Key takeaways:
- Understand the nature and features of equity and preference shares, rights issues, and bonus shares.
- Grasp their practical application, benefits, and regulatory conditions.
- Develop the ability to analyze their impact on a company’s financial structure and shareholder value.
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Equity Share Capital
Concept and Features
Equity share capital represents the ownership stake in a company. Equity shareholders are the real owners: they have voting rights, a claim on residual profits, and bear the highest risk. These shares offer the possibility of higher returns, but also expose holders to the risk of loss if the company underperforms.
- Voting rights: Equity shareholders participate in key decisions, elect directors, and influence company policy. Their power is proportional to the number of shares held.
- Residual claim: In the event of winding up, equity shareholders receive their share only after all liabilities and preference shares are settled.
- Risk-return tradeoff: Equity shares offer no fixed dividend; returns depend entirely on company performance. If profits rise, dividends and share prices may increase. When profits fall, shareholders may get nothing.
Equity financing is the backbone of long-term capital for listed companies. It signals confidence to the market and can absorb business shocks better than debt-heavy structures.
Types of Equity Financing
a. Equity Shares
Equity shares, sometimes called ordinary shares, are the most common type of shares issued by companies. They represent a permanent source of capital, as they are generally not redeemable. Shareholders enjoy variable returns and have residual claims on profits and assets.
b. Rights Issue
A rights issue is an offer to existing shareholders to purchase additional shares, usually at a price below market value, in proportion to their current holdings. This method allows companies to raise fresh capital while giving existing shareholders a chance to maintain their ownership percentage.
- Meaning: Rights issues are governed by Section 62 of the Companies Act, 2013. Only existing shareholders on a specific record date are eligible.
- SEBI Guidelines: The Securities and Exchange Board of India (SEBI) mandates disclosures in the offer document, sets minimum subscription requirements, and ensures fair pricing and timelines. Companies must inform stock exchanges and provide adequate notice to shareholders.
- Benefits: Existing shareholders can buy shares at a discount, avoid dilution of their ownership, and possibly realize capital gains if the market price exceeds the offer price.
For instance, if a company announces a 1:4 rights issue at ₹100 per share when the market price is ₹120, each shareholder can buy one extra share for every four held, often making it an attractive proposition.
c. Bonus Shares
Bonus shares are issued by capitalizing a part of the company’s reserves or profits, converting these into new shares allocated to existing shareholders, free of cost. The total capital increases, but individual ownership percentage remains unchanged.
- Conditions for issue: Bonus issues require authorization by the Articles of Association and shareholder approval in a general meeting. Companies must have adequate free reserves or securities premium, and cannot default on statutory dues.
- Advantages: Bonus shares reward shareholders, increase liquidity in the market, and can make the share price more affordable for small investors. They do not involve cash outflow for the company.
- Signaling effect: A bonus issue often signals management’s confidence in the company’s future prospects, suggesting that past profits are sustainable and growth is expected.
| Feature | Rights Issue | Bonus Issue |
|---|---|---|
| Consideration | Shares issued at discounted price (cash inflow) | Shares issued free (no cash inflow) |
| Affects ownership percentage | No, if all exercise their rights | No |
| Impact on reserves | No major impact | Reserves decrease, share capital increases |
| SEBI/Legal compliance | High | High |
d. Preference Shares
Preference shares are a hybrid instrument, combining features of debt and equity. Holders receive a fixed dividend before anything is paid to equity shareholders, and have priority in repayment of capital during liquidation. However, they generally lack voting rights unless their dividends are in arrears.
- Cumulative: Unpaid dividends accumulate and must be paid before any equity dividend.
- Redeemable: Can be bought back by the company after a fixed period, providing flexibility in capital structure management.
- Convertible: Can be converted into equity shares under preset terms, offering potential for capital appreciation.
| Type | Pros | Cons | Impact on Financial Structure |
|---|---|---|---|
| Cumulative | Protects investors’ dividend expectations | Increases liability in low-profit years | Fixed obligation, but less risky for company than term loans |
| Redeemable | Temporary capital; aids in capital planning | Repayment obligation at maturity | Provides flexibility, avoids permanent dilution of control |
| Convertible | Attracts investors seeking growth | Dilutes equity over time if converted | Initially less dilutive, but may increase equity base later |
Preference shares, while lacking the growth potential of equity shares, offer stability to investors and can help companies balance risk and control in their capital mix.
Example
Let’s consider a company, ABC Ltd., with the following scenario:
- ABC Ltd. has authorized capital of ₹10 crore, divided into equity and preference shares.
- It issues a 1:2 rights issue at ₹50 per share. A shareholder with 200 shares can buy 100 more at a discount, raising fresh funds.
- The company declares a 1:1 bonus issue by capitalizing reserves, doubling the number of equity shares but not collecting any cash.
- It has ₹2 crore in 8% cumulative preference shares. Due to losses last year, no dividend was paid. This year, it must pay last year’s arrears plus the current year’s dividend before distributing any to equity shareholders.
Through these instruments, ABC Ltd. manages ownership, rewards loyal shareholders, and finances expansion—all while navigating the regulatory landscape.
Understanding the nuances of equity shares, rights and bonus issues, and preference shares is vital as these instruments not only shape a company’s capital structure but also influence investor confidence, market perception, and long-term strategy.