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MEANS OF FINANCE

To meet the cost of project, following means of finance are available Share capital Term loans Debenture capital Deferred credit Incentive sources Miscellaneous sources

Share capital There are two types of share capital, equity and preference capital. Equity capital represents contribution made by owners of business, equity share holders, who enjoy the rewards and bear the risk of ownership. Equity capital being risk capital does not carry any fixed rate of dividend. Preference capital represents contribution made by preference share holders and dividend paid is generally fixed. Term loans These are provided by financial institutions and commercial banks are secured borrowings which are very important source (sometimes major source) for financing new projects as well as expansion, modernization and renovation of existing firms. There are two broad types of term loans available in India rupee term loan and foreign currency term loans. While former are given for financing land, building, civil works, indigenous plant and machinery, and so on. The later is provided for meeting foreign currency expenditure towards import of equipment and technical know-how. DEBENTURE CAPITAL It is similar to promissory note. Debentures are primarily instruments of raising debt capital. There are two broad types of debentures, non-convertible and convertible. There are several variations in convertible debenture. Convertible debentures are convertible wholly or partly and optionally or compulsorily into equity shares. The terms of conversion are announced in advance. Non-convertible debentures are straight debt instrument carrying fixed rate of interest and having a maturity of 5 to 9 years. Interest is payable quarterly half-yearly or yearly.

DEFERRED CREDIT Many times suppliers of the plant and machinery offer a deferred credit facility under which payment for purchase of plant and machinery can be made over a period of time. Also many times for development of backward areas, Government offers deferred payment of taxes, which acts a margin for working capital.

INCENTIVE SOURCES The Government agencies may provide financial support as an incentive to certain type of promoters for setting up industrial units in certain locations. These incentive may take form of seed capital assistance (provided at nominal rate of interest to enable the promoter to meet his contribution towards the project), or capital subsidy (to attract industries to certain locations), or tax deferment or exemption (particularly from sales tax) for certain period.

MISCELLANEOUS SOURCES

Some portion of the project finance may come from other sources like unsecured loans, public deposits, leasing and hire purchase finance. Unsecured loan are typically provided by the promoters to bridge the gap between the promoters contribution and the equity capital the promoters can subscribe to. Public deposits represent unsecured borrowings from public at large. Leasing and hire purchase finance represent a form of borrowings different from the conventional term loans and debenture capital.

PLANNING THE MEANS OF FINANCE

Till now we have seen means of finance which can be tapped for a project. How should you go about determining the specific means of finance for a given project? The guidelines and considerations which should be borne in mind for this purpose are as follows:

Norms of regulatory bodies and financial institutions Key business considerations

Norms of regulatory bodies and financial institutions


In some countries the proposed means of finance for a project must either be approved by a regulatory agency or confirm to certain norms laid down by the Government or financial institutions in this regard. The primary purpose of such regulation is to impart discipline to project financing decisions and provide a measure of protection to investors. In addition the norms of financial institutions, which often provide substantial assistance to the project significantly shape and circumscribe the project financing decisions. Key Business Considerations: The Key business considerations which are relevant for project financing decisions are cost, risk, control and flexibility. Cost In general cost of debt funds is lower than cost of equity funds. This is because interest payable on debt capital is tax deductible expense whereas the dividend payable on equity capital is not. Risk two main sources of risk for a firm are : business risk and financial risk. Business risk refers to the variability of EBIT and arises mainly from fluctuations in demand and variability of prices and cost. Financial risk represents risk arising from financial leverage. It must be emphasized that while debt capital is cheap, it is also risky because of fixed financial burden associated with it. Generally the affaires of the firm are, or should be managed in such a way that the total risk borne by equity share holders, which consists of business risk and financial risk is not unduly high. This implies that if the firm is exposed to high degree of business risk, its financial risk should be kept low. On the other hand if firm has low business risk profile, it can assume high degree of financial risk. Control From the point of view of promoters of the project, the issue of control is important. They would ordinarily prefer a scheme of financing which enables them to maximize their control, the current as well as potential, over the affairs of the firm, given their commitment of funds to the project. As the percentage of promoter holding declines the risk of hostile takeover rises. In large projects promoters holding of around 40% is considered healthy.

Flexibility This refers to the ability of a firm to raise further capital from any source it wishes to tap to meet the future financing needs. This provides maneuverability to the firm. In most practical situations, flexibility means that the firm does not fully exhaust its debt capacity. Put differently it maintains reserve borrowing powers to enable it to raise debt capital to meet largely unforeseen future needs.

ESTIMATES OF SALES AND PRODUCTION Starting point of profitability projections is forecast of sales revenue, for which following points should be kept in mind: 1. It is not advisable to assume high level of capacity utilization in the first year of operation. Even if technology is simple and company may not face any technological problems in achieving high rate of capacity utilization in the first year itself, there is likelihood of other constraints like raw material shortage, limited power market for the product, marketing tie-ups etc.. It is sensible to assume that capacity utilization will be low in first year and will gradually rise thereafter to reach maximum level in third or fourth year. A reasonable assumption with respect to capacity utilization should be as under 1st year 2nd year 40-50% 50-70% 70-90%

3rd year onwards -

2. It is not necessary adjustments for stocks of finished goods. For practical purpose it should be assumed that sales will be equal to production. 3. The selling price considered should be the price realizable by the company net of excise duty. 4. Selling price used may be present selling price. It is generally assumed that change in production cost will be proportionately matched by change in selling price. If a portion of production is saleable at controlled price, it should be factored in. Sales and production are closely inter-related. Hence they should be estimated together. For this purpose following format may be used.

ESTIMATES OF PRODUCTION AND SALE Details may be furnished separately for each product until plant reaches maximum capacity utilization.

PRODUCT 1 1ST Yr 1. Installed capacity (qty p.a.) 2. No of working days 3. No. of shifts 4. Estimated production per day (qty) 5. Estimated annual production (qty) 6. Estimated output as % of plant capacity 7. Value of sales ( Rs. In lacs.)

PRODUCT 2 2ND 3RD 4TH yr yr yr

2ND 3RD 4TH 1ST yr yr yr yr

COST OF PRODUCTION Given the estimated production, the cost of production may be worked out. The major components of cost of production are: Material cost Utilities cost Labour cost Factory overhead cost

Materials The most important element of cost, comprising of cost of raw material, additives, components, consumable stores and spares which are required for production. Guidelines for estimation 1. The requirement of various material inputs per unit of output may be established on the basis of following: a) theoretical consumption norms, b) experience of the industry, c) specification of machinery supplier. 2. Total requirement of various input materials can be obtained from the expected output during the year. 3. The prices of input material are considered on CIF basis. 4. The present cost of material is considered ignoring inflation same as in case of sales revenue. 5. Seasonal fluctuations in cost must be considered in estimating cost of input materials. Utilities Utilities consists of Power, water and fuel. The requirement may be determined on the basis of norms specified by collaborator, consultant etc or the consumption standards in the industry, whichever is higher. While cost of power and water can be estimated to great extent, that of fuel is difficult to estimate and hence should be taken on higher side. Labour Labour costs consists of all the manpower employed in the factory. First is estimated the number of staff in various categories that are required. Then by doing detailed analysis total labour cost is estimated. The labour cost may be raised by min 5% per annum. Labour cost is calculated for the year in which the maximum capacity utilization is achieved. For the earlier year when the capacity utilization tends to be low somewhat lower labour cost may be estimate but not proportionately. Factory Overheads - The expenses on repairs and maintenance, rent, taxes, insurance and so on are collectively referred to as factory overheads. Repairs and maintenance expenses depend on the state of machinery and tend to be lower in initial years and higher in later years. Rent, taxes, insurance may be calculated at

existing rates. In addition provision should be kept for meeting miscellaneous factory expenses and contingency margin.

WORKIGN CAPITAL REQUIREMENT AND ITS FINANCING Estimation of working capital and its financing involves following steps 1. Working capital requirement consists of following: i) raw material and components ii) stocks of goods in process iii) stocks of finished goods, iv) debtors, v) operating expenses, and vi) consumable stores. 2. The principle sources of working finance are i) working capital advances provided by Commercial Banks, ii) trade credit, iii) accruals and provisions, iv) long term sources of financing. 3. There are limits to obtaining working capital advances from commercial banks. They are in two forms i) the aggregate permissible bank finance as per lending norms followed by the bank, ii) against each current asset a certain amount of margin money is to be provided by the firm. 4. The Tondon committee has suggested three methods of calculating maximum permissible bank finance for working capital. The method generally employed now is second method which is as under Current assets as per norms x 0.75 non-bank current liabilities like trade credit and provisions The implication of this norm is that at least 25% of current assets must be supported by long term sources of finance.

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