Types of Financing
Types of financing examines the menu of long-term and short-term funds and the trade-off among cost, risk, control and flexibility. A CMA candidate should be able to match an instrument to the asset it funds and to the issuer's cash-flow profile.
Core instruments
- Equity share capital is permanent, carries residual voting control and dividends that are not contractual.
- Preference shares rank before equity for dividend and repayment, often carry a fixed rate and may be cumulative, participating or convertible.
- Debentures and bonds are secured or unsecured debt with fixed interest and maturity; term loans are bank or financial-institution debt with covenants.
- Short-term sources include trade credit, bank overdraft, cash credit, commercial paper, factoring and bill discounting.
- Leasing gives use without ownership; hire purchase transfers ownership on the final instalment; retained earnings are internal equity.
Worked example
A firm needs ₹20 crore and has 10 lakh existing shares. EBIT is ₹6 crore and tax is 25%. If it issues 10% debt, interest is ₹2 crore, PAT is ₹3 crore and EPS is ₹30. If it issues equity at ₹100, it adds 20 lakh shares; PAT is ₹4.50 crore and EPS is ₹15. Debt doubles EPS, but also doubles financial risk, so the choice depends on EBIT stability and covenant headroom.
Traps
Preference dividend is not tax-deductible; commercial paper is unsecured and short-term; a bonus issue raises no cash; a rights issue avoids dilution to outsiders; lease payments are operating outflows, not ownership capital.