Sources of finance are classified based on the time period for which the money is required. Some of the sources for long term finance include, share capital or equity shares, preference capital/shares, retained earnings, debentures/bonds, term loans from financial institutions and commercial banks as well as venture funding to name a few.
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What is long-term finance
Long term finance are capital requirements for a period of more than 1 year. Depending on various factors, the period can stretch for more than 5 to 20 years. Expenditure on fixed assets such as plant, machinery, land and buildings are funded by long term finance. These various sources are described below.
Equity shares are classified under sources of long-term finance because they are irredeemable and represent an ownership in a company. Equity shares are the main source of finance for most companies that give investors the rights to vote, share profits and claims on assets. There are different types of equity shares offered by companies. Initially, companies are financed with equity finance as its source of capital from the founder or owners of the company. As the company grows more money may be required to grow its operations so investors from the private sector can be approached to invest into the company. These can be friends, venture capitalists and mutual funds. After a certain point the company may require huge amounts of capital. Thus, it can invite the public to invest in the company through an initial pubic offering. In order to continue obtaining funds from the general public a company can offer a follow-on public offer.
- Authorised share capital (This is the maximum amount of capital a company can offer)
- Subscribed share capital (A part of issued share capital that an investor accepts and agrees to)
- Paid up capital (a part of the subscribed capital investors pay; this is the amount of money that is invested in the business)
- Rights shares (these are a source of long-term finance issued to existing shareholders in order to protect their ownership rights)
- Bonus shares (these are shares issued in the form of dividends)
- Sweat equity shares (Another source of long-term finance; when a firm offers shares to its employees, these are referred to as sweat equity shares. Such shares are offered to employees or directors as a reward for their exceptional work)
Preference shares are a source of long-term finance that provide a fixed rate of dividends and carry rights over ordinary shares. Preference shares rank higher than ordinary shares because they are paid out first. Also, in the event of liquidation preference shares are paid out first before ordinary shares. They can also be referred to as a hybrid source of long-term financing instruments because they have characteristics of both ordinary shares and long-term debt. For example, preference shares carry fixed dividends like debt, which carries fixed interest payments. Similarly, the payment of preference dividends is at the discretion of management the same way the payment of ordinary shares is not compulsory.
- Participating preference shares (these shares have fixed dividends but share in the remaining profit)
- Redeemable preference shares (the company can buy back these shares in the future and the redemption can be at a date set by the company or the preference shareholders)
- Convertible preference shares (these preference shares can be converted to other financial securities such as debentures, ordinary shares or loans)
Bonds are a popular source of long-term finance. They represent an agreement or a contract between the issuer (the borrower) and the lender. The borrower promises the lender to pay back the principal amount and interest based on the pre-determined terms of the bond. Using bonds as a source of finance is expensive. Thus, only governments and large companies are the only institutions that issue bonds. Since governments usually use this source of long-term finance the risks associated with bonds is very low.
The main characteristics of bonds are;
- The principal amount borrowed
- The coupon rate, that is the interest rate on the long-term debt
- Term of maturity, the number of years that elapse until the principal amount can be redeemed
- Price quotes based on the percentage of par value.
Debentures are another popular source of long-term finance. Debentures are bonds issued by private companies and have a specific purpose. They carry a floating or a fixed coupon rate with a capital amount which is payable at a future date. Companies issue debentures to investors and pay them a fixed amount of interest on the nominal value of the debenture. The deed trust specifies the term of the debenture together with coupon rate.
Types of Debentures/Bonds
- Redeemable and irredeemable (these types of debentures/bonds can be bought back by the issuing company after a certain period of time)
- Convertible debentures/bonds (can be converted into equity shares)
- Non-convertible debentures/bonds
- Fully and partly convertible (fully convertible debentures/bonds can be converted into equity shares. Partly convertible debentures/bonds have 2 parts: one part is converted into equity and the other part is nonconvertible)
- Secured (the debentures/bonds have collateral backing them in the event of bankruptcy)
- Naked (these debentures have no collateral)
- Fixed rate debentures/bonds (fixed rate means that these debentures/bonds have a fixed interest rate over the life of the security)
- Floating rate (the interest rate is adjusted annually based on a benchmark such as the prime lending rate)
- Zero coupon (these debentures/bonds do not carry any coupon rates)
- Callable and puttable debentures/bonds (callable debentures/bonds can be bought back by the issuing company and puttable debentures/bonds can be sold back by the holders)
- Subordinated debentures/bonds (the debentures/bonds can only be redeemed after all other debts have been paid off in the event of liquidation)
Other sources of Long-term finance
- Retained earnings (a company can fund its operations from retained earnings)
- Venture funding (a source of long-term finance mainly used by start-ups)
- Term loans (another source of long-term financing from banks)
- Euro Issue (a name given to sources of long-term finance or capital available outside the home country. For example, American depository Receipts (ADR), global depository receipts (GDR)and foreign currency convertible bonds (FCCB)