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Preference and Equity Capital

Preference Capital

The Preference Capital is that portion of capital which is raised through the issue of the preference shares. This is the hybrid form of financing that has certain characteristics of equity and certain attributes of debentures.

Advantages of Preference Capital

  • There is no legal obligation on the firm to pay a dividend to the preference shareholders.
  • The redemption of preference shares is not distressful for a firm since the shares are redeemed out of the profits and through the issue of fresh shares (preference shares and equity shares).
  • The preference capital is considered as a component of net worth and hence the creditworthiness of the firm increases.
  • Preference shareholders do not enjoy the voting rights, and thus, there is no dilution of control.

Disadvantages of Preference Capital

  • It is very expensive as compared to the debt-capital because unlike debt interest, preference dividend is not tax deductible.
  • Although, there is no legal obligation to pay the preference dividends, when the payment is made it is done along with the arrears.
  • The preference shareholder can claim prior to the equity shareholders, in case the dividends are being paid or at the time of winding up of the firm.
  • If the company does not pay or skips the preference dividend for some time, then the preference shareholders could acquire the voting rights.

The preference capital is similar to the equity in the sense: the preference dividend is paid out of the distributable profits, it is not obligatory on the part of the firm to pay the preference dividend, these dividends are not tax-deductible.

The portion of the preference capital resembles the debentures: the rate of dividend is fixed, preference shareholders are given priority over the equity shareholders in case of dividend payment and at the time of winding up of the firm, the preference shareholders do not have the right to vote and the preference capital is repayable.

Equity Capital

Invested money that, in contrast to debt capital, is not repaid to the investors in the normal course of business. It represents the risk capital staked by the owners through purchase of a company’s common stock (ordinary shares).

The value of equity capital is computed by estimating the current market value of everything owned by the company from which the total of all liabilities is subtracted. On the balance sheet of the company, equity capital is listed as stockholders’ equity or owners’ equity. Also called equity financing or share capital.

Advantage of Equity Capital

(i) Fixed Costs Unchanged By Equity Capital

Equity financing has no fixed payment requirements. As a result, the investments do not increase a company’s fixed costs or fixed payment burden. In addition, dividends to be paid to equity investors can be deferred and cash can be directed to business opportunities and operating requirements as needed.

(ii) Collateral-Free Financing

Equity investors do not require a pledge of collateral. Existing business assets remain unencumbered and available to serve as security for loans. In addition, assets purchased with equity capital can be used to secure future long-term debt.

(iii) Long-Term Financing

Equity investors are focused on future earnings and increasing the value of a business rather than the immediate return on their investment in the form of interest payments or dividends. As a result, businesses can rely on equity capital to finance projects for which the earnings or returns may not occur for some time, if at all.

(iv) Convenant-Free Financing

A lender is concerned with the repayment of debt. The lender wants to ensure that loan proceeds increase company assets, which generate cash to repay loans. Therefore, lenders establish financial covenants that restrict how loan proceeds are used. Equity investors establish no such covenants; they rely on governance rights to protect their interests.

Disadvantage of Equity Capital

(i) Investor Expectations

Neither profits nor business growth nor dividends are guaranteed for equity investors. The returns to equity investors are more uncertain than returns earned by debt holders. As a result, equity investors anticipate a higher return on their investment than that received by lenders.

(ii) Business Form Requirements

Legal restrictions govern the use of equity financing and the structure of the financing transactions. In fact, equity investors have financial rights, including a claim to distributed dividends and proceeds from the sale of the company in which they invest. The equity investors also have governance rights pertaining to the board of directors election and approval of major business decisions. These rights dilute the ownership and control of a company and increase the oversight of management decisions.

(iii) Financial Returns Distribution

Each investor in a company has a right to the cash flow generated by the business after all other claims are paid. If the business is sold, the owners share cash equal to the net proceeds of the business if a gain occurs on the sale. The investors’ net return is equal to the net proceeds of the sale less the cash they invested in the business. The legal restrictions that govern the use of equity financing determine the return received by an individual.

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