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NIOS Class 12 Business Studies Chapter 12 Long – Term Sources of Business Finance
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Long – Term Sources of Business Finance
Chapter: 12
Module – 3 Business Finance
INTEXT QUESTIONS 12.1
1. Complete the following chart that compares equity shares and preference shares:
| Basis of difference | Equity Shares | Preference Shares |
| (i) Payment of dividend on shares. | Dividend paid after paying dividend on preference shares. | (a) …………………………………………………….. |
| (ii) Repayment of capital | (b) ………………………. ………………………. | Capital is refunded in preference over the equity shares. |
| (iii) Voting rights | (c) ………………………. ………………………. | Do not carry voting rights |
| (iv) Accumulation of Dividend | Dividend is not accumulated and therefore cannot be carried forward. | (d) …………………………. ………………………… |
Ans:
| Basis of difference | Equity Shares | Preference Shares |
| (i) Payment of dividend on shares. | Dividend paid after paying dividend on preference shares. | Dividend is paid on these shares in preference to the equity shares. |
| (ii) Repayment of capital | (b) Share capital refunded only after the refund of preference share capital. | Capital is refunded in preference over the equity shares. |
| (iii) Voting rights | (c) Shareholders enjoy voting rights. | Do not carry voting rights |
| (iv) Accumulation of Dividend | Dividend is not accumulated and therefore cannot be carried forward. | (d) Unpaid dividends are accumulated and are carried forward to the future years, in case of cumulative preference shares. |
2. Some of the features of the different methods of raising long-term capital are given below. Identify the features that relate to equity shares, preference shares and debentures and write it in brackets.
(i) In case of winding up of the company, the capital is refunded after payment of debentures but before payment to equity shareholders. ( )
Ans: Preference shares.
(ii) Their holders are creditors of the company for a fixed period. ( )
Ans: Debentures.
(iii) Their holders are the owners of the company and enjoy voting rights.( )
Ans: Equity shares.
(iv) They bear high degree of risk-in case of losses they do not get dividend and in case of winding up of the company, they are the last to get a refund of their invested money. ( )
Ans: Equity Shares.
(v) Their holders have no say in the management of the company and they do not have the right to attend the company’s meetings. ( )
Ans: Debentures.
3. Mention the difference between shares and Debentures, on the basis of the criteria listed below:
| Basis | Shares | Debentures |
| (i) Status. | ||
| (ii) Rights. | ||
| (iii) Security. | ||
| (iv) Risk. |
Ans:
| Basis | Shares | Debentures |
| (i) Status. | Owners of the company. | Creditors of the company. |
| (ii) Rights. | Right to vote and determine policies of the company. | No right to attend company’s meetings. No say in company’s management. |
| (iii) Security. | Not required. | Generally secured. So sufficient fixed assets required to issue debentures. |
| (iv) Risk. | High. | Little Risk. |
INTEXT QUESTIONS 12.2
I. Give the full form of the following abbreviations:
(a) IFCI.
Ans: Industrial Finance Corporation of India.
(b) SFC.
Ans: State Financial Corporation.
(c) ADR.
Ans: American Depository Receipt.
(d) GDR.
Ans: Global Depository Receipt.
(e) FDI.
Ans: Foreign Direct Investment.
II. Which method of long-term financing, Public Deposit or Retention of Profits, are being referred to, in each of the following statements:
(a) Management is less careful about funds utilization by this method. ( )
Ans: (a) Retained Earnings.
(b) To raise funds through this method, an advertisement is generally given through the newspapers. ( )
Ans: Public Deposit.
(c) They offer flexibility and the funds can be refunded when not required. ( )
Ans: Public Deposit.
(d) They offer benefit to shareholders as company may draw upon them to pay dividend to them. ( )
Ans: Retained Earnings.
(e) No obligation on the company to pay interest on it or repay the money. ( )
Ans: Retained Earnings.
III. (a) How are funds raised through lease financing? Explain briefly, in your own words.
Ans: Lease financing is a popular medium and long-term financing option in which the owner of an asset grant another person the right to use the asset in exchange for a periodic payment. The asset’s owner is known as the lessor, and the user is known as the lessee.
(b) List any two limitations of long-term borrowings from Commercial Banks.
Ans: Following are the limitations of long-term borrowing from commercial banks:
(i) Banks require personal guarantee or pledge of assets while granting loans. So the business cannot raise further loans on these assets. Thus, it reduces the borrowing capacity of the borrowers.
(ii) In case the short-term loans are extended again and again, there is always uncertainty about their continuity.
| TERMINAL EXERCISE |
Very Short Answer Questions:
1. What is meant by lease financing?
Ans: Lease is a contract whereby one can use the assets of the other with due permission of the owner on payment of rent without purchasing them. The owner of the asset is called ‘lessor’ and the user is called ‘lessee’. The period of use is called the lease period after which the lessee may opt for purchase of the asset.
2. State the meaning of ‘Preference shares’.
Ans: Preference Shares are those shares which carry preferential rights in respect of dividend and return of capital. Before any dividend is paid to the equity shares, the dividend at a fixed rate must be paid on the preference shares. However, this dividend is payable only if there are profits. Again at the time of winding up, the holder of the preference shares will get the return of their capital before anything is paid to the equity shareholders.
| Short Answer Questions |
1. Distinguish between GDR and ADR.
Ans:
| American Depository Receipts (ADR) | Global Depository Receipts (GDR) |
| The depository receipts which are issued by a USA-based bank for trading only in American Stock markets are known as American Depository Receipts (ADR). The ADRs are issued only to the American citizens. | The issue of Global Depository Receipts (GDRs) and American Depository Receipts (ADRs) are different methods of raising funds from foreign sources. Under this method the shares of Indian companies are issued in the form of depository receipts (Global or American) that are traded on the foreign markets. |
2. ‘Finance is considered as the life-line of the business, especially in the modern day’. Give reasons for the same.
Ans: Finance is considered as the lifeblood of an industry because finance is the master key that provides access to all the sources for being employed in manufacturing and merchandising activities. Financial support to set up new enterprises as well expansion and modernisation of the existing enterprises.
3. Give two merits and two limitations of equity shares, from the point of view of the management.
Ans: Advantages from Management’s point of view:
(i) A company can raise capital by issuing equity shares without creating any charge in its fixed assets.
(ii) The capital raised by issuing equity shares is not required to be paid back during the lifetime of the company. It will be paid back only when the company is winding up.
Demerits of Equity Shares from Management’s point of view:
(i) It requires more formalities and procedural delay to raise funds by issuing equity shares. Also the cost of raising capital through equity share is more as compared to debt.
(ii) As the equity shareholders carry voting rights, groups are formed to influence the votes and grab the control of the company. This may lead to conflict of interests, which is harmful for the smooth functioning of a company.
4. Explain the four types of preference shares that a company can issue.
Ans: A company has the option to issue different types of preference shares. Let us look at different types of preference shares a company can issue.
(i) Convertible and Non-convertible Preference Shares: The preference shares which can be converted into equity shares after a specified period of time are known as convertible preference shares. Otherwise, they are known as nonconvertible preference shares.
(ii) Cumulative and Non-cumulative Preference Shares: In cumulative preference shares, the unpaid dividends are accumulated and carried forward for payment in future years. On the other hand, in non-cumulative preference shares, the dividend is not accumulated if it is not paid out of the current year’s profit.
(iii) Participating and Non-participating Preference Shares: Participating preference shares have a right to share the profit after making payment of dividend at a pre-decided rate to the equity shares. The non-participating preference shares do not enjoy such a right.
(iv) Redeemable and Irredeemable Preference Shares: Preference shares having a fixed date of maturity are called redeemable preference shares. Here, the company undertakes to return the amount to the preference shareholders immediately after the expiry of a fixed period. On the other hand, where the amount of the preference shares is refunded only at the time of liquidation, those are known an irredeemable preference shares.
| Long Answer Questions |
1. What are ‘Debentures’? Describe three merits and three limitations of debentures as a source of long-term finance for a company.
Ans: The companies can raise long-term funds by issuing debentures that carry assured rate of return for investors in the form of a fixed rate of interest. It is known as debt capital or borrowed capital of the company. The debenture is a written acknowledgement of money borrowed. It specifies the terms and conditions, such as rate of interest, time of repayment, security offered, etc. These are offered to the public to subscribe in the same manner as is done in the case of shares.
Merits of Debentures:
(a) Debentures are secured loans. On winding up of the company, they are repayable before making any payment to the equity and preference shareholders.
(b) The debentureholders get assured return irrespective of profit.
(c) Issue of debentures enables the company to provide high return to equity shareholders when the earnings of the company are good. This is called Trading on Equity.
Demerits of Debentures:
(a) If the earnings of the company are uncertain and unpredictable, issue of debentures may pose serious problems due to fixed obligation to pay interest and repay the principal. So, when the company expects good and stable income, then only it should issue debentures.
(b) The company, which issues debentures, creates a charge on its assets in favour of debentureholders. So a company not having enough fixed assets cannot borrow money by issuing debentures.
(c) The assets of the company once mortgaged cannot be used for further borrowing. So, issue of debentures reduces the borrowing capacity of the company.
2. Differentiate between ‘Shares’ and ‘Debentures’ as sources of long-term finance.
Ans:
| Basis | Shares | Debentures |
| (i) Status | Shareholders are the owners of the company. They provide ownership capital which is not refundable unless the company is liquidated. | Debentureholders are the creditors of the company. They provide loans generally for a fixed period, which are to be paid back. |
| (ii) Nature of turn on investments | Shareholders get dividends. Its amount is not fixed as it depends on the profit of the company. | Interest is paid on debentures at a fixed rate. Interest is payable even if the company is running at a loss. |
| (iii) Rights | Shareholders are the real owners of the company. They have the right to vote and determine the policies of the company. | Debentureholders do not have the right to attend meetings of the company. So they have no say in the management of the company. |
| (iv) Security | No security is required to issue shares. | Generally debentures are secured. So, sufficient fixed assets are required when debentures are to be issued. |
| (v) Order of repayment | Share capital is paid back only after paying the debentureholders and creditors. | Debentureholders have the priority of repayment over shareholders. |
| (vi) Risk | Risk is high due to uncertainty of returns. | Little risk due to certainty of return. |
3. What is meant by Special Financial Institutions (SFIs)? Explain two merits and two demerits of taking loans from SFIs as a source of long-term funds.
Ans: Special Financial Institutions (SFIs): After independence a large number of financial institutions have been established in India with the primary objective to provide medium and long-term financial assistance to industrial enterprises. Institutions like Industrial Finance Corporation of India (IFCIs), Industrial Reconstruction Bank of India, State Financial Corporation (SFCs), State Industrial Development Corporation (SIDCs) have been established to provide financial support to set up new enterprises as well expansion and modernisation of the existing enterprises.
These financial institutions grant loans for a maximum period of 25 years. These loans are covered by mortgage of company’s property and/or hypothecation of stocks/ shares etc.
The major benefit derived from such loans are:
(i) The rate of interest payable is lower than the market rate. and
(ii) The amount of loan is large.
4. Write explanatory notes on:
(a) Retention of Profits.
Ans: As per The Companies Act 2013, companies are required to transfer a part of their profits in reserves like General Reserve, Debenture Redemption Reserve and Dividend Equalisation Reserve etc. These reserves can be used to meet long-term financial requirements like purchase of fixed assets, renovation and modernisations etc. This method of financing long-term financial requirement is also called as Retention of Profit.
Merits Following are the benefits of retention of profit:
(i) Cheap Source of Capital: No expenses are incurred when capital is available from this source. There is no obligation on the part of the company either to pay interest or pay back the money. It can safely be used for expansion and modernisation of business.
(ii) Bring Financial Stability: A company which has enough reserves can face ups and downs in business. Such companies can continue with their business even in depression, thus building up their goodwill.
(b) Public Deposits, as methods of Long-term finance.
Ans: Public Deposits: It is a very old method of finance practised in India. When commercial banks were not there, people used to deposit their savings with business concerns of good repute. Even today it is a very popular and convenient method of raising short and medium term finance. Under this method companies can raise funds by inviting their shareholders, employees and the general public to deposit their savings with the company. To attract the public, the company usually offers a higher rate of interest than the interest on bank deposit. The period for which companies accept public deposits ranges between six months to sixty months.
