Long Answer Type
Question 1: Explain trade credit and bank credit as sources of short-term finance for business enterprises.
Answer: Trade credit is given by one business firm to another for purchase of goods or services. The amount of trade credit depends on many factors; such as mutual trust, sales performance and creditworthiness of the buyer organization. Trade credit can be very useful for new and small firms as it does not involve cost of borrowing. The debtor usually needs to repay the amount within a specified period. In some cases, the duration of trade credit may be prolonged depending on future business prospects.
Banks are important sources of short term and medium term finance for business enterprises. A bank may pay a lump sum amount or credit may be paid in certain installments. The rate of interest depends on the size of the firm and level of interest in the economy. Unlike the trade credit, credit from bank involves cost of borrowing because the debtor has to pay some interest on the borrowed amount. Moreover, procuring credit from a bank can be time consuming as it involves lot of paper work.
Both trade credit and bank credit can be steady and reliable sources of fund. The fact, that a business firm is able to get credit either from trade partners or from banks is a positive sign of creditworthiness of the organization. While trade credit is available on easier terms and conditions, bank credit can involve difficult terms and conditions.
Question 2: Discuss the sources from which a large industrial enterprise can raise capital for financing modernisation and expansion.
Answer: Following are the various sources from which a large industrial enterprise can raise capital for financing modernization and expansion:
- Commercial Paper: Commercial paper is an unsecured promissory note issued by a firm to raise funds for a short period. The period is usually between 90 days to 364 days. Since commercial paper is unsecured, hence it can only be issued by firms having good credit rating.
- Public Deposit: A company can raise funds by inviting the public to deposit their savings with the company. The rate of interest is usually higher than those offered by banks and hence many people may be interested in opting for public deposit. A company with good standing and credit rating can easily attract public deposit.
- Equity and Preferential Shares: Equity and preference shares are utilized by companies when they have to implement expansion and modernization plan. This tool is utilized by both new and old companies but in order to do so, a company needs to have a very good track record. Moreover, a company can only get the approval of raising capital through this route after thorough scrutiny by the SEBI.
- Debentures: Debentures are secured loans by investors and the company has to pay back the amount after a fixed interval. Since cost of sourcing finance through debentures can be quite high, hence only big companies are in a position to issue debentures.
- Financial Institutions: Many financial institutions invest money in corporate because they want to invest public money in safe options. It is obvious that big companies provide much safer option for financial institutions.
- International Financing: Some big companies also opt for international financing. This is done by issuing GDRs and ADRs. It is quite logical that a company which has a good brand equity in home country as well as abroad can be in a better position to raise funds through this route.
Question 3: What advantages does issue of debentures provide over the issue of equity shares?
Answer: Equity shares do not give fixed returns, rather returns on equity shares fluctuate as per the performance of the company during a given period. Investors who want a fixed return and are risk averse prefer to invest in debentures. Unlike equity shares; debentures do not provide voting rights to the investor and hence company’s control is not diluted in case of debentures. In case of a huge profit, company does not need to share the profit with investors who had invested through debentures. Financing through debentures is less costly as compared to equity shares. In case of debentures, the interest payment is tax deductible which gives some advantage to the company. Issue of equity shares requires more formalities compared to debentures and hence debentures may be preferred in certain situations. Debentures are suitable when a company’s performance is stable over a period of time.
Question 4: State the merits and demerits of public deposits and retained earnings as methods of business finance.
Answer: Merits of Public Deposits:
- Simple procedure of obtaining public deposits.
- Cost of public deposit is generally lower than cost of borrowing from banks.
- Control of the company is not diluted.
- Fixed assets of the company are free to be utilized for raising funds from other sources.
Demerits of Public Deposits:
- It is very difficult for small companies to raise funds through public deposits.
- This is not a reliable source.
- In case of large size requirement, collection of deposits can be very difficult.
Merits of Retained Earnings:
- It is a permanent source of fund for the company.
- Does not involve any explicit cost; in the form of interest, dividend or floatation cost.
- Provides greater degree of flexibility and freedom to the organization.
- Helps in increasing the market price of shares of the company.
Demerits of Retained Earnings:
- Excessive ploughing back of retained earnings may cause resentment among shareholders.
- In case of fluctuating profits, it can be an uncertain source.
- It may lead to sub-optimal use of funds.
Question 5: Discuss the financial instruments used in international financing.
Answer: Following are the various financial instruments used in international financing:
- Global Depository Receipts (GDRs): Local currency shares are delivered to the depository bank. The depository bank then issues depository receipts against these shares. These receipts are denominated in US dollars and are known as GDRs. It is a negotiable instrument and can be traded like equity shares. Indian companies raise capital from international markets through this tool. A holder of GDR can convert it into the number of shares it represents; as per his convenience. The holders of GDRs do not have voting rights but they are entitled to dividends as and when announced by the company.
- American Depository Receipts (ADRs): When the GDR is issued in the USA, it is known as ADR. ADRs can be bought and sold in American stock markets; like equity shares. ADRs can only be bought by a US citizen and can only be traded on the American stock exchange.
- Foreign Currency Convertible Bond (FCCBs): Foreign currency convertible bonds are equity linked debt securities that are to be converted into equity or depository receipts after a specific period. Thus, a holder of FCCB has the option of converting it into equity shares or just retaining the bonds. FCCBs are issued in foreign currency. They carry a lower rate of interest compared to any other similar non-convertible debt instrument. They are similar to convertible debentures issued in India.
Question 6: What is a commercial paper? What are its advantages and limitations?
Answer: Commercial paper is an unsecured promissory note issued by a firm to raise funds for a short period. The period is usually between 90 days to 364 days. Since commercial paper is unsecured, hence it can only be issued by firms having good credit rating.
Merits of Commercial Paper:
- It is sold on an unsecured basis and does not have restrictive clause.
- It has high liquidity; because it can be easily transferred.
- Cost of CP is less than cost of borrowing from commercial banks.
- It provides a continuous source of fund. Maturing commercial paper can be repaid by issuing new commercial papers.
- Commercial Paper can be utilized by companies to park excess fund.
Limitations of Commercial Paper:
- This can only be issued by financially sound companies.
- The size of issue is limited to the excess liquidity available with the suppliers of funds at a particular time.
- If the company is not in a position to redeem it due to financial constraints, extending its maturity is not possible.