Long-Term Sources of Finance for Organizations

Long-Term Sources of Finance for Organizations (with Examples)

Long-term finance refers to funds that are required for a period exceeding one year, typically used for acquiring fixed assets, funding major expansion projects, or restructuring capital. Here are several key sources:

1. Equity Financing: This involves selling ownership stakes in the company.

• Ordinary Shares (Common Stock): Represent the basic ownership of a company. Shareholders have voting rights and receive dividends (if declared) after preference shareholders.
  • Example: A startup issues 1 million ordinary shares to raise initial capital from investors in exchange for a percentage of ownership. Existing public companies can issue new shares through a Follow-on Public Offering (FPO) to fund expansion.
  • Distinctive Features:
    • No fixed repayment obligation: Investors become part-owners and share in the company’s profits (and losses). Dividends are discretionary and not tax-deductible for the company.
    • Dilution of ownership: Issuing more shares reduces the percentage ownership of existing shareholders.
    • Increased equity base: Strengthens the company’s financial position and borrowing capacity.
    • Voting rights: Ordinary shareholders typically have the right to vote on important company matters.
• Preference Shares (Preferred Stock): These shares give holders preferential rights over ordinary shareholders regarding dividends and asset distribution in case of liquidation. They often do not carry voting rights.
  • Example: A manufacturing company issues preference shares to raise capital for a new plant. These shares offer a fixed dividend rate, making them attractive to income-seeking investors.
  • Distinctive Features:
    • Fixed dividend: Usually pays a predetermined dividend rate.
    • Priority over ordinary shares: Preference shareholders receive dividends and assets before ordinary shareholders.
    • Often non-voting: Typically do not have voting rights in the company’s affairs.
    • Hybrid nature: Has features of both debt (fixed income) and equity (ownership).
• Retained Earnings: Profits generated by the company that are not distributed as dividends but are reinvested back into the business.
  • Example: A profitable software company uses a portion of its annual profits to fund research and development for new products.
  • Distinctive Features:
    • Internal source of finance: Does not involve external parties or transaction costs.
    • Increases shareholders’ equity: Represents reinvested profits belonging to the owners.
    • Reflects profitability: The availability of retained earnings depends on the company’s past profitability.

2. Debt Financing: This involves borrowing funds that need to be repaid with interest over a specified period.

• Long-Term Loans: Loans obtained from banks or financial institutions with a repayment period of more than one year.
  • Example: A small business takes out a 10-year term loan from a bank to finance the purchase of new machinery.
  • Distinctive Features:
    • Fixed repayment schedule: Requires regular principal and interest payments.
    • Interest expense: Interest payments are tax-deductible for the company.
    • No dilution of ownership: Lenders do not gain ownership in the company.
    • Collateral may be required: Secured loans require assets to be pledged as security.
• Debentures and Bonds: Debt instruments issued by a company to raise long-term funds from the public or institutional investors.
  • Example: A large infrastructure company issues ₹500 crore worth of 10-year bonds with a fixed coupon rate to finance a highway project.
  • Distinctive Features:
    • Tradable instruments: Bonds can be bought and sold in the secondary market.
    • Fixed interest rate (coupon): Usually pays a predetermined interest rate over the life of the bond.
    • Maturity date: The principal amount is repaid on a specified future date.
    • Credit rating: Bonds are often rated by credit rating agencies, influencing their interest rates.
• Lease Financing (Capital Leases): A long-term contract where the lessee gains control and substantially all the risks and rewards of ownership of an asset, even though legal title may or may not eventually be transferred.
  • Example: An airline leases a new aircraft for 15 years, treating it almost as if it owns it on its balance sheet.
  • Distinctive Features:
    • Use of asset without upfront purchase: Allows access to assets without a large initial investment.
    • Obligation to pay lease rentals: Regular payments are required over the lease term.
    • Potential for ownership transfer: The lessee may have an option to purchase the asset at the end of the lease term.
    • Impact on balance sheet: Capital leases are recognized as assets and liabilities on the balance sheet.

3. Hybrid Financing: These instruments combine features of both debt and equity.

• Convertible Debentures/Bonds: Debt instruments that give the holder the option to convert them into equity shares of the issuing company at a predetermined price within a specified period.
  • Example: A growing technology company issues convertible debentures to raise funds. Investors are attracted by the fixed interest payments and the potential to benefit from the company’s future stock price appreciation.
  • Distinctive Features:
    • Dual nature: Starts as debt but can be converted into equity.
    • Lower interest rate: Typically offer a lower interest rate compared to non-convertible debt due to the conversion option.
    • Potential for capital gains: Holders can benefit if the company’s share price rises above the conversion price.

Financing the Purchase of Ships: Options and Distinctive Features

The shipping industry has unique characteristics that influence ship financing. Ships are very high-value, mobile assets with long lifespans. Here are the common financing options:

1. Equity Financing (for Ship Purchase):

• Issuance of Shares: Shipping companies can raise capital by issuing new ordinary or preference shares, as described earlier.
  • Distinctive Feature: Equity provides a strong capital base, crucial in the cyclical shipping industry where periods of low freight rates can strain finances. However, it dilutes ownership.
• Retained Earnings: Profitable shipping companies can reinvest their earnings to fund vessel acquisitions.
  • Distinctive Feature: A self-funded approach reduces reliance on external financing and associated costs. However, it depends on the company’s profitability and dividend policy.

2. Debt Financing (for Ship Purchase):

• Ship Mortgage Loans: These are loans specifically secured by a mortgage on the vessel.
  • Options:
    • Commercial Bank Loans: Banks with shipping finance expertise provide term loans with repayment schedules tailored to the vessel’s expected earnings and lifespan.
    • Export Credit Agencies (ECAs): Government-backed agencies in shipbuilding nations offer attractive financing terms (lower interest rates, longer tenors) to support their domestic shipbuilding industries.
    • Specialized Shipping Finance Institutions: Some financial institutions focus solely on providing financing to the shipping sector.
  • Distinctive Features:
    • Security: The ship itself serves as collateral, reducing the lender’s risk.
    • Loan-to-Value (LTV) Ratio: Lenders typically finance a portion of the vessel’s value (e.g., 60-80%), requiring the borrower to provide the remaining equity.
    • Covenants: Loan agreements often include covenants (conditions) that the borrower must adhere to, such as maintaining certain financial ratios or insurance coverage.
    • Repayment Structure: Can be structured with balloon payments at the end or amortized over the loan term.
• Shipping Bonds: Larger shipping companies can issue bonds to raise funds from capital markets for fleet expansion.
  • Distinctive Features: Access to a broader investor base, but requires a strong credit rating. Bond covenants can also apply.
• Sale and Leaseback: A shipping company sells a vessel to a financial institution and then leases it back for a long period.
  • Distinctive Features: Frees up capital tied to the vessel while retaining its use. Lease payments are tax-deductible as operating expenses (depending on the lease classification).
• Mezzanine Financing: A hybrid of debt and equity, providing subordinated debt that can often be converted into equity. Can be used to bridge the gap between senior debt and equity.
  • Distinctive Features: Higher interest rates than senior debt but less dilutive than pure equity.

3. Other Specialized Financing Options:

• Bareboat Charter with Purchase Option: A charter agreement where the charterer operates and maintains the vessel and has an option to purchase it at the end of the charter period. This can act as a form of deferred financing.
  • Distinctive Features: Allows the charterer to gain control of the vessel with lower upfront costs, with the possibility of eventual ownership.
• Private Equity and Hedge Funds: These investment firms may provide equity or debt financing to shipping companies, often seeking higher returns.
  • Distinctive Features: Can be a source of substantial capital but may come with specific terms and exit strategies for the investors.
• Joint Ventures: Forming a partnership with another company to jointly acquire and operate a vessel, sharing the investment burden.
  • Distinctive Features: Risk and cost sharing but requires careful coordination and agreement between partners.

The choice of financing for ship purchases depends on factors such as the shipping company’s size, financial health, risk appetite, market conditions, and the specific characteristics of the vessel being acquired. Often, a combination of different financing sources is used to fund large fleet expansions.