What are Equity shares?

Equity Share Meaning

An equity share, normally known as ordinary share is a part ownership where each member is a fractional owner and initiates the maximum entrepreneurial liability related to a trading concern. These types of shareholders in any organization possess the right to vote.

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Features of Equity Shares Capital

• Equity share capital remains with the company. It is given back only when the company is closed.
• Equity Shareholders possess voting rights and select the company’s management.
• The dividend rate on the equity capital relies upon the obtainability of the surfeit capital. However, there is no fixed rate of dividend on the equity capital.

Types of Equity Share

• Authorized Share Capital- This amount is the highest amount an organization can issue. This amount can be changed time as per the companies recommendation and with the help of few formalities.
• Issued Share Capital- This is the approved capital which an organization gives to the investors.
• Subscribed Share Capital- This is a portion of the issued capital which an investor accepts and agrees upon.
• Paid Up Capital- This is a section of the subscribed capital, that the investors give. Paid-up capital is the money that an organization really invests in the company’s operation.
• Right Share- These are those type of share that an organization issue to their existing stockholders. This type of share is issued by the company to preserve the proprietary rights of old investors.
• Bonus Share- When a business split the stock to its stockholders in the dividend form, we call it a bonus share.
• Sweat Equity Share- This type of share is allocated only to the outstanding workers or executives of an organization for their excellent work on providing intellectual property rights to an organization.

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Merits of Equity Shares Capital

• ES (equity shares) does not create a sense of obligation and accountability to pay a rate of dividend that is fixed
• ES can be circulated even without establishing any extra charges over the assets of an enterprise
• It is a perpetual source of funding, and the enterprise has to pay back; exceptional case – under liquidation
• Equity shareholders are the authentic owners of the enterprise who possess the voting rights

Demerits of Equity Shares Capital

• The enterprise cannot take either the credit or an advantage if trading on equity when only equity shares are issued
• There is a risk, or a liability overcapitalization as equity capital cannot be reclaimed
• The management can face hindrances by the equity shareholders by guidance and systematizing themselves
• When the firm earns more profits, then, higher dividends have to be paid which leads to raising in the value of the shares in the marketplace and its edges to speculation as well

Difference between Equity Shares and Preference Shares

Equity share and Preference share are the two types of share that a company issues. Equity share is an ordinary share. Preference share experience the perquisites of the dividend distribution first. The equity stockholders get the opportunity to cast their vote in major business decisions.

The company preference share receives the dividend at a fixed rate. Whenever there is an issue with the company, the preference share gets the right to return of the capital before the equity share.

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What are the main objectives of financial management?

The primary objective of financial management is to maximize shareholder’s wealth by maximizing the current market value of equity share.

(a) Maximize shareholder’s wealth

• This is the primary objective of financial management, which is also known as “the wealth maximization concept”.
• This means to maximize the current market value of equity shares of the company, which is only possible if there is optimum utilization of funds to achieve organizational objectives.
• Shareholder’s wealth can be calculated as;

The number of equity shares held by a shareholder X Current market value of each share.

(b) Procurement of sufficient funds at the lowest possible costs

• Funds must be procured at the lowest possible cost.
• The company should try to minimize the cost involved in the procurement of funds.
• Cost of capital is a very important parameter in deciding long term success of the financial plan.

(c) Optimum utilization of acquired funds

• The major challenge in front of an enterprise is to ensure that the returns must exceed the costs.
• This objective ensures that available funds are utilized effectively and efficiently.

(d) Ensure safety of investment

• A good financial decision is focused on the safety of the investment.
• The companies have to build their reserves of funds and maintain them.
• The money acquired should be invested judiciously to get the maximum return on investment.

(e) To achieve a sound capital structure

• A proper mix of equity and debt should be maintained so that there are a sound and fair composition of capital.

Explain the Concept of Capital Structure

Meaning of capital structure

• Capital structure is the mix of owners funds (Equity) and borrowed funds (Debt).
• More debt leads to more risks but increases profitability due to less cost. Hence, more debt should be introduced in capital structure, keeping risk in mind.
• Thus, a company should optimize risk and return and choose such a capital structure which maximizes shareholders wealth.
• Capital structure = Debt + Equity = Total Capital

What Are the Factors Affecting the Capital Structure?

(a) Cash flow position

• A company must consider its cash flow position before issuing debt.
• Cash must be sufficient for operating expenses or for payment of its fixed liabilities.
• Also, the buffer should be maintained by the company to tackle future uncertainties.

(b) Return on investment (ROI)

High ROI

• It means Return on investment is higher than the rate of interest.
• That means the company is able to generate good returns out of its investment.
• Thus, it is beneficial for a company to raise finance through borrowed funds.
• This is also called trading on equity.
• This ultimately maximizes Earning per Share (EPS) of the company.

Low ROI

• It means Return on investment is lower than the rate of interest.
• That means the company is NOT able to generate good returns out of its investment.
• Thus, if a company raises finance through borrowed funds, it will not be beneficial.
• This ultimately reduces Earning per Share (EPS) of the company.

(c) Cost of Debt

• The rate of interest payable on debenture or loans or borrowed funds is the cost of debt.
• If the company can raise debt at a lower rate, its borrowing power increases, and it can take more debt.

(d) Cost of Equity

• Debt attracts financial risk for the equity shareholders, which consequently increase the required rate of return for equity shareholders.
• If a debt is used more than a certain limit cost of equity will increase sharply and EPS will decline.

(e) Floatation cost

• Funds raising cost is known as floatation cost.
• Public issue of the debenture will prove costly than taking debt from any financial institution.

(f) Risk consideration

• Firm bears two types of business risk:

(i) Financial risk: Risk of repayment of debt.

(ii) Operating risk: Risk of recovering operating expenses.

• If Firm’s business risk is lower, its capability to use debt is higher.

(g) Stock market condition

Bullish Phase

• In the bullish phase of the stock market, raising equity is very easy as equity shares could be sold at a higher price.

Bearish Phase

• In the bearish phase of stock market debt proves to be a better option for raising funds.

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The above mentioned is the concept, that is elucidated in detail about ‘Equity shares’ for the Commerce students. To know more, stay tuned to BYJU’S.