2. Discuss the sources from which a large industrial enterprise can raise capital for financing modernisation and expansion.
Solution:
The following are some of the sources of long-term funds.
(a) Equity shares: These shares represent the ownership capital of a company. The holders of such shares are known as equity share holders and enjoy a say in the management and gain higher returns when the profits are higher. They are also called the owners of the company, or residual owners, since payments to them are made only after paying the external debts or claims.
(b) Retained earnings: Firms generally keep a certain fraction or part of their profits before distributing dividends to their shareholders. These undistributed profits are known as retained earnings because the funds are kept for future use.
(c) Preference shares: These types of shares provide the shareholders a preferential right regarding the repayment of capital and payment of earnings after a certain specified period of time. Such repayment to the preference share holders is made in accordance with the terms specified in Section 80 of the Companies Act, 1956.
(d) Debentures: Debentures are financial instruments used by companies to raise long-term debt capital. They imply that a company has borrowed a certain sum of money which it will repay later to the debenture holders. Just like loans, they carry a fixed rate of return and specify in advance the time for repayment of the debts.
(e) Loans from banks and other financial institutions: Business enterprises can borrow funds for a fixed period of time from banks and financial institutions in return for a fixed periodic payment called interest. The time for repayment of such a loan is fixed and is stated in advance at the time of granting the loan.
3. What advantages does issue of debentures provide over the issue of equity shares?
Solution:
Debentures are financial instruments used by companies to raise long-term debt capital. They imply that the company has borrowed a certain sum of money which it will repay later to the debenture holders. They are considered as fixed income securities as they carry a fixed rate of return and are repayable on a certain pre-specified date in the future.
The following are the advantages of issuing debentures over issuing equity shares.
(a) The issue of equity shares denotes the dilution of ownership of a firm. This is because the equity share holders own specified shares of the company and have voting rights. In contrast, debenture holders do not have any rights in the company. That is, they do not enjoy voting rights or any kind of ownership in the firm. Rather, they are only entitled to a fixed amount as payment. Thus, debentures do not result in any kind of dilution of ownership of the firm. Thus, issuing debentures is more advantageous for a firm than issuing equity shares.
(b) In order to issue shares, a company has to incur huge costs. Besides, it has to pay dividends to its shareholders, which are not tax-deductible. On the other hand, a company receives tax deductions on the interest paid to its debenture holders. Hence, issuing debentures is advantageous for a firm in terms of low costs.
(c) Debentures carry a fixed rate of return. This implies that irrespective of the profit earned, the company has to pay only a fixed interest to its debenture holders. On the other hand, a company that issues shares has to pay dividends to the shareholders, which varies with the profit—i.e., the higher the profit, the higher will be the dividends. Thus, companies prefer to issue debentures if they expect to earn higher profits in a year.
4. State the merits and demerits of public deposits and retained earnings as methods of business finance.
Solution:
Public deposits: Organisations raise public deposits directly from the public to finance their short-term as well as medium-term financial requirements. The rate of return on such deposits is generally higher than the return paid on bank deposits. In case a person is interested in investing in a business (by depositing money), then he or she can submit a prescribed form along with the deposit. In return for this sum borrowed, the organisation issues a deposit receipt as a token of acknowledgment of the debt.
Merits of Public Deposits
(a) Raising money by accepting public deposits is a very simple process with few regulations involved.
(b) The cost of raising funds by accepting public deposits is generally lower than the cost involved in borrowing loans from commercial banks.
(c) The depositors do not have any voting or management rights. Thus, acceptance of public deposits does not result in any dilution of ownership of the business.
Demerits of Public Deposits
(a) The amount of money that can be raised from public deposits is limited as it depends on the availability of funds and the willingness of people to invest in the company concerned.
(b) Generally, it is difficult for new companies to raise capital through public deposits as people lack faith in them.
(c) When a firm has huge capital requirements, it may face difficulty in borrowing funds through the issue of public deposits.
Retained Earnings: Firms usually keep a certain part of the profits earned before distributing dividends to their shareholders. These undistributed profits are retained in the business for future use and are known as retained earnings.
Merits of Retained Earnings
(a) As these funds are raised internally, they do not involve any kind of explicit costs, such as floatation cost and interest.
(b) High amounts of retained earnings can lead to an increase in the price of equity shares.
(c) Since these are surplus profits retained in the business, they help in reducing the burden of unexpected losses.
Demerits of Retained Earnings
(a) Retained earnings are an uncertain source of finance as the business profits keep fluctuating from time to time.
(b) In case a firm reinvests a large portion of profits in the business, then very little funds are left for payments to the shareholders, and this creates dissatisfaction among them.
(c) Firms often fail to recognise the opportunity cost of the earnings retained in the business. As a result, these funds are often misused or sub-optimally used.