CAIIB ABFM Module B Unit 1 : Sources Of Finance and Financial Strategies

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Oct 5

CAIIB Paper 3 ABFM Module B Unit 1 : Sources Of Finance and Financial Strategies (New Syllabus)

IIBF has released the New Syllabus Exam Pattern for CAIIB Exam 2023. Following the format of the current exam, CAIIB 2023 will have now four papers. The CAIIB Paper 3 (ADVANCED CONCEPTS OF FINANCIAL MANAGEMENT) includes an important topic called "Sources Of Finance and Financial Strategies". Every candidate who are appearing for the CAIIB Certification Examination 2023 must understand each unit included in the syllabus.

In this article, we are going to cover all the necessary details of CAIIB Paper 3 (ABFM) Module B (THE MANAGEMENT PROCESS) Unit 1 : Sources Of Finance and Financial Strategies, Aspirants must go through this article to better understand the topic, Sources Of Finance and Financial Strategies and practice using our Online Mock Test Series to strengthen their knowledge of Sources Of Finance and Financial Strategies. Unit 1 : Sources Of Finance and Financial Strategies

Introduction

Owners or promoters: finance to start the business is generally provided by the persons who moot the idea of business.
Since the owners are going to stay with the project, their finance is long term finance.
However, if the project is too big and the promoters do not have enough money, normally long-term borrowing is preferred.
Since at times, processing of term loans takes time, promoters also go in for bridge finance which is a temporary funding to fill the time gap between the fund requirement and the actual release by the long-term lenders.
Term finance is provided by banks and financial institutions.
Debt equity ratio: Which means how much ideally promoters should contribute as equity and how much they should borrow for long term.
This depends on various factors but the general and safe norm is if equity is Rs. 100, one can safely borrow up to Rs. 200. [2:1]
The entire requirement of long-term funds will depend on the size and capital requirement of the project.
Working capital finance: The finance required for running a business [Current assets - current liabilities]
Current assets: Which are created and extinguished in an operational cycle.
An operational cycle: Time or period in which cash, after going through various forms is converted back into cash.
For example, with cash you buy raw materials that are converted into finished goods through work in process and later when the finished goods are sold, they are converted into debtors or receivables and upon realisation or debt collection, the cash comes back into the business.
Clearly, you need funds for all these activities and functions before you realise profits.
Like in any business, and depending on the creditworthiness of the business entity and the established norms, credit is generally available for procuring goods.
Therefore, to that extent, fewer funds are required.
The gap between these assets and the said liabilities is the working capital gap which can be financed by a bank.
However, the bankers will always insist on the borrower to provide his contribution towards the gap.
The quantum of working capital finance varies from time to time based on the level of business activities and the gap.

It also depends on how you manage and minimise the gap.
Financial strategies are those permutations and combinations which a business adopts or avails to satisfy its funds requirements, whether these are long-term or short-term.
Strategies are so worked out as to maximise the advantages and minimise the cost of funds.
A clean finance is the costliest, because the lender who has no assets to fall upon in case of a default and runs higher risks which he would cover by charging higher rate of interest.
Equity is a clean finance and although it appears to be cheap, the cost of servicing is very high because the equity shareholders will expect good returns over the years in the form of dividend, which is always distributed after the company pays its taxes.

Equity Capital

Capital generally means the amount invested for establishing a business which is owned by the promoter.
In accounting terms, it means the amount remaining after selling all the assets and paying off all the liabilities.
It also represents the money the owner brought in at the time of setting up the business and the profits he earned but did not take away over a period of time.
Over a period of time, as business developed, various forms of organisations or entities evolved with the arrival of corporates.
A corporate has hordes of investors who come from various walks of life and who may neither know one another nor may be related to each other.
It was at the time of arrival of corporates, that the term Equity got coined.
Equity means a quality of being fair or impartial, something that is fair and just.

Equity capital has the following features as well as advantages;

Each unit has the same value called nominal value.
Equity holder has two types of financial rights; the right to income (dividend) and the right to retaining surplus assets in case of liquidation.
Additionally, they also have voting rights (except in case of Differential Voting Right shares), whenever so required by the governing act viz. Companies Act, 2013
Anyone can buy or subscribe to any number of Equity Shares subject the terms and conditions prescribed in the Articles of Association of the Company
All subscribers to the Equity Shares are governed by a common document called Memorandum and Articles of Association
All subsequent transferees of such shares also have to abide by the above document.
The Equity Shareholder can exit at will by following the prescribed rules.
If the company is listed on a stock exchange, the liquidity of the Equity Shares increases since the holder can sell it to anyone through the exchange.
Equity Shares can be priced by the issuer at the nominal value or at a premium or discount subject to extant regulations and guidelines.
Also, subject to extant regulations and guidelines, Equity Capital can be enhanced, reduced, subdivided, bought back or issued free of cost.

Some other terms related to the equity capital are:

Authorised Capital or Nominal Capital.

This represents the maximum amount of capital that the company is authorised to issue which can be in any instalments as the Board decides.
This is prescribed by the Memorandum and Articles of Association of the Company and in case of any change, the company has to go to the shareholders as prescribed in the Act.

Issued Share Capital

The part of authorised capital which is issued to public for subscription.
This includes shares issued for cash and for consideration other than cash to promoters of a company or other people.

Subscribed Share Capital;

It is the portion of the issued share capital that is subscribed to by the public, i.e., applied for and allotted by the company.
It also includes the face value of the company's shares issued for consideration other than cash.
It is possible that all the shareholders, who have been called upon to subscribe to the capital, may not respond and therefore the actual subscribed capital may be less than the called up one.

Called-up Share Capital:

This is that part of the Issued Capital that the company has called up from the shareholders. The call can be one or more subject to the extant regulations and need of funds by the company.

Paid up Share Capital:

Paid up capital is the amount of money a company has received from shareholders in exchange of shares.
However, even after subscription, some may skip or delay the actual payment and, in such case, the paid-up capital can still be lesser than the subscribed capital.
Calls in Arrears are a part of the called up or subscribed capital which the company can follow up and rightfully collect when the shareholders fail to pay the full or part amount.
Unpaid Share Capital is, as the name suggests, the amount finally determined as unpaid for which the management can take suitable decision.
Forfeited Shares are that part of the subscribed capital which is not fully paid as required and as a final resort, the company forfeits the amount so that it can be reissued as the Board decides, subject to the regulations.

Why Equity Capital and not Long-Term Loans?

Except owners or promoters, no one would be able to take the inherent risk.
The relations and friends also can be convinced to take or participate in the risk.
Lenders can never assume the risk because they are interested in the immediate and guaranteed return or reward.
Hence equity is a natural choice and the first option to raise funds.

Depending of the size of the project, the equity portion is determined. Apart from the natural and the first choice, raising funds through equity have quite a few advantages which are enumerated below:

Although there is expectation, the equity holders are not required to be paid compulsorily any reward or interest or compensation.
Unlike loans, there is no repayment involved.
It provides the risk capital which otherwise is difficult to source.
It gives to the holder a sense of ownership
Higher amount of equity provides higher level of safety and confidence to the lenders.

Internal Accruals

As a measure of financial prudence, no company can or would like to distribute the entire earnings after tax to the shareholders.

There are also dividend distribution rules which the regulators want the management to follow.

As a result, part of the Profit After Tax (PAT) is retained in the company, which is usually reflected in the general reserve.

These retained profits are internal accruals of the company.

These arise out of the cash profits i.e.

PAT,
Non-cash profits charged to the Profit & Loss account, in the form of provisions or reserves
Depreciation charged to the Profit & Loss account.

Advantages:

There is no restriction on the use of internal accruals, except as mentioned above.
These can be used for long term as well as short term purposes.
Internal accruals do not have any cost for use or servicing
Internal accruals are readily available.
Internal accruals are as liquid as the form in which these remain invested.
The use or availing of internal accruals does not change the ownership structure or results in the dilution of control.
There is no cost of raising these funds.

Disadvantages

Just because internal accruals are readily and easily available, there is tendency of indiscriminate application of retained earnings.
The cost of these funds in reality is higher because these represent undeclared dividend.
These funds, therefore, belong to the equity shareholders and they expect reasonable return on these.
Retained earnings are deprivation of dividend and over- use of such earnings may hurt the shareholders particularly the minority shareholders.
The company cannot build a good dividend track record resulting into lesser interest by investing public.
Safety cover provided by the retained earnings is reduced by the use of it.
The ease of use and no cost element induces the management to lock up the funds in projects which may not be as well scrutinised as the ones undertaken with IPO proceeds or borrowed funds. This hurts the equity holders.

Preference Capital

This is that part of the capital which provides lesser risk to the investor compared to that which is taken by the equity investors. As the name suggests, the holder gets a preference with respect to dividend as well as payment is case of liquidation, which is one of the major monetary considerations for any investor. It is a quasi-risk capital because it is not as safe as secured debts which get payment priority over preference shares in case of liquidation of a company. Host of regulations with regard to the issue of preference shares exist. If equity is a common stock, preference share is preferred stock.

Let's now see what are the main features of the preference capital:

It is a stock which is preferred over equity shares with regards to the payment of dividend and repayment in case of liquidation.
Unlike equity capital, the dividend rate of preference share is fixed just like debentures.
Generally speaking, the preference shares are entitled to dividend if distributable profits are available and hence dividend distribution is not obligatory like equity capital.
Like equity capital, preference shares are paid dividend out of post-tax profits and hence the dividend on preference shares is not a tax-deductible expense.
There are cumulative preference shares where the dividend is guaranteed. In other words, if in a year the company does not have enough profits to declare dividend, it is accumulated to the credit of the shareholders and paid when, in a subsequent year, the distributable surplus is available.
Redeemable Preference Shares are those which get repaid as per the terms of issue. Under the current provisions of the Companies Act, 2013, companies limited by shares are prohibited from issuing Preference Shares which are not redeemable. All the preference shares are required to be redeemed within a period not exceeding 20 years. Redemption has to be made out of profits or out of the proceeds of fresh share issue for such redemption purpose. However, in case of banks, perpetual debt instruments can be issued.
Preference shareholders have a limited right to participate in voting only on some of the resolutions as specified in the Companies Act, 2013. Where dividend on preference shares has not been paid for two years or more, such shareholders get a right to vote on all company resolutions.

Why companies raise preference capital and the reasons are not far away to find:

It is a good source of funds for very long period up to twenty years. In case of infrastructure companies, the period can even be more than twenty years.
Mostly such securities are privately placed and hence the cost of raising such funds is not high.
There is no compulsion to pay dividend unless cumulative preference shares are issued.
The recurring cost in the form of dividend is fixed and known beforehand unlike dividend on equity shares.
The current owners do not have to dilute their equity holding and hence they retain the present level of control over management.
It is a part of the net worth of the company and hence it helps is improving the debt equity ratio.
Absence of voting rights, unless the company skips dividend for two or more years, gives a comfort to the management who generally does not like interference.
No security is provided to the preference shareholder unlike in case of debentures.

However, there are certain drawbacks, from the point of view of the management and the equity shareholders, which are enumerated below.

Possibility of management interference in case of non-payment of dividends for more than two years.
Dividend paid is a non-deductible expenditure which increases the real cost of funding.
Redemption reserves are to be created leading to lower retained earnings which in turn may affect long term capital out lay plans to be funded out of internal accruals.
Equity shareholders feel side-lined when the preference for dividend payout is given to preference shareholders.
In case of liquidation, these shareholders get prior charge over the residual assets compared to the equity shareholders.
Contingency of voting right devolution to these shareholders creates uncertainty and apprehension in the mind of the management.

Term Loans

This is another major source of long-term finance by which a company can obtain term loans from banks or financial institutions.
While banks also give working capital finance, the Financial Institutions are allowed to give only such loans which are repayable over the years as per the terms and conditions of the sanction.
This source is different from equity and relatively, cheaper to service. The equity forms are either a permanent source where repayment is not there or a very long period like 20 years is available for repayment in the case of preference shares or capital. Term loans can be for long to medium terms stretching to about ten years.

The main features of Term Loans are described below:

Period: All loans, except demand loans, are term loans and are generally granted for short terms to long terms. Short term loans are repaid within a year. Long term is period from 5 to 10 years and medium term is a range from 1 to 5 years. This is the period within which the loans are to be fully repaid. Loans granted for housing are generally for long period ranging from 5 years to 30 years.
Purpose: Term loans are granted to acquire assets like land, buildings, plant and machinery to establish a factory or set up a project which are tangible and have a long useful life. For the reasons such as long gestation period, slow start to cash generation cycle and longer life, a longer period is granted for repayment. If the project is already running and loan is taken for capacity build up, a shorter period up to 5 years will suffice as cash flows are already there. Short to medium term loans are preferred for other tangible assets such computers, peripherals, furniture, renovations etc. Loans are also granted for housing and soft furnishing.
Interest: Term loans carry a fixed and predetermined rate of interest. The rate to be charged is negotiated and depends upon factors such as period, risk, rating of the borrower or creditworthiness as well as the purpose. Interest is payable either monthly or quarterly and sometimes it is embedded into the equal monthly instalment (EMI) which combine both interest and principal.
Repayment: Loans are generally repaid over the granted period and generally in instalments which are monthly, quarterly, half yearly or yearly. In some specific but time bound acquisition of assets, there is recovery by bullet payment in one shot. Moratorium is granted for principal repayments where projects are large and cash generations are likely to take time.
Currency: In many large projects, the import component of assets is quite large where the loans are granted in foreign currency to facilitate proper requirement, since the quotations are foreign currency denominated and by the time the actual import takes place the INR element may be a different amount.
Security: Uncertainty over a long period obviously enhances risk perception and so also insecurity in the mind of the lender. Even otherwise, no lender can or will lend without securing the term loan by creating charge over the primary assets.
Amount of loan: In case of purchase of existing assets, the lender carries out an independent valuation and after providing a margin to cover value fluctuation and borrower's margin or contribution, the loan amount is determined. In cases where the term loan is for creation of fixed assets by the borrower, the loan amount is arrived at by the debt/equity ratio, as decided by the lender.
Appraisal: The appraisal process of a term loan by the lender depends on the size and complexity of the project financed. However, no term loan is granted without examining the economic viability and technical feasibility.
WCTL: This is not a type of normal term loan given by any bank or Financial Institution. It is a term loan against the current assets. It is used in the banking industry when a working capital loan, given by a bank, is not being properly serviced by the borrower due to temporary liquidity constraints.
Conversion: Conversion of loan into equity is generally not a planned action except when the banks and the borrower agree upfront to convert loans into equity at a later stage. In such a case, at the expiry of the agreed term, the loan is converted into the equity of the borrower. The valuation mechanism is pre-agreed. Sometimes, it is optional for the lender to convert.
Moratorium: It takes time for any project to start generating cash flows, positive cash flows and profits. Bigger the project, longer the time. Therefore, till such time the borrower starts generating required cash flows, the lenders give time to start the repayment.

A list of typical terms, conditions and requirements incorporated in the loan agreements.

Reconstitution of the board.
Induction of the independent directors.
A seat on the board.
Prior consent or approval of the lender required for following actions: Examples; Mergers, hiving off, restructuring, new projects, equity expansion or dilution, investments in or creation of subsidiaries, fresh or big funding exercise etc.
Statutory registrations or approvals.
Infusion of additional funds by the promoters.
Prohibition on withdrawal of loans or funds already brought in by the promoters.
Consent required of the lender if any other loans are being repaid.
Restrictions on dividend pay-outs.
Submission of quarterly data and annual audited financial statements.
Requirements of rating by independent and reputed rating agency.
Ceiling on further borrowings.
Inspections and visits.
Insisting on First charge failing which pari-passu charge.
Prohibition on creating further charges.
Pledge of promoters' shares or collaterals of personal assets of the promoters.
Restrictions on promoters' right to dispose their shares.
Appointment of compliance officers and proper Key Managerial Persons.
Strong Corporate governance.
Maintenance of prudent financial ratios including debt equity.

Debentures

Section 2(30) of the Companies Act, 2013 defines "debenture" which includes debenture stock, bonds or any other instrument of a company evidencing a debt, whether constituting a charge on the assets of the company or not. In other words, it is a written instrument acknowledging debt by the company promising repayment at a certain future date.
This is another form of long- term borrowing targeted at various individuals or institutions that subscribe to the issue and pay to the company. The terms of issue like tenure, rate of interest, denomination, minimum subscription, total issue size etc. all form part of the issue document.

The following are the main features of debentures:

Features:

An instrument: Debenture is an instrument issued by the borrower company promising to pay, at fixed future date, a certain amount to the holder.
Agreement or deed. If debentures are issued to more than 500 persons, Trustees are required to be appointed to look after interest of the debenture holders.
Regulations: Section 71 of the companies Act, 2013 contains provisions relating to issue of debentures covering the points such as manner, procedures, convertibility, voting rights, redemption, creating reserves, prospectus or invitation, trust etc.
Fixed tenure: Loans are repaid in instalments over a period of time. On the other hand, debentures are repaid on a fixed date on expiry of the term. Repayment on maturity is also called redemption. Perpetual bonds are also permitted to be issued.
Fixed rate of interest: The rate of interest is also prefixed. In case of so called, Zero- Coupon bonds also, a fixed rate of interest, payable at the time of redemption, is involved as these are issued at a discount to their redemption value.
Options with the issuer: The company issuing debentures can incorporate an option like call option where it can repay the principal before due date at a fixed price. This is called call option.
Option with the investor: The mpany issuing debentures can incorporate an option like put option where the investor has the option to demand redemption before due date at a fixed price. This is called put option.
No voting rights: Section 71(2) of the Companies Act,2013 prohibits giving any voting rights to a debenture holder.
Stake in the company: In case of convertible (wholly or partly) debentures, which are permitted to be issued, the debenture holder gets an equity stake in the company after conversion in the equity followed by voting rights. The ratio of conversion as well as the price at which shares will be valued is indicated in the offer document.

Types of debentures:

Based on tenure: There are debentures specifying redemption with call options, put options, or with fixed tenure under this kind. Perpetual bonds with call option, are also permitted to be issued.
Based on security: Many a times, to offer lower rate of interest and a sense of security to the investors, secured debentures are issued providing first or second charge over the fixed assets of the company and appointing trustees if the number of holders exceeds 500.
Based on Convertibility: To provide additional incentive to the investors, the companies issue partly or fully convertible debentures so that at a future date, upon conversion, the debentures holders can be growth participants and also have voting rights.
Based on negotiability: The debenture is a debt instruments and mostly transferable by way of a registered transfer form. However, in case of bearer debentures the transfer takes place by mere delivery. Such debentures are rare due to concerns such as money laundering and benami transactions.

Advantages and disadvantages:

Advantages emanate from the features of debentures such low cost of raising of funds, known and fixed future interest liability, known date of redemption liability facilitating planning of fund management, no dilution of owners' equity and management powers, flexibility to provide negotiated cost of servicing and redemption period beforehand, some of which are not available in Institutional Long Terms where the company does not have as much bargaining power.
Disadvantages are that once issued, no negotiation of terms is possible, rating requirement may create some unanticipated problems, statutory requirement of creating reserve funds and investment there of and finally you deal with numerous investors as against one lender in case of Long-Term Loan.

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CAIIB ABFM Module B Unit 1 Sources Of Finance and Financial Strategies ( Ambitious_Baba )