LONG TERM FINANCE
Ideal capital structure is composing of mixture of debt and equity finance. Debt is a cheaper source of finance as interest cost is tax deductible, while dividend on equity is taxable. However one cannot opt for exclusive debt finance on account of restriction by lenders and availability of sufficient amount of cash flow to service the debt.
Following are the pros and cons of various long term source of finance. For ideal capital structure one need to evaluate all these options before making the final selection.
COMMON SHARES
Advantages:
- Right to vote
- Right to transfer through sale of shares
- Right of earning
- Limited liability
Disadvantages:
- Least priority in profit
- High cost while floating in public
- Dividend is not tax deductible
PREFERENCE SHARES
Preferred shares with redemption privileges are very similar to debt with a fixed payment each year- the accounting for such shares is to treat them as debt and not equity. Preference shares without redemption privilege are treated as equity.
Advantages:
- Diviend can be differed for future years
- Debt equity ratio may improve
- No dilution of control on account of non-voting power
- No charge on assets like bank loan
Dis-advantages:
- In case of liquidity, last priority but before common shares
- Return is limited and fixed
- No voting right
- Dividend is not tax deductible
BANK LOAN
Advantages:
- Easy form of finance, obtained quickly
- Less costly compare to other finance as interest cost is tax deductible
Disadvantages:
- Have to observe bank convent
- Charge on assets by bank
- Debt to equity ratio may go up
Bonds
Bonds will require regular cash outflows to pay the interest expense but this differs from a loan in that no principal repayments are required before the bond is due. The interest expense is deductible for tax purposes. It will increase debt equity ratio.
Fully Convertible bonds
The fully convertible debentures are comprised of two components: a financial liability with a contractual arrangement to deliver cash at a specified time and an equity instrument where the holder is to convert it into a fixed number of shares at the end of X years. For accounting purposes, it would be required to record the liability and equity components separately. This will impact the debt-to-equity ratio by the amount recorded under each component and could result in a breach of the debt covenant. It will also be required to clearly disclose the specific characteristics of the fully convertible debt in the financial statements.
