LECTURE 3
SOURCES OF FINANCE
LEASE FINANCING
Lease financing is one of the important sources of medium- and long-term financing • The owner of an asset gives another person, the right to use that asset against periodical payments. The owner of the asset is known as lessor and the user is called lessee.
MERITS
It enables the lessee to acquire the asset with a lower investment.
• Simple documentation makes it easier to finance assets.
• Lease rentals paid by the lessee are deductible for computing taxable profits.
• It provides finance without diluting the ownership or control of business.
LIMITATIONS
A lease arrangement may impose certain restrictions on the use of assets.
• The normal business operations may be affected in case the lease is not renewed.
• It may result in higher payout obligation in case the equipment is not found useful and the lessee opts for premature termination of the lease agreement and .
PUBLIC DEPOSITS
Public deposits refer to the unsecured deposits invited by companies from the public mainly to finance working capital needs. A company wishing to invite public deposits makes an advertisement in the newspapers.
• Any member of the public can fill up the prescribed form and deposit the money with the company. The company in return issues a deposit receipt. This receipt is an acknowledgement of debt by the company. The terms and conditions of the deposit are printed on the back of the receipt. The rate of interest on public deposits depends on the period of deposit and reputation of the company.
MERITS
- The procedure of obtaining deposits is simple and does not contain restrictive conditions as are generally there in a loan agreements.
- 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.
LIMITATIONS
New companies generally find it difficult to raise funds through public deposits
• It is an unreliable source of the 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.
COMMERCIAL PAPER
Commercial Paper or CP is defined as a short-term, unsecured money market instrument, issued as a promissory note by big corporations having excellent credit ratings. As the instrument is not backed by collateral, only large firms with considerable financial strength are authorised to issue the instrument.
MERITS
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 source
• A commercial paper provides a continuous source of funds.
• Companies can park their excess funds in commercial paper thereby earning some good retunes on the same.
LIMITATIONS
Only financially sound and highly rated firms can raise money though commercial papers
• The size of money that can be raised though 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.
EQUITY SHARES
Equity shares are the main source of finance of a firm. It is issued to the general public. Equity shareholders do not enjoy any preferential rights with regard to repayment of capital and dividend. They are entitled to residual income of the company, but they enjoy the right to control the affairs of the business and all the shareholders collectively are the owners of the company.
MERITS
Equity shares are suitable for investors who are willing to assume risk for higher returns
• Payment of dividend to the equity shareholders in not compulsory
• Equity capital serves as permanent capital as it is to be repaid only at the time of liquidation of a company
• Equity capital provides credit worthiness to the company and confidence to prospective loan providers
LIMITATIONS
Investors who wants 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 ravishing 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.
PREFERENCE SHARES
Preference shares allow an investor to own a stake at the issuing company with a condition that whenever the company decides to pay dividends, the holders of the preference shares will be the first to be paid.
This shares, often with no voting rights, which receive their dividend before all other shares and are repaid first at face value if the company goes into liquidation
MERITS
Preference shares provide reasonably steady income in the form of fixed rate of return and safety of investment.
• Preference shares are useful for those investors who want fixed rate of return with comparatively low risk.
• It does not affect the control of equity shareholders over the management as preference shareholders don’t have voting rights.
LIMITATIONS
Preference shares are not suitable for those investors who are willing to take risk and are interested in higher returns .
• Preference capital dilutes the claims of equity shareholders over assets of the company.
• The rate of dividend on preference shares is generally higher than the rate of interest on debentures.
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