Table of Contents:-
- Sources of Project Finance
- Equity Shares
- Preference Shares
- Internal Accruals
- Debentures
- Bonds
- Term Loans
- Hire Purchase
- Lease Financing
Sources of Project Finance
After the project cost is ascertained, it is essential to analyze the available sources of finance to meet the project cost. Carefully selecting the most suitable combination of sources is necessary for completing the project.
Equity capital refers to funds raised through the sale of shares of ownership in a company known as equity or stock to investors. In contrast, debt capital involves borrowing money from lenders or creditors with the promise of repayment over time, usually with interest.
The combination of debt and equity should be judiciously chosen, as it will vary according to the project’s specific characteristics.
The main sources of project finance include the following:
- Equity Shares
- Preference Shares
- Internal Accruals
- Debentures
- Bonds
- Term Loans
- Hire Purchase
- Lease Financing
Equity Shares
Equity shares are also referred to as ordinary shares or common shares. The equity shareholders are the company’s real owners, as they have voting rights and enjoy decision making authority on essential matters related to the company. The shareholders’ return is in the form of a dividend, dependent on the company’s profits and capital gain/loss at the time of their sale. They enjoy higher returns if the company performs well and may not receive any dividend if it does not perform well or when the Board of Directors do not recommend any dividend for payment. Therefore, equity shares are often called “variable income securities.” They are the last ones to receive repayment in the event of the company’s liquidation.
Features of Equity Shares
Given below are the most significant features of equity shares:
1) Owned Capital
Equity share capital is owned capital because it belongs to the shareholders, who own the company.
2) Fixed Value or Nominal Value
Every share has a fixed or nominal value. For example, the price of a share is $10, indicating its fixed or nominal value.
3) Distinctive Number
For identification, every share is assigned a distinct number, similar to a roll number.
4) Attached Rights
A share grants its owner the rights to receive dividends, vote, attend meetings, and inspect the books of accounts.
5) Return on Shares
Shareholders are entitled to a return on shares known as a dividend, which depends on the company’s profitability and financial performance. Higher profits lead to higher dividends, and vice versa.
6) Transfer of Shares
Equity shares provide high liquidity because they are easily transferable. If a person no longer wants their shares, they can sell them to anyone, transferring them to that person.
7) Benefit of the Right Issue
Equity shareholders have certain rights when a company issues new shares. The company must offer the new shares first to equity shareholders in proportion to their existing shareholding. If they decline the offered shares, they can be issued to others. Thus, equity shareholders benefit from participating in correct issues.
8) Benefit of Bonus Shares
Companies issue bonus shares to common shareholders from their retained earnings. These shares are issued free of cost in proportion to existing equity shareholdings. If shareholders decline the offered shares, they can be issued to others. Thus, equity shareholders benefit from participating in bonus share issues.
9) Irredeemable
Equity shares are always irredeemable, meaning the equity capital is not repayable for the company’s lifetime.
10) Capital Appreciation
While the nominal or par value of equity shares remains fixed, their market value fluctuates based on the company’s profitability and prosperity. Higher dividends and profits lead to an appreciation in the value of shares.
Advantages of Equity Shares
The advantages of equity shares are as follows:
1) Advantages to Investors
i) Capital Profit: When the company progresses and generates profit, the market value of the shares increases. Shareholders then can sell their shares at higher prices to gain capital.
ii) Interest in the Company’s Activities: Equity shareholders and owners are keenly interested in the company’s affairs.
iii) Ideal for Investment: Equity shares are an excellent investment for individuals willing to take risks.
iv) Right to Interfere in Management: Equity shareholders can participate in management by attending general meetings with voting rights and electing the board of directors.
2) Advantages to Company
i) Non-Fixed Burden of Dividend: Dividends paid on equity shares are not fixed and depend on the profit generated. Unlike fixed preference shares, dividends are not a burden.
ii) No Cash Outflow: Equity shares represent long-term capital investment, so the company need not worry about cash outflow. These funds remain available as long as the company does not liquidate.
iii) Risk Bearing: Investing in equity shares involves bearing the risk associated with the company’s performance, acting as a defence for the company. When raising long-term finances, companies often take calculated risks to enhance profitability.
iv) Availability of Fixed Capital: Companies fulfil their long-term financial needs by issuing equity shares. Funds from this source are allocated to acquire fixed assets.
Disadvantages of Equity Shares
Equity shares may have the following disadvantages:
1) Disadvantages to Investors
i) Uncertainty of Income: Management is not obligated to pay dividends, even for significant profits, as they may retain earnings for company expansion or diversification.
ii) Irregular Income: Dividend payments depend on company profits, leading to inconsistency, especially when profits are marginal.
iii) Capital Loss: During share price reductions, selling shares may lead to capital loss for investors, especially if they need to sell urgently.
iv) Less Attractive to Modest Investors: Equity shares may need to be more appealing to investors seeking regular and consistent income from their investments.
2) Disadvantages to the Company
i) Difficult to Address Over-Capitalization: Reducing the number of equity shares in cases of over-capitalization is challenging.
ii) Centralization of Control: Transferable equity shares allow a few individuals to gain control of the company by purchasing a significant number of shares, potentially leading to centralized management.
iii) Change in Management Policy: Changes in shareholders can result in management and company policy shifts due to the sale and purchase of equity shares.
Preference Share
Preference capital is a hybrid form of financing that combines features of both equity and debentures. It shares several similarities with equity and debentures as follows:
1) Similarities with Equity
i) Preference dividends are generally payable only from distributable profits.
ii) A preference dividend is not an obligatory payment but entirely within the directors’ discretion.
iii) A preference dividend is not a tax-deductible payment.
2) Similarities with Debentures
i) The dividend rate on preference capital is usually set at a fixed rate.
ii) The claim of preference shareholders is before the claim of equity shareholders.
iii) Preference shareholders either do not have voting rights or have limited voting rights compared to shareholders.
Features of Preference Shares
Given below are the features of preference shares:
1) Accumulation of Dividends
Preference shares may be cumulative or non-cumulative regarding dividends. In India, with few exceptions, preference shares typically carry a cumulative feature regarding dividends. Unpaid dividends on cumulative preference shares are carried forward and become payable once dividends are resumed.
2) Call-ability
The terms of preference share issues may include a call feature, granting the issuing company the right to call the preference shares, wholly or partly, at a specific price.
3) Convertibility
Preference shares may sometimes be convertible into equity shares under certain circumstances. Holders of convertible preference shares can convert them into equity shares at a specific ratio within a specified period.
4) Redeemability
Preference shares may be classified as perpetual or redeemable. A perpetual preference share has no maturity period, whereas a redeemable preference share has a limited life after which it is retired. Most preference issues are redeemable.
5) Participation in Surplus Profits and Assets
Companies may issue participating preference shares, granting preference shareholders the right to share in surplus profits each year (profits left after paying preference and equity dividends at specific rates) and in residual assets (assets left after meeting the claims of preference shareholders) in the event of liquidation, according to a particular formula.
6) Voting Power
Before the commencement of the Companies Act of 1956, companies could issue preference shares carrying voting rights. Preference shares issued after the commencement of the Companies Act of 1956 do not have voting rights.
Types of Preferences Shares
Given below are the various types of preference shares:
1) Cumulative Preference Shares
These shares have the right to claim dividends for years without profits. Whenever divisible profits occur, cumulative preference shares receive dividends for all previous years in which dividends could not be declared.
2) Non-Cumulative Preference Shares
Holders of these shares have no claim for arrears of dividends. They receive dividends only if the company has made sufficient profits and cannot claim arrears of dividends in subsequent years.
3) Redeemable Preference Shares
A company’s capital is usually repaid only at liquidation. Since preference shares have no maturity date, the company is not obliged to return the share capital to shareholders. However, the company may issue redeemable preference shares if permitted by its articles of association. The company can redeem redeemable preference share capital after a certain period, subject to restrictions outlined in the Companies Act. These shares must be fully paid up, and redemption can be done either from profits or through the issuance of new capital to ensure the company’s resources are maintained.
4) Irredeemable Preference Shares
These shares cannot be redeemed unless the company is liquidated.
5) Convertible Preference Shares
Shareholders holding these shares may have the right to convert them into equity shares after a specific period. These are called convertible preference shares, and the company’s articles of association must outline the rules governing conversion.
6) Non-Convertible Preference Shares
These shares cannot be converted into equity, and shareholders do not have the option to convert them into equity shares.
7) Participating Preference Shares
Holders of these shares participate in the surplus profits of the company above and beyond the fixed dividend amount. They receive a fixed dividend rate first and then a reasonable dividend rate on equity shares. If surplus profits remain after both dividends are paid, participating preference shareholders are entitled to a share of the surplus earnings as specified in the articles of association.
8) Non-Participating Preference Shares
These shares receive only a fixed dividend rate and do not participate in the company’s surplus profits beyond the specified fixed dividends.
Advantages of Preference Shares
The advantages of preference shares can generally be grouped under two main categories:
1) Advantages to Investors
i) Priority in Repayment of Capital: Preference shareholders prioritise capital repayment compared to equity shareholders.
ii) Enhanced Security: During recessions or declines in profits, preference shares offer enhanced security as an investment.
iii) Regular and Fixed Income: Preference shares provide investors with a fixed and regular dividend, offering a stable income source.
iv) Reduced Risk: Preference shareholders face less risk in their investment due to the preference for repayment and dividends.
v) Protection of Interests: Like equity shareholders, preference shareholders have veto power to protect their rights.
2) Advantages to the Company
i) Non-Interference in Management: Preference shareholders do not have the right to interfere in the company’s management.
ii) Economic Financing: Issuing preference shares is cheaper than issuing equity shares, making it a cost-effective source of finance.
iii) Access to a Wide Capital Market: Conservative investors, less inclined to take risks, often prefer to invest in preference shares, allowing the company to access a broader capital market.
iv) No Asset Collateralization: Companies issuing preference shares do not need to mortgage their assets, simplifying future financing options.
Disadvantages of Preference Shares
1) Disadvantages to Investors
i) Fixed Dividend Rate: Non-participating preference shares pay dividends at a fixed rate, meaning investors do not directly benefit from the business’s progress.
ii) Uncertain Redemption of Preference Shares: Redeemable preference shares can be redeemed at the company’s discretion, leading to uncertainty for investors.
iii) Limited Voting Rights: Preference shareholders, despite being owners, have restricted voting rights and cannot participate in company management.
2) Disadvantages to the Company
i) Disadvantage to Equity Shareholders: In times of lower profits, equity shareholders suffer because preference shareholders first receive dividends at a fixed rate.
ii) Fixed Financial Obligation: The company incurs a fixed financial burden as it must pay dividends even without profits.
iii) High Cost of Capital: Dividends paid to preference shareholders are not tax-free, making it more expensive to raise capital through preference shares compared to debentures.
iv) Difficulty in Raising Additional Capital: Company law often requires permission from preference shareholders to issue new shares or debentures, making it challenging for companies to raise additional capital.
Debentures
A debenture is an instrument issued by a company under its official seal, acknowledging indebtedness to one or more individuals in exchange for the money provided. Essentially, it is a security issued by a company as a debt. In India, a public limited company can raise debt capital through debentures after obtaining a business commencement certificate if its memorandum of association permits it.
The Indian Companies Act states, “debenture includes debenture stock, bonds, and any other security of a company whether constituting a charge on the assets of the company or not.”
However, the act does not explicitly define what a debenture is. To understand the term better, we can refer to the definition given by Prof. Naidu and Datta, which states, “A debenture is an instrument issued by the company under its common seal, acknowledging a debt and setting forth the terms under which they are issued and are to be paid.”
Features of Debenture
The following are the features of Debentures:
1) Fixed Interest Rate: Debenture holders, individuals or entities lending money to a company are entitled to pro-payment of interest at a fixed rate.
2) Maturity: Debentures are repayable after a fixed period, typically five or seven years, as per agreed terms.
3) No Voting Rights: Debenture holders do not possess voting rights.
4) Secured Assets: Typically, debentures are secured. If the company fails to pay interest on debentures or repay the principal amount, debenture holders can recover it by selling the company’s assets.
Types of Debentures
Debentures are classified into the following types:
1) From a Security Point of View
i) Naked/Simple Debentures: These debentures are not secured on any asset.
ii) Mortgage Debentures: These debentures are secured on a particular asset or all the company’s assets. Companies in India can issue secured and unsecured debentures as per the Securities and Exchange Board of India (SEBI) and the Companies Act, 2013.
2) From a Permanence Point of View
i) Redeemable Debentures: These debentures are repayable after a specified period, either in a lump sum or by instalments during the company’s lifetime.
ii) Non-redeemable Debentures: These are also known as perpetual debentures; they are financial instruments issued by a company that do not have a fixed maturity date or redemption period.
3) From the Record’s Point of View
i) Bearer Debentures: These debentures are payable to the bearer and can be transferred by delivery. Interest is paid to the holder of the coupon attached to the debentures.
ii) Registered Debentures: These debentures are payable to the persons whose names appear in the Register of Debenture holders. Ownership transfer requires the execution of a transfer deed. Interest is paid to the holder of the interest coupon based on the company’s official records.
4) From a Convertibility Point of View
i) Convertible Debentures: Holders of these debentures have the right to convert them into shares.
ii) Non-Convertible Debentures (NCD): Holders of these debentures do not have the right to convert them into shares.
5) From a Priority Point of View
i) First Debentures: These debentures have the first claim on the assets charged as security.
ii) Second Debentures: These debentures have the second claim on the assets charged.
Advantages of Debenture
The advantages of issuing debentures are as follows:
1) Advantages to the Company
i) Lower Rate of Interest: The interest rate payable on debentures is not only fixed but is usually lower than the rate of dividend paid on shares.
ii) Trading on Equity: The company can trade on equity by issuing debentures because the interest rate on debentures is usually lower than the rate of earnings, allowing the company to declare a higher dividend rate on equity shares.
iii) Tax Benefits: The payment of interest on debentures is charged against the company’s profits as per income tax rules, reducing the tax liability. In contrast, dividend payments are an appropriation of profit, not a charge against profits.
iv) Certainty of Finance: Debentures are issued for a reasonably long period, ensuring financial stability and allowing the company to adjust its financial plans accordingly.
v) Capital from Moderate Investors: Debentures attract finance from investors seeking fixed income with minimum risk, providing capital security.
vi) Controlling Over-Capitalization: Over-capitalization can be controlled by redeeming the redeemable debentures, providing flexibility in the company’s capital structure.
2) Advantages to Investors
i) Fixed and Stable Income: Debentures offer investors a fixed interest rate, allowing them to estimate their income in advance accurately.
ii) Safety of Investment: Debenture holders have specific or general charges on the company’s assets, ensuring the safety of their investment.
iii) Liquidity: Debentures are more liquid investments with a ready market, and they can be used as collateral security by investors to raise loans from financial institutions.
iv) Fixed Maturity Period: Many investors prefer debentures due to their definite maturity period.
v) Conversion of Loan: Debenture holders can convert their holdings into shares at a specified time, especially in the case of convertible debentures.
Disadvantages of Debenture
The disadvantages of debentures are as follows:
1) Disadvantages to the Company
i) Fixed Charge on Assets: Debentures impose a fixed charge on all company assets, preventing the company from raising further loans against these assets if necessary.
ii) Fixed Financial Burden: The interest payable on debentures is a fixed financial obligation deducted from the company’s profits. This fixed expense must be paid even in the absence of profits, posing a burden on the company, especially during periods of insufficient profitability.
iii) Risk of Liquidation: Debenture holders have the right to demand the company’s liquidation if the company fails to pay the interest on debentures. Thus, issuing debentures carries the risk of company liquidation, especially during lean periods.
2) Disadvantages to Investors
i) Lack of Control: Debenture holders are creditors, not company owners, and therefore have no authority to control the company’s affairs.
ii) Absence of Additional Profits: Debenture holders receive fixed interest income regardless of the company’s profits. They do not participate in the company’s profits, even during periods of high profitability.
iii) Uncertainty: Investors holding redeemable debentures with a specified redemption period may experience uncertainty regarding their redemption.
Bond
A bond is a type of debt security in which the authorized issuer owes the holder a debt and is obliged to repay the principal amount along with interest (the coupon) at a specified future date called maturity. A bond functions as a loan and security with various terms and conditions. The issuer acts as the borrower, the bondholder as the lender, and the coupon as the interest. Bonds enable the issuer to finance long-term investments and projects using external funds.
Bonds are typically issued by various entities in the primary markets to raise capital, attract investors, and meet their funding requirements. These entities include public authorities, credit institutions, companies, and supranational institutions in the primary markets. One standard method of issuing bonds is through underwriting. In underwriting, one or more securities banks or firms, forming a syndicate, purchase an entire issue of bonds from an issuer and then resell them to investors. The security firm assumes the risk of buying the whole bond issue from the issuer, with the obligation to resell it to investors. Government bonds are commonly sold through auctions conducted by the government via a process known as bond auctions.
Features of Bond
The major features of a bond are given as follows:
1) Nominal, Principal, or Face Amount
This is the initial amount of a loan or investment on which the issuer pays interest and must be repaid at the end of the term.
2) Issue Price
This is the price at which investors buy the bonds when they are first issued, typically Rs. 1,000. The net proceeds that the issuer receives from issuing securities can be calculated by subtracting the issuance fees from the issue price and then multiplying them by the nominal amount.
3) Maturity Date
This is the date on which the issuer is obligated to repay the nominal amount of the bond to the bondholder. Upon completing all payments, the issuer has no more obligations to the bondholders after maturity. The time remaining until a bond’s maturity date is often called the tenure, term, or maturity. Debt securities with a term of less than one year are generally classified as money market instruments rather than bonds. Most bonds issued by governments, corporations, and other entities have a term of up to thirty years. Some bonds have been issued with maturities of up to one hundred years, and some may need to mature more.
Within U.S. Treasury securities, bonds can be categorized into three different groups based on their maturity:
i) Short-Term (Bills): Maturities up to one year,
ii) Medium-Term (Notes): Maturities between one and ten years;
iii) Long-Term (Bonds): Maturities greater than ten years.
4) Coupon
This is the fixed or variable rate of interest that the issuer pays the bondholders periodically. Usually, this interest rate is fixed throughout the bond’s term. It can also vary based on a money market index such as LIBOR (London Interbank Offered Rate) or other indices. The name “coupon” originates from the fact that physical bond certificates were issued with coupons attached to them in the past, which could be detached and redeemed for interest payments. On coupon dates, the bondholder can present the coupon to a bank or financial institution in exchange for the interest payment.
5) Coupon Dates
These are the dates on which the issuer pays the coupon to the bondholders. In the U.S., most bonds are issued with semi-annual coupon payments, meaning they pay interest to bondholders every six months. In Europe, most bonds are issued annually, providing investors with a single coupon payment once a year.
6) Indentures and Covenants
An indenture is a formal debt agreement that establishes the terms of a bond issue, while covenants specify the clauses within this agreement. Covenants specify bondholders’ rights and issuers’ duties, including specific actions that the issuer must fulfil or is prohibited from performing.
7) Optionality
A bond may contain an embedded option that can add flexibility option-like features to the holder or the issuer.
i) Callability: Some bonds give the issuer the right to repay the bond before maturity or call dates. Most callable bonds allow the issuer the option to repay the bond at its face value if they choose to exercise the call option. With some callable bonds, the issuer may be required to pay a premium to bondholders in addition to repaying the bond’s face value, known as Call Premium. This is mainly true for high-yield bonds. These have stringent covenants, restricting the issuer in operations. To be free from these covenants, the issuer can repay the bonds ahead of schedule, albeit at a significant cost.
ii) Putability: Some bonds give the holder the right to force the issuer to repay the bond before the maturity date on the put dates.
iii) Call Dates and Put Dates: These are the dates on which callable and putable bonds can be redeemed yearly.
8) Convertible Bond
A bondholder can exchange a bond for several shares of the issuer’s common stock.
9) Exchangeable Bond
This allows for the exchange of shares of a corporation other than the issuer.
Types of Bonds
Types of Bonds are explained below:
1) Fixed Rate Bonds
Fixed-rate bonds have a coupon that remains constant throughout the bond’s life.
2) Floating Rate Bond
Floating rate bonds have a coupon linked to an index. Standard indices include money market indices, such as LIBOR, Euribor, or CPI (the Consumer Price Index). Floating rate bonds (generally called notes) are common because they appeal to bank investors who are unwilling to take the risk of fixed rates.
The issuer appoints a bank as a reference agent to fix the rate periodically, usually every three or six months, by reference to a market rate. This is the London Inter-Bank Offered Rate (LIBOR) because of its international acceptability, although local IBORs, e.g., are used in Hong Kong, Singapore, or Tokyo.
3) High-Yield Bonds
Credit rating agencies rate High-yield bonds below investment grade. As these bonds are riskier than investment-grade bonds, investors expect to receive greater yields. High-yield bonds have lower credit ratings and higher yields, commonly called junk bonds.
4) Zero Coupon Bonds (Deep Discount Bonds)
Zero coupon bonds don’t pay interest. These bonds are issued at a substantial discount from their face value. The bondholder receives the total principal amount upon maturity or redemption date.
The return to the investor is the capital appreciation realized on sale or redemption. One advantage is improved cash flow for the issuer, as the issuer does not have to pay interest, which is effectively “rolled up” until final redemption. The investor’s tax position may be improved, as they may not be liable to pay income tax on the discount, making the earnings tax-free until redemption. However, this depends upon the tax laws in the jurisdiction of the investor and the issuer.
5) Inflation-Linked Bonds
Inflation-linked bonds, also known as inflation-indexed or real-return bonds, have their principal amount indexed to inflation. The interest rate is lower than for fixed-rate bonds with similar maturity. However, as the principal amount of inflation-linked bonds grows with inflation, the payments increase as well.
6) Other Indexed Bonds
Other indexed bonds include equity-linked notes and bonds indexed on a business indicator (income, added value) or a country’s GDP.
7) Asset-Backed Securities
Asset-backed securities (ABS) are financial instruments whose interest and principal payments are backed by a pool of underlying cash flows from other assets. For example, asset-backed securities include Mortgage-Backed Securities (MBS), Collateralized Mortgage Obligations (CMO), and Collateralized Debt Obligations (CDO).
8) Subordinated Bonds
Subordinated bonds have a lower priority than other bonds of the issuer in case of liquidation. In bankruptcy or liquidation, a hierarchy of creditors is established. Examples of subordinated bonds can be found in bonds issued by banks, financial institutions, and asset-backed securities (ABS).
9) Perpetual Bonds
Perpetual bonds, often called perpetuities, have no maturity date.
10) Bearer Bond
A bond is an official certificate issued without a named holder. The bondholder with the paper certificate can claim the value of the bond, including any interest payments or principal repayment, according to the terms of the bond agreement.
11) Registered Bond
A registered bond is a bond whose ownership (and any subsequent purchaser) is recorded by the issuer or a transfer agent. Upon maturity, interest payments and the principal are directly sent to the registered owner and recorded by the issuer or a registrar.
12) Municipal Bond
A municipal bond is a bond issued by a state, U.S. Territory, city, local government, or their agencies. Interest income received by holders of municipal bonds is often exempt from federal income tax and if the bonds are issued by the state in which an individual resides, they are often exempt from state income tax as well. However, municipal bonds issued for specific purposes may not be tax-exempt.
13) Book-Entry Bond
A book-entry bond is a bond that does not have a paper certificate. With the growth of technology and changes in financial practices, the physical processing of paper bonds and interest coupons became more expensive and inefficient. The issuers of bonds and banks that previously collected coupon interest for depositors have tried to discourage using paper bonds and coupons in favour of electronic or digital alternatives. In modern finance, many book-entry bond issues do not offer the option of a paper certificate, even to investors who prefer them. It means they are electronically registered rather than issued as physical paper certificates.
Advantages of Bond
1) Advantages to the Company
i) Interest payments on debt, including bond interest, are tax-deductible for the issuer, while dividends paid to stockholders are not.
ii) Bondholders do not participate in the company’s earnings growth.
iii) Debt is repaid in cheaper rupees during periods of inflation
iv) Company control remains undiluted.
v) Financing flexibility can be achieved by including a call provision in the bond indenture, which allows the company to pay the debt before the bond’s maturity date. However, the issuer pays a price for this advantage through the higher interest rates that callable bonds require than non-callable bonds.
vi) It may safeguard the company’s future financial stability if used in times of tight money markets when short-term loans are not available.
2) Advantages to the Investors
For investors, bonds have the following advantages:
i) It pays a fixed interest payment each year that provides stability, income, and risk management benefits.
ii) They are safer than equity securities.
Disadvantages of Bond
1) Disadvantages to the Company
i) Interest charges must be met regardless of the company’s earnings.
ii) Debt must be repaid at maturity.
iii) Higher debt implies greater financial risk, which may increase the cost of financing.
iv) Indenture provisions may place stringent restrictions on the company.
v) Overcommitments may arise from errors in forecasting future cash flow.
2) Disadvantages to the Investors
i) Bonds carry interest rate risk, which is the possibility that the principal will be lost if interest rates increase and the bond’s value decreases.
ii) Bonds do not contribute to corporate profitability.
iii) Bondholders have no voting rights and, therefore, no say in the company’s operations.
Term Loans
Term loans, also called term finance, represent a source of debt finance generally repayable in over a year but less than ten years. They are employed to finance the acquisition of fixed assets and working capital margin. Term loans differ from short-term bank loans, which are employed to finance short-term working capital needs and tend to be self-liquidating over time, usually less than one year. There are various banks/institutes providing loans. Some of them include:
1) Central Financial Institutions/Development Banks
Financial institutions like IFCI (Industrial Financial Corporation of India), IRBI (Industrial Reconstruction Bank of India), and development banks like IDBI (Industrial Development Bank of India), ICICI Bank, SIDBI, GIC, EXIM, etc.
2) State Financial Corporations (SFCs)
All central states have their own SFC for funding medium-sized projects. They are all refinanced by IDBI. For example, state financial corporations like APSFC (Andhra Pradesh State Financial Corporation) in Andhra Pradesh and UPFC (Uttar Pradesh Financial Corporation) in Uttar Pradesh are some examples of financial institutions that issue bonds to raise funds for various developmental projects and infrastructure initiatives within their respective states.
3) State Industrial Development Corporations (SIDCs)
SIDCs are not restricted to financing but are also responsible for zones for industrial developments and infrastructural facilities. Pithampur (near Indore) and Mandideep (near Bhopal) are developed by MPAKVN (Madhya Pradesh Audhyogie Kendra Vikas Nigam). Similarly, MIDC (Maharashtra Industrial Development Corporation) and GIDC (Gujarat Industrial Development Corporation) have developed several industrial areas in their respective states and contributed towards their development.
4) Commercial Banks
All commercial banks finance long-term debt at a predefined interest rate, generally with collateral security. Nationalized and private commercial banks play a significant role in funding industrial and service projects.
5) Private Financing
Private companies and NBFCs also provide long-term project loans.
Features of Term Loan
The features of a term loan are given as follows:
1) Security
Term loans typically represent secured borrowing. Usually, assets financed with the proceeds of the term loan provide the primary collateral or security for the loan. Other firm assets can also be used as collateral security.
All loans provided by financial institutions, including interest, liquidated damages, commitment charges, expenses, etc., are secured by:
i) First equitable mortgage of all immovable properties of the borrower, both present and future, and
ii) Hypothecation of all movable properties of the borrower, both present and future, subject to prior charges in favour of commercial banks for obtaining working capital advances in the ordinary course of business.
2) Interest Payment and Principal Repayment
The interest on term loans is a definite obligation payable irrespective of the firm’s financial situation. Financial institutions charge interest rates to the general category of borrowers based on the credit risk profile of the proposal, usually subject to a specific floor rate. Financial institutions impose penalties for defaults. In the event of default in payment of instalments of principal and interest, the borrower is liable to pay additional interest calculated at the rate of 2% per annum for the period of default on the amount of principal and interest in default. In addition to interest, lending institutions levy a commitment fee on the unutilized portion of a loan and the interest.
3) Restrictive Covenants
Financial institutions generally impose restrictive conditions on borrowers to protect their interests.
Advantages of Term Loan
The advantages of term loans are given as follows:
1) Borrowers’ Point of View
Term loans offer the following advantages to the borrower:
i) In post-tax terms, the cost of the loans is lower than the cost of equity capital or preference capital.
ii) Term loans do not result in dilution of control, as lenders do not have the right to vote.
2) Lenders’ Point of View
Term loans appear attractive to the lender for the following reasons:
i) Term loans earn a fixed interest rate and have a definite maturity period.
ii) Term loans represent secured lending.
iii) Term loans carry several restrictive covenants to protect the lender’s interest.
Disadvantages of Term Loan
Term loans may have the following disadvantages:
1) Borrowers’ Point of View
The disadvantages of term loans from the borrower’s point of view are as follows:
i) The interest and principal repayment are obligatory payments. Failure to meet term loan payments may threaten the firm’s financial health, viability, and existence.
ii) Term loan contracts carry restrictive covenants that may reduce managerial freedom. Furthermore, they entitle the lenders to put their nominee(s) on the board of the borrowing company.
iii) Term loans increase the firm’s financial risk, which, in turn, tends to raise the cost of equity capital.
2) Lenders’ Point of View
The disadvantages to the lender of the term loan are as follows:
i) Term loans do not carry voting rights.
ii) Term loans are not represented by negotiable securities (although if term loans can be securitized, this limitation can be overcome).