Corporate Finance

Assignment II
Name: Manisha Patil
Roll No. : 56

Date: 1 October, 2010

Q1. Define briefly the features of equity shares as source of long
term finance.

Introduction:

When a firm wants to invest in long term assets, it must find the needs to
finance them. The firm can rely to some extent on funds generated
internally. However, in most cases internal resources are not enough to
support investment plans. When that happens the firm may have to curtail
investment plan or seek external funding. Most firms choose to take external
funding. They supplement internal funding with external funding raise from a
variety of sources. A company might raise new funds from the following
sources:

Sources of funds

 The capital markets:

i) new share issues, for example, by companies acquiring a stock market
listing for the first time

ii) rights issues

 Loan stock
 Retained earnings
 Bank borrowing
 Government sources
 Business expansion scheme funds
 Venture capital
 Franchising.

Equity Share capital:

Equity shares or ordinary shares are those shares which are not preference
shares.

Dividend on these shares is paid after the fixed rate of dividend has been
paid on preference shares. The rate of dividend on equity shares is not fixed
and depends upon the profits available and the intention of the board.

In case of winding up of the available and the intention of the board. In case
of winding up of the company, equity capital can be paid back only after
every other claim including the claim of preference shareholders has been
settled.
The most outstanding feature of equity capital is that its holders control the
affairs of the company and have an unlimited interest in the company's
profits and assets. They enjoy voting right on all matters relating to the
business of the company. They may earn dividend at a higher rate and have
the risk of getting nothing. the importance of issuing ordinary shares is that
no organisation for profit can exist without equity share capital. This is also
known as risk capital.

Equity capital represents the ownership capital. The equity shareholders

collectively own the company and enjoy all the rewards and the risks
associated with the ownership. However, unlike the sole proprietor or the
partner of the firm, the downside risk of the shareholders is limited to their
capital contribution.

Residual Claim: It refers to the residual income on which the shareholders

have a right. Residual income is the income left after the claims of all others
lenders of long-term finance in the form of interest and taxes have been met.
It is the figure of profit after tax less dividend to be paid to preference
shareholders.

The equity shareholders have a residual claim on the income of the

company. The company has distributed the whole profit as dividend to the
equity holders or the company may retain a part of its profit. The dividend
decision is the decision of the board of directors. Equity Shareholders cannot
contest it in a court of law.

Liquidation: Refers to the closure of a company. It may be due to losses and

non-viability of the operations. The capital contributed by the equity
shareholders cannot be redeemed until the liquidation of the company.

From the company’s point of view funds through equity capital has both
advantages and disadvantages.

 Advantages of equity shares:

• Long-term and Permanent Capital: It is a good source of long-

term finance. A company is not required to pay-back the equity
capital during its life-time and so, it is a permanent sources of capital.
 • No Fixed Burden: Unlike preference shares, equity shares suppose
no fixed burden on the company's resources, because the dividend on
these shares are subject to availability of profits and the intention of the
board of directors. They may not get the dividend even when company
has profits. Thus they provide a cushion of safety against unfavorable
development

• Credit worthiness: Issuance of equity share capital creates no

change on the assets of the company. A company can raise
further finance on the security of its fixed assets.

•Risk Capital: Equity capital is said to be the risk capital. A company

can trade on equity in bad periods on the risk of equity capital.

• Dividend Policy: A company may follow an elastic and

rational dividend policy and may create huge reserves for its
developmental programmes.

 Disadvantages of equity shares:

• Dilution in control: Each sale of equity shares dilutes the voting

power of the existing equity shareholders and extends the voting or
controlling power to the new shareholders. Equity shares are
transferable and may bring about centralization of power in few hands.
Certain groups of equity shareholders may manipulate control and
management of company by controlling the majority holdings which
may be detrimental to the interest of the company.

• Trading on equity not possible: If equity shares alone are issued,

the company cannot trade on equity.

•Over-capitalization: Excessive issue of equity shares may result in

over-capitalization. Dividend per share is low in that condition which
adversely affects the psychology of the investors. It is difficult to cure.

• No flexibility in capital structure: Equity shares cannot be paid

back during the lifetime of the company. This characteristic creates
inflexibility in capital structure of the company.

•High cost: It costs more to finance with equity shares than with other
securities as the selling costs and underwriting commission are paid at a
higher rate on the issue of these shares.
 •Speculation: Equity shares of good companies are subject to hectic
speculation in the stock market. Their prices fluctuate frequently which
are not in the interest of the company.

 Equity shares is source of Long term finance

Reasons: No fixed maturity, no obligation to redeem

No compulsion to pay dividends

Provides leverage capacity

Dividends tax exempt for investors

 Pros of Equity Financing:

Equity financing allows you to cut out the bank as a business partner.
Instead of spending cash on loan repayments, you can use the infusion from
equity investors to grow your business. Furthermore, equity investors help
reduce your personal risk in the business.

In the event your business fails, you would still be required to pay back any
bank loans you take, or reorganize the debt payment under bankruptcy
protection. Equity investors, however, usually don’t have the same rights as
debtors; you would not be required to return their original investment in the
event your business collapses, for example. Equity investment should be
viewed as a long-term solution and a means to inject both cash and
experience into your startup.

Cons of Equity Financing

If you’re seeking cash for the short term, offering equity is not the right
approach. Investors want their capital to help the company make good
investments and position itself for medium- and long-term growth. If your
cash flow hasn’t picked up as you expected, you may want to call a bank
instead. Furthermore, you’ll have to cede some control over your company’s
operations if you offer stock to investors.

Consider what your long-term strategy is for your business. Shareholders will
be looking for a plan to get a return on their investment, and that plan could
include merging with another company, selling the company to a larger firm,
or conducting a public stock offering which would then allow investors to sell
their stock on the open market. Along with sharing control, you’ll also be
sharing the profits. Make sure to run the calculations on any potential equity
agreement: You may find that you’re paying a larger percentage of your
profits to investors than you would toward a bank loan.
Q2.

a) If you deposit Rs. 6,50,000 in a bank account which pays 12%

interest. How much can you withdraw annually for a period of
10 years?

b) An investor deposits Rs 35,000 at the beginning of each year for

8 years in a bank and the deposit earns a compound interest @
11% p.a. How much amount he will have at the end of 8 years?

c) A company offers 18 % interest on deposits. What is the

effective rate of interest if compounding is done a) Half-yearly
b) Quarterly and c) Monthly?

d) You borrow Rs. 11,50,000 at 12% interest p.a. to purchase a

Honda car. Loan is to be repaid in 30 EMI’s payable at the end of
each month. Determine the amount of EMI.

e) You want to buy a house after 6 years when it is expected to

cost Rs 55 lakhs. How much should you save annually if your
savings earn a compound return of 14%?