Question

Which of the following security can be forfeited for non-payment of allotment or call money?
(I) Equity Shares
(II) Equity Shares, Preference Shares
(III) Preference Shares, Equity Shares & Debentures
(IV) Debentures
Select the correct answer from the options given below :-

• A. (I) only
• B. (III) only
• C. (I) & (IV) only
• D. (II) only

Answer 1

The correct option is D (II) only

Meaning:

Equity shares are the main source of finance of a firm. It is issued to the general public. Equity share¬holders do not enjoy any preferential rights with regard to repayment of capital and dividend. They are entitled to residual income of the company, but they enjoy the right to control the affairs of the business and all the shareholders collectively are the owners of the company.

Features of Equity Shares

The main features of equity shares are:

1. They are permanent in nature.

2. Equity shareholders are the actual owners of the company and they bear the highest risk.

3. Equity shares are transferable, i.e. ownership of equity shares can be transferred with or without consideration to other person.

4. Dividend payable to equity shareholders is an appropriation of profit.

5. Equity shareholders do not get fixed rate of dividend.

6. Equity shareholders have the right to control the affairs of the company.

7. The liability of equity shareholders is limited to the extent of their investment.

Advantages of Equity Shares

Equity shares are amongst the most important sources of capital and have certain advantages which are mentioned below:

i. Advantages from the Shareholders’ Point of View

(a) Equity shares are very liquid and can be easily sold in the capital market.

(b) In case of high profit, they get dividend at higher rate.

(c) Equity shareholders have the right to control the management of the company.

(d) The equity shareholders get benefit in two ways, yearly dividend and appreciation in the value of their investment.

ii. Advantages from the Company’s Point of View:

(a) They are a permanent source of capital and as such; do not involve any repayment liability.

(b) They do not have any obligation regarding payment of dividend.

(c) Larger equity capital base increases the creditworthiness of the company among the creditors and investors.

Disadvantages of Equity Shares:

Despite their many advantages, equity shares suffer from certain limitations. These are:

i. Disadvantages from the Shareholders’ Point of View:

(a) Equity shareholders get dividend only if there remains any profit after paying debenture interest, tax and preference dividend. Thus, getting dividend on equity shares is uncertain every year.

(b) Equity shareholders are scattered and unorganized, and hence they are unable to exercise any effective control over the affairs of the company.

(c) Equity shareholders bear the highest degree of risk of the company.

(d) Market price of equity shares fluctuate very widely which, in most occasions, erode the value of investment.

(e) Issue of fresh shares reduces the earnings of existing shareholders.

ii. Disadvantage from the Company’s Point of View:

(a) Cost of equity is the highest among all the sources of finance.

(b) Payment of dividend on equity shares is not tax deductible expenditure.

(c) As compared to other sources of finance, issue of equity shares involves higher floatation expenses of brokerage, underwriting commission, etc.

Preference shares are those shares which carry certain special or priority rights. Firstly, dividend at a fixed rate is payable on these shares before any dividend is paid on equity shares.

Secondly, at the time of winding up of the company, capital is repaid to preference shareholders prior to the return of equity capital. Preference shares do not carry voting rights. However, holders of preference shares may claim voting rights if the dividends are not paid for two years or more on cumulative preference shares and three years or more on non-cumulative preference shares.

Preference shares have the characteristics of both equity shares and debentures. Like equity shares, dividend on preference shares is payable only when there are profits and at the discretion of the Board of Directors.

Preference shares are similar to debentures in the sense that the rate of dividend is fixed and preference shareholders do not generally enjoy voting rights. Therefore, preference shares are a hybrid form of financing.

Advantages:

1. Appeal to Cautious Investors:

Preference shares can be easily sold to investors who prefer reasonable safety of their capital and want a regular and fixed return on investment.

2. No Obligation for Dividends:

A company is not bound to pay dividend on preference shares if its profits in a particular year are insufficient. It can postpone the dividend in case of cumulative preference shares also. No fixed burden is created on its finances.

3. No Interference:

Generally, preference shares do not carry voting rights. Therefore, a company can raise capital without dilution of control. Equity shareholders retain exclusive control over the company.

4. Trading on Equity:

The rate of dividend on preference shares is fixed. Therefore, with the rise in its earnings, the company can provide the benefits of trading on equity to the equity shareholders.

5. No Charge on Assets:

Preference shares do not create any mortgage or charge on the assets of the company. The company can keep its fixed assets free for raising loans in future.

6. Flexibility:

A company can issue redeemable preference shares for a fixed period. The capital can be repaid when it is no longer required in business. There is no danger of over-capitalisation and the capital structure remains elastic.

7. Variety:

Different types of preference shares can be issued depending on the needs of investors. Participating preference shares or convertible preference shares may be issued to attract bold and enterprising investors.

Preference shares can be made more popular by giving special rights and privileges such as voting rights, right of conversion into equity shares, right of shares in profits and redemption at a premium.

Disadvantages:

1. Fixed Obligation:

Dividend on preference shares has to be paid at a fixed rate and before any dividend is paid on equity shares. The burden is greater in case of cumulative preference shares on which accumulated arrears of dividend have to be paid.

2. Limited Appeal:

Bold investors do not like preference shares. Cautious and conservative investors prefer debentures and government securities. In order to attract sufficient investors, a company may have to offer a higher rate of dividend on preference shares.

3. Low Return:

When the earnings of the company are high, fixed dividend on preference shares becomes unattractive. Preference shareholders generally do not have the right to participate in the prosperity of the company.

4. No Voting Rights:

Preference shares generally do not carry voting rights. As a result, preference shareholders are helpless and have no say in the management and control of the company.

5. Fear of Redemption:

The holders of redeemable preference shares might have contributed finance when the company was badly in need of funds. But the company may refund their money whenever the money market is favourable. Despite the fact that they stood by the company in its hour of need, they are shown the door unceremoniously.