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Factors Affecting the Choice of the Source of Funds

Financial requirements of a business are of various types - long term, short term, fixed and fluctuating. Hence, business firms route to many types of sources for raising funds. Short-term borrowings offer the advantage of reduced cost owing to reduction of idle capital, but long - term borrowings are considered as an inevitable requirement on many grounds. Correspondingly, equity capital has a vital role to
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Companies Rush to Float GDR Issues

It's not the IPO (initial public offer) market alone which is humming with activity. Companies - mostly small and medium-sized - are rushing to the overseas market to raise funds through Global Depository Receipts (GDRs). Five firms have already raised $464 million (around Rs 2,040 crore) from the international markets through GDR offerings this year. This is almost double of $228.6 mn raised by nine companies in 2004 and $63.09 mn mobilised by four companies in 2003. Nearly 20 companies are waiting in the wings to launch GDR issues worth over $1 bn in the coming months. On the other hand, though the number of companies going for FCCB (Foreign Currency Convertible Bonds) issues has come down, several companies are still in the FCCB race, thanks to lax rules and disclosure norms. For example, Aarti Drugs Ltd. has decided to raise $12 mn by issuing FCCBs. Significantly, small and medium companies are now taking the GDR route to raise funds this time even for a small amount. For example, Opto Circuits has decided to go for a GDR issue of $20 mn with a green-shoe option of $5 mn. The share price of this company shot up by 370 per cent from Rs 34 on May 17, 2004 to around Rs 160 on the BSE recently. Videocon Industries, Lyka Labs, Indian Overseas Bank, Jubilant Organosys, Maharashtra Seamless, Moschip Semiconductors, and Crew BOS are planning GDR issues. Two banks - UTI Bank ($240 million) and Centurion Bank ($70 million) - raised funds from the GDR market recently. Companies now prefer GDR over FCCB issues in view of the rise in interest rates abroad.

play in raising funds in a corporate sector. As we are aware, no source of funds is devoid of limitations, it is sensible to use a combination of sources, rather than relying only on a single source. There are numerous factors listed below that affect the choice of this combination and make it a very complex decision for the business.
  1. Cost: Here we look at two types of cost viz., the cost of procurement of funds and cost of utilising the funds. Both these costs should be taken into consideration while deciding about the source of funds used by an organisation.
  2. Financial Strength and Stability of Operations: The financial strength of a business also serves as a key determinant. While making the choice of source of funds, business should be financially sound so that the company is able to repay the principal amount and interest on the borrowed amount. When the income/financial position of the organisation is not stable, fixed charged funds like preference shares and debentures should be carefully selected as these add to the financial burden of the organisation.
  3. Form of Organisation and Legal Status: The form of business organisation and status plays a major role in the choice of a source for raising funds. For instance, a partnership firm cannot raise money by issuing equity shares as these can be issued only by a joint stock company.
  4. Purpose and Time Period: Business should plan based on the time period for which the funds are utilized. A short-term need for example can be dealt by borrowing funds at low rate of interest through trade credit, commercial paper, etc. For long term finance, sources such as issue of shares and debentures are more apposite. Correspondingly, the main purpose for which funds are required need to be analyzed so that the source is matched with the utilization of the same.
  5. Risk Profile: Business should analyze every source of finance in terms of the risk involved. For instance, there is minimal risk in equity as the share capital has to be repaid only at the time of disolvency of the company and dividends need not be paid if profits are not generated. A loan on the other hand, has a settlement schedule for both the principal and the interest. It is mandatory to pay the interest irrespective of the profit or loss incurred by the company.
  6. Control: There are certain sources of fund that may affect the control and power of the owners in the management of the company. Issuance of equity shares may lead to dilution of the control. For instance, as equity share holders enjoy voting rights, there are possibilities for the financial institutions to take control of the assets or impose conditions as part of the loan agreement. Thus, it is advisable for a business firm to analyze the extent to which they are willing to share their control over business.
  7. Effect on Credit Worthiness: The credit worthiness in the market is affected by the dependence of business on certain sources. For example, issuance of secured debentures might affect the interest of unsecured creditors of the company and develop chances for an adverse effect and their willingness to extend further loans as credit to the company.
  8. Flexibility and Ease: One another aspect affecting the choice of a source of finance is the flexibility and ease in availing funds. Restrictive provisions, detailed investigation, analysis and documentation in case of borrowings from banks and financial institutions could be the reason for a business organisations to avoid it, if other options are readily available.
  9. Tax Benefits: Various other sources may also be weighed with respect to the tax benefits. For example, as the dividend on preference shares is not tax deductible, interest paid on debentures and loan is tax deductible and may, for this reason opt for seeking tax advantage.
Key Terms
  • Finance Owned capital Fixed capital
  • Working capital Borrowed capital Short term sources
  • Restrictive conditions Long term sources Charge on assets
  • Voting power Fixed charge funds Accounts receivable
  • Bill discounting Factoring GDRs
  • FCCBs ADRs

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