Make a comparative assessment of different type of securities from the point of view of capital structuring. Under what conditions different types of securities would be considered more suitable.
Answer. Some types of securities are:
Common Shares
Represent ownership of a company. Shareholders have the right to elect directors; to vote on certain corporate matters; and to share in any residual assets of the company if it is wound up. Shareholders enjoy the rewards and bear the risks of ownership. However, their liability unlike the liability of the owner in a proprietary firm and in a partnership concern, is limited to their capital contributions.
Expected return
May take the form of dividends or capital gains/losses. Many companies try to pay dividends regularly. Others may not pay dividends at all. Often, return will depend mainly on changes in share price, which can go up or down, sometimes dramatically.
Risk
Moderate to Very High. Based on company profitability, financial stability, management capabilities, exposure to economic slumps, foreign exchange, and competition. Common shareholders are last to claim assets in cases of insolvency.
Evaluation
Company’s point of view: The most important source of long-term financing, equity shares offers the following advantages:
q It represents permanent capital. Hence, there is no liability for repayment.
q It does not involve any fixed obligation for payment of dividends.
q It enhances the creditworthiness of the company. In general, other things being equal, the larger the equity base, the higher the ability of the company to obtain credit.
The disadvantages are:
q The cost of equity capital is high, usually the highest. The rate of return required by equity shareholders is generally higher than the rate of return required by other investors.
q Equity dividends are payable from post-tax earnings. They are not tax-deductible payments.
q The cost of issuing equity stock is generally higher than the cost of issuing other types of securities. Underwriting commission, brokerage costs, and other issue expenses are high for equity capital
q Sale
Preference Shares
Typically give holders the right to a fixed dividend before any dividends can be paid to common shareholders. Shareholders may have no voting rights, but special features on redemption or conversion of preferred shares into common shares exist in many cases.
Expected return
Dividends are generally fixed, but company may reduce or suspend dividends. Capital gains potential is usually less than that of common shares. Conversion and redemption privileges and other special features may enhance potential for price increases.
Risk
Moderate to High. Comments regarding common shares apply. Reduction or expected reduction in dividends may significantly impact share price. Tax authorities, employees, and creditors have claim on assets before preferred shareholders in cases of insolvency.
Features
Cumulation of dividends: preference shares may be cumulative or non-cumulative with respect of dividends. The unpaid dividends on cumulative preference shares are carried forward and payable when the dividend is resumed. For example, if the dividend payment on a 13% cumulative preferred share is skipped for 4 years, a dividend arrear for 52% is payable. Note that a company cannot declare equity dividends unless preference dividends are paid with arrears.
Callability: The terms of preference share issue may contain a call feature by which the issuing company enjoys the right to call the preference shares, wholly or partly, at a certain price.
Convertibility: Preference shares may sometimes be convertible into equity shares. The holders of convertible preference shares enjoy the option of converting preference shares into equity shares at a certain ratio during a specified period. For example, the preference shareholders may enjoy the option of converting preference shares into equity shares in the ratio of 1:5 after 2 years for a period of 3 months.
Redeemability: Preference shares may be perpetual or redeemable. A perpetual preference share has no maturity period, whereas a redeemable preference share has a limited life after which it is supposed to be retired. Most preference issues are redeemable.
Voting power: Preference shares do not carry voting rights. A preference shareholder, however, is entitled to vote on every resolution placed before the company if (i) the preference dividend is in arrears for two years or more in the case of cumulative of preference shares, or (ii) the preference dividend has not been paid for a period for a two or more consecutive preceding years or for an aggregate period of three or more years in the preceding six years ending with the expiry of the immediately preceding financial years.
Evaluation
Company’s Point of View: There are some advantages in issuing preference capital from the company’s point of view:
q There is no legal obligation to pay preference dividend. A company does not face bankruptcy or legal action if it skips preference dividend.
q There is no redemption liability in the case of perpetual preference shares. Even in the case of redeemable preference shares, financial distress may not be much because (i) periodic sinking fund payments are not required, and (ii) redemption can be delayed without significant penalties.
q Preference capital is generally regarded as part of net worth. Hence, it enhances the creditworthiness of the firm. Of course, some consider it as part of debt.
q Preference shares do not, under normal circumstances, carry the voting right. Hence, there is no dilution of control.
q No collateral is pledged in favour of preference shareholders. Hence the mortageable assets of the firm are conserved.
Preference capital, however, suffers from some serious shortcomings:
q Compared to debt capital, it is very expensive source financing because the dividend paid to preference shareholders is not, unlike debt interest, a tax-deductible expense.
q Though there is no legal obligation to pay preference dividends, skipping them can adversely affect the image of the firm in the capital market and may create control problems.
Debentures
Akin to promissory notes, debentures are instruments for raising long-term debt capital. Debenture holders are the creditors of the company. The obligation of the company towards its debenture holders is similar to that of a borrower who promises to pay interest and capital at specified times.
Characteristics of Debentures
q Trustee : When the debenture issue is sold to the investing public, a trustee is appointed through a deed. The trustee is usually a bank or a n insurance company or a financial institution. Entrusted with the role of protecting the interest of debenture holders, the trustee is responsible to ensure that the borrowing firm fulfills its contractual obligations.
q Security : Often debentures are secured by a charge on the immovable properties, both present and future, of the company by way of equitable mortgage.
q Debenture Redemption Reserve : For all debenture issues with a maturity period of more than 18 months, a Debenture Redemption Reserve (DRp) has to be created. The company should create a DRP equivalent to at least 50% of the total amount of issue before redemption commences.
q Coupon Rate : Previously the coupon rate (or interest rate) on debentures was subject to a celling fixed by the Ministry of Finance. No such ceiling applies now. A company is free to choose the coupon rate. Further, the rate may be fixed or floating. In the latter case it is periodically determined in relation to some benchmark rate
q Maturity Period: Earlier the average redemption period for non-convertible debentures was supposed to be about seven years. Now there is no such restrictions. A company has freedom to choose the redemption (maturity) period.
q Call and put feature: Debentures occasionally carry a “call” feature, which provides the issuing company the option to redeem the debentures at a certain price before the maturity date. Sometimes the debentures may have a ‘put’ a feature which gives the holder the right to seek redemption at specified times of predetermined prices.
q Convertibility: A company may issue debentures, which are convertible into equity shares at the option of the debenture holders. The ratio of conversion and the period during which conversion can be effected are specified at the time of debenture issue. Straw Products Limited, for example, issue 200,000, 12% secured convertible debentures of Rs 300 each in 1981. These debentures carried a conversion feature entitling the debenture holders the right to seek conversion into a certain number of equity shares during a specified period
Evaluation
Company Point of view: Debentures offer the following advantages to the issuing company :
q The specific cost of debt capital, represented be debentures, is lower than the cost of preference of equity capital. This is because the interest on debentures tax-deductible and hence the effective post tax cost of debentures is lower.
q Debenture financing does not result in dilution of control since debenture holders are not entitled to vote.
q The fixed monetary burden associated with debenture financing, irrespective of changes in price level, has appeal to many companies..
The disadvantages of debenture financing are :
q The debenture interest and capital repayment are obligatory payments. Failure to meet these payments can cause a great deal of embarrassment.
q The protective convents associated with the debenture issue may be restrictive
q Debenture financing enhances the financial risk associated with the firm. This may increase the cost of equity capital.
Term Loans
Term loans, also referred to as term finance, represent a source of debt finance which is generally which is generally repayable in more than one year but less than 10 years. They are employed to finance 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 need and tend to be self-liquidating over a period of time, usually less than one year.
Features
Security: Term loans typically represent secured borrowings. Usually assets which are financed with the proceeds of the term loan provide the prime security. Other assets of the firm may serve as collateral security. All loans provided by financial institutions, along with interest, liquidated damages, commitment charges, expenses, etc., are secured.
Interest payment and principal repayment: The interest on term loans is a definite obligation that is payable irrespective of the financial institutions charge an interest rate that is related to the credit risk of the proposal, subject usually to certain floor rate. Financial institutions impose a penalty for default. The principal amount of a term loan is generally repayable over a period of 6 to 10 years.
Restrictive Covenants: In order to protect their interest, financial institutions generally impose restrictive conditions on the borrowers. Some common covenants:
q Broad-base its board of directors and finalize its management set-up in consultation with and to the satisfaction of the financial institutions.
q Make arrangements to bring additional funds in the form of unsecured loans/deposits for meeting overruns/shortfalls.
q Refrain from undertaking any new project and/or expansion or make any investment without the prior approval of the financial institutions;
q Obtain clearances and licenses from various government agencies;
q Repay existing loans with concurrence of financial institutions
q Refrain from additional borrowings or seek the consent of financial institutions for additional borrowings;
q Reduce the proportion of debt in its capital structure by issuing additional equity and preference capital;
q Limit its dividend payment to a certain rate or seek the consent of financial institutions to declare dividend at a higher rate;
q Refrain from creating further charges on its assets;
q Provide periodic information about its operations;
q Limit the freedom of the promoters to dispose of their shareholding; and
q Effect organizational changes and appoint suitable professional staff;
Evaluation
Company’s Point of View: term loans offer the following advantages to the borrowers:
v In post-tax terms, the cost of term loans is lower than the cost of equity capital or preference capital.
v Term loans do not result in dilution of control, as lenders do not have the right to vote.
The disadvantages of the term loans from the borrower’s point of view are:
v The interest and principal repayment are obligatory payments. Failure to meet these payments may threaten the existence of the firm.
v Term loan contracts carry restrictive covenants which may reduce managerial freedom. Further, they entitle the lenders to put their nominee(s) on the board of the borrowing company.
v Term loans increase the financial risk of the firm. This, in turn, tends to raise the cost of euqity capital.
When a company is growing rapidly, for example when contemplating investment in capital equipment or an acquisition, its current financial resources may be inadequate. Few growing companies are able to finance their expansion plans from cash flow alone. They will therefore need to consider raising finance from other external sources. In addition, managers who are looking to buy-in to a business ("management buy-in" or "MBI ") or buy-out (management buy-out" or "MBO") a business from its owners, may not have the resources to acquire the company. They will need to raise finance to achieve their objectives.
A key consideration in choosing the source of new business finance is to strike a balance between equity and debt to ensure the funding structure suits the business.
The main differences between borrowed money (debt) and equity are that bankers request interest payments and capital repayments, and the borrowed money is usually secured on business assets or the personal assets of shareholders and/or directors. A bank also has the power to place a business into administration or bankruptcy if it defaults on debt interest or repayments or its prospects decline.
In contrast, equity investors take the risk of failure like other shareholders, whilst they will benefit through participation in increasing levels of profits and on the eventual sale of their stake. However in most circumstances venture capitalists will also require more complex investments (such as preference shares or loan stock) in additional to their equity stake.
The overall objective in raising finance for a company is to avoid exposing the business to excessive high borrowings, but without unnecessarily diluting the share capital. This will ensure that the financial risk of the company is kept at an optimal level.
A sound or appropriate capital structure should have the following features:
v Return: the capital structure of the company should be most advantageous. Subject to other considerations, it should generate maximum returns to the shareholders without adding additional cost to them.
v Risk: the use of excessive debt threatens the solvency of the company. To the point debt does not add significant risk it should be used, otherwise its use should be avoided.
v Flexibility: The capital structure should be flexible. It should be possible for a company to adapt its capital structure with a minimum cost and delay if warranted by a changed situation. It should also be possible for the company to provide funds whenever needed to finance its profitable activities.
v Capacity: The capital structure should be determined within the debt capacity of the company, and this capacity should not be exceeded. The debt capacity of a company depends on its ability to generate future cash flows. It should have enough cash to pay creditors’ fixed charges and principal sum.
v Control: The capital structure should involve minimum risk of loss of control of the company. The owners of closely-help companies are particularly concerned about the dilution of control.
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