Question

The directors of a company have decided to modernise the plants and machinery at an estimated cost of Rs. one crore, but could not decide whether to issue preference shares or debentures for this purpose. As finance manager of the company, advise the directors whether to issue preference shares or debentures in the interest of the company.

Answer 1

As a finance manager, I advised the directors on the advantages and disadvantages of preference shares and debentures from the company's perspective.

The merits of preference shares are given as follows:

1. Preference shares offer consistent income, a predetermined rate of return, and investment protection.
2. Preference shares are ideal for investors seeking a fixed rate of return with minimal risk.
3. Equity shareholders retain control over management because reference shareholders lack voting rights.
4. Paying a set dividend rate to preference shares can allow a corporation to increase dividend rates for equity shareholders during periods of prosperity.
5. In the event of a company's liquidation, preference shareholders receive preferential reimbursement over equity shareholders.
6. Preference capital does not generate a charge against a company's assets.

The major limitations of preference shares as a source of business finance are as follows:

1. Preference shares are not ideal for investors seeking large returns.
2. Preference capital dilutes equity shareholders' claims over the company's assets.
3. Preference shares tend to pay bigger dividends than debentures.
4. Investors cannot expect a guaranteed return on these shares because dividends are only paid when the company makes a profit. These shares may not be attractive to investors.
5. The dividend is not deductible from earnings as an expense, so it does not result in tax savings like interest on loans.

The merits of raising funds through debentures are given as follows:

1. It is preferred by investors who want fixed income at lesser risk.
2. Debentures are fixed-change funds that do not participate in the company's profits.
3. Debentures are best suited for dependable sales and earnings.
4. Debentures do not have voting rights, allowing equity stockholders to maintain influence over management.
5. Debentures are a more cost-effective financing option than preferred or equity capital because the interest payment is tax-deductible.

Debentures as a source of funds have certain limitations. These are given as follows:

1. Debentures are fixed charge instruments that permanently impact a company's earnings. The danger increases as the company's earnings change.
2. Redeemable debentures require companies to make plans for repayment on certain dates, even amid financial difficulties.
3. Each corporation has a specific borrowing capability. Debentures limit a company's ability to borrow further capital.

Conclusion: The cost of modernising the plant and machinery is roughly one crore. The initiative is low-risk and expected to yield results within a year. The corporation should consider issuing debentures as the most cost-effective financing option for the project.