Merits and Limitations of Equity shares
There are several advantages to the company in raising equity share capital as a source of finance and to the shareholders by making investments in shares. They are as follows:
A) To the shareholders
- High rate of dividends: In case there are good profits, there is a possibility of getting a high rate of dividend as the profit left over after paying interest on debentures and dividend on preference shares belongs to the equity shareholders.
- Increase in Market Value: The value of equity shares goes up in the stock market with the increase in profits of the concern.
- Liquidity: Equity shares can be easily sold in the stock market.
- Control: Equity shareholders have greater say in the management of a company as they have voting rights.
- Pre-emptive Rights: They enjoy pre-emptive rights when the company announces subsequent issue of equity shares of additional funds.
- Facility of by back: Buy-Back of shares by the company gives much liquidity to the equity shareholders.
B) To the management
- No charge of assets: A company can raise fixed capital by issuing equity shares without creating any charge on fixed assets.
- No need to repay: The capital raised by issuing equity shares is not required to be paid back during the life time of the company. It will be paid back only if the company is wound up.
- Less Risk: There is liability on the company regarding payment of dividend on equity shares. The company may declare dividend only if enough profits.
- Ploughing back of profits: Profits can be reinvested in the company as there is no compulsory obligation on the part of a company to pay dividend every year.
- More Credibility: Equity shares provide credibility to the business. Loans are raised on the basis of equity shares. When the equity shares are well employed in the business, the prospective creditors feel confident to invest in the loans raised by the company.
Though they are many advantages for both the company and shareholders there are certain limitations too which are as follows:
A) To the shareholders
- No fixed return: Equity shares have the risk of fluctuating returns. The dividend to the shareholders is based on the profit earned by the business. If the company performs poor in a year, the shareholders get nothing at all.
- No guarantee of dividends: Even if the company gets profits there is no guarantee of payment of dividends to equity shareholders. The board of directors decides whether to declare dividend or not.
- Residual Claimants: If there are preference shareholders equity share holders get dividend only after payment of dividend to the preference shareholders.
- Over capitalisation: In the case of management miscalculates the long term financial requirements, it may raise more funds than required by issuing shares. This may amount to over-capitalization which is turn leads to low value of shares in the stock market.
- Control in the hands of few people: Though the equity shareholders are the real owners of the company with voting rights, in reality only a handful of persons control the votes and manage the company.
- More risk: In the liquidation of a company, they are the very last party to get refund d of the money invested. Equity shareholders actually swim and sink with the company.
- Speculative Losses: The holders of equity shares suffer speculative losses due to frequent fluctuations in their market value.
- Loss of control: Additional issue of equity shares will reduce the control of original equity shareholders.
- Not safe and secure: Equity shares are not attractive to those who desire to incest in safe securities with a fixed income. Investment in equity shares creates feeling of insecurity as they are last in the payment of dividend as well as capital.
B) To the company:
If the entire financial requirement of the company is met through equity shares alone the company would be deprived of the benefits of trading on equity.
- Over capitalisation: As equity capital cannot be redeemed there is a danger of over capitalisation.
- Permanent Burden: Equity shares capital is permanent in a company. Normally it cannot be refunded even when the company has sufficient funds. The recent amendment however, permits company to buy back its shares for cancellation subject to certain restrictions.
- More legal formalities: There are lengthy legal formalities to be compiled with before making public issues of shares.
- Not useful in emergencies: Equity shares can is issued only when the market condition is good and healthy. Especially when the market is in recession it is very difficult to procure funds by issue of equity shares. So it is not possible to secure funds by making equity issue as when needed.
- Group conflicts: As the equity share holders carry voting rights groups are formed to corner the votes and to grab the control the company. Conflict of interest would develop which is harmful for the smooth functioning of a company.
- No attraction: Investors who desire in safe securities with a fixed income have no attraction for such shares. It can be obtained by only those people who are willing to bear the risk.
- Leads to speculation: During prospectus period higher dividends have to be paid leading to increase value of shares in the market and thereby giving opportunity for speculation.
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