do not appear on the register of debenture holders. Such debentures are transferable by mere delivery. Payment of interest is made by means of coupons attached to debenture certificate.
5. Redeemable debentures:
Debentures are mostly redeemable i.e. payable at the end of some fixed period, as mentioned on the debenture certificate. Repayment can be made at fixed date at the end of specific period or by instalments during the life time of the company. The provision of repayment is normally made ina trust deed.
6. Irredeemable debentures:
These kind of debentures are not repayable during life time of the, company. They are repayable only after the liquidation of the company or when there is breach of any condition or when some contingency arises.
7. Convertible debentures:
Convertible debentures give the right to the holder to convert them into equity shares after a specific period. Such right is mentioned.in the debenture certificate. The issue of convertible debenture must be approved by special” resolution in general meeting before they are issued to public.
8. Nonconvertible debentures:
Non-convertible debentures are not convertible into equity shares on maturity. These debentures are normally redeemed on maturity date. These debentures suffer from the disadvantage that there is no appreciation in value.
What are the Merits and Demerits of Equity Shares.
Advantages of company: The advantages of issuing equity shares maybe summarized as below:
- Long-term and Permanent Capital: It is a good source of long-term finance. A company is riot required to pay-back the equity capital during its life-time and so, it is a permanent sources of capital.
- No Fixed Burden: Unlike preference shares, equity shares suppose no fixed burden on the company’s resources, because the dividend on these shares is subject to availability of profits and the intention of the board of directors. They may not get the dividend even when company has profits. Thus they provide a cushion of safety against unfavourable development
- Credit worthiness: Issuance of equity share capital creates no change on the assets of the company. A company can raise further finance on the security of its fixed assets.
- Risk Capital: Equity capital is said to be the risk capital. A company can trade on-equity in bad periods on the risk of equity capital.
- Dividend Policy: A company may follow an elastic and rational dividend policy and may create huge reserves for its developmental programmes.
Advantages to Investors: Investors or equity shareholders may enjoy the following advantages:
- Mare Income: Equity shareholders are the residual claimant of the profits after meeting all the fixed commitments. The company may add to the profits by trading on equity. Thus equity capital may get dividend at high in boom period.
- Right to Participate m the Control and Management: Equity shareholders have voting rights and elect competent persons as directors to control and manage the affairs of the company.
- Capital profits: The market value of equity shares fluctuates directly with the profits of the company and their real value based on the net worth of the assets of the company. An appreciation in the net worth of the company’s assets will increase the market value of equity shares. It brings capital appreciation in their investments.
- An Attraction of Persons having Limited Income: Equity shares are mostly of lower denomination and persons of limited recourses can purchase these shares.
- Other Advantages: It appeals most to the speculators. Their prices in security market are more fluctuating.
Disadvantages of equity shares:
Disadvantages to company: Equity shares have the following disadvantages to the company:
- Dilution in control: Each sale of equity shares dilutes the voting power of the existing equity shareholders and extends the voting or controlling power to the new.shareholders. Equity shares are transferable and may bring about centralization of power in few hands. Certain groups of equity shareholders may manipulate control and management of company
- Trading on equity not possible: If equity shares alone are issued, the company cannot trade on equity.
- Over-capitalization: Excessive issue of equity shares may result in overcapitalization. Dividend per share is low in that condition which adversely affects the psychology of the investors. It is difficult to cure.
- No flexibility in capital structure: Equity shares cannot be paid back during the lifetime of the company. This characteristic creates inflexibility in capital structure ofthe company.
- High cost: It costs more to finance with equity shares than with other securities as the selling costs and underwriting commission are paid at a higher rate on the issue of these shares.
- Speculation: Equity shares of good companies are subject to hectic speculation in the stock market. Their prices fluctuate frequently which are not in the interest ofthe company.
Disadvantages to investors: Equity shares have the following disadvantages to the investors:
- Uncertain and Irregular Income: The dividend on equity shares is subject to availability of profits and intention of the Board of Directors and hence the income is quite irregular and uncertain. They may get no dividend even three are sufficient profits.
- Capital loss During Depression Period: During recession or depression periods, the profits of the company come down and consequently the rate of dividend also comes down. Due to low rate of dividend and certain other factors the market value of equity shares goes down resulting in a capital loss to the investors.
- Loss on Liquidation: In case, the company goes into liquidation, equity shareholders are the worst suffers. They are paid in the last only if any surplus is available after every other claim including the claim of preference shareholders is settled.