Chapter 3- Sources of Finance

EQUITY SHARES

They are the real owners of the company.  Full voting rights are guaranteed to equity shareholders. They participate in the meetings of the shareholders, elect directors and approve major changes in the policies and programmes of the company. Equity shares are listed at the stock exchange and are freely transferable.

The rate of dividend is not fixed. It is decided by the board of directors on the basis of profits left after making payments of preference shares dividend. Therefore, the investors bear the maximum risk but may enjoy the maximum profits if the company’s performance is good.

Advantages of Equity Shares

A.)  From the company point of view

1. Permanent capital – The funds raised through issue of equity shares is permanent capital for the company. It is not required to be refunded during the lifetime of the company. This amount is mostly used to generate fixed assets of the company.

2. No charge on assets – A company is not required to mortgage or create a charge on the assets of the company for raising funds through issue of equity shares.

3. No burden on profits – It is not obligatory on the part of the company to pay dividend on equity shares in case the profits are not sufficient or the company decides to retain profits for expansion or modernisation.

4. Source of strength – Equity share capital reflects the strength of the company because it is used for fixed assets and does not create burden for its repayment or payment of dividend on regular basis.

5. Large funds – Equity shares have a small nominal value (say Rs.10 per share). It encourages the investors to invest in equity shares. There is no limit of number of members in a public company. Therefore, a large number of persons invest in equity shares and the company will be in a position to collect huge amount of money through equity shares.

B.) From the shareholder point of view

1. Voting rights – Equity shareholders have full voting rights and participate in the meetings of shareholders. They elect directors and approve major policy changes.

2. Higher dividend – The rate of dividend on equity shares is not fixed. It depends upon profits, in case the earnings of the company are good, the directors recommend high rate of dividend.

3. Capital appreciation – Equity shares are listed at the stock exchange and the prices of shares go up in case the performance of the company has been good and the market conditions are also favourable.

5. Bonus shares and Right shares – Bonus shares and Right shares are issued only to the equity shareholders.

5. Tax benefits – The company gives tax-free dividend to the equity shareholders.

Disadvantages of Equity Shares

A.) From the company point of view

1. Manipulation of control – The management of the company may be manipulated by few shareholders to maintain the control of the company in their own hands. Sometimes, they may not work in the interest of the company.

2. Overcapitalisation – The funds raised through equity shares are not returned during the lifetime of the company. Sometimes, more capital is raised than required which results in overcapitalisation. It reduces earnings per share.

3. No trading on equity – If all the funds are raised through equity shares, the company will not be able to take advantage of trading on equity.

4. Costly – The cost of raising funds through issue of equity shares is high. A lot of money is spend on underwriting commission, brokerage and other expenses.

B.) From the shareholders point of view

1. High risk – Equity shareholders bear the maximum risk. They are the last to get return on their investment, i.e., dividend and the capital when the company is closed.

2. Uncertainty of dividend – Dividend on equity shares is paid only out of profits. In case, the profits are not sufficient, no dividend is paid.

3. Concentration of power in few hands – Some shareholders keep the control of the company in their own hands by holding majority shares. Therefore, small investors may remain at the mercy of such shareholders.

4. Unhealthy speculation – The stock market fluctuates wildly because of speculations by few operators. The management of the company may also indulge into such activities which causes extensive loss to the innocent investors.

PREFERENCE SHARES

These are those types of shares on which a fixed rate of dividend is paid, and

1.       Dividend on preference shares is paid in priority to equity shares dividend, i.e., the preference dividend is paid before dividend is paid on equity shares.

2.       Return of Capital: Preference share capital is paid back (returned) in priority to equity share capital in the event of or at the time of winding up (closing of) of the company.

Features/characteristics of Preference Shares

1.       A fixed rate of dividend is paid on preference shares.

2.       The preference shareholders have preference in getting the dividend. It is paid in priority to equity share dividend.

3.       The preference share capital is returned in priority to equity share capital, if the company is closed.

4.       Preference shareholders do not have voting rights and cannot take part in the meetings of the shareholders.

5.       A company can issue different kinds of preference shares, like redeemable, non-redeemable, commulative or non-commulative shares, etc.

Types of Preference shares

1.       Cumulative preference shares – These preference shares have a right to get dividend out of the profits and in case the profits are insufficient, the dividend is to be carried forward and paid out of the future profits.

Non-cumulative preference shares – Dividend on such shares is paid only out of the current year’s profit and in case the profits are not sufficient, no dividend is to be paid and the preference shareholders do not have the right to get the ‘arrears’ (past unpaid amount) of dividend in the future.

2.       Redeemable preference shares – Such shares are redeemed (paid back) after a fixed period of time and the preference share capital is returned to the shareholders.

Irredeemable preference shares – The amount raised from such shares is not redeemed during the lifetime of the company and is to be paid back only after the winding up of the company.

3.       Convertible preference shares – Those preference shares which are given the right or option to get their shares converted into equity shares after a fixed period of time, are known as convertible preference shares.

 Non-convertible preference shares – Those preference shares which are not convertible into equity shares, are known as non-convertible preference shares.

4.       Participating preference shares – These are those preference shares on which the investors have the right to participate in the surplus profits left after paying all dividends (i.e., preference share dividend as well as dividend on equity shares).

 Non-participating preference shares – Only a fixed rate of dividend is paid on these shares and there is no right to participate in the surplus profits.

Advantages of preference shares

A.) From the point of view of the company

1. Appeal to cautious investors – A company is able to raise funds from those investors, who want more security and stability or regularity in their earnings as compared to equity shares.

2. No interference in management – Preference shareholders do not have voting rights, therefore, the shareholders are not allowed to interfere in the management and decisions of the company.

3. No charge on assets – A company is not required to create a charge on the assets of the company. Therefore, the assets can be used for raising loans in the future.

4. Trading on equity – The rate of dividend payable on preference shares is fixed. When the earnings of the company are good, a higher rate of dividend can be paid on equity shares.

5. No burden on profits – There is no obligation on the company to pay dividend in case of insufficient profits or when there are losses in the company.

6. Flexibility – A company can maintain flexibility in its capital structure by issuing redeemable preference shares.

B.)    From the point of view of the investors (Preference shareholders)

1. Stable and regular dividend – There is a higher possibility of getting stable and regular dividend because preference dividend is paid before the equity share dividend.

2. Less risk – Preference shares are less risky as compared to equity shares because there is no fluctuation in the prices of shares and there is better security to their investment as compared to equity shares.

3. Redemption – Most of the preference shares are redeemable after a fixed period of time. Therefore, the investors can get back their investment from the company.

4. Cummulative Dividend – In case of cummulative preference shares, the dividend is carried forward and the arrears are paid out of the future profits.

Disadvantages of Preference Share

A.) From the point of view of the company

1. Low appeal – Preference shares have a very low appeal to the investors. A cautious investor prefers debentures than preference shares.

2. Permanent burden – There is a permanent burden on the company to pay dividend on cumulative preference shares

3. More legal formalities – A company has to follow a number of legal formalities when preference shares are to be redeemed

4. Costly – The dividend on preference shares cannot be treated as business expense, therefore, the company has to pay higher rate of tax.

B.) From the point of view of the investors

1. No voting rights – Preference shareholders cannot participate in the meetings of the shareholders.

2. No capital appreciation – Preference shares are not listed at the stock exchange, therefore, there is no possibility of increase of capital appreciation of preference shares.

3. No guarantee of dividend – Dividend on preference shares is paid only out of profits. In case a company continues to suffer losses, no dividend will be paid even on preference shares.

4. Fear of being shown the door – Preference shares are redeemable. A company has the option to pay back the preference share capital in case it has surplus funds.