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Debt Financing — Transcript

by NPTEL-NOC IITM · 3,721 words · 583 segments · language en · Watch on YouTube

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0:04[music]
0:17[music]
0:20>> Welcome.
0:22Welcome to banking and finance law
0:24school.
0:26This is the third week. This week we are
0:28discussing kinds of financing. As part
0:32of it, we will discuss debt finance in
0:34the 12th session now.
0:37This week, while we have discussing
0:39different kinds of finance, we have
0:41discussed about kinds of debt finance in
0:44the previous class and we are continuing
0:46our discussion about kinds of debt
0:49finance in this class.
0:51Now, debt is obtained by mortgaging
0:54immovable property. In the previous
0:56class, we have seen about debt financing
0:59using immovable property and mortgage is
1:02very popularly used to do take loans by
1:05mortgaging immovable property. Usually,
1:08very high value debts are obtained by
1:11mortgaging immovable property because
1:14immovable property is generally more
1:16expensive or more costly than movable
1:19property at times. So, home loans,
1:21infrastructure loans, etc. are kinds of
1:24examples of this kind of
1:27debt financing.
1:29Now, transfer of property act describes
1:32about various kinds of mortgage like
1:34simple mortgage, equitable mortgage,
1:37English mortgage, and
1:39the mortgage by conditional sale like
1:41that. Now, you can do different kinds of
1:44mortgages. You can do by depositing your
1:47title deeds and registering. This is
1:49just one method of mortgaging. So,
1:52usually, you can do it with or without
1:54depositing title deeds depending on the
1:56kind of mortgages that you have chosen.
1:59The more popular form of mortgages
2:02by depositing title deeds, and they may
2:04insist on registration because at times
2:07registering a mortgage will act as a
2:10better proof for the secured creditor.
2:13And usually these formal financial
2:15institutions insist for registering the
2:18mortgage so that it acts as a proof of
2:21mortgage for them.
2:24And when
2:26they take debt finance in multiple
2:28forms, it is so their debentures is one
2:31very popular form. While shares are
2:34about equity financing, debenture is
2:36about debt financing. So when the
2:39companies issue debentures and the
2:41people who invest in those debentures
2:43are like lenders to them. In a way,
2:46these are long-term debentures are
2:48generally long-term, and they usually
2:50promise a fixed return. That is on the
2:53basis of a fixed rate of interest it is
2:55calculated. So but they are called as
2:58returns, and they are periodically paid
3:01like yearly, half yearly, or quarterly
3:03like that. Debenture holders will get
3:05fixed amount periodically, and on the
3:07end of it, you can get a final or full
3:10amount on its maturity if there is
3:13something like that. There could be
3:15irredeemable debentures, we will come to
3:17that later, but usually they are prepaid
3:20at the end of its period.
3:22Now there are also junk bonds which are
3:24issued by companies. Junk bonds, as the
3:27name suggests, they are very low-rated,
3:30very high-risk kind of instrument, and
3:32they promise very high returns. And
3:35people who want to invest, they can
3:37invest. They promise very high value
3:39return and periodic payment and final
3:42repayment could be there. There are
3:44other kind of
3:45instruments that are issued by the
3:47companies which are called convertible
3:49debentures. Convertible debentures means
3:52they are issued as debt instruments like
3:54a debenture or something like that. And
3:57if it not repaid, it will get converted
4:00to equity. So, I join a company as a
4:03debenture holder, but when it is not
4:05repaid to me or periodic returns I am
4:07not getting it, automatically becomes a
4:10I or become an equity shareholder. That
4:13means that will get converted into
4:14share. That is how a convertible
4:17debenture operates.
4:20Now, let us understand how debt and
4:23equity finance operate in a company
4:26context. For example, a company wants if
4:29it what kind of finance it should take.
4:32Should it issue shares to the investors
4:35so that they get equity finance or
4:37should they go to some financial
4:39institution or to the debenture holders
4:42or to raise debent- money through
4:44debentures. So, a company will be at a
4:47kind of thought stage where it needs
4:49finance, but what kind of finance it
4:52should raise. So, whether it should
4:54raise debt finance or whether it should
4:56raise equity finance. So, these are the
4:58comparisons that a company will have to
5:01decide which kind of finance it should
5:03go for it at that point of time. For
5:06example, if it is giving you equity
5:08finance, to that extent ownership is
5:11lost. For example, a company worth is
5:14100 crore and suppose 10 crores worth of
5:17shares it has given to shareholders. So,
5:1910% of ownership in the company has gone
5:23to those shareholders.
5:24But suppose the same 10 crores it is
5:27raised as debt finance, 100% ownership
5:30is with the company existing company
5:32only. The 10 crore investment came only
5:35as debt. So, there is no ownership
5:37distribution that happens in a debt
5:40finance. They are not owners. They don't
5:42have right to vote. They don't They
5:44don't have any say in the decision of
5:46the company. The company can operate as
5:49it like. So, these people who invested
5:51money through debt can't say anything
5:53about how they are running the company
5:55like this. So, these are some of the
5:57advantages of debt finance over equity
6:00finance people say.
6:02But, there is also other thing like tax
6:04benefits. When you take debt finance,
6:06you are in a loan. So, there is no tax
6:09on that property. But, equity finance
6:11comes as a property or an investment and
6:14it will be taxed to some extent. So,
6:16debt finance always brings some amount
6:19of tax benefits to the company where
6:22they are taking debt. But, one problem
6:25with debt finance is it has to be
6:27repaid. While equity finance, there is
6:29no need to repay. If the company
6:32uh it is company owners only. So, they
6:34the investment comes in a way to the
6:36extent of share they have given to those
6:39shareholders. So, there is no need to
6:41repay that thing. And company profits
6:44will have no impact on debt finance. Of
6:46course, they may not repay. That is a
6:48different story. But, if the company is
6:50making good profits, the also the debt
6:54holders will not get any additional
6:56advantage. They get paid fixed amount as
6:59return and mature value they will get or
7:02whatever rate of interest the debt is
7:04there, that much amount they will take
7:05and go. But, when the company makes huge
7:08profits, the shareholders get the
7:10benefit out of it and those profits get
7:12distributed to the shareholders. And the
7:16people who invest in debt instruments
7:18are called debenture holders. And the
7:20people who invest in the equity finance
7:23in shares are called shareholders. So,
7:26these are the some of the major
7:27distinction and the laws governing
7:29shareholders is different from the law
7:32governing debenture holders. Even when
7:34the company goes into liquidation, how
7:36does they recover the money? That is a
7:38completely a different law that governs
7:41the recovery of debenture holders
7:43investment and the recovery of
7:44shareholders investment. So, the entire
7:47law is very different and the operations
7:50of these are very distinct. In between
7:52debt and finance, there is something
7:54called mezzanine finance, which is a
7:56kind of combination of certain qualities
7:59of debt and certain qualities of equity.
8:01So, this kind of financing is called
8:03mezzanine finance. These can be offered
8:06in the form of convertible instrument,
8:08like you provide it in the form of
8:10equity, but if the company makes huge
8:12profits, the equity may be repaid and
8:15the company can retain its full
8:17ownership. It may be repaid as a form of
8:19debt only. Or it may be taken as debt,
8:22but if it is remained unpaid, it can get
8:24convertible into equity. So, this kind
8:27of financing helps the companies to
8:30devise ways which are suitable to them.
8:33And in these kind of financing, law is
8:36determined by the terms of that
8:38agreement. So, the agreement of
8:40financing will determine what kind of
8:42financing is that. So, we can't say in
8:45the beginning whether it is convertible
8:47debenture or whether it is convertible
8:49equity. It depends on what is the
8:52agreement that is made between the
8:53financer and the company. And the
8:56prevalent these are kind of mezzanine
8:58finance is highly prevalent in the
9:00markets and these are helpful to suit
9:03the companies requirements. So, company
9:05neither wants debt nor wants equity, but
9:08wants something in between, they can go
9:10and choose a form of mezzanine finance.
9:13And usually the company's financial
9:15capacity at that point of time will
9:18influence the decision of financing. So,
9:21what kind of financing it wants, at what
9:23time it wants, when it wants, what
9:25amount it wants, in what form it wants,
9:27they will decide and they will choose
9:29and they will opt for that particular
9:32kind of finance on that particular day.
9:34Now, equity finance also can come in two
9:37forms. One is called the private equity
9:40and other is public equity. Now, what is
9:42meant by private equity? A company
9:44shareholder are private equity
9:47investment. When the shares of a company
9:49are given to the other people or when a
9:52company shares are distributed among the
9:54people, it is a form of equity. Say for
9:57example,
9:58a hospital wants to give shares only to
10:01the doctors who are working there.
10:04That particular hospital may be
10:05incorporated as a company and they want
10:08to give that shares to those doctors
10:11only. Then they will not give these
10:13shares to other people. This kind of
10:15equity where the company chooses its
10:18shareholders is called private equity.
10:21Or there are also private equity firms
10:23where I want equity finance, but I don't
10:26want to give my shares to anybody or
10:29whoever wants to invest. I only want to
10:31take it now from a particular private
10:34equity firm and I want to repay it
10:36tomorrow and take it into my ownership.
10:40So this option is available when I go
10:42with the private equity. Or I can sell
10:45with the agreement, I will go It's a
10:47kind of mezzanine finance also. I can go
10:50to a private equity firm, tell them to
10:53invest in the form of equity, and I may
10:55repay to them when I make huge profits,
10:58and then I become complete owner of my
11:01company. So this is how a company can
11:03determine its shareholders or don't want
11:06some public to enter into their
11:09ownership territory, they may choose
11:11private equity. As opposed to that,
11:14public equity is where a company issues
11:17public offering. First time when a
11:20company goes to the public, it is called
11:21initial public offering. So an IPO where
11:25the SEBI will determine due diligence,
11:27all disclosures will be made, and the
11:29company can go to a stock exchange and
11:31open it for public to subscribe or it
11:34may offer initial public offering
11:36through other routes. Now, when the
11:38shares are subscribed by public at large
11:40who are not related to the company or
11:43who don't know about company or anybody
11:45willing can invest if they meet the
11:47eligibility criteria. That kind of
11:49equity is called public equity and those
11:52shares can be listed on the stock
11:54exchanges and they can be traded also on
11:57the exchange markets. So, this kind of
12:00equity where and private equity is
12:02generally privately placed, not publicly
12:05traded. So, this makes it the very
12:07distinction between the equity finance
12:10or the form of equity finance that a
12:13company may obtain at a given point of
12:15time.
12:18The other kind of financing option that
12:21a company has is called the junk bonds.
12:24Now, these are in a way offered a kind
12:26of debt markets in the open debt markets
12:29they can be offered. They can also be
12:31offered to private equity firms. Usually
12:34these are can be convertible instruments
12:37only. Junk bonds, who will buy, who will
12:39float? Companies which are in distress
12:42are companies which are startups who
12:44don't have goodwill in the market but
12:46have potential to grow rapidly. They
12:49might offer junk bonds but because these
12:51are high risk, because company in
12:54distress or a company which is yet to
12:56make a name in the market means they are
12:59high risk. They may go wrong for any
13:01reason. So, usually if you go to credit
13:04rating of that particular company or the
13:06startup, they either get no rating or
13:08very low rating. So, this kind of
13:11problem makes the company shares or any
13:13kind of bonds in the market people to
13:16invest is very highly improbable. So,
13:19they have very high risk. So, because
13:21they are very
13:23low investment attractive instruments,
13:26what they tend to do is they promise
13:28very high returns on those bonds. So,
13:31this kind of bonds where they promise
13:34very high return and there is also very
13:36high probability of it being defaulted,
13:40these are often called junk
13:41[clears throat] bonds. And any people
13:44who will invest in these junk bonds,
13:45when we say it is very high risk and the
13:48return or is also very high,
13:50there are investors who want to take
13:52that kind of risk also. There are
13:54companies or there are some firms which
13:57may keep certain amount of money for
13:59only taking these kind of risk. Usually
14:02hedge funds also take these kind of
14:04risks. So, there are investors who are
14:07looking for high return worth investment
14:10where they don't mind investing certain
14:12amount and taking very high risk if the
14:14return is very very high. And if they
14:17are not able to repay, they may get
14:19equity share in that startup or in that
14:22company. So, junk bonds also are
14:24prevalent in the market and companies
14:26may float them for the purpose of
14:28financing depending on their financial
14:31condition
14:33at that particular point of time.
14:36Now, the other kind of instruments that
14:39the companies generally float are
14:41debentures. Debentures are the debenture
14:43holders will invest in the company like
14:46shareholders invest in equity. Debenture
14:49holders invest in the
14:51loan kind of thing where they get a
14:53fixed return and payable after the
14:55mature date. Now, these debentures also
14:58we can classify, if we want to classify
15:01debentures on the nature of debenture,
15:03we can call them as convertible
15:05debenture and non-convertible debenture.
15:08Convertible debenture means a debenture
15:10can be converted into equity or equity
15:13linked instrument kind of thing similar
15:16to equity or something like that
15:17depending on that agreement or the terms
15:20of that debenture deed. So, this kind of
15:22instruments which are convertible are
15:24called convertible debenture. A
15:26non-convertible debenture, as opposed to
15:29that, will remain a debenture
15:31throughout. So, it can't be converted
15:33into any other form, and you have to pay
15:35returns as promised and maturity value
15:38as promised. That's all. And on the
15:41basis of security provided to the
15:43debentures, the debentures can be
15:45classified into secured debenture and
15:48unsecured debentures.
15:51Now, secured debentures means those
15:53debentures which are backed by some
15:54collateral as a security. That is the
15:57assets of that company or something like
15:59that which are giving being mortgaged,
16:02pledged, or hypothecated to that
16:04particular debenture holders. We call
16:06them as secured debentures. In contrary
16:09to that, unsecured debentures do not
16:11have any security as guaranteeing
16:13payment for that, and their debenture
16:16holders will operate like unsecured
16:18uh debenture holders only for recovery
16:21purposes.
16:22And on the basis of redemption of a
16:24debenture, we can classify a debenture
16:26into redeemable debenture and
16:29irredeemable debenture. A redeemable
16:32debenture means a fixed return is
16:34promised periodically, and the end date,
16:373 years, 5 years, or 10 years, generally
16:39long term, 10 years, 15 years, where you
16:42get a maturity value. After 5 years,
16:44this amount will be paid, and every year
16:47or every month or every 3 months or
16:49every 6 months or every year, this
16:51amount will be paid to the debenture
16:53holders. Like that, fixed amount is
16:55specified. This is called redeemable
16:57debenture. As opposed to that, an
16:59irredeemable debenture only promises
17:02periodic return, and there is no final
17:04payment. So, as long as the company,
17:06until it goes for liquidation, as long
17:09as the company is in the market, the
17:11debenture holder will keep getting fixed
17:13amount as return, and there is nothing
17:16like a fixed final value where they get
17:19the uh finally redeemed, that won't be
17:21there for them. This is the
17:23classification among the debentures that
17:27distinguishes multiple kinds of
17:29debentures. These debentures can be
17:31registered and they can be unregistered
17:33also. And companies at times appoint a
17:36debenture trustees. The trustee is
17:39created and a trustee will look after
17:41the interest of the debenture holders.
17:43Now, why does company create a trust and
17:46a trustee for debenture holders is
17:48essentially to ensure the debenture
17:51holders that their debentures and the
17:53security provided to their debentures
17:56are intact and there is no manipulation
17:58and the company is maintaining its
18:00account very well and the periodic
18:02returns are properly paid to the
18:04debenture holders. All this will be
18:06taken care by the debenture trustee and
18:09the debenture holders can feel ensured
18:11that they will get their periodic
18:12returns very safely and without any
18:15malafide actions or something like that.
18:18So, companies when they are wanting
18:20debenture holders to invest with some
18:22amount of assurance, they may establish
18:24this trust to ensure their safety. So,
18:27this case is a very good practice among
18:29the companies to ensure more debenture
18:31holders safety. And generally debentures
18:34are unsecured only, but however, these
18:37days secured debentures also have become
18:39very prominently available in the market
18:42and they are highly prevalent. Usually
18:45in the olden days, debenture holders are
18:47considered unsecured, but nowadays there
18:50are many many debenture holders or many
18:52debentures which are available in the
18:54markets as secured debentures as opposed
18:57to unsecured debentures. Markets are
18:59evolving and debt financing markets also
19:02are changing
19:04nature and way of financing in a way.
19:08There are also something called debt
19:10securities. Now, these are securities
19:12which are also traded in the open
19:14market. In a way, these are kinds of
19:17bonds issued by government or companies,
19:19usually long-term bonds or sometimes a
19:22fixed return periodic instruments that
19:24are given and
19:25on a specific maturity value which is
19:28called coupon rate which with interest
19:30is called like that. So, a very popular
19:32government issues infrastructure bonds.
19:34When government want to build
19:36infrastructure for the nation, it will
19:38issue infrastructure bonds. It may
19:40promise some tax concession on those
19:42bonds and people who invest in those
19:44bonds will take a fixed return after 3
19:47years or 5 years with certain lump sum
19:50amount, something like that. These are
19:51also a form of debt backed by government
19:54promise and companies also can issue
19:56these kind of bonds. These are usually
19:59considered low-risk investment with
20:01fixed return and these can be traded
20:03also on the exchange for better because
20:06for those people who want to invest but
20:08don't know whether their money will get
20:10stuck and if what happens in between if
20:12they want to liquidate their
20:15what you call it a form of liquid
20:16finance model instrument if they are
20:19looking for, still there is an
20:20encouragement for them to invest in
20:22these kind of debt securities. Very many
20:25government bonds are available in the
20:28markets. Time and again government keep
20:30issuing these bonds and of course
20:32companies also issue these bonds and
20:34these bonds are usually considered a
20:37kind of debt bonds only and these are a
20:39form of debt securities. These are
20:41popularly referred to as debt securities
20:45and not as debentures or something like
20:47that. Now, why these many kinds of
20:50financing models have evolved in the
20:52market? There are multiple reasons why
20:55different kind of financing models have
20:57evolved. Even within a company, a
21:00company might need financing at multiple
21:02stages, maybe at seed stage, maybe at
21:05market expansion stage, maybe at growth
21:07stage, or maybe at acquisition stage.
21:10So, multiple different kind of financial
21:13stages and multiple business needs
21:16require multiple different kinds of
21:19credits and different kinds of credit
21:21access and different kind of credit
21:23instruments. So, we can't say one size
21:26fits all doesn't suit the markets today.
21:29Markets are evolving and with
21:30globalization, extensive multinational
21:33operations, cross-border operations have
21:36evolved. The amount of finance needs has
21:38evolved like never before. And different
21:41kinds of finance options allows the
21:43markets to choose the option that is
21:46best to suitable for their business at
21:48any given point of time.
21:51So, this mandates the economy to provide
21:53for those multiple kind of credit
21:56sources, credit access, and credit
21:59instruments suitable for different
22:01situations. So, this is a kind of
22:04necessity which created in the financial
22:07markets has evolved to cater to these
22:10needs and different kind of instruments
22:13have come into prevalence in the market
22:16and the older kind of instruments also
22:19have changed the scope of their
22:21governance or in a way their model of
22:23access providing. Like mezzanine finance
22:26is a kind of best example to suit
22:29multiple needs, multiple situations,
22:32combination of different kinds of
22:34financing in one instrument. All this is
22:36a kind of evolution of finance markets
22:40and the market needs. And companies also
22:42today have multiple chances and multiple
22:45access, multiple instruments available
22:48in the market, and companies also can
22:49raise finance in multiple ways. In a
22:52way, there is no depth of finance in the
22:54market today in the in India or in other
22:57countries. But what is very important is
23:00a wisdom, a financial decision of a
23:03company or a business firm at any given
23:05point of time. What kind of finance they
23:08should take at what point of time will
23:10determine their success
23:12many a times, especially financial
23:14success. So, your financial
23:16understanding of different kinds of
23:19finance helps in taking a better
23:21decision at that point of time. So, it
23:24is very important to understand
23:26different kinds of finance and how they
23:28operate in the market. So, we will
23:31discuss about leverage buyout in the
23:34next class, which is also a kind of
23:36finance used to do acquire firms. So,
23:39these kinds of finance helps you to
23:42understand the different kinds of the
23:44impact implication of each kind of
23:47finance in the market.
23:49With this, we will conclude the
23:51discussion on debt financing kinds in
23:54the in this class, and we will go and
23:56discuss more specifically the leverage
23:59buyout in the next class. Thank you.

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