FADM 1, Class 4

Class 4

Financing Decisions - Source

v Owners Money

o Capital

o Reserves

§ Retained Profit

§ Other Profit

v Outsider’s Money

1. Loans/Bonds/Debentures/Public Deposits -Explicit rate of interest by the business to the customer / loan giver

2. Suppliers

3. Customers – Unearned Revenue / Advances received from customer

4. Employees – Salary/expenses due but not paid

Return on Capital (Profit on Money) & Return of Capital (Protection on Money) – By default, return is return on capital.

Why so many Sources – Every investor has different risk appetite (Financial Innovation – Designing of Instruments of Source)

Preference Shares

v Have preference over the Equity Shares with respect to return on and return of capital

o Preference Share Holders will get dividend before equity share holders

o They will also get back capital before equity share holders, but after debt holder (only when business is closed)

o The rate of dividend is also fixed (Dividend is constant / fixed)

o At PBIT, Pay Interest & arrive at PBT; At PBT, pay Tax, arrive at PAT; Now pay Dividend to preference share out of PAT; what is left, may or may not be given to rest of shareholders as dividends. In case profit is not given, then it is retained profit. Hence Equity shareholders are called residuary share holders

o Not a very popular product (Have features of both debt & equity)

Is Preference share is debt or equity?

Types of Preference Share (A preference share by default are non-redeemable / non-participating / non-cumulative / non-convertible – More like equity)

1) Redeemable preference share – Preference shares which are to be repaid after a specific period of time. They are more like a debt & less like equity.

2) Participating preference share – They are those shares who will get their profit dividend and they have the right to participate in the residuary profit. They are more like a debt & less like equity.

3) Cumulative preference share – If there is loss in Q1, but profit in Q2, then give preference share for both. They are more like a debt & less like equity.

4) Convertible preference share – Convertible into equity or bonds.

Equity Shares / Common Shares / Ordinary Shares

· An equity share is a share which is not a preference share (they don’t have a preference with respect to return on capital). It is a source which is not a debt or preference share. Hence, they are called residuary source (They get dividend & capital only after preference share)

· Hence, they take the maximum risk (High risk, high gains)

How to raise equity capital?

· Public Issue

o IPO & FPO (Further / Subsequent)

§ Face Value

· Value written on the face of the document

· Capital is always shown in the Balance Sheet at face value

· Dividend is always calculated on the face value

§ Issue Price

· The price at which the shares are sold / issued by the company. It is a transaction between company and shareholder.

· IP=FV: Issue at PAR

· IPShare Discount: Deficit of issue price wrt face value. It is classified as loss & shown as negative on the Source side of balance sheet.)

· IP>FV: Issue at PREMIUM (Share Premium: Excess of issue price over face value. It is classified as other profit. It is on the Source side in Balance sheet. Company is not under obligation to return it)

§ Market Value

· The price at which the shares are traded in the market (secondary market). It is traded between shareholder (except company who comes into picture only in case of a buyback)

· Whether shares are issued at premium or at discount, the money available to the shareholder on liquidation depends on the realizable / MV of the asset

· Private Issue (Approaching MFs, HNIs)

· Bonus Issue

· Rights Issue

Dividend

· Dividend is distribution of profit. It is a payment & not an expense. It is post determination of profit.

· Dividend is not an expense, whereas interest is an expense. Dividend & Interest are both payment. If not paid, both are liabilities.

· Dividend is always calculated on the FV

· Dividend can be distributed in the following manner:

o Cash: Cash Dividend

o Stock: Stock Dividend or Bonus Shares

· Cash dividend

o Retained Profit reduces

o Cash reduces (If not paid, then create liability)

o Net-worth/ Equity / Book Value reduces (NW per Share = BV per Share) as retained profit has reduced keeping capital and no. of shares constant. Hence, price of shares falls after declaration of dividend.

§ BV per Share = (A-L) / No. of Shares

· Shows Asset-backup per share – How much asset is available for shareholder

§ BV per Share = (Capital + Reserves) / No. of shares

· Stock Dividend

o Distribution of Profit in the form of shares

o Retained Profit falls

o No Change in cash

o Capital will increase (Dilution of retained profit, which is transferred to Capital)

o Net Worth remains same (As reserves are converted to Capital)

o Stock dividend is also known as Capitalisation of Reserves

o BV per share falls as the number of shares increases

o 1:2 (1 for 2, 1 share issued for 2 share I am holding)

Financial Items	Before Dividend	After Dividend
		Cash Dividend	Stock Dividend (1:2)
Source
Capital	100000	100000	150000
Reserves	500000	450000	450000
Loan	200000	200000	200000
CL	50000	50000	50000
Total	850000	800000	850000
Asset
Cash	200000	150000	150000
Stock	300000	300000	300000
Fixed Asset	350000	350000	350000
Total	850000	800000	800000
NW	600000	550000	600000
No of Shares	10000	10000	15000
BV per share	60	55	40

Rights Issue

· Issue of shares to the existing shareholders (Rights issue is raising capital whereas bonus issue is distribution of profit)

· Capital & Cash goes up. If at premium, reserves goes up

· To protect the share dilution of existing shareholders, the company act says that current share holder needs to be offered the subsequent issue 1^st, but they do not have a duty to buy (It is a right to buy).

· Also, the share is issued at a price lower than the market price

· Many times promoters only come forward to buy the right issue. As stated above, the rights issue is at lower price than market. Hence, promoters get good opportunity to buy back shares at a price very much less than the market.

· As number of shares goes up, the price of the share falls

Stock Split

· Reduction of face value (Say from 10 to 5)

· Number of shares goes up, keeping capital & reserves constant

· BV per share falls

· Hence, MV falls

· Purpose: Increase liquidity, so that small investor can buy it (stocks which are very highly priced)