Question

Provide the advantages and disadvantages of both raising capital using ordinary shares and preference shares to a company.

Answer 1

the ordinary share capital advantages and disadvantages

Advantage: No Repayment Requirement

When you use equity capital, you have no obligation to make interest payments or to repay equity investors’ initial investment. Debt capital, on the other hand, requires periodic interest payments and repayment of the borrowed principal. Although you might distribute some of your profits as dividends to equity holders, you can skip these payments if necessary. This advantage helps your small business keep more of its profits and allows more spending flexibility.

Advantage: Lower Risk

In general, a business that uses more equity than debt has a lower risk of bankruptcy. If a business suffers a setback and fails to make its interest payments, its creditors can force it into bankruptcy. Equity investors have no such rights. They must wait out any potential downturns to be able to benefit when a business prospers. For example, assume you finance your small business with all equity and have a bad year. Investors might be disappointed, but their only option is to hope for improvement.

Advantage: Bringing in Equity Partners

While the money is a definite advantage of new equity, the partners that you'll work with also have a vested interest in seeing your business succeed. If these partners have a good deal of expertise, connections and influence, this could make all the difference between a struggling or thriving business. Additionally, having good equity partners can make increase the odds of securing more attractive debt if needed in the future.

Disadvantage: Ownership Dilution

Various share capital pros and cons exist, but one of the worst negatives as an owner is the loss of control over the company. The advantages of owners capital investments typically include a certain amount of control over the enterprise through the ownership of a large percentage of the company's shares of stock.

With every share of stock you sell to investors, you dilute, or reduce, your ownership stake in your small business. Because equity investors typically have the right to vote on important company decisions, you can potentially lose control of your business if you sell too much stock.

For example, assume you sell a majority of your company’s outstanding stock to raise money, and investors disapprove of the company’s progress. In this case, because of your choices and your reduced ownership percentage, they might have the power to vote you out of a leadership position and bring in new management.

Disadvantage: Higher Cost

Although equity does not require interest payments, it typically has a greater overall cost than debt capital. Stockholders shoulder more risk from their perspective compared to creditors because they are last in line to get paid if the company goes bankrupt. Consequently, equity investors demand a higher rate of return on their investment. You typically must give up more stock for a lower price when you raise equity to compensate investors for this risk.

Disadvantage: Time and Effort

It takes a good deal of time and effort to get a loan, from getting through the loan application to getting through the underwriting process. However, the process to secure equity funding can be even more time-consuming and arduous. It typically takes the right connections and a powerful pitch deck to get the equity you need.

Advantages and disadvantages of raising capital through preference share

Advantage

NO LEGAL OBLIGATION FOR DIVIDEND PAYMENT

There is no compulsion of payment of preference dividend because nonpayment of dividend does not amount to bankruptcy. This dividend is not a fixed liability like the interest on the debt which has to be paid in all circumstances.

IMPROVES BORROWING CAPACITY

Preference shares become a part of net worth and therefore reduces debt to equity ratio. This is how the overall borrowing capacity of the company increases.

NO DILUTION IN CONTROL

Issue preference share does not lead to dilution in control of existing equity shareholders because the voting rights are not attached to the issue of preference share capital. The preference shareholders invest their capital with fixed dividend percentage but they do not get control rights with them.

NO CHARGE ON ASSETS

While taking a term loan security needs to be given to the financial institution in the form of primary security and collateral security. There are no such requirements and therefore, the company gets the required money and the assets also remain free of any kind of charge on them.

DISADVANTAGES OF PREFERENCE SHARES

COSTLY SOURCE OF FINANCE

Preference shares are considered a very costly source of finance which is apparently seen when they are compared with debt as a source of finance. The interest on the debt is a tax-deductible expense whereas the dividend of preference shares is paid out of the divisible profits of the company i.e. profit after taxes and all other expenses. For example, the dividend on preference share is 9% and an interest rate on debt is 10% with a prevailing tax rate of 50%. The effective cost of preference is same i.e. 9% but that of the debt is 5% {10% * (1-50%)}. The tax shield is the main element which makes all the difference. In no tax regime, the preference share would be comparable to debt but such a scenario is just an imagination.

SKIPPING DIVIDEND DISREGARD MARKET IMAGE

Skipping of dividend payment may not harm the company legally but it would always create a dent on the image of the company. While applying for some kind of debt or any other kind of finance, the lender would have this as a major concern. Under such a situation, counting skipping of dividend as an advantage is just a fancy. Practically, a company cannot afford to take such a risk.

PREFERENCE IN CLAIMS

Preference shareholders enjoy a similar situation like that of an equity shareholder but still gets a preference in both payment of their fixed dividend and claim on assets at the time of liquidation.