Sources of Finance (Equity Shares, Preference Shares, Debentures, Banks, Financial Institutions) – Long Answer Questions
Medium Level (Application & Explanation)
Q1. Explain the meaning and features of equity shares as a source of finance. Why are they called ownership capital? Support your answer with examples.
Answer:
Equity shares represent the ownership of a company. People who buy these shares become part-owners and get voting rights in key decisions like electing directors or approving major policies.
Money collected by issuing equity shares is called share capital, also known as ownership capital or owner’s funds, because it belongs to the owners and is permanent in nature.
Equity shareholders receive dividends only if the company makes profits, and the rate is not fixed. In case of losses, they may get no dividend.
Equity capital is not repaid during the life of the company. Repayment happens only at winding up, after paying off debts.
Examples: Buying shares of Tata Motors or Reliance Industries makes you an owner with voting rights. A startup can raise funds by issuing equity to the public or private investors, without taking on debt.
Q2. Describe preference shares and their key rights. Why do many investors consider them a stable investment option?
Answer:
Preference shares are a special class of shares with preferential rights over equity shares in two ways: first, they receive a fixed dividend before equity shareholders; second, they have priority in repayment during winding up.
Money raised is called preference share capital. This capital is useful for companies that want to attract investors who desire regular income with relatively lower risk than equity.
Typically, preference shareholders do not have voting rights in routine matters; they may get voting rights only in special circumstances like non-payment of dividends.
Investors choose preference shares for stability, as the dividend is pre-determined (for example, 8%).
Examples: If ABC Ltd. issues 8% preference shares, these shareholders are paid before equity holders. During liquidation, they are repaid their capital earlier than ordinary shareholders, which reduces their risk.
Q3. What are debentures? Explain their features, benefits to investors, and obligations for companies.
Answer:
Debentures are instruments by which companies borrow money from the public. Buyers of debentures are creditors, not owners.
Debenture holders receive fixed interest at a specified rate (e.g., 10%), usually periodically, irrespective of whether the company earns profits.
For investors, debentures provide regular income and generally carry lower risk than equity, as they have priority over shareholders in claims.
For companies, debentures are useful when they need funds without diluting control. However, companies must pay interest even in loss-making years, which is a fixed financial burden.
Debentures may be secured (backed by assets) or unsecured.
Examples: Investing in debentures of NTPC Ltd. provides periodic interest. A company can issue ₹1 crore in debentures to meet expansion needs quickly without giving up ownership.
Q4. Explain how commercial banks support business finance. Describe at least four methods and when each is suitable.
Answer:
Commercial banks provide short-term and medium-term finance through multiple methods:
Cash Credit: A limit is sanctioned against stock or receivables; interest is charged on the amount used. Suitable for working capital.
Overdraft (OD): Allows withdrawal beyond the balance up to a limit, typically against security or fixed deposits. Useful for temporary cash gaps.
Term Loans: Loans for a fixed period (short/medium term) to buy machinery or equipment.
Bills Purchase/Discounting: Banks give money in advance against trade bills; ideal for businesses selling on credit.
Letter of Credit (LC): A bank’s payment guarantee to suppliers, essential for export/import transactions.
Banks are chosen for speed, flexibility, and confidentiality. Example: A firm uses OD to pay suppliers when funds are tight or uses bills discounting to meet immediate expenses.
Q5. What role do financial institutions play in industrial development? Explain their features, benefits, and suitable use-cases with examples.
Answer:
Financial institutions set up by the government provide long-term and medium-term funds to support industrial growth and infrastructure.
They offer both owned capital (like equity-type support) and loan capital at competitive interest rates with special schemes for priority sectors.
These institutions often provide longer repayment periods, moratoriums, and advisory support for project appraisal and development.
They are suitable for projects with long gestation periods, technology development, or regional development goals.
Examples:
IDBI supports new industries with project finance.
SIDBI funds MSMEs and tech startups for expansion.
National Housing Bank (NHB) assists housing finance companies and real estate-linked projects.
Businesses choose them for affordable, patient capital, especially when commercial bank loans or market instruments are insufficient.
High Complexity (Analytical & Scenario-Based)
Q6. A founder wants to raise funds without losing decision-making power, keep the cost of capital reasonable, and maintain investor confidence. Compare equity shares, preference shares, and debentures, and recommend a balanced mix.
Answer:
Equity Shares: Provide permanent capital but cause dilution of control because equity holders get voting rights. Cost of equity can be high due to dividend expectations and market pressure. Good for long-term stability but not ideal if control is crucial.
Preference Shares: Offer fixed dividends and generally no voting rights, thus minimal dilution of control. Helpful for income-seeking investors and stable funding. However, dividends are payable only from profits.
Debentures: No dilution of ownership; carry fixed interest payable even in loss years, creating financial obligation but boosting investor confidence through regular payments.
Recommendation: Use a blend—major portion in debentures for control and credibility, a limited tranche of preference shares for stability, and minimal equity to avoid excessive dilution while ensuring a solid capital base.
Q7. Your company expects a temporary loss this year but must keep cash flows predictable for lenders and investors. Should you issue debentures? Analyze benefits, risks, and safeguards.
Answer:
Benefits:
No dilution of control since debenture holders are creditors, not owners.
Fixed interest builds trust with investors who prefer steady returns.
Can be secured against assets to lower interest cost.
Risks:
Interest must be paid even in losses, pressuring cash flows.
Breach of covenants can lead to penalties or recall of loans.
Issue convertible debentures with a lower coupon to reduce immediate outflow.
Create a sinking fund for interest/redemption.
Stagger maturities and align with cash-flow forecasts.
Use credit enhancement (security/guarantees) to reduce interest rate.
Conclusion: Issue debentures only with strong cash-flow planning and risk controls, possibly combined with bank OD for flexibility.
Q8. A seasonal manufacturer gets a one-time bulk discount on raw materials but lacks immediate cash. Evaluate cash credit, overdraft, bills discounting, and letter of credit to choose the best banking mix.
Answer:
Cash Credit (CC): Best for financing inventory; limit is tied to stock/receivables. Interest is charged only on the amount utilized. Ideal for buying discounted raw materials.
Overdraft (OD): Suitable for short, temporary gaps; flexible but may carry a higher rate than CC. Useful as a backup when CC limit is fully used.
Bills Discounting: Converts credit sales into immediate cash by discounting bills with the bank. Effective if the firm has receivables to monetize.
Letter of Credit (LC): Offers a bank guarantee to the supplier; can secure the discount even without upfront cash by assuring payment on presentation of documents.
Recommendation: Use an LC to lock the discount and arrange CC for funding the purchase. Keep OD as a cushion and deploy bills discounting post-sale to recycle working capital.
Q9. An infrastructure project has a long gestation period, high initial costs, and slow revenue ramp-up. Should the firm prefer financial institutions over equity or debentures? Justify with trade-offs.
Answer:
Financial Institutions:
Offer long-term finance with structured repayment, moratoriums, and lower rates.
Provide project appraisal and policy-linked benefits. Suited for infrastructure with long payback.
Equity:
No mandatory payments; absorbs risk during early years.
But causes dilution of control and may demand high returns due to project risk.
Debentures:
Keep control intact but require fixed interest, straining cash flows during slow ramp-up.
Might need security and strict covenants.
Conclusion: Prefer a core loan from financial institutions for tenure and flexibility, add measured equity to absorb early risk, and use limited debentures later when cash flows stabilize. This mix balances *cost...
