Sources of-finance

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  • 1. Financial Management Assignment SOURCES OF FINANCE Risk and sources of finance A limiting factor in the provision of finance for successful business is that fearful word RISK which is uppermost in every lender/s mind. The extent to which the budding entrepreneur can illustrate to his financial backer that the risk element can be controlled through careful planning and implementation of common sense management procedures, will largely determine the success with which the finance tap can be opened to the benefit of the entrepreneur and the finacier. To achieve this, small businessmen must not only have an understanding of how to reach the sources of finance available to them, but must also know how to capitalize on the use of these sources in order to reduce the risk factor. This Problem Solver will give you some reasonable pointers in this regard. Fundamental to the approach will be the fact that the development of small businesses should be based on sound business principles and disciplines, thereby assisting in the efficiency and profitability of their activities. Obtaining funds – the correct approach When you go to an outfitter to buy a suit, you make sure that it is neither too large nor too small but rather that it fits you perfectly. In the same way, the “financial suit” of your business should fit perfectly or it will cause problems. Whenever possible, long-term assets should be financed by long-term sources of finance. Short- term assets, such as stock and debtors, should be financed by short-term sources of money, e.g. overdrafts. A business can be throttled by having to repay short-term liabilities quickly from the sale of long-term assets which you may not wish to dispose of. Let us look at certain fundamental questions which you should answer in your own mind regarding the obtaining of finance: • Where and when should you look for money for your business? • Is debt good or bad or both? • When you need a loan what should you know before you ask for it? If you were to survey business concerning their major problems, the lack of money would be near the top of many lists. Even a profitable business can run into financial difficulties because debts are repaid by cash flow and not by profits, an important distinction which often escapes many entrepreneurs. Money therefore can be the foundation of the success of a business. It can also lead to problems or failure. Although insufficient funds can close a business, misuse or poor management of money can also contribute to problems. For instance, you may burden yourself with the wrong kind of money or get too much or too little. Another essential factor is to acquire your money at the right time – neither too early nor too late. In a nutshell, to manage the finances of your business successfully you need to do the following: • Recognize when you need funds. • Identify the various sources of funds. • Effectively manage your funds to take full advantage of the least expensive sources. 1
  • 2. Financial Management Assignment Establish an effective financial plan that will take full advantage of all sources without damaging your credit rating or endangering your sources. Diagnosis of your needs The best financing package for your business requires careful planning. An effective plan is based on these questions: • Why do you need money? • How are you going to use your money? • How much money do you need? • How much can you afford to pay for your funds? • How and when will you pay the money back? These questions should be asked before you need money. By planning ahead you will not have to make a last minute rush to get money. Last minute money tends to be more expensive! Understanding your financial needs There are several different ways to solve any financial problem that your business encounters. Running to the bank for a loan may be neither the easiest nor the best solution to your problem. In order to develop the best financial plan to help you to succeed, you need to know two things. Firstly, what sources are available for the money that you need? Secondly, what is the best or the most appropriate source? There are three general categories of funding sources for your business. These are: • Internal Sources. • Equity. • Debt. The first place that you should look is inside your business. Internal sources may be the cheapest and easiest to tap. If your internal sources are not adequate you will need to look at external sources. As stated there are two external sources of funds; the equity of the business and debt. Each of these sources should, inter alia, be considered under the following headings: • Cost – How will the source of funds affect your cash flow/profit? • Risk- Will the source expose your business to danger? • Flexibility – Will the source limit your ability to seek additional funds or use of funds? • Control –Could you lose control of your business or have to share the decision-making because of the source you use? • Availability –When can you acquire the funds? 2
  • 3. Financial Management Assignment INTERNAL SOURCES OF FUNDS There are three sources of funding within your business – profits, customers and suppliers. Profits Profit management and distribution is the first internal funding source. When a business makes a profit, the owners have two choices. They can either take the money out of the business or leave it in the business. Money taken out reduces the capital or equity of the business. However, if the owner chooses to leave the profits in the business, the capital increases and can be used to finance the expansion of the business. Even more important, in inflationary times, these retained profits can be used to offset the increased replacement costs of both current and fixed assets. Profits are like the interest on a savings account. If you take the interest out of your savings account every year, the balance of the account will grow only if you add more money. However, if you leave the interest in the account, then it starts to compound and your account balance grows faster. As an internal source of finance, assets and liability management must also be carefully watched. If an item is stock is a slow mover, you may wish to sell it at a discount and stop ordering it. You might also consider selling some of your fixed assets in favour of a less costly alternative in order to generate cash. For example, it might be cheaper to reimburse your employees for the use of their personal cars rather than buy or lease vehicles for the business. For an example of liabaility management see details under the heading “Suppliers Credit”. Customers You can raise money from your customers by expediting your collections from them. If you can get money moving into your business faster, you will have more available for your needs. For instance, if your customers pay you quickly, you will have the cash necessary to take advantage of cash or quantity discounts. These discounts can reduce the cost of your merchandise and thereby increase your profits. You can increase customer collections in two ways. Firstly, you can encourage partial payments on long term projects where appropriate. Secondly, you can put an aggressive credit collection policy into effect. This should reduce the number of bad debts that you might acquire as well as encourage your customers to pay their debts quickly. Both of these methods will increase your cash flow. Suppliers’ credit This is an excellent source of low –or no-cost money. Suppliers may be willing to extend interest- free credit on purchases of goods or services to well established customers. This means that you may be able to order, obtain delivery, and sell an item before you have to pay for it. This is the same as an interest free loan. To keep this source available to you, however, it is essential that you build and safeguard your relationships with your suppliers carefully. Summary The risk involved in using internal sources is normally very low. However, you must be alert to do some dangers. For example, you need to be careful that you do not alienate your customers with an overly aggressive credit policy. Also, you should not convert to cash those that are productive and necessary for the effective operation of your business. Your stock has to be broad enough to 3
  • 4. Financial Management Assignment satisfy normal customer demand. Internal sources thus give maximum flexibility, as long as they are used carefully. Finally, it should be noted that the availability of internal funds depends on circumstances and you may need to supplement with external funds. However, the firm that makes full use of its internal funds by carefully managing all of its assets and controlling its costs will find that it is much more attractive to external sources of funds. This should make it easier to raise money when it is needed. EXTERNAL SOURCES OF FUNDS Equity Equity is one of the two external funding sources available to you. Equity funds are those generated by the invested capital of a firm. The best source of start-up funds is equity and if you do not have the funds available personally, you should look to other sources such as partners, co- members in a close corporation, or co-shareholders in a private company. Of course, if you want to “go it alone” or cannot find willing investors, you may need to resort to borrowing (debt). Remember, however, that you will encourage financial backing from outsiders if you show that you are making an adequate financial contribution yourself. One of the causes of applications for finance being rejected is the failure by the owners of the business to make an adequate personal capital contribution. Your potential financial backer may regard this as lack of commitment. Borrowing (debt) The prospects of a small business depend almost entirely on the ability, energy and character of the person in charge. Whoever supplies the business with debt finance is in fact risking his capital on the accuracy of his judgement of the personal capacity of the owner of the business. Thus, however good the small business manager may be, only those who have had the opportunity to become closely acquainted with him are likely to have the necessary confidence to entrust him with their money. The amount of cash required by you is likely to be raised in direct proportion to your finacier’s willingness to invest based on his assessment of your training, experience, expertise, etc. Every financier will have his own individual approach to the client, but if one takes the average bank manager as an example, one thing is certain: the banker regards his relationship with his client as a partnership and, like all good partners, he is trying to be as difficult as possible or to make the maximum amount of money out of his customer. The banker knows that success is dependant upon the success of his client and the building of a long term relationship between the bank and the client and the building of a long term relationship between the bank and the client. With this in mind, the relationship with your banker should be one of complete honesty. Always keep your bank manager informed – if things are going wrong, tell him; if things are going right, also tell him! In this way both parties will be better equipped to make progress into the future. 4
  • 5. Financial Management Assignment SHORT –TERM SOURCES OF DEBT FINANCE The most common forms are: Bank overdraft This is probably the most available and appropriate source of short-term borrowings. Subsequently to negotiation, the bank allows the borrower to overdraw his account up to a specified limit, which is reviewed on a regular basis, normally annually. This gives the entrepreneur the flexibility of altering his financing requirements from day to day according to his cash flow. With overdrafts, interest is calculated on the daily outstanding balance. This means that no interest is paid on any unutilized portion of the facility. Interest rates charged fluctuate with the prime rate and this facility is generally used for financing increases in working capital. However, it is also useful when bridging finance is required where a gap exists between a long-term debt and the long- term source of finance becoming available. It is important to realize that bank overdrafts are repayable on demand. Factoring Factoring is a term referring to the raising of funds by the sale or assign-ment of book debts to a third person i.e. a factor. The sale is normally with recourse to the “seller” for uncollectable debts. It may include all or some of the debts sold. The system may require the debtor to pay direct to the factor or via the original creditor as an agent for the factor, and completes the transaction as agent of the factor. This latter method has the advantage of maintaining the confidentiality of the arrangement between the seller and the factoring house. Factoring is a very convenient method of financing shortages in working capital and is frequently an attractive proposition to a new business faced with a substantial growth in sales which need to be financed. However, one needs to ensure that gross income margins generated by these sales can satisfactory absorb the costs of the factoring procedure. An additional advantage of factoring accrues to the seller by the possible savings in staff and paperwork associated with maintaining accounts and monitoring debtors. Furthermore, cash is received immediately and the seller is not obliged to include a discount for prompt payment. Most banks have factoring divisions. Shippers finance A shipper (or customer) is a financial institution which provides finance and a host of other services to its clients.Today, the functions of the confirming houses take the following basic forms: • Providing working capital:The confirmer provides facilities to clients, to create additional working capital and enable the client to finance his stock and receivables. Sophisticated forms of finance are provided which can briefly be summarized into three broad categories: • An overseas purchase facility. • A local purchase facility. • The discounting of customers’ bills. • Providing services:The confirmer attends to the physical handling of the goods and the documentation relative thereto, and provides specialized services in order to expedite receipt and reduce the cost of imports into South Africa. • Providing backing, assistancr and financial expertise:The confirmer backs and assists the client with the technical and credit expertise that the confirming house’s management possesses, thereby increasing profitability and thus helping companies to grow from small to large organizations. 5
  • 6. Financial Management Assignment MEDIUM-TERM SOURCES OF DEBT FINANCE In financial language, ‘medium-term’ can be thought of as constituting a broad and ill-defined border between short-term and long-term. As a result, this type of finance has a variety of applications such as financing additional working capital, acquisition of fixed assets, etc. Medium-term loans A common form of finance is the “medium-term loan” which normally provides finance for up to five years and in accordance with a strict set of conditions outlined in a term loan letter of offer by the financial institution and accepted by the client. Generally the lender will require security for the loan and seek to entrench the safety of the loan by imposing certain restrictions on the borrower, such as maximum permissible equity to debt and working capital ratios, and limitations on the sale or pledge of assets and payment of dividends. Term loans are normally tailored to meet the particular cash flow requirements of a business. They are used for the finance of both current assets and fixed assets. Instalment sale Previously known as Hire Purchase, the most common application is to finance the acquisition of vehicles or equipment. In terms of the regulations in the Credit Agreements Act, a deposit is normally required and, depending on the acquisition, the period for payment is fixed. The goods purchased are registered in the owner’s name and are always taken as prime security for the debt. Leasing Leasing is a method of reducing capital funding requirements. Instead of acquiring finance to purchase fixed assets, the process is cut short by obtaining the use but not ownership of the required assets in return for a periodic lease payment. Leasing, based on the principle that income is earned from the use of an asset, not the ownership, provides the following advantages: Cash resources may be released for more profitable trading and for the provision of working capital. Maintenance costs are reduced to a minimum by immediate replacement with new equipment at the end of the lease period. Plant and equipment are financed over a period directly related to their productive capacity and useful life. Budgeting is simplified, as the monthly cash flows are known, as is the date when the equipment must be replaced. Rental payments are deducted in full for tax purposes. These payments are a charge against profits before tax, whereas Instalment sale payments are paid out of income after tax. 6
  • 7. Financial Management Assignment LONG-TERM SOURCES OF FINANCE Long-term debt finance Into this category fall building societies and insurance companies. Insurance company policy holders can, under certain conditions, borrow money against the surrender value of their policies and this may be one way of raising capital for the new venture of your choice. Building societies, on the other hand, may be open to entertaining your proposal for long-term loan against the security of your private residence. These funds could then be injected into your business. Participation bonds Bond finance for up to 20 years can be arranged for the erection of commercial/industrial property or against commercial/industrial premises owned by you. No capital (i.e. interest only) is repaid for the first five years. Thereafter the loan is repaid in annual instalments. For bond purposes the value of the property is based on its revenue-producing potential and not on the replacement or intrinsic value of the property. The long-term sources of finances can be raised from the following sources: • Share capital or Equity Share. • Preference shares. • Retained earnings. • Debentures/Bonds of different types. • Loans from financial institutions. • Loan from State Financial Corporation. • Loans from commercial banks. • Venture capital funding. • Asset securitisation. • International Conclusion As you negotiate for your financial needs, remember that self-confidence and realisms will play an important part in your negotiating ability with financiers. Success or failure of your plans will ultimately rest with you. Finally, bear in mind that financial institutions are eager to put their money into enterprises which point to successful growth. Capitalize on this to your long-term benefit! 7
  • 8. Financial Management Assignment DIVIDEND Definition: Dividend is the distribution of value to shareholders. Dividend Policy: What happens to the value of the firm as dividend is increased, holding everything else (capital budgets, borrowing) constant. Thus, it is a trade-off between retained earnings on one hand, and distributing cash or securities on the other. Dividends are payments made by a corporation to its shareholder members. It is the portion of corporate profits paid out to stockholders. When a corporation earns a profit or surplus, that money can be put to two uses: it can either be re-invested in the business (called retained earnings), or it can be paid to the shareholders as a dividend. Many corporations retain a portion of their earnings and pay the remainder as a dividend. Joint stock Company, a dividend is allocated fast as a fixed amount per share. Therefore, a shareholder receives a dividend in proportion to their shareholding. For the joint stock company, paying dividends is not an expense; rather, it is the division of an asset among shareholders. Public companies usually pay dividends on a fixed schedule, but may declare a dividend at any time, sometimes called a special dividend to distinguish it from a regular one Cooperatives, on the other hand, allocate dividends according to members' activity, so their dividends are often considered to be a pre-tax expense. SETTLEMENT OF DIVIDEND Dividends are usually settled on a cash basis, as a payment from the company to the shareholder. They can take other forms, such as store credits (common among retail consumers' cooperatives) and shares in the company (either newly-created shares or existing shares bought in the market.) Further, many public companies offer dividend reinvestment plans, which automatically use the cash dividend to purchase additional shares for the share holders. TYPES OF DIVIDEND Cash dividend: It takes various forms 1. Regular cash dividend – cash payments made directly to stockholders, usually each quarter 2. Extra cash dividend – indication that the “extra” amount may not be repeated in the future 3. Special cash dividend – similar to extra dividend, but definitely won’t be repeated 4. Liquidating dividend – some or all of the business has been sold Stock Dividends: 1. Pay additional shares of stock instead of cash. 2. Increases the number of outstanding shares. 3. Small stock dividend a. Less than 20 to 25% 8
  • 9. Financial Management Assignment b. If you own 100 shares and the company declared a 10% stock dividend, you would receive an additional 10 shares 4. Large stock dividend– more than 20 to 25% PROCEDURE OF ISSUING DIVIDEND 1. Declaration Date – Board declares the dividend and it becomes a liability of the company. 2. Ex-dividend Date a. Occurs two business days before date of record b. If you buy stock on or after this date, you will not receive the dividend c. Stock price generally drops by about the amount of the dividend 3. Date of Record – Holders of record are determined and they will receive the dividend payment 4. Date of Payment – cheques are mailed FACTORS AFFECTING DIVIDEND POLICY Several factors must be considered when establishing a firm’s dividend policy. These include • The liquidity position of the firm – just because a firm has income doesn’t mean that it has any cash to pay dividends. • Need to repay debt – oftentimes there are negative covenants that restrict the dividends that can be paid as long as the debt is outstanding. • The rate of asset expansion – the greater the rate of expansion of the firm, the greater the need to retain earnings to finance the expansion. • Control of the firm – if dividends are paid out today, equity may have to be sold in the future causing a dilution of ownership. • Legal Considerations: ✔ Technically, it is illegal to pay a dividend except out of retained earnings. This is to prevent firms from liquidating themselves out from underneath the creditors. ✔ Internal Revenue Service Section 531 – Improper Accumulation of funds. This is to prevent individuals from not paying dividends in order to avoid the personal income taxes on the dividend payments. TYPES OF DIVIDEND POLICY • Constant Payout Ratio • Constant Dollar Dividend Policy • Regular with Extras The Dividend policy is explained with and example as follows. 9
  • 10. Financial Management Assignment India Ltd., Dividend Policy: I.DECLARATION DIVIDEND SHALL BE DECLARED OR PAID ONLY OUT OF - i) Current Year’s profit a) After providing for depreciation in accordance with law b) After transferring to the reserves such amount of Profit as may be prescribed, or ii) The Profits for any previous financial year(s) a) After providing for depreciation in accordance with law,and b) Remaining undistributed, or iii) out of i) & ii) both II. LOSSES Before declaring any dividend, * the losses, if any, of any previous year(s) must be set off * against the profits of the Company for the current year or previous years. III. DECLARATION OF DIVIDEND OUT OF RESERVES - Board should avoid the practice of Declaration of Dividend out of Reserves. IV. AMOUNT OF DIVIDEND 1. Board shall endeavor to maintain the Dividend Payout Ratio.* (Dividend/ Net Profit for the year) as near as possible to 50% subject to a. Company’s need for Capital for its growth plan b. Positive Cash Flow * To be reviewed every 2 to 3 years. V. FACTORS TO BE CONSIDERED BEFORE DECLARING DIVIDEND. 1. Plough back of profits i. e. future capital expenditure programme including a) New project b) Expansion of capacities of existing units c) Renovation/ Modernisation d) Major Repairs & Maintenance 2. Likelihood of crystallization of contingent liabilities, if any 3. Contingency Fund 4. Acquisition of brands/ businesses 5. Sale of brands/ businesses. VI) TIMING 1) Interim Dividend - Board to declare - Based on review of profits earned during the current year - to date - one to three times a year 2) Final Dividend - Board to recommend to members for their approval - Based on review of profits arrived at as per audited financial statements, for the year - Max. once in a year. 10
  • 11. Financial Management Assignment BONUS SHARE Definition: A bonus share is a free share of stock given to current shareholders in a company, based upon the number of shares that the shareholder already owns. While the issue of bonus shares increases the total number of shares issued and owned, it does not increase the value of the company. Although the total number of issued shares increases, the ratio of number of shares held by each shareholder remains constant. An issue of bonus shares is referred to as a bonus issue. Depending upon the constitutional documents of the company, only certain classes of shares may be entitled to bonus issues, or may be entitled to bonus issues in preference to other classes. A bonus issue (or scrip issue) is a stock split in which a company issues new shares without charge in order to bring its issued capital in line with its employed capital (the increased capital available to the company after profits). This usually happens after a company has made profits, thus increasing its employed capital. Therefore, a bonus issue can be seen as an alternative to dividends. No new funds are raised with a bonus issue. Unlike a rights issue, a bonus issue does not risk diluting your investment. Although the earnings per share of the stock will drop in proportion to the new issue, this is compensated by the fact that you will own more shares. Therefore the value of your investment should remain the same although the price will adjust accordingly. The whole idea behind the issue of Bonus shares is to bring the Nominal Share Capital into line with the true excess of assets over liabilities. Whether Bonus shares are miraculous? Few things match the sheer joy of getting a fat bonus at work. That is what shareholders of a good company feel when their company decides to throw a few shares (free of cost) in their direction. Here’s explaining what bonus shares are all about and why investors like investing in such companies. Free shares are given to you and are called bonus shares. Make money with shares. They are additional shares issues given without any cost to existing shareholders. These shares are issued in a certain proportion to the existing holding. So, a 2 for 1 bonus would mean you get two additional shares -- free of cost -- for the one share you hold in the company. If you hold 100 shares of a company and a 2:1 bonus offer is declared, you get 200 shares free. That means your total holding of shares in that company will now be 300 instead of 100 at no cost to you. Bonus shares are issued by cashing in on the free reserves of the company. The assets of a company also consist of cash reserves. A company builds up its reserves by retaining part of its profit over the years (the part that is not paid out as dividend). After a while, these free reserves increase, and the company wanting to issue bonus shares converts part of the reserves into capital. What is the biggest benefit in issuing bonus shares is that its adds to the total number of shares in the market. Say a company had 10 million shares. Now, with a bonus issue of 2:1, there will be 20 million shares issues. So now, there will be 30 million shares. This is referred to as a dilution in equity. Now the earnings of the company will have to be divided by that many more shares. Since the profits remain the same but the number of shares has increased, the EPS (Earnings per Share = Net Profit/ Number of Shares) will decline. Theoretically, the stock price should also decrease proportionately to the number of new shares. But, in reality, it may not happen. A bonus issue is a signal that the company is in a position to service its larger equity. What it means is that the management would not have given these shares if it was not confident of being able to increase its profits and distribute dividends on all these shares in the future. A bonus issue is taken as a sign of the good health of the company When a bonus issue is announced, the company also announces a record date for the issue. The record date is the date on which the bonus takes effect, and shareholders on that date are entitled to the bonus. After the announcement of the bonus but before the record date, the shares are referred to as cum-bonus. After the record date, when the bonus has been given effect, the shares become ex- bonus. 11
  • 12. Financial Management Assignment ISSUE OF BONUS SHARES Bonus shares are issued by converting the reserves of the company into share capital. It is nothing but capitalization of the reserves of the company. There are some conditions which need to be satisfied before issuing Bonus shares: 1) Bonus shares can be issued by a company only if the Articles of Association of the company authorizes a bonus issue. Where there is no provision in this regard in the articles, they must be amended by passing special resolution act at the general meeting of the company. 2) It must be sanctioned by shareholders in general meeting on recommendations of BOD of company. 3) Guidelines issue by SEBI must be complied with. Care must be taken that issue of bonus shares does not lead to total share capital in excess of the authorized share capital. Otherwise, the authorized capital must be increased by amending the capital clause of the Memorandum of association. If the company has availed of any loan from the financial institutions, prior permission is to be obtained from the institutions for issue of bonus shares. If the company is listed on the stock exchange, the stock exchange must be informed of the decision of the board to issue bonus shares immediately after the board meeting. Where the bonus shares are to be issued to the non-resident members, prior consent of the Reserve Bank should be obtained. Only fully paid up bonus share can be issued. Partly paid up bonus shares cannot be issued since the shareholders become liable to pay the uncalled amount on those shares. It is important to note here that Issue of bonus shares does not entail release of company’s assets. When bonus shares are issued/credited as fully paid up out of capitalized accumulated profits, there is distribution of capitalized accumulated profits but such distribution does not entail release of assets of the company. ISSUE OF BONUS SHARES BY PUBLIC SECTOR UNDERTAKINGS It has come to the notice of the Government that a number of Central Government Public Sector Undertakings are carrying substantial reserves in their balance sheets against a relatively small paid up capital base. The question of the need for these enterprises to capitalize a portion of their reserves by issuing Bonus Shares to the existing shareholders has been under consideration of the Government. The issue of Bonus Shares helps in bringing about at proper balance between paid up capital and accumulated reserves, elicit good public response to equity issues of the public enterprises and helps in improving the market image of the company. Therefore, the Government has decided that the public enterprises, which are carrying substantial reserves in comparison to their paid up capital sold issue Bonus Shares to capitalize the reserves for which the certain norms/conditions and criteria may be followed and fulfilled. There are some SEBI guidelines for Bonus issue which are contained in Chapter XV of SEBI( Disclosure & Investor Protection) Guidelines, 2000 which should be followed in deciding the correct proportion of reserves to be capitalized by issuing Bonus Shares. Private sector banks, whether listed or unlisted, can also issue bonus and rights shares without prior approval from the Reserve Bank of India. Liberalising the norms for issue and pricing of shares by private sector banks, the RBI said that the bonus issue would be delinked from the rights issue. However, central bank approval will be required for Initial Public Offerings (IPOs) and preferential shares. These measures are seen as part of the RBI's attempt to confine itself to banking sector regulation and leave the capital market entirely to the SEBI. Under the guidelines, private sector banks have also been given the freedom to price their subsequent issues once their shares are listed on the stock exchanges. The issue price should be based on merchant bankers' recommendation, the RBI has said. It means though RBI approval is not required but pricing should be as per SEBI guidelines. The RBI, however, clarified that banks will have to meet SEBI's requirements on issue of bonus shares. As per current regulations, private sector banks whose shares are not listed on the stock exchange are required to obtain prior approval of the RBI for issue of all types of shares such as public, preferential, rights or special allotment to employees and bonus. Banks whose shares are 12
  • 13. Financial Management Assignment listed on the stock exchanges need not seek prior approval of the RBI for issue of shares except bonus shares, which was to be linked with rights or public issues by all private sector banks. BONUS ISSUE & SEBI GUIDELINES The SEBI has issued guidelines for Bonus issue which are contained in Chapter XV of SEBI ( Disclosure & Investor Protection) Guidelines, 2000. A company issuing Bonus Shares should ensure that the issue is in conformity with the guidelines for bonus issue laid down by SEBI (Disclosure & Investor Protection) Guidelines, 2000. It is a detailed guideline which talks about that the bonus issue has to be made out of free reserves, the reserves by revaluation should not be capitalized. Bonus issue should not be made in lieu of dividend. There should be no default in respect to fixed deposits. Bonus issue should be made within 6 month from date of approval. This is not exhaustive but a lot of things are more in the guidelines regarding this. Bonus issue vis-à-vis Share split There is much hair-splitting on the relative benefits of a bonus issue vis-à-vis a share split. An investor with a short-term outlook may benefit by a split, while one willing to wait may prefer a bonus issue. - Laxmikant Gupta A few years ago, corporate action relating to existing shares was relegated to mainly dividends, rights issues and bonus issues. Now a days splitting of shares has become a common phenomenon. What a stock split does is divide each of the existing shares into a number of shares of a lower value. Unlike in the case of a bonus issue, the existing shares are converted into new shares of a lower value. In a bonus issue, additional new shares are allotted to the shareholder; the existing shares continue as they are, and there is no change in their face value. The news about bonus issues or share splits is normally received positively by shareholders. Bonus or split in units is normally done when the Net Asset Value of the fund is at respectable levels. Similarly, normally, corporates announce bonus or split when the share price goes to a respectable level and the management sees bright prospects for profitability and net worth. With splitting of paid-up capital allowed, corporate started doing it without touching the reserves. This way they could limit the paid-up capital value even while increasing the liquidity of shares in the market, which is always desirable. The Balance-Sheet perspective Rewarding by bonus shares means actual capitalization of reserves. Rewarding by split does not mean anything from the balance-sheet perspective. It only increases the liquidity of stock by reducing the paid-up capital. If the corporate comes up with further new share issues, by way of private placement, the lower base of the paid-up capital and the higher percentage stake of new investors can be attractive features if the capital has only been split. If expanded by bonus shares, then, the existing shareholders would already have a higher stake vis-à-vis further new issue size. Of course, the equity dilution will be lower in that case. As per Section 55 of The Income-Tax Act, 1961 bonus shares entail zero costs while all the purchase cost can be loaded on to the original shares. For bonus shares, the one-year holding requirement for Long-Term Capital Asset (LTCA) eligibility starts from the allotment date of bonus shares. In the case of split, the one-year eligibility is along with the original form of capital, which is split. In other words, the one-year does not start on the split date but on the date of purchase of original shares. When does the shareholders benefit - by bonus or by split? For a long-term investor, neither option makes a difference. Relative benefit on either option may get neutralised over time. In case of further shares issue by way of private placement, the equity dilution may be less had shareholders been rewarded with bonus issues. However, much depends on the pricing and the premium parts of the issue. An investor with a short-term outlook may benefit by a split rather than a bonus issue. Shares after split are recognised as LTCA if originally these have been held for one year. However, in the case of bonus issues, the new shares need to be held for one year to become LTCA. Periodic bonus announcements show up the real strengths of a company in building up reserves, in its profit model and, of course, in the intention to reward. Further, splitting is more beneficial to short-term stakeholders, while bonus shares are more for long-term stakeholders. Bonus Issue & Taxation: For some years now, the issue of bonus equity shares has been a common phenomenon on the Indian bourses. However, one reads about other types of bonuses being issued by companies to 13
  • 14. Financial Management Assignment shareholders. While some issue bonus dividends, while others proposes to issue bonus preference shares. The big question: what will be the tax treatment of the different types of bonuses, and which is more beneficial? To get a grip on the tax treatment, one needs to understand two provisions in the tax laws: the definition of dividend, and the manner of computing capital gains in respect of bonus issue of securities. .Bonus dividends: This is a one-time dividend given on a particular occasion through the issue of dividend warrants (cheques). The company pays this out of its post-tax profits, and, therefore, does not get any deduction from its taxable income. Bonus debentures: Since bonus debentures are covered by the definition of dividends due to their specific inclusion, shareholders will have to pay tax on the capital value of the debentures they get. Further, since bonus debentures are issued out of the post-tax profit accumulated by the company, the company does not get any deduction for the value of the debentures that have been issued. In subsequent years, when the debentures are either sold or redeemed, the sale price or the redemption amount received by the debenture holder will not be taxable to the extent of the capital value of the debentures already taxed as dividend in the year of the issue of the bonus debentures. A view is however possible that, the issue of bonus debentures is also covered by the provisions relating to taxation of capital gains on the sale of bonus issues, since it involves the allotment of a security (debenture) without any payment. Since it is covered under two different provisions of law, the provision that is more specific to the case will be applicable. Again, since the definition of dividends has a specific reference to the distribution of debentures to shareholders, the more acceptable view is that the issue of bonus debentures should be regarded as dividends, rather than be covered by the provisions relating to capital gains from bonus issues.In subsequent years, when the company pays interest on the debentures, the company is allowed a deduction for this while computing its taxable income; the interest is taxable as the income of the debenture holders who receive it. Therefore, where bonus issues of debentures are concerned, they are not tax-efficient at the time of issue, but are subsequently tax-efficient over the life of the debentures. Bonus issues of preference shares: The issue of such a bonus to equity shareholders does not involve any distribution of assets by the company to shareholders, nor is it otherwise specifically included in the definition of dividends. Such bonus issues will, therefore, be governed by the provisions relating to capital gains from bonus issues, and will not be taxed as dividends. Therefore, at the time of the issue of bonus preference shares, neither is the shareholder taxed, nor does the company get a deduction from its taxable income for the value of the bonus preference shares. When the bonus preference shares are finally sold by the shareholder or redeemed, the cost of the preference shares is to be taken as nil, and the entire sale/redemption proceeds taxable as capital gains in the shareholder’s hands. In subsequent years, however, preference dividends declared by the company are taxable as dividend income in the shareholder’s hands; on the company’s part, the dividend has to be distributed out of its post-tax profits, for which it does not get any deduction from its taxable income. Therefore, this is tantamount to double taxation of the company’s profits in subsequent years, since the company pays tax on its profits, while the shareholder pays tax on the distributed profits received as preference dividends. Bonus issues of preference shares are, therefore, tax-efficient in the year of allotment, but not so over the subsequent life of the preference shares. Therefore, in the current scenario, bonus preference shares are more beneficial from a shareholder’s tax perspective when compared with bonus debentures. However, when we compare the situation over the subsequent life of the preference shares or debentures, debentures prove to be more tax- friendly. Capital v/s Revenue Expenditure: Fusion & Confusion: It is said that India has the most complex Income-tax legislation. The tax system bristles with complexities and uncertainties. Consequent upon this there are problems of evasions and avoidance. As such, let us probe two fiercely debated concepts of taxation laws i.e. Capital & Revenue Expenditure which is very much relevant mentioning here. These two propositions are rays with different wave-lengths but from the same source. While the former is susceptible to tax being more extensive, the latter is advantageous to assessee. This is being done with regard to the issuance of bonus shares but simultaneously dealing with other tests mechanism. The controversy was whether the expenditure incurred by the assessee Company on account of issue of bonus shares was Revenue Expenditure or a Capital Expenditure. This was remotely connected with Section 37 of The Income Tax Act, 1961 and Section 75 (1)(c)(I) of the 14
  • 15. Financial Management Assignment Companies Act, 1956. On this issue, there was a conflict of opinion between the High Courts of Bombay & Calcutta on the one hand and Gujarat & Andhra Pradesh on the other. The Bombay and Calcutta High Courts were of the view that the expenses incurred in connection with bonus shares is a revenue expenditure whereas Gujarat and Andhra Pradesh High courts have taken a contrary view and have ruled that the expenses incurred in connection with the bonus shares is in the nature of capital expenditure because it expanded the capital base of the Company. This matter went to the Apex Court in the case of CIT, Mumbai v. General Insurance Corporation. In the instant case before their Lordships the assessee Company had during the concerned accounting year - incurred expenditure separately for the increase of its authorised share capital and the issue of bonus shares. The assessee being unsuccessful at various forums finally went to the Supreme Court on the second category i.e. the nature of expenditure incurred in the issuance of bonus shares. In Empire Jute Company Ltd v. CIT Supreme Court laid down the test for determining whether a particular expenditure is revenue or capital expenditure. It was observed that there was no all- embracing formula, which could provide ready solution to the problem, and that no touchstone had been devised. It laid down that every case had to be decided on its own canvass keeping in mind the broad picture of the whole operation in respect of which the expenditure has been incurred. The Apex Court endorsed the text laid down by Lord Cave, LC, in Altherton v. British Insulated and Helsby Cables Ltd. In this case it was observed that when an expenditure was made, not only once and for all but with a view to bringing into existence an asset of advantage for the enduring benefit of a trade then there was a very good reason for treating such an expenditure as properly attributable not to Revenue but to Capital. This brings us to the crux of the problem. One of the arguments that could be advanced is that the expenses incurred towards issue of bonus shares conferred an enduring benefit to the Company, which resulted in an impact on the capital structure of the Company, and in that perception it should be regarded as capital expenditure. Conversely, the issuance of bonus shares by capitalisation of reserves was merely reallocation of a company’s fund and there was no inflow of fresh funds or increase in the capital employed which remained the same therefore did not result in conferring an enduring benefit to the Company and therefore the same should be regarded as revenue expenditure. The “enduring benefit” is of paramount importance while examining the rival contentions with which these two concepts are interwoven. There is also no unanimity in verdicts of various High Courts. In the back ground, the Supreme Court laid down the test whether a particular expenditure was Revenue or Capital in Empire Jute Company Ltd. v. CIT whereas the cases of Karnataka and Gujarat High Court dealt with the issuance of fresh shares and therefore the ratio decidendi of these courts did not apply to the issuance of bonus shares. However, the view as taken appears to be as laying down correct law. The Supreme Court did not agree with the observation of learned author A. Ramaiya which was of the view that while issuing bonus shares a Company converts the accumulated large surplus into Capital and divides the Capital among the members in proportion to their rights. The learned author felt that the bonus shares went by the modern name “Capitalisation of Shares”. The Apex Court has, therefore, marshalled the entire arithmetic and chemistry of the two very important propositions of the taxation law i.e. Capital expenditure and Revenue expenditure and made over a conceptual clarity by reiterating the evolved principle of “enduring benefit” vis-à-vis reallocation of a Company’s fund. The court has also laid down acid test for determining these two contingencies although the occasion was the event of issuance of bonus shares. The Capital expenditure is expenditure for long-term betterments or additions. This expenditure is in the nature of an investment for future chargeable to capital asset account whereas revenue expenditure is incurred in the purchase of goods for resale, in selling those goods and administering and carrying of the business of the Company. The free wheeling dissections by the Apex Court in Commissioner of Income Tax v. General Insurance Corporation of the various limbs of these twin concepts has cleared much of the haze. The Court held that the expenditure incurred in connection with the issuance of bonus shares is in the nature of revenue expenditure. The Bench said “the issue of bonus shares by capitalization of reserves is merely a reallocation of company’s funds. There is no inflow of fresh funds or increase in the capital employed, which remains the same. If that be so, then it cannot be held that the Company has acquired a benefit or advantage of enduring nature. The total funds available with the company will remain the same and the issue of bonus shares will not result in any change in the capital structure of the company. Issue of bonus shares does not result in the expansion of capital base of the company.” Conclusion: The economy is booming, the markets are buoyant, and Indian companies are increasing their profitability. Consequential of all this, many companies have announced issues of bonus shares to their shareholders by capitalizing their free reserves this year. In this bullish market, shareholders have benefited tremendously, even after accounting the inevitable reduction in share prices post- 15
  • 16. Financial Management Assignment bonus, since the floating stock of shares increases. The whole purpose is to capitalize profits. We can say that Bonus shares go by the modern name of “Capitalisation Share”. Fully paid bonus shares are not a gift distributed of capital under profit. No new funds are raised. Earlier there was also a lot of confusion & chaos between the two fiercely debated concepts of taxation laws i.e. Capital & Revenue Expenditure which was finally settled after the case which come up in SC in 2006, named Commissioner of Income Tax v. General Insurance Corporation. Now it is also settled law that a bonus issue in the form of fully paid share of the company is not income for the Income Tax purpose. The undistributed profit of the company is applied and appropriated for the issue of bonus shares. Webilography: • http://www.businesscentral.co.za/businesstips/sourcesfinance.htm • http://www.legalserviceindia.com/article/l204-Issue-of-Bonus-Shares.html • http://group.tnt.com/investors/shareinformation/dividendguidelines/index.aspx • http://www.caclubindia.com/experts/experts_message_display.asp?group_id=34531 • http://www.rbi.org.in/Scripts/ECMUserParaDetail.aspx?Id=100&CatID=14 • http://www.investorwords.com/5425/bonus_share.html • http://en.wikipedia.org/wiki/Special:Search?search=dividend+policies&go=Go • http://www.stockmarketindia.net/reliance-power-bonus-shares-free-for-all- shareholders/ 16