Investors consider on equity financing because of its level of return, its riskiness of returns, the ease on liquidating the investment, its capital gain tax, and the degree of control.
The level of return on equity financing would be expected to be higher that the level of return associated with ‘safe’ investment such as government securities. Equities provide an opportunity to make investments where returns are related fairly directly to commercial success. Most investment opportunities of this type require investors to spend time managing the assets in which their money is invested; they also expose investors to unlimited liability. However, equities enable delegation of day-to-day management to the directors and protect the investors’ other assets.
Returns both in terms of capital gains and of dividends are not certain by any means. Negative returns are very common over periods of a year or two (or less), though historically above-average positive returns compensate for these. A period of adverse trading could cause the value of a particular firm’s ordinary shares to fall to zero, losing the shareholder the entire amount invested in those shares.
Dividends are taxed as income in the hands of the shareholders, at marginal rates up to 40 per cent. Capital appreciation is subject to rather less severe capital gain tax at rates similar to those applied to income. The firm may consider the equity financing because of these factors : Issue costs, Servicing costs, obligation to pay dividends, obligation to redeem the investment, tax deductibility of dividends, and the effect on control and freedom of action in the corporate.
The issue costs vary considerably according to the method used to raise the new equity and finance raised; ranging from virtually nothing up to about 15 per cent of the new finance raised. Equity holders expect relatively high returns in terms of capital appreciation and dividends. Dividends represent an explicit costs. The capital appreciation results from the fact that sooner or later profits not paid out as dividends are expected to end up in the hands of the shareholders, even if they have to wait until the firm is liquidated before this happens. Thus one way or another, the entire profits will eventually be paid out to shareholder. The shareholders can not directly force payment of a particular level of dividend in particular year, although ultimately the dividends must be paid.
There is also no obligation to redeem the investment unless (or until) the firm is liquidated. Because of this and to some extent because of the flexibility on dividend levels, finance provided by ordinary shareholders does not impose much by way of cash flow obligation on the firm.
Meanwhile in contrast with the servicing of virtually all other types of finance, dividends are not tax deductible in arriving at the firm’s corporation tax liability. This tends to make dividends more expensive than a similar gross equivalent loan interest rate.
Where new equity finance is raised from other than the existing shareholders in the same proportions as their original investment, voting power will shift to some extent, perhaps to a large extent, and possibly with it control of the firm. This is not necessarily a feature of all increases in equity financing. In fact the two most important means of raising equity finance for most firms, retained profits and rights issues, generally avoid this problem. Most firms’ annual general meetings are characterized by a distinct absence of most of those entitled to be present and to vote. Control is a factor which is more likely to be of concern to ordinary shareholders in small firms.