Benefits and Disadvantages of Equity Finance

Equity financing is one of the main funding options for any company. To understand the pros and cons of equity finance from a company point of view, let’s discuss the benefits and disadvantages of equity as a source of financing.

Advantages and Disadvantages of Equity Finance


Permanent Source of Finance

Equity financing is the permanent solution to finance needs of a company. No company’s main focus or objective can be financial management only. A product manufacturing company will have an objective of producing high-quality goods and reach to its right consumer. A service provider company will ensure providing high-quality services. Equity finance provides that leverage to the management to continuously focus on fulfilling their core objectives. It keeps management away from the hassles of raising funds again and again like other sources of financing viz. debt. Debt is raised and paid back over a period of time.

Benefits and Disadvantages of Equity FinanceNo Obligatory Dividend Payments

Equity finance for a new company is like blessings of an angel. The main limitation of a new company is the uncertainty of cash flows. Equity mode of finance gives management a breathing space by having no fixed obligation to pay dividends. A company can choose to pay no dividend or smaller dividends as per the cash flow position.

Open Chances of Borrowing

A company, majorly financed by equity, always has a controlled financial leverage ratio. Financial leverage ratio measures the ratio of financing by equity and debt. A bank or any other financial institutions require a company to invest roughly 20 to 25% by equity to finance other 75 to 80% debt. Lower levered firms have higher chances of smooth borrowing of debt in times of need.

Retained Earnings

A company develops an internal source of finance by having equity finance on board. The earnings which a company generates using the capital can be retained with the company to finance the increased working capital and other fund requirements. It obviates the other hassles of raising funds via other sources. Also, if the funds are utilized in projects with higher returns compared to what is available to the equity shareholders, the company effectively achieves its objective of shareholder’s wealth maximization.

Rights Shares

A company can get required capital via an issue of rights shares from its existing capital providers which has almost nil floatation cost. Floatation cost is the cost incurred in raising funds.

From Company point of view


Floatation Cost

Financing through equity is the most difficult way of getting funds to the company. Not only does it require a lot of statutory compliances but also have other costs like fee of a merchant banker, other expenses such as brokerage, underwriting fee, and lots of other issue expenses.

High Cost of Funds

Equity finance is considered to be the costly source of finance especially in comparison to debt. The obvious reason is the higher required rate of return from equity share investors. Since equity share investment is a high-risk investment, an investor will always expect a higher rate of returns.

No Tax Shield

The dividends distributed to the shareholders are not a tax deductible expense. On the contrary, the interest expense is an eligible expense for tax benefits. A 12% interest rate with 40% prevailing Tax Rate makes the effective cost of funds to be 7.2% {12% * (1-40%)} in case of debt. This benefit is not available to the equity source of financing and therefore, it is considered as a costly source of financing.

Underwriting of Shares

At the time of offering equity shares to the public, the company normally requires the appointment of underwriters. The job of an underwriter is to assume the risk of subscription. Underwriters would agree to subscribe the shares to an agree on extent if not subscribed by the general public and will charge a fee for that service. The fee may be in the form of upfront payment or may be a discounted equity share price.

Dilution of Control

When a company raises funds via equity, it dilutes the existing shareholder’s control. Percentage shareholding is reduced when new shareholders are introduced. In the case of debt financing, the control does not dilute.

No Benefit of Leverage

Debt funding has an indirect benefit available to the existing owners. Since a project with the higher rate of return (12%) than the cost of debt funds (8%) would enhance the welfare of the shareholders. It is because the margin of 4% will be distributed to the existing shareholders. If the project was financed by equity, this additional benefit would not have occurred to the existing shareholders but would equally distribute between old and new shareholders.

Last updated on : August 31st, 2017
What’s your view on this? Share it in comments below.

Leave a Reply

Difference between Operating and Financial Lease
  • Hypothecation
  • .Credit Appraisal of Term Loans by Financial Institutions like Banks
    Credit Appraisal of Term Loans by Financial …
  • Equity Share and its Types
    Equity Share and its Types
  • Foreign Currency Convertible Bond (FCCB)
    Foreign Currency Convertible Bond (FCCB)
  • Subscribe to Blog via Email

    Enter your email address to subscribe to this blog and receive notifications of new posts by email.

    Join 122 other subscribers

    Recent Posts

    Find us on Facebook

    Related pages

    m&m proposition iwhat are the factors affecting dividend policyhow to analyze debt to equity ratioloan vs overdraftirr conceptexplain capital budgeting processbanking advantages and disadvantagesadvantages and disadvantages of abc costingon invoice discount definitionmeaning of npvbill receivable definitionwhat do you mean by redemption of debenturecalculating dividend payout ratiodifference between sblc and bgzero coupon bonds definitionbank overdraft liabilitygaap accounting for leasespvifa financial calculatorsundry creditors definitioninstalment sales accountingcapital lease operating leasewacc calculationscredit card meaning in marathiideal stock turnover ratioformula for weighted average cost of capitalm&m finance companyhow to calculate sales turnover ratiogearing ratio debt to equitygaap rules for capitalization of fixed assetsprofitability index formuladisadvantages of horizontal analysiscommon size balance sheet ratiosinvestopedia current ratiocredit sales formulaoperating lease journal entriesproject payback calculatorunsecured debentureglobal depository receipts exampleliquidated valuewealth maximization and profit maximizationdefinition bank overdraftformula internal rate of returndividend discount model valuationissuing debenturesdividend discount calculatorlimitations of marginal costinghypothicationdisadvantages of economic order quantity modeldtr financeis marketable securities a current assetvariable costs are controllable and fixed costs are notwhat does negative eps meannpv in project managementcost of equity formulasnpv valuation methodsundry definition accountingbill receivable definitionfinancial and operating leverageprofitability ratios formulasdefine callable bondshow to calculate inventory turnover ratioasset turnover meaningbest capital budgeting methodcash accruals formulalease agreement for plant and machineryexample of debenturescalculating dividend payout ratiodiscounted pay backwhat is the basic accounting equationeva calculation formulafinancial management advantages and disadvantagesdisadvantages of mergers and takeoverspayback method formula