Sources of Business Finance: Borrowed Funds
"Ranchi Electronics Ltd." is a successful company planning to diversify into the manufacturing of smart electric meters. This expansion requires an investment of ₹40 Crores. The CEO, Mr. Sahay, is strictly against diluting the ownership of the existing shareholders by issuing new equity. Instead, he prefers a source of finance that carries a fixed rate of interest and can be raised from the general public. He knows that the interest paid on such funds is a tax-deductible expense, which will lower the company's overall tax liability. The company decides to issue a specific debt security for a period of ten years. These investors will not have any voting rights, and their return is guaranteed regardless of whether the company makes a profit or a loss. The board believes this "creditor-ship" security will allow the firm to trade on equity and increase the earnings per share for its original owners.
Questions:
(a) Identify the source of fund being discussed here.
(b) Explain the "Meaning of Borrowed Funds" based on this scenario.
(c) State any two advantages of this source to the company.
(a) Identify the source of fund being discussed here.
(b) Explain the "Meaning of Borrowed Funds" based on this scenario.
(c) State any two advantages of this source to the company.
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Answer:
(a) Debentures: These are long-term debt instruments issued by a company under its seal, acknowledging a debt and promising to pay a fixed rate of interest.
(b) Borrowed Funds: These are funds raised through loans or borrowings from external sources. Unlike owners' funds, they carry a legal obligation to pay fixed interest and repay the principal after a specific period.
(c) Advantages:
1. Tax Benefit: Interest paid on debentures is a tax-deductible expense, reducing the company's tax burden.
2. No Dilution of Control: Debenture holders do not have voting rights, so the control of existing shareholders remains intact.
(a) Debentures: These are long-term debt instruments issued by a company under its seal, acknowledging a debt and promising to pay a fixed rate of interest.
(b) Borrowed Funds: These are funds raised through loans or borrowings from external sources. Unlike owners' funds, they carry a legal obligation to pay fixed interest and repay the principal after a specific period.
(c) Advantages:
1. Tax Benefit: Interest paid on debentures is a tax-deductible expense, reducing the company's tax burden.
2. No Dilution of Control: Debenture holders do not have voting rights, so the control of existing shareholders remains intact.
An ambitious entrepreneur in Patna, Mr. Verma, wants to set up a massive solar-power park in a rural district. The project is highly capital-intensive and requires a long-term loan of ₹100 Crores. Regular commercial banks were hesitant to provide such a large amount for a fifteen-year period. Mr. Verma approached a specialized "Development Bank" established by the government. After a rigorous appraisal of the project's technical and financial feasibility, the institution sanctioned the loan. Besides the money, the institution also provided Mr. Verma with expert technical advice and a detailed market survey report. The loan agreement included certain "restrictive covenants," such as limitations on the company's ability to pay dividends until the debt is serviced. Mr. Verma realized that while the procedure was time-consuming, this source provided the "stable" long-term capital required for such a large-scale national infrastructure project.
Questions:
(a) Identify the source of finance utilized by Mr. Verma.
(b) Discuss the role of "Financial Institutions" in industrial development as highlighted in the case.
(c) Mention one limitation of this source mentioned in the scenario.
(a) Identify the source of finance utilized by Mr. Verma.
(b) Discuss the role of "Financial Institutions" in industrial development as highlighted in the case.
(c) Mention one limitation of this source mentioned in the scenario.
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Answer:
(a) Loans from Financial Institutions: Specifically, specialized development banks like IFCI, IDBI, or SIDBI.
(b) Role: Financial institutions provide long-term finance which commercial banks may not provide. They also offer promotional services like technical advice, market surveys, and managerial assistance, acting as "Developmental Agencies."
(c) Restrictive Covenants: These institutions often place restrictions on the company’s autonomy, such as limits on dividend payments or further borrowings, to protect their own investment.
(a) Loans from Financial Institutions: Specifically, specialized development banks like IFCI, IDBI, or SIDBI.
(b) Role: Financial institutions provide long-term finance which commercial banks may not provide. They also offer promotional services like technical advice, market surveys, and managerial assistance, acting as "Developmental Agencies."
(c) Restrictive Covenants: These institutions often place restrictions on the company’s autonomy, such as limits on dividend payments or further borrowings, to protect their own investment.
"Bihar Garments Pvt. Ltd." is a successful retail chain. During the upcoming wedding season, the company expects a massive surge in demand and needs ₹50 Lakhs to stock up on inventory and raw materials for the next six months. The Managing Director approached their regular bank for assistance. The bank offered a facility where the company can withdraw funds as and when needed, and interest would be charged only on the actual amount utilized, not on the entire sanctioned limit. The bank required the company to provide its current stock of clothes as a "floating charge" for the security of the loan. The MD was pleased because this source provided high flexibility and secrecy, as no prospectus or public disclosure was required. The funds were disbursed within a week, allowing the company to capture the seasonal market opportunity without any long-term debt burden on its balance sheet.
Questions:
(a) Identify the specific banking facility mentioned in the case.
(b) Explain the "Meaning of Loans from Commercial Banks" in the context of business finance.
(c) State one major advantage of using bank loans for short-term requirements.
(a) Identify the specific banking facility mentioned in the case.
(b) Explain the "Meaning of Loans from Commercial Banks" in the context of business finance.
(c) State one major advantage of using bank loans for short-term requirements.
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Answer:
(a) Cash Credit (or Bank Overdraft): Specifically, a facility where money is withdrawn against the security of current assets.
(b) Commercial Bank Loans: Banks provide funds for different periods in the form of loans, overdrafts, and cash credit. They are a primary source of Working Capital for businesses.
(c) Business Secrecy: Unlike public issues (shares/debentures), information provided to a bank is kept confidential. No public disclosure is required, maintaining the firm's privacy.
(a) Cash Credit (or Bank Overdraft): Specifically, a facility where money is withdrawn against the security of current assets.
(b) Commercial Bank Loans: Banks provide funds for different periods in the form of loans, overdrafts, and cash credit. They are a primary source of Working Capital for businesses.
(c) Business Secrecy: Unlike public issues (shares/debentures), information provided to a bank is kept confidential. No public disclosure is required, maintaining the firm's privacy.
A well-established company in Jamshedpur, "Tata-Auxiliary," needs ₹5 Crores for a medium-term period of two years to upgrade its logistics fleet. The company decided not to go to a bank or issue debentures. Instead, they invited the general public to deposit their savings directly with the company. They offered an interest rate of 9%, which was higher than the 6% offered by most banks for the same period. The company also published an advertisement in local newspapers detailing its financial health and past performance. Within two weeks, the required amount was collected. The CFO noted that this source is much cheaper than a bank loan and does not require the company to mortgage any of its assets as security. However, he warned that this source is only available to highly reputed companies, as the public will only deposit money in firms they trust.
Questions:
(a) Identify the source of finance discussed in this case.
(b) Why is this source considered "unsecured" in nature?
(c) Mention one benefit of this source for both the company and the investor.
(a) Identify the source of finance discussed in this case.
(b) Why is this source considered "unsecured" in nature?
(c) Mention one benefit of this source for both the company and the investor.
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Answer:
(a) Public Deposits: These are deposits raised directly from the public to meet medium and short-term financial needs.
(b) Unsecured Nature: Public deposits do not require the company to create a "charge" or mortgage over its assets. They are raised based on the company's reputation and creditworthiness.
(c) Benefits:
1. For Company: Lower cost of finance compared to bank loans and no charge on assets.
2. For Investor: Higher rate of interest compared to bank deposits for the same duration.
(a) Public Deposits: These are deposits raised directly from the public to meet medium and short-term financial needs.
(b) Unsecured Nature: Public deposits do not require the company to create a "charge" or mortgage over its assets. They are raised based on the company's reputation and creditworthiness.
(c) Benefits:
1. For Company: Lower cost of finance compared to bank loans and no charge on assets.
2. For Investor: Higher rate of interest compared to bank deposits for the same duration.
Two friends, Rohan and Sohan, are debating the best way to finance their new startup. Rohan argues that they should use "Owners' Funds" like Equity Shares because it provides permanent capital and they won't have the stress of monthly interest payments if the business struggles initially. Sohan, however, believes that "Borrowed Funds" like a Bank Loan are better because the interest is a tax-deductible expense and they won't have to share their hard-earned profits or decision-making power with outside shareholders. They both realized that every source has its own risk and cost. Owners' funds act as a "security cushion" for creditors, while borrowed funds increase the "financial risk" of the firm. They eventually decided to use a healthy mix of both to maintain a balanced capital structure that optimizes cost and risk.
Questions:
(a) Distinguish between "Owners' Funds" and "Borrowed Funds" on the basis of: (i) Risk and (ii) Control.
(b) Why are borrowed funds considered a "Fixed Financial Burden"?
(c) Explain the concept of "Bonds" as a form of borrowed funds.
(a) Distinguish between "Owners' Funds" and "Borrowed Funds" on the basis of: (i) Risk and (ii) Control.
(b) Why are borrowed funds considered a "Fixed Financial Burden"?
(c) Explain the concept of "Bonds" as a form of borrowed funds.
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Answer:
(a) Distinction:
1. Risk: Owners' funds carry no risk of repayment, but borrowed funds carry high Financial Risk (repayment of principal and interest is mandatory).
2. Control: Owners' funds dilute control (shareholders have voting rights), while borrowed funds do not affect management control.
(b) Fixed Burden: Borrowed funds require the payment of a fixed rate of interest regardless of whether the company earns a profit or suffers a loss. This creates a mandatory financial obligation.
(c) Bonds: Bonds are debt instruments similar to debentures but are generally issued by Government agencies or large corporations. They carry a fixed rate of interest and are used to raise long-term capital for specific projects.
(a) Distinction:
1. Risk: Owners' funds carry no risk of repayment, but borrowed funds carry high Financial Risk (repayment of principal and interest is mandatory).
2. Control: Owners' funds dilute control (shareholders have voting rights), while borrowed funds do not affect management control.
(b) Fixed Burden: Borrowed funds require the payment of a fixed rate of interest regardless of whether the company earns a profit or suffers a loss. This creates a mandatory financial obligation.
(c) Bonds: Bonds are debt instruments similar to debentures but are generally issued by Government agencies or large corporations. They carry a fixed rate of interest and are used to raise long-term capital for specific projects.
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