Normally firms issue three types of capital, viz., equity, preference and debenture capital based on the risk, return and ownership pattern.
Equity Capital
Equity shareholders are the owners of the business. They enjoy the residual profits of the company after having paid the preference shareholders and other creditors of the company. Their liability is restricted to the amount of share capital they contributed to the company. Equity capital provides the firm the advantage of not having any fixed obligation for dividend payment but offers permanent capital with limited liability for repayment. However, the cost of equity capital is higher than other capital. Firstly, since the equity dividends are not tax-deductible expenses. Secondly, the high costs of issue. In addition to this since the equity shareholders enjoy voting rights, excess of equity capital in the firm’s capital structure will lead to dilution of effective control.
Entrepreneurs are most likely to give up significant amounts of equity in their businesses in the start-up phase than in any other. To avoid having to give up majority control of their companies early on, entrepreneurs should strive to launch their companies with the smallest amount of money possible.
Preference Capital
Preference Capital is the capital which carries preference over Equity capital at the time of Payment of dividend and at the time of winding up of the company. In other words, the shareholders of a company holding preference share are not the owners of the co. The preference shareholders get fixed percentage of dividend from the profit earned by the company. Also they get preference over equity shareholders during the time of payment of dividend and during the time of winding up of the company.
Other features of the preference capital include the call feature, wherein the issuing company has the option to redeem the shares, (wholly or partly) prior to the maturity date and at a certain price. Prior to the companies Act 1956 companies could issue preference shares with voting rights. However, with the commencement of the companies Act 1956 the issue of preference shares with voting rights has been restricted to only in the following cases:
- There are arrears in dividend for two or more years in case of cumulative preference shares.
- Preference dividend is due for a period of two or more consecutive preceding year or
- In the preceding six years including the immediately preceding financial year, if the company has not paid the preference dividend for a period of three or more years.
Types of preference capital
- Cumulative or Non-cumulative preference shares
- Redeemable or perpetual preference shares.
- Convertible or non-convertible preference shares.
For cumulative preference shares, the dividends will be paid on a cumulative basis, in case they remain unpaid in any financial year due to insufficient profits. The company will have pay up all the arrears of preference dividends before declaring any equity dividends. On the other hand, the non-cumulative shares don’t enjoy such rights to dividend payments on cumulative basis.
Redeemable preference shares will be redeemed after a given maturity period while the perpetual preference share capital will remain with the company forever.
Debenture Capital
A debenture is a marketable legal contract whereby the company promises to pay its owner, a specified rate o interest for a defined period of time and to repay the principal at the specific date of maturity. Debentures are usually secured by a share on the immovable properties of the company.
A trustee usually represents the interest of the debenture holders and this trustee (which is typically a bank or an insurance company or a firm of attorneys) is responsible for ensuring that the borrowing company fulfills the contractual obligations embodied on the contract. If the company issues debentures with a maturity period of more than 18 months, then it has to create a debenture redemption reserve (DRR), which should be at least half of the issue amount before the redemption commences. The company can also attach call and put options. With the call option the company can redeem the debentures at a certain price before the maturity date and similarly the pit option allows the debenture holder to surrender the debentures at a certain price before the maturity period.
The cash flowing from the act of issuing the debenture by the company is called a debenture capital and is different from any other capital in certain unique ways. One of the ways in which a debenture capital differs from items like bank loans is the fact that the remittance of the debenture capital is not hinged on the provision of any type of capital on the part of the company. In such transactions all the company requires is a sterling reputation in the business community, which means that the debenture capital may be described as a sort of unsecured loan.
Type of Debentures
Debentures can be classified based on the conversion and security. A few types of debentures are as follows: –
- Non-convertible Debentures (NCDs) – These debentures cannot be converted into equity shares and will be redeemed at the end of the maturity period.
- Fully Convertible Debentures (FCDs) – These debentures will be converted into equity shares after a specified period of time at one stroke or in installments. These debentures may or may not carry interest till date of conversion. In the case of a fully established company with as established reputation and good, stable market price, FCDs are very attractive to the investors as their bonds are getting automatically converted into shares which may be at time of conversion be quoted much higher in the market compared to what the debenture holders paid at the time of FCS issue.
- Partly Convertible Dentures (PCDs) – These are debentures, a portion of which will be converted into equity share capital after a specified period, whereas the NCD portion of the PCD will be redeemed as per the terms of issue after the maturity period. The non-convertible portion of the PCD will carry interest right up to redemption, whereas the interest on the convertible portion will be only up to the date of immediately preceding the date of conversion.
- Secured Premium Notes (SPNs) – This is a kind of NCD with an attached warrant that has recently started appearing in the Indian market. This was first introduced by TISCO, which issued SPNs aggregating Rs.346.50 crore to existing shareholders on a right basis. Each SPN is of Rs.300 face value. No interest will accrue on the instrument during the first 3 years after allotment. Subsequently, the SPN will be repaid in 4 equal installments of Rs.75 each from the end of the fourth year together with an equal amount of Rs.75 with each installment. This additional Rs.75 can be considered either as interest (regular income) or premium on redemption (capital gain) based on the tax planning of the investor.
The warrant attached to the SPN gives the holder the right to apply for and get allotment of one equity share for Rs.100 per share through cash payment. This right has to be exercised between one and one-and-half year after allotment, by which time the SPN will be fully paid-up.
Apart from these sources by way financial instruments, there are some new financial instruments, like
- Non-voting Shares
- Detachable Equity Warrants
- Participating Debentures
- Participating Preference Shares
- Convertible debenture with options
- Third Party Convertible Debenture
- Mortgage-backed Securities
- Convertible Debentures Redeemable at Premium
- Debt-Equity Swaps
- Zero-coupon Convertible Note.
