Fundamentals of Accounting Business Finance 15. Shares & Debentures This lesson introduces you to the concept of Shares & Debentures. As you have already learnt, long-term sources of finance are one of the most critical factors in the success or failure of a Company. These sources could either be debt (debentures) or equity (shares). Both of these are important instruments of raising funds for a Corporate. Hence an understanding of this topic will enable you to understand this important aspect of fund raising. Issuance of both shares and debentures by a Company is regulated by the Companies Act, 1956. Hence it would be pertinent for a you to study the relevant provisions of the Act to understand the relevant concepts better.
15.0 Objectives Based on the outcome of this Lesson, you will be able to: • • •
Understand the meaning of shares and its features Understand the meaning of debentures and its features Understand differences between the 2 sources of capital and their respective importance
15.1 Introduction For many businesses, the issue about where to get funds from for starting up, development and expansion can be crucial for the success of the business. It is important, therefore, to understand the various sources of finance open to a business and are able to assess how appropriate these sources are in relation to the needs of the business. Financing a company through the sale of stock in a company is known as equity financing. Alternatively, debt financing (for example issuing bonds) can be done to avoid giving up shares of ownership of the company. Unofficial financing known as trade financing usually provides the major part of a company's working capital (day-to-day operational needs). Trade financing is provided by vendors and suppliers who sell their products to the company at short-term, unsecured credit terms, usually 30 days. Equity and debt financing are usually used for longer-term investment projects such as investments in a new factory or a new foreign market. Customer provided financing exists when a customer pays for services before they are delivered, e.g. subscriptions and insurance.
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As we have seen in earlier lessons, there are various sources of finance for a business. These sources broadly fall into 2 categories: 15.1.1 Internal Sources Traditionally, the major sources of finance for a limited company were internal sources: 1. 2. 3. 4.
Personal savings Retained profit Working capital Sale of assets
15.1.2 External Sources Ownership Capital In this context, 'owners' refers to those people/institutions who are shareholders. Sole traders and partnerships do not have shareholders - the individual or the partners are the owners of the business but do not hold shares. Ownership Capital refers to the funds provided by these owners to the business. Non-Ownership Capital This type of source refers to the funds received by the business from people who are not owners. Hence Banks, Financial Institutions, Finance companies, Suppliers (who give credit for the goods bought from them) are such non-owners who provide the Capital. Now that we are familiar with the Owned and Non-Owned Capital let us discuss in detail these 2 sources of finance.
Self-Check Questions Fill in the Blank 1. Financing the projects of the Company by selling stock is called ________ Financing. Answer True or False 2. Equity and Debt Financing is normally used for short term projects 3. Working Capital is an external source of finance
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15.2 Shares Strictly speaking in financial language, Stock is the Capital raised by a Company through the sale of shares. However, in common language, stock and shares have been referred to the same thing. Hence now it is commonly accepted that a Company sells shares to raise Capital. Shares are units of investment in a limited company, whether it be a public or private limited company. For e.g. if one divides a piece of bread into 5 pieces, then each of the 5 pieces is called a share of the total bread. Similarly, the total equity capital of a Company is divided into several parts called a Share which then can be sold to people who are willing to pay the price for such a share. These people who buy the shares are called Shareholders. Each of these shares has a right to vote on any matter put forward to the shareholders. Each share carries one vote. 15.2.1 Need to Issue Shares The owners of a company may want additional capital to invest in new projects within the company. They may also simply wish to reduce their holding, freeing up capital for their own private use. By selling shares they can sell part or all of the company to many part-owners. The purchase of one share entitles the owner of that share to literally share in the ownership of the company a fraction of the decision-making power, and potentially a fraction of the profits, which the company may issue as dividends. In the common case of a publicly traded corporation, where there may be thousands of shareholders, it is impractical to have all of them making the daily decisions required to run a company. Thus, the shareholders will use their shares as votes in the election of members of the Board of Directors of the company. In a typical case, each share constitutes one vote i.e. a policy of one share – one vote. Hence if a person owns 50% of the shares of a Company, he carries 50% voting power and hence is the majority owner of the Company. Companies may, however, issue different classes of shares, which may have different voting rights. Although ownership of 51% of shares does result in 51% ownership of a company, it does not give the shareholder the right to use a company's building, equipment, materials, or other property. This is because the company is considered a legal person, thus it owns all its assets itself. This is important in areas such as insurance, which must be in the name of the company and not the main shareholder. Owning the majority of the shares allows other shareholders to be out-voted - effective control rests with the majority shareholder (or shareholders acting in concert). In this way the original owners of the company often still have control of the company.
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Self-Check Questions Answer True or False 4. A Company raises capital by selling shares. 5. Irrespective of the number of shares held, each person has only one vote. 6. All the assets of the Company are owned by the shareholders.
15.2.2 Types of Shares 1. Ordinary Shares 2. Preference Shares Ordinary Shares or Common shares implies the most usual and commonly held form of stock in a Company. Shareholders of common stock have voting rights in a Company’s matters. In order of priority in a liquidation of a corporation, the owners of common stock are near the last. Dividends paid to the stockholders must be paid to preferred shares before being paid to common stock shareholders. Share Capital refers to the total capital of a Company. It can be broken up into: Authorised Share Capital The memorandum of association of a limited company states the amount of authorised or nominal share capital. It also says how the share capital is divided into individual shares of a set amount, such as Rs.10/- a share. This is also called the par value of the shares. A Company may decide to charge a premium for selling its shares. Hence a Company may sell shares at Rs.20/- per share. This will mean that the Company is charging a premium of Rs.10/- per share over and above the par value of Rs.10/- per share. A company can increase its authorised share capital by passing an ordinary resolution at a general meeting. Equally, a company can decrease its authorised share capital by passing an ordinary resolution to cancel some shares - this is called 'diminution of capital'. Issued share Capital Issued share capital refers to that part of the authorised share capital that has actually been issued, released or sold by the company e.g. XYZ Ltd. has authorised share capital of 1 crore shares at a nominal (par) value of Rs.10/each aggregating to Rs.10 crores but its issued share capital comprises just over 0.60 crore shares of Rs.10/- each totaling to Rs.6 crores.
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The difference between the authorised and issued share capital represents the number and value of shares that the company can issue should it need to raise further capital. XYZ Ltd., therefore, could issue around 0.40 crores shares to take its issued share capital up to its current maximum authorised share capital of 1 crore shares. The issued share capital cannot exceed the authorised share capital although companies can increase their authorised share capital if they need to. Subscribed and Paid-up Share Capital Subscribed Capital refers to that part of the issued share capital which is purchased by the shareholders. In the above example, XYZ Ltd. has issued 0.6 crore shares but they receive applications only for 0.5 crores shares. Hence the subscribed capital is Rs.5 crores. Also, the Company may not ask applicants to pay full Rs.10/- per share e.g. XYZ Ltd calls for only Rs.6 per share. Hence the total capital that the Company will call for will be = 50,00,000 * Rs.5 = Rs.2.5 crores i.e. this will be the paid up capital of the Company. Preference shares is ownership in a Company, which has a priority in the distribution of dividends and assets over common stock but after bondholders. The safety of the principal of preferred stock is greater than that of common stock. Unlike common stock, preferred stock usually has several rights attached to it: •
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The core right is that of preference in dividends. Before a dividend can be declared on the common shares, any dividend obligation to the preferred shares must be satisfied. The dividend rights are often cumulative, such that if the dividend is not paid it accumulates in arrears. Preferred stock has a par value or liquidation value associated with it. This represents the amount of capital that was contributed to the corporation when the shares were first issued. Preferred stock has a claim on liquidation proceeds of a stock corporation, equivalent to its par or liquidation value. This claim is senior to that of common stock, which has only a residual claim. Almost all preferred shares have a fixed dividend amount. The dividend is usually specified as a percentage of the par value or as a fixed amount e.g. XYZ Ltd 6% Series A Preference Shares. Unlike debt securities, however, a company is not legally required to pay preferred dividends and will not be in default for missing a preferred dividend payment. Some preferred shares have special voting rights to approve certain extraordinary events (such as the issuance of new shares or the approval of the acquisition of the company) or to elect directors, but most preferred shares provide no voting rights associated with them. Some preferred shares only gain voting rights when the preferred dividends are in arrears. Usually preferred shares contain protective provisions which prevent the issuance of new preferred shares with a senior claim. Individual series of 5
preferred shares may have a senior, pari-passu or junior relationship with other series issued by the same corporation. The above list, although including several customary rights, is far from comprehensive. Preferred shares, like other legal arrangements, may specify nearly any right conceivable. Preferred shares normally carry a call provision, enabling the issuing corporation to repurchase the share at its (usually limited) discretion. Some corporations contain provisions in their charters authorising the issuance of preferred stock whose terms and conditions may be determined by the board of directors when issued. These "blank check" preferred shares are often used as takeover defense. These shares may be assigned very high liquidation value that must be redeemed in the event of a change of control or may have enormous super voting powers. There are various types of preferred stocks that are common to many corporations: • •
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Cumulative Preferred Stock - If the dividend is not paid, it will accumulate for future payment. Non-cumulative Preferred Stock - Dividend for this type of preferred stock will not accumulate if it is unpaid. This type is very rare, because the payment of dividends is always at the discretion of the board of directors. Convertible Preferred Stock - This type of preferred stock carries the option to convert into a common stock at a prescribed price. Exchangable Preferred Stock - This type of preferred stock carries the option to be exchanged for some other security upon certain conditions. Participating Preferred Stock - This type of preferred stock allows the possibility of additional dividend above the stated amount under certain conditions. Perpetual Preferred Stock - This type of preferred stock has no fixed date on which invested capital will be returned to the shareholder. Most preferred stock is issued without a set redemption date. Puttable Preferred Stock - These issues have a "put" privilege whereby the holder may, upon certain conditions, force the issuer to redeem shares.
Self-Check Questions Answer True or False 7. Payment of dividend on Common shares has a priority over dividend on preference shares. 8. A Company’s Subscribed and paid-up capital cannot exceed its authorised share capital. 9. Preference shares have priority for distribution of dividend and assets over bondholders.
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15.3 Debentures Whilst the following sources of finance are important, they are not classed as Ownership Capital - Debenture holders are not shareholders, nor are banks who lend money or creditors. Only shareholders are owners of the company. These are referred to as non-ownership capital and are a part of the external sources of capital. These take the form of: • • • • •
Debentures Other loans Overdraft facilities Hire purchase Lines of credit from creditors In this present chapter we will study in detail about Debentures.
15.3.1 Meaning of Debenture A debenture is an instrument of debt executed by the company acknowledging its obligation to repay the sum at a specified rate and also carrying an interest. It is only one of the methods of raising the loan capital of the company. A debenture is thus like a certificate of loan or a loan bond evidencing the fact that the company is liable to pay a specified amount with interest and although the money raised by the debentures becomes a part of the company's capital structure, it does not become share capital. Debenture holders have the right to receive their interest payments before any dividend is payable to shareholders and, most importantly, even if a company makes a loss, it still has to pay its interest charges. If the business fails, the debenture holders will be preferential creditors and will be entitled to the repayment of some or all of their money before the shareholders receive anything. A debenture with a fixed charge has a fixed rate of interest and might be presented as: '10% Debenture 2005/2008 Rs.1,00,000
In this case, the debenture is redeemable (will be paid back) between 2005 and 2008, has a face value of Rs.100,000 and the fixed interest rate is 10%. A debenture issued with a floating charge means that the interest rate is not fixed and such debentures are usually not tied to any specific asset such as land or buildings.
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15.3.2 Provisions Regulating Issue of Debentures The power to issue debentures can be exercised on behalf of the company at a meeting of the Board of Directors {Section 292(1)(b) of the Companies Act}. A public company may, however, require the approval of shareholders to borrow money in excess of the aggregate of its paid up capital and free reserves.{Section 293 (1) (d)}. Consent of the shareholders would also be required for selling, leasing or disposing of the whole or substantially the whole of the undertaking of the company under section 293 (1) (a). Debentures have been defined under Section 2 (12) of the Act to include debenture stocks, bonds and any other securities of the company whether constituting a charge on the Company’s assets or not. The attributes of a debenture are: • • • •
A movable property. Issued by the company in the form of a certificate of indebtedness. It generally specifies the date of redemption, repayment of principal and interest on specified dates. May or may not create a charge on the assets of the company. The debentures issued under the Act shall not carry any voting rights. In the case of public issue of debentures, there would be a large number of debenture holders on the register of the company. As such it shall not be feasible to create charge in favour of each of the debenture holder. A common methodology generally adopted is to create Trust Deed conveying the property of the company. A Trust deed is an arrangement enabling the property to be held by a person or persons for the benefit of some other person known as beneficiary. The Trustees declare the Trust in favour of the debenture holders. The Trust Deed may grant the Trustees fixed charge over the freehold and leasehold property while a floating charge may be created over other assets. The Company shall allow inspection of the Trust Deed and also provide copy of the same to any member or debenture holder of the company on payment of such sum as may be prescribed. Failure to provide the same would invite penalties by way of fine under the Act. Any provision contained in the Trust Deed, which exempts a Trustee from liability for breach of Trust, is void.
15.3.3 Types of Debentures Secured / Unsecured Debentures Debentures are loans that are usually secured and are said to have either fixed or floating charges with them. A secured debenture is one that is specifically tied to the financing of a particular asset such as a building or a machine. Then, just like a loan for a private house, the debenture holder has a legal interest in that asset and the company cannot
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dispose of it unless the debenture holder agrees. If the debenture is for land and/or buildings it can be called a mortgage debenture. An unsecured debenture is one which does not have any charge on any asset and in case of a default by the Company, the holder of the debenture cannot sell off any asset to recover the value of his debenture. Convertible / Non Convertible Debentures: At the time of issuance, the Debentures can be issued with a convertible option. Under this option, the Company offers to convert the full value of the debenture (Fully Convertible) or a part of the value of debenture (Partly Convertible) into equity shares in future at a particular price e.g. XYZ Ltd issues 2,00,000 8% Debentures of Rs.100/- each. At the end of 24 months, each Debenture of Rs.100/- will be converted into 2 equity shares of Rs.10/- at a price of Rs. 50/per share. This will mean that the debenture is fully convertible and the Company is charging a premium of Rs.40/- per share. Alternately, Rs.60/- per Debenture will be converted into 1 equity share of Rs.10/each at a premium of Rs.50/- per share and the Balance Rs.40/- will continue as the Non-Convertible Portion earning interest at 8% and redeemable at the end of 5 years. Redeemable / Non Redeemable Debentures: Debentures issued may be redeemable at the end of a particular period or they may be issued for perpetuity i.e. never to be redeemed. However in practice, debentures are always redeemable and only in very rare cases non redeemable debentures may be issued.
Self-Check Questions Answer True or False 10. One of the methods of Debt financing is through Debentures. 11. Like shares, Debentures also have voting rights. 12. Debenture holders are also part owners of the Company. 13. Debentures can be either secured or convertible but not both.
15.4 Summing Up Funding is an important factor for the success of a Company. Debt and Equity are the 2 forms of funding. Shares and Debentures are the sources of equity and debt funding respectively. Both shares and debentures have various features and are of various types. 9
15.5 Answers to Self-Check Questions 1. Equity 2. False 3. False. 4. True 5. False 6. False. 7. False 8. True 9. False. 10. True 11. False 12. False 13. False
15.6 Terminal Questions 1. 2. 3. 4. 5.
What are shares? What is the need for a Company to issue shares? Explain the difference between Authorised, Issued and Subscribed Capital? What are preference shares and explain the features of Preference shares? Explain the meaning of Debentures? Explain the various types of Debentures?
15.7 Glossary •
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Ownership Capital: This refers to the funds provided by these owners to the business. In this context owner refers to those people/institutions who are shareholders Non-Ownership Capital: This type of source refers to the funds received by the business from people who are not owners Shares: These are units of investment in a limited company, whether it be a public or private limited company Issued share capital: This refers to that part of the authorised share capital that has actually been issued, released or sold by the company Subscribed and Paid-up Share Capital: This refers to that part of the issued share capital which is purchased by the shareholders Preference share: This refers to ownership in a Company, which has a priority in the distribution of dividends and assets over common stock Debenture: This is an instrument of debt executed by the company acknowledging its obligation to repay the sum at a specified rate and also carrying an interest