Benefits and Disadvantages of Equity Finance

What is Equity Financing?

Equity financing is when a corporation sources funds from an investor who agrees to share profit and loss to the extent of its share without expecting any fixed return (interest etc). These investors become the owners of the company to the extent of their share of investment.

Equity financing is one of the main funding options for any corporation. To understand the pros and cons of equity finance from a company point of view, let’s discuss the benefits and disadvantages of equity as a source of financing.

Advantages and Disadvantages of Equity Finance

Advantages

Permanent Source of Finance

Equity financing is the permanent solution to financial needs of a company. No company’s main focus or objective can be financial management only. A product manufacturing company will have an objective of producing high-quality goods and reach to its right consumer. A service provider company will ensure providing high-quality services. Equity finance provides that leverage to the management to continuously focus on fulfilling their core objectives. It keeps management away from the hassles of raising funds again and again like other sources of financing viz. debt. Debt is raised and paid back over a period of time.

Benefits and Disadvantages of Equity FinanceNo Obligatory Dividend Payments

Equity finance for a new company is like blessings of an angel. The main limitation of a new company is the uncertainty of cash flows. Equity mode of finance gives management a breathing space by having no fixed obligation to pay dividends. A company can choose to pay no dividend or smaller dividends as per the cash flow position.

Open Chances of Borrowing

A company, majorly financed by equity, always has a controlled financial leverage ratio. Financial leverage ratio measures the ratio of financing to equity and debt. A bank or any other financial institutions require a company to invest roughly 20 to 25% of equity to finance other 75 to 80% debt. Lower levered firms have higher chances of smooth borrowing of debt in times of need.

Retained Earnings

A company develops an internal source of finance by having equity finance on board. The earnings which a company generates using the capital can be retained by the company to finance the increased working capital and other fund requirements. It obviates the other hassles of raising funds via other sources. Also, if the funds are utilized in projects with higher returns compared to what is available to the equity shareholders, the company effectively achieves its objective of shareholder’s wealth maximization.

Rights Shares

A company can get required capital via an issue of rights shares from its existing capital providers which have almost nil floatation cost. Floatation cost is the cost incurred in raising funds.

From Company point of view

Disadvantages

Floatation Cost

Financing through equity is the most difficult way of getting funds to the company. Not only does it require a lot of statutory compliances but also have other costs like fee of a merchant banker, other expenses such as brokerage, underwriting fee, and lots of other issue expenses.

High Cost of Funds

Equity finance is considered to be the costly source of finance especially in comparison to debt. The obvious reason is the higher required rate of return from equity share investors. Since equity share investment is a high-risk investment, an investor will always expect a higher rate of returns.

No Tax Shield

The dividends distributed to the shareholders are not a tax-deductible expense. On the contrary, the interest expense is an eligible expense for tax benefits. A 12% interest rate with 40% prevailing Tax Rate makes the effective cost of funds to be 7.2% {12% * (1-40%)} in case of debt. This benefit is not available to the equity source of financing and therefore, it is considered as a costly source of financing.

Underwriting of Shares

At the time of offering equity shares to the public, the company normally requires the appointment of underwriters. The job of an underwriter is to assume the risk of subscription. Underwriters would agree to subscribe the shares to the extent not subscribed by the general public and will charge a fee for that service. The fee may be in the form of upfront payment or maybe a discounted equity share price.

Dilution of Control

When a company raises funds via equity, it dilutes the existing shareholder’s control. Percentage shareholding is reduced when new shareholders are introduced. In the case of debt financing, the control does not dilute.

No Benefit of Leverage

Debt funding has an indirect benefit available to the existing owners. Since a project with the higher rate of return (12%) than the cost of debt funds (8%) would enhance the welfare of the shareholders. It is because the margin of 4% will be distributed to the existing shareholders. If the project was financed by equity, this additional benefit would not have occurred to the existing shareholders but would equally distribute between old and new shareholders.

Last updated on : March 9th, 2018

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One Response

  1. Paul Sharp

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