Equity Shares 107

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PRESENTATIONONEQUITY SHARES


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SOURCES OF FINANCE

Internal Sources

Retained profit, sale of assets, reducing stocks, tradecredit

External Sources

Personal savings, commercial banks, building societies,factoring services, share issue, debentures

INTERNAL SOURCES OF FINANCE:

Definition

These are sources of finance that come from thebusiness' assets or activities.


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1. Retained ProfitIf the business had a successful trading year and

made a profit after paying all its costs, it could usesome of that profit to finance future activities .

This can be a very useful source of long term

finance, provided the business is generating profit.1.Reducing Stocks

Stock is a type of asset (see balance sheet work for

more on assets) and can be sold to raise finance.

Stock includes the business' holdings of raw

materials (inputs), semi-finished products and alsofinished products that it has not yet sold.


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Trade Credit

a business does not normally pay for thingsbefore it takes possession of them. Instead, itwill usually place an order for supplies / inputsand will pay after receiving the items. It is goodpractice to pay quickly (often within one month)

as this will help the business develop a goodrelationship with its suppliers.


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SHARE

DEFINITION

A share represents aparticipation in the capitalof a company. A shareholder is in theory apartner in the company. It gives him the rights,proportionally to his holdings, to participate in

the management of the company, to receive theprofits and to dispose of the net assets of thecompany.


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Types of shares

A company may have many different types of shares that

come with different conditions and rights.

There are four main types of shares:

Ordinary Shares: These shares are standard shares with nospecial rights or restrictions. They have the potential to give

the highest financial gains, but also have the highest risk.Ordinary shareholders are the last to be paid if the company iswound up.

Preference shares: These shares typically carry a right that

gives the holder preferential treatment when annual dividendsare distributed to shareholders. Shares in this category have afixed value, which means that a shareholder would not benefitfrom an increase in the business' profits. However,


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usually they have rights to their dividend ahead ofordinary shareholders if the business is in trouble.

Cumulative preference shares: These sharesgive holders the right that, if a dividend cannotbe paid one year, it will be carried forward tosuccessive years. Dividends on cumulative

preferred shares must be paid, despite the earninglevels of the business.

Redeemable shares: These shares come with an

agreement that the company can buy them backat a future date - this can be at a fixed date or atthe choice of the business. A company cannotissue only redeemable shares.


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EQUITY

Introduction

What is equity?

Equity is the term commonly used to describe the

ordinary share capital of a business.

Ordinary shares in the equity capital of a business

entitle the holders to all distributed profits after theholders of debentures and preference shares have

been paid.


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Ordinary ( equity) sharesOrdinary shares are issued to the owners of a company.

The market value of a company's shares is determined bythe price another investor is prepared to pay for them. In

the case of publicly-quoted companies, this is reflected in

the market value of the ordinary shares traded on the stock

exchange (the "share price").In the case of privately-owned companies, where there is

unlikely to be much trading in shares, market value is often

determined when the business is sold or when a minority

shareholding is valued for taxation purposes.These SHARES are a form of ordinary shares, which are

entitled to a dividend only after a certain date or only if

profits rise above a certain


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amount. Voting rights might also differ from thoseattached to other ordinary shares.

Why might a company issue ordinary shares?

A new issue of shares might be made for severalreasons:

(1)The company might want to raise more cash

For example might be needed for the expansion of a

company's operations. If, for example, a companywith 500,000 ordinary shares in issue decides toissue 125,000 new shares to raise cash, should itoffer the new shares to existing shareholders, orshould it sell them to new shareholders instead?

- Where a company sells the new shares to existingshareholders in proportion to their existingshareholding in the company, this is known as aRIGHT ISSUE.


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(2) The company might want to issue new sharespartly to raise cash but more importantly to 'float' itsshares on a stock market.

When a UK company is floated, it must makeavailable a minimum proportion of its shares to thegeneral investing public.

(3) The company might issue new shares to the

shareholders of another company, inorder to take it over

There are many examples of businesses that use theirhigh share price as a way of making an offer for other

businesses. The shareholders of the target businessbeing acquired received shares in the buying businessand perhaps also some cash.


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Sources of equity finance

There are three main methods of raising equity:

(1) Retained profits: That is retaining profits,rather than paying them out as dividends. This isthe most important source of equity.

(2) Rights issues: That is an issue of newshares. After retained profits, rights issues are thenext most important source.

(3) New issues of shares to the public: That is

an issue of new shares to new shareholders. Intotal in the UK, this is the least important sourceof equity finance.


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SHARE HOLDERS VOTING RIGHTS: Equity share holders enjoy the right to elect the

board of directors of the company. There are 2 systems of voting may be followed

for this purpose

Majority rule voting

proportionate rule voting1.Majority rule voting:

This system is commonly used in India.

Under this system of voting , Each share carriesone vote and each director position is filledindividually.


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This means that if a shareholder owns 100 equity shares

of a company which has 7 director positions, he has 100

votes for each of the 7 director positions. Thus, he is

entitled to cast 100 votes when position 1 is being filledup, 100 votes when position 2 is being filled up, 100 votes

when position is being filled up, so on and so forth.

From the above recital it is clear that a group which has

more than 50 percent of outstanding equity shares canensure that each director position is filled by a candidate

of its choice.

In practice of course this can often be ensured with amuch smaller equity holding, say between 20 and 30

percent , because the remaining equity shareholders

usually do not participate In voting or fail to exercise

their effectively


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2.PROPORTINATE RULE SYSTEM:

Under this system of voting the number of

votes enjoyed by a shareholder is equal ofshares held by him times the number ofdirectors to be elected.

For example: If a share holders holds 1000 shares and the

number of directors to be elected is seven ,the shareholders will have 7000 votes .He

may spread his votes in any manner he likes.


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DIFFERENCE BETWEEN MAJORITYRULE VOTING AND PROPORTINATERULE VOTING

The principal difference between the majorityrule and proportionate rule voting systems isthat under the former a majority is able to electall the members of the board whereas under thelater significant minority, if it casts its votesintelligently, is assured of some representationon the board.

Is there a way of determining the number ofshares needed to guarantee the election of acertain number of directors? Yes, the followingformula helps in doing precisely that:

N b f h i d l i b


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Number of shares required to elect a certain numberof directors=

Number of shares outstanding * Number of directors

desired to be elected Total number of directors to be

elected+1

To illustrate, consider the following information about

a company: (i) number of outstanding shares: 1million, (ii) director positions: 7,and (iii) directorsdesired to be elected: 2. the number of shares requiredto guarantee the election of two directors is:

100,000 * 2 +1= 250,001 7+1


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An important source of long-term financing,equity capital offers the following advantages:

1.There is no compulsion to pay dividends. Itthe firm has insufficiency of cash, it can skipequity dividends without suffering any legallconsequences.

2. Equity capital has no maturity date and hencethe firm has no obligations to redeem.

3. Because equity capital provides a cushion to

lenders, it enhances the creditworthiness of thecompany. In general, other things being equal,the larger the equity base, the greater the abilityof the firm to raise debt finance on favourable

terms.


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4. Presently, dividends are tax-exempt inthe hands of investors. The company

paying equity dividend, however, isrequired to pay a dividend tax of 10percent.

The disadvantages of raising finances by

issuing equity shares are as follows: Sale of equity shares to outsiders dilutes

the control of existing owners.

The cost of equity capital is high, usuallythe highest. The rate of return required byequity shareholders is generally higher thanthe rate of return required by otherinvestors.


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Equity dividends are paid out of profit aftertax, whereas interest payments are tax

deductible expenses. This makes the relativecost of equity more. Partially offsetting thisadvantage is the fact that Equity dividendsare tax-exempt whereas interest income istaxable in the hands of investors.

the cost of issuing equity shares is generallyhigher than the cost of issuing other types of

securities. Underwriting commission,brokerage costs, and other issue expensesare high for equity issues.


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RIGHTS OF EQUITY SHARE

HOLDERS

Right to Control:

Equity shareholders as owners of the firm elect the

board of directors and have the right to vote on

every resolution placed before the company. Theboard of directors, in turn selects the management

which control the operations of the firm. Hence,

equity shareholders in theory, exercise an indirect

control over the operations of the firm.


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Pre-emptive Right:

The pre-emptive right enables existing equity

shareholders to maintain their proportionalownership by purchasing the additional equity

shares issued by the firm.

The law requires companies to give existingequity share holders the first opportunity to

purchase, on prorata, basis, additional issues of

equity capital.


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This pre-emptive right ensures that the

management cannot issue additional shares

to persons or groups who are favorably

disposed towards it and there by strengthenits control over the firm. More important, the

pre-emptive right protects the existing share

holders from the dilution of their financialinterest as a result of additional equity issue.


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1.Right to income:

The equity investors have a residual claim to the

income of the firm. The income left after satisfyingthe claims of all other investors belongs to theequity share holders. This income is simply equalto profit after tax minus preferred dividend. It may

be noted here that equity shareholders are entitledto dividend that is declared by the board ofdirectors. The dividend decision is the prerogativeof the board of directors and equity shareholders

cannot challenge this decision in a court of law.The income of equity shareholders may be retainedby the firm or paid out as dividends


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In this respect the position of equityshareholder differs markedly from thatof suppliers of debt capital :

Debentures holders, for example, cantake legal action against the companyfor its failure to meet contractual

interest payment and principalrepayment, irrespective of the financialcircumstances of the company.

Equity shareholders, on the other hand,cannot challenge the dividend decisionof the board of directors in a court oflaw, however impressive the financial

performance of the company may be.


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Right in Liquidation:

As in the case of income, equity share holders have

a residual claim over the assets of the firm in the

event of liquidation. Claims of all others-debenture holders, secured lenders, unsecured

lenders, others creditors, and preferred

shareholders- are anything in the event of

liquidation because the liquidation value of asset isnot adequate to meet fully the claims of others.


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THANK YOU

Equity Shares 107

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