Meaning of financing
Means of Financing
To meet the estimated costs of the project, finance is required. In every project, finance is arranged from two sources internal and external Internal sources refer to the owner’s own money. However, a major portion of money is arranged from the external sources. On the basis of extent of permanence, the financial needs are classified into two typestal needs, the means of finance can be classified into two fixed capital and working capital. On the basis of these capipoints are discussed in detail as follows:
Funds required to acquire fixed assets are termed as fixed capital. The total amount of fixed capital is determined through project capital cost estimates. Accuracy in the project capital cost estimates is very important. Any error in the estimates will have a long term impact on the financial position and profitability of the project. Risk factor is quite high in fixed assets investments. Inaccurate estimation can lead to over capitalisation or undercapitalisation, both of them having their disadvantages.
The fixed capital estimation is a function of personal judgement of the promoters and the availability of finance. So far, no precise tool has been evolved to indicate the exact amount of capital required by a concern. There are some factors, however, which may enable the concern to decide about the adequate amount of fixed capital. A few of these factors are Nature of the business-capital intensive or labour
-Size of business-large or small
-Trends in the economy
-Provision of subcontracts etc.
Sources of Long Term Finance
Long term finance is needed to acquire assets which are of fixed nature. The examples of fixed assets are land and building, plant & machinery etc. The long term sources of finance, generally include the followings
1. Share Capital-Share capital is of two types equity shares and preference shares. Both of these are discussed as follows.
(i) Equity Share Capital-Equity share capital repre-
sents the contribution made by the owners of the business.Equity shareholders enjoy the rewards and bear the risks of ownership. Equity capital carries no fixed rate of dividend. It is residuary in nature. Equity capital provides the strength to the capital structure of the company. It also acts as a base for adding debt into the capital structure. Equity capital represents permanent capital and there is no liability for repayment. No fixed obligation as to the payment of dividend or interest is created. But the cost of equity capital is relatively very high.
(ii) Preference Share Capital-Preference share capital represents the capital contributed by the preference share holders. Preference shares have two basic rights viz. to receive the dividend and to get back their capital in preference to the equity share holders. The dividend paid on these shares is generally fixed. A company can issue different types of preference shares, conferring special rights on preference shareholders e.g. redeemable preference shares, cumulative preference shares, participating preference shares etc. Preference capital is a hybrid form of financing, having some features of equity capital and some features of debt capital. These shares have a fixed rate of dividend but dividend is to be paid only if there are profits. Thus, these shares are not a burden on the finances of the company like debt capital. This capital lends flexibility to the capital structure, because in the situation of excess capital, it can be redeemed. Preference capital is resorted to when the promoters do not want a reduction in their profits but need a wider net worth base to satisfy the requirements of the creditors. Preference share capital is an unattractive source of finance because of the high cost associated with it.
2. Debentures. Debentures are the instruments used for raising debt capital. These are very commonly used creditorship securities. Debentures are secured investments and carry fixed rates of dividend. Debentures can be convertible or non-convertible in nature depending upon whether these can be converted into equity share capital or not. Debentures with fixed rate of interest enable the company to take advantage of trading on equity. The shareholders can retain control and earn more on their investments. The capital structure, thus, becomes flexible. The cost of debentures is comparatively low as the interest on debentures is allowed as deduction for income tax purposes. However, the debentures add more financial risk. In recent years, companies in India have issued debentures but convertible debentures with the option to convert them into equity shares.
3. Term Loans-Term loans are provided by the financial institutions and commercial banks. These are considered very safe borrowings. Term loans are a very important and major source of finance for financing new projects as well as expansion, modernisation and renovation of the existing ones.
In India, there are two types of term loans-rupee term loans and foreign currency term loans. Rupee term loans and foreign currency. given for financing the fixed capital requirements of business.
Term loans provide the benefit of trading on equity.The owners retain the control of their company. The financial structure become flexible since these roans can be returned whenever money is not required. It is comparatively a cheaper source of finance. The term lending institutions can, however, put restrictions on the promoters of the company.
4. Deferred Credit-The suppliers of machinery may provide deferred credit facility whereby the payment for the machinery can be made over a period of time. The interest rate and the period of repayment may vary widely. The suppliers may, however, ask for a bank guarantee from the buyer for providing this credit facility.
5. Government Incentives-Goverment also provides support and incentives to certain type of entrepreneurs for setting up projects in certain locations. These incentives can be in the form of:
(i) Seed Capital Assistance- Capital assistance
provided at a very low rate of interest to enable the promoter to meet his contribution to the project.
(ii) Capital Subsidy- Subsidies are provided to
attract industries to certain locations.
(III) Tax Exemptions- Tax exemptions can be pro
vided for a certain number of initial years.
6. Unsecured Loans & Deposits- Unsecured loan
are typically provided by the promoters to bridge the between the promoters contribution as required by the financial institutions and the equity capital the promoters can subscribe to. These loans carry a lower rate of interest and cannot be taken back without the prior permission the financial institutions.
Public deposits represent the unsecured borrowing from the public at large. These deposits are preferred to loan term loans from financial institutions because these do no carry any restrictive convenants. However, these are not viable source of finance for new projects.