Financial Management and Strategic Management · Types of Financing

Long-term Sources of Finance: Equity, Preference Shares and Debentures

Updated 5 October 2026

Long-term sources are funds kept for many years to buy fixed assets and fund growth. They are equity shares, preference shares, debentures, term loans and retained earnings. To answer, define the source, list features, then give merits and demerits from the company's and the investor's side.

Understand Long-term Sources: Equity, Preference Shares and Debentures

A company needs long-term money to buy plant, build capacity or fund expansion. This money stays in the business for many years. It comes from owners (equity, preference, retained profits) or from lenders (debentures, term loans). The key question is who bears risk and who gets control.

Equity shares are owners' capital. Holders get dividend only if the company declares it. When the company is wound up, they get what is left after everyone else is paid, so they rank last. They carry voting rights, so they control the company. Equity is permanent and has no fixed burden, but it is costly: dividends are not tax-deductible and new issues dilute control and earnings per share.

Preference shares sit between equity and debt. They carry a fixed rate of dividend and have priority over equity in dividend payment and in repayment of capital on winding up. Holders usually have no voting rights. They can vote on resolutions that affect their rights, and when their dividend has remained unpaid for two years or more. Types include cumulative and non-cumulative, redeemable, participating and non-participating, and convertible and non-convertible. Under Section 55 of the Companies Act, 2013, a company cannot issue irredeemable preference shares. Preference shares must be redeemed within 20 years from the date of issue. A company engaged in setting up and dealing with infrastructure projects may issue preference shares for more than 20 years (Rule 10 of the Companies (Share Capital and Debentures) Rules, 2014). In that case, at least 10% must be redeemed each year from the 21st year, on a proportionate basis, at the option of the preference shareholders. Preference dividend is an appropriation of profit after tax, so there is no tax shield.

Debentures are loans raised by the company by issuing a certificate of debt. Holders are creditors, not owners. They receive fixed interest, which is a tax-deductible expense, and interest must be paid even if there is a loss. Types include secured and unsecured, redeemable and irredeemable (perpetual), convertible (fully or partly) and non-convertible, and registered and bearer. Debentures do not dilute control, but they raise financial risk and may carry a charge on assets.

Term loans are loans from banks and financial institutions for a fixed period, usually repaid in instalments, often secured on assets and often with covenants. Retained earnings are profits kept back and reinvested. They need no issue cost and no outside approval, but they are not free: shareholders expect a return on them. Heavy retention may also reduce dividends and upset shareholders.

Key rules to remember

Equity shares: core rule: Residual claim + voting rights + no fixed dividend; Equity bears the highest risk, so it expects the highest return and carries no tax shield.
Preference shares: core rule: Fixed dividend + priority over equity - usually no voting rights; Dividend is an appropriation of post-tax profit. Cumulative shares carry forward unpaid dividend. Redemption period is as stated in the concept above: within 20 years under Section 55, with the infrastructure exception.
Debentures and term loans: core rule: Fixed interest + repayment obligation + tax-deductible interest; Debt gives a tax shield but increases financial risk and must be serviced even in a loss year.
Liquidation waterfall under the IBC (Section 53, Insolvency and Bankruptcy Code, 2016): (1) Insolvency resolution process costs and liquidation costs → (2) Workmen's dues for the 24 months before the liquidation commencement date and debts owed to secured creditors who relinquish their security (equal rank) → (3) Wages and unpaid dues to employees (other than workmen) for the 12 months before the liquidation commencement date → (4) Financial debts owed to unsecured creditors → (5) Government dues for the 2 years before the liquidation commencement date, and the unpaid balance of secured debts after enforcement of security (equal rank) → (6) Remaining debts and dues → (7) Preference shareholders → (8) Equity shareholders; Section 53 applies only when a corporate person is being liquidated under the Insolvency and Bankruptcy Code, 2016. It is not a general ranking rule for every question on debentures or other sources. It is also beyond the usual FM scope, so treat it as a supplement. Debentures do not always rank at step (4). Their rank depends on whether they are secured: - **Secured debenture holders** who relinquish their security to the liquidation estate rank at step (2). - **Secured debenture holders** who enforce their security realise it outside the waterfall. Any unpaid balance after enforcement ranks at step (5), equal with government dues. - **Unsecured debenture holders** are unsecured financial creditors and rank at step (4). Government dues rank in step (5) only for the 2 years before the liquidation commencement date. Unsecured financial creditors (including unsecured debenture holders) rank above them. Equity is paid last, which is why it carries the most risk.
Retained earnings: Retained earnings = Profit after tax − Dividends paid; An internal source with no issue cost, but it has an opportunity cost to shareholders.

How to solve Long-term Sources: Equity, Preference Shares and Debentures questions

Most questions ask you to explain, differentiate, or choose a source. Use one routine for all of them.

1Read the verb: explain, differentiate, state merits and demerits, or advise.
2Define the source in one line, saying whether it is owners' capital or borrowed capital.
3List its key features: return, risk, control, repayment, tax treatment.
4Give merits and demerits, and label each as company's view or investor's view.
5For differences, write point by point: return, voting, repayment, tax, risk, claim on assets.
6For advice questions, match the facts (tax rate, control concerns, cash flow stability) to the source.
7Close with a one-line conclusion.

Quickest way: Four-test method for MCQs and written answers

When to use it: Use it when you must compare sources or pick one quickly.

Test 1 - Ownership: equity, preference and retained earnings are owners' funds (preference is a hybrid); debentures and term loans are borrowed.
Test 2 - Return: fixed or variable, and tax-deductible or not.
Test 3 - Control: only equity usually carries votes. Preference holders can vote on resolutions affecting their rights, or when their dividend is unpaid for two years or more.
Test 4 - Risk: fixed obligations raise financial risk.
In MCQs, eliminate options that call debenture holders owners or give preference holders ordinary voting rights.
In written answers, use a two-column difference or numbered points, with 5-6 points for 5-6 marks.

Common mistakes in Long-term Sources: Equity, Preference Shares and Debentures

Treating preference dividend as tax-deductible.
Preference is seen as similar to debt because the dividend is fixed.
Fix: Remember it is a distribution of profit after tax. Only interest on debentures and loans is deductible.
Calling debenture holders owners of the company.
Both debentures and shares are issued as securities.
Fix: Debenture holders are creditors. They get interest, not dividend, and have no ordinary voting rights.
Saying retained earnings are a free source.
No issue cost and no payment appear in the books.
Fix: Say they have no explicit cost but carry an opportunity cost, because shareholders expect a return.
Writing only merits or only demerits.
Students run out of time or recall only one side.
Fix: Write at least three of each, and split between company and investor view where asked.
Mixing up cumulative and participating preference shares.
Both relate to dividends and sound alike.
Fix: Cumulative: unpaid dividends carry forward. Participating: also share in surplus profit beyond the fixed rate.

Worked examples

Example 1

Differentiate between equity shares and preference shares. (5 marks)

Show the solution

Start with the nature: equity is the ownership capital with a residual claim; preference is a hybrid with a preferential claim.
Compare dividend: equity gets a variable dividend that depends on profit and board decision; preference gets a fixed rate.
Compare priority: preference is paid dividend and capital before equity.
Compare voting: equity has voting rights; preference generally does not, except in cases the Companies Act allows.
Compare repayment: equity is not redeemed during the company's life; preference shares must be redeemed within 20 years from issue, as irredeemable preference shares cannot be issued under Section 55. State the infrastructure exception once, as given in the concept above.
Compare risk and return: equity has higher risk and higher potential return; preference has lower risk and a limited return.

Answer: Equity shares are owners' residual capital with variable dividend, voting rights, no redemption and the highest risk. Preference shares carry a fixed dividend, priority in dividend and repayment, generally no voting rights, must be redeemed within 20 years of issue (subject to the infrastructure exception) and have lower risk.

Example 2

A company with stable cash flows wants to raise ₹50,00,000 for expansion without diluting control and wants a tax benefit. Which long-term source suits it better: equity shares or debentures? Give reasons.

Show the solution

Control: equity shares give new shareholders votes, which dilutes control. Debentures do not.
Tax: interest on debentures is deductible when computing taxable profit; equity dividend is not.
Cash flow: stable cash flows make fixed interest and repayment manageable.
Risk: debentures raise financial risk if profits fall, so the company should keep its debt level within reasonable limits.
Other: debentures may need security on assets, and covenants may restrict the company.

Answer: Debentures suit the company better, as they avoid dilution of control, give a tax shield on interest and can be serviced from stable cash flows. The company must watch its debt level and security requirements.

Exam tips

Differences between equity and preference shares and the types of debentures are favourite short-answer questions. Learn the point-by-point layout.
In MCQs, check the exact word: cumulative, participating, convertible and redeemable each mean something different.
Always state tax treatment: interest is deductible, dividends are not.
For retained earnings, give both merits (no issue cost, no dilution, no obligation) and demerits (opportunity cost, may upset shareholders, possible under-use of funds).
For term loans, mention instalment repayment, security, covenants and lower issue cost than a public issue.

Practice questions from Types of Financing

Long-term Sources: Equity, Preference Shares and Debentures: frequently asked questions

What is the main difference between equity shares and preference shares?

Equity shares carry variable dividends, voting rights and the highest risk. Preference shares carry a fixed dividend and priority in payment, but usually no voting rights. Dividends on both are appropriations of profit after tax and are not tax-deductible.

What are the main types of debentures?

Debentures are classified by security (secured or unsecured), redemption (redeemable or irredeemable), convertibility (convertible or non-convertible) and registration (registered or bearer). Write the basis of each classification, then give a one-line meaning of each type.

What are the merits and demerits of retained earnings?

Merits: no issue cost, no dilution of control, no fixed obligation and quick availability. Demerits: they have an opportunity cost, dividends may fall, and over-retention can lead to poor use of funds.

Why are term loans a popular long-term source?

They are quicker to arrange than a public issue and have lower issue costs. Interest is tax-deductible. But they bring fixed repayment, security demands and covenants.