Distinguish between Equity share Finance and Debenture Finance.
Equity shares and debentures are the two most common types of securities issued by a company for raising long-term funds. The issue of shares and debentures are almost governed by the same rules and legal formalities. However, both differ from each other in respect of the following points.
I. Status: A shareholder or member is a partly owner of the company whereas a debenture holder is only a creditor. Thus share is a ownership security as against debenture which credit-worthy security.
II. Yield: A debenture holder gets interest at a fixed rate irrespective of the profits earned by the company. Payment of debenture interest must be paid even if company has earned no profit or it goes into loss. On the other hand, shareholders are paid dividend on shares held by them and not at a fixed rate. Shareholders don’t receive any dividend unless company makes a profit. Even when the company makes a profit, the payment makes a profit. Even when the company makes a profit, the payment of dividend normally depends on the discretion of Board of Directors. In case of debentures, directors have no option but only to pay interest.
III. Voting Rights: A shareholder being owner of the company has voting right and can interface in the management and control of the business. A debenture holder, however, has no voting right in the company.
IV. Terms of Repayment: The amount of debentures must be repaid in accordance with the terms of issue. But shares, except redeemable preference shares, cannot be redeemed before the liquidation of the company.
V. Order repayment: On winding up of the company, debentures are repaid first before any payment is made to either preference or equity shareholders. Shareholders are the last claimants for the refund of capital.
VI. Conditions of Issue: Debentures may be issued either at par or at a premium or at discount, but there are restrictions on issue of shares at a discount. Such restrictions are given u/s 79 of the Companies Act.
VII. Charge on Profits: Interest on debentures is a charge on profits and is to be paid where or not the company has made a profit. Dividend on shares, however, is not a charge on profits. Dividend is paid only when company makes a profit.
VIII. Tax Provisions: From tax point of view, interest on debentures is deductible expenditure and, therefore, debentures certainly have tax advantage over shares. Dividend on shares is not deductible while arriving at the total income of the company.
While taking decisions for raising of long term fund, a company has to decide which security-debentures or shares, the company should issue. Equity shares enjoy some advantages over debentures. (i) They are cheapest and easiest way of providing risk capital. There is no commitment regarding payment of dividend. But interest on debenture is to be paid whether there are profits or not. (ii) They grow with the growth of the company. Their real worth is in most of the cases, more than their face value. (iii) They are ideal investment for advantureous and spirited investors, debentures are good for those who like fixed income. (iv) Control over a company is exercised only through equity shares. Debentures holders have no voice in the management of the company. However, debentures too have their distinctive edge over the issue of equity shares – (i) The investment in debentures is safe. In economic depression, the value of their investment does not decline much. (ii) The return is fixed and certain. There is no fluctuation in return. They will get the interest even if there is no profit. (iii) Company of good repute can issue debentures and trade on equity. (iv) Moreover, the issue of debentures has tax advantage, as the interest to be paid on debentures is a charge on profits and it reduces the taxable income of the company.
Thus, a company should prefer issue of shares to debentures in the following circumstances:
I. In case of a manufacturing company, equity shares should be issued in the beginning. However, every company has to issue equity share capital in the beginning. It should avoid issue of debentures at the time of commencement of business.
II. When fresh capital is required to be raised by an existing company whose previous whose previous earnings have been unstable, only equity shares should be issued.
A company should prefer debentures to equity issue in the following circumstances:
I. When sales and earnings are relatively small.
II. When marginal cost of debt is less than the cost of equity or so long as it lowers the cost of capital or, in other words, when trading on equity is advantageous.
III. When a general price level price level is expected to be high.
IV. When the existing debt-equity ratio is low.
V. When retention of existing control pattern is the most important consideration in rising finances because debentures carry no voting rights.
VI. When it does not affect the cash flow situation of the company adversely.
While deciding upon the use of debt vs. equity financing the management should bear the above points in mind. But, however, there may be several other considerations to be considered (see factors affecting capital structure in previous chapter) depending upon the nature of the business and the severity of the situation.