Types of Shares:
There are two types of shares. They are:
1. Equity Shares
2. Preference Shares
1. Equity shares:
We also know equity shares as ordinary shares. These shares have voting rights. Equity share is a main source of finance for any company giving investors the right to vote, share market profits and claim on assets.
We know a share that is not a preference share as an equity share. It doesn’t offer a fixed rate of return. They don’t get a fixed rate of dividends. It entitles the whole of the profit of a company to these shareholders, only after paying a fixed dividend to preference shareholders.
Features of Equity Shares:
- They are permanent.
- Equity shareholders are the actual owners of the company and they bear the highest risk.
- Equity shares are transferable. i.e. ownership of equity shares can be transferred with or without consideration to other people.
- Dividend payable to equity shareholders is an appropriation of profit.
- Equity shareholders do not get a fixed rate of dividends.
- They limit the liability of equity shareholders to the extent of their investment.
Advantages of Equity Shares:
- Equity shares do not create any obligation to pay a fixed rate of dividends.
- Equity shares can be issued creating no charge over the asset of the company.
- It is a permanent source of capital and the company has to repay it except under liquidation.
- Equity shareholders are the real owners of the company who have voting rights.
- With profits, equity shareholders are the real gainers with increased dividends and appreciation in the value of shares.
Disadvantages of Equity Shares:
- If only equity shares are issued, the company cannot take advantage of trading on equity.
- As equity capital cannot be redeemed, there is a danger of overcapitalization.
- Equity shareholders can put obstacles for management by manipulating and organizing themselves.
- During prosperous periods, higher dividends have to be paid to lead to an increase in the value of shares in the market, and it leads to speculation.
- Investors who desire to invest in safe securities with a fixed income have no attraction for such shares.
Calculating Equity Shares:
Calculating the cost of equity share capital
The cost of equity share capital is that part of the cost of capital payable to equity shareholders. Every shareholder gets shares for getting a return on it. So, for a company’s point of view, it will cost and the company must earn more than the cost of equity capital to leave unaffected the market value of its shares.
We can calculate the types of cost of equity shares capital using the following methods:
1. Dividend yield method or Dividend-Price ratio method:
According to the dividend yield method or dividend-price ratio method, “Cost of equity capital is a minimum rate which will be equal to the present value of future dividend per share with a current price of a share.
Cost of equity = Dividend per equity share/ Market price or net proceeds of per share.
Ke = DPS/ MPPS or NPPS
A company issues 1,500 shares of Rs. 150 each at a premium of 12%. The company has been paying a 23% dividend to equity shareholders for the past five years and expects to maintain the same. Compute the cost of equity capital. Will it make any difference if the market price of the equity share is Rs. 230?
Ke= DPS/MPPS or NPPS
=23/110 X 150
If the market price of the equity shares is 230.
23/230 X 100
2. Dividend yield plus growth in dividend method
We base the dividend yield plus growth in the dividend method on the assumption that the company is growing and its share market value is also increasing. In that situation, shareholders want more than a simple dividend, so the company can provide more profit according to growth. So, we will add it to the previously calculated cost of equity capital.
Cost of Equity Capital = DPS/ MPPS or NPPS + Rate of growth in dividends
Ke = DPS/ MPPS or NPPS + G%
A company plans to issue 1,500 new equity shares of Rs. 150 each for the person. We expect the floatation costs to be 7% of the share price. The company pays a dividend we expect of Rs. 15 per share initially and the growth in dividends to be 5%. Compute the cost of a new issue of equity shares.
If the current market price of an equity share is Rs. 180, calculate the cost of existing equity share capital.
15/180+7% = 19.0%
3. Earning yield method:
According to this method, the cost of equity capital is the minimum rate that we have to earn on the market price of a share. Its formula is:
Ke = Earnings per share/Net proceeds or market price per share
Ke = EPS/ MPPS or NPPS
A firm is considering an expenditure of Rs. 50 lakhs for expanding its operations. The relevant information is:
Number of existing equity shares = 20 Lakhs
The market value of the existing share = Rs. 50
Net Earning = Rs. 95 Lakhs
Compute the cost of existing equity share capital and of new equity capital assuming that they will issue new shares for Rs. 50 per share and the costs of a new issue will be Rs. 1 per share.
Earning per share = earning/total number of shares = 95/20
= Rs. 4.75
Ke = 4.75/50 X 100
Ke = 9.5%
Cost of new equity capital
Ke = 4.75/50-1 X 100 = 9.69%
2. Preference Shares:
Preference shares are those shares that carry certain special or priority rights. First, dividends at a fixed rate are payable on these shares before they pay any dividend on equity shares.
Second, at the time of the winding-up of the company, it repays the capital to preference shareholders before the return of equity capital.
Preference shares do not carry voting rights. However, holders of preference shares may claim voting rights if they do not pay the dividends for two years or more on cumulative preference shares and three years or more on non-cumulative preference shares types.
Features of Preference Shares:
- Preference shares are a long-term source of finance.
- The dividend payable on preference shares is higher than the debenture interest.
- Preference shareholders get a fixed rate of dividends irrespective of the volume of profit.
- We know it as the hybrid security because it also bears some characteristics of debentures.
- The preference dividends tax in India is not tax-deductible expenditure.
- Preference shareholders do not have any voting rights.
- Preference shareholders have the preferential right for repayment of capital in case of the winding-up of the company.
- Preference shareholders also enjoy a preferential right to receive the dividend.
Advantages of Preference Shares:
- The earnings per share of existing preference shareholders are not diluted if fresh they issue preference shares.
- Preference shares increase the earnings of equity shareholders, i.e. it has a leveraging benefit.
- Preference shareholders do not have any voting rights and hence do not affect the decision making of the company.
- The preference dividend is payable only if there is profit.
Disadvantages of Preference Shares:
- The preference dividend is not tax-deductible and hence it is costlier than a debenture.
- With a cumulative preference share, the arrear dividend is payable when the company earns a profit, which creates a huge financial burden on the company.
- Redemption of preference share again creates a financial burden and erodes the capital base of the company.
- Preference shareholders get dividends at a constant rate and will not increase even if the company earns a huge profit, which makes this form of finance less attractive.
- Preference shareholders do not enjoy voting rights and hence their fate is decided by the equity shareholders.
Calculating Preference Shares:
Calculating the cost of preference share capital
The cost of preference share capital is that part of the cost of capital in which we calculate the amount payable to preference shareholders in the form of dividends with a fixed rate. We can calculate the types of cost of preference shares using the following methods.
The Formula for Types of Cost of Preference Shares
Irredeemable Preference Share
Kp = Dp/NP
Redeemable Preference Share
Kp = Dp+ ( (RV-NP)/n)/ (RV+NP)/2
Kp = Cost of Preference Share
Dp = Dividend on preference share
NP = Net proceeds from the issue of preference share (Issue price–Flotation cost)
RV = Redemption Value
N = Period of preference share
A company issues 30,000 irredeemable preference share at 9% whose face value is Rs. 50 each at a 4% discount. Find out the cost of preference share capital.
Dividend on Preference share (Dp) = 50*9/100 = 4.5
Discount = 50*4.5/100 =2.25
Net proceeds (NP) = 50-2.25 = 47.75
Kp = Dp/NP
Company XYZ, a small company, issued 70,000 shares of 10 each and pays Rs. 9 per share as dividends. Further issue 20,000 debentures of Rs. 110 each and the interest pays by the company is 7%. The company wants to expand its business by opening a new branch in different cities. It wants to finance its expansion project through 8% preference shares. Find out:
- Cost of preference share if issues 110 of Rs. 80 each at a 4% discount and redeem at a 5% premium after 9 years.
- Which one is good for the company redeemable preference share or irredeemable preference share?
- Flotation cost Rs. 9 each.
Discount= 80*0.04 = 3.2
Issue price = 80-3.2 = 76.8
Net proceeds = 76.8–3.2 = 73.6
Dividend = 0.08*80 = 6.4
Premium amount = 80*0.04 = 3.2
Redemption value = 80 + 3.2 = 83.2
Irredeemable Preference share:
Kp = Dp/NP
= 8.33 %
Redeemable Preference share:
Net proceeds = 80-3.2 – 9 = 67.8
Kp = Dp+ ((RV-NP)/n)/ (RV+NP)/2
Here, 6.4 + ((83.2-67.8)/10)/ (83.2+67.8)/2
Then, kp= 6.4+ (1.54/75.2)
So, kp= 6.4 + 0.020
Finally, kp= 6.42 %
The cost of redeemable preference shares is less than the irredeemable preference share by 2.55%. So, the redeemable preference share is beneficial for Company XYZ.
Classification of Shares:
We can classify types of equity shares under the following categories:
1. Authorized Share Capital:
- It is the maximum amount of capital that a company can issue. The companies can increase it from time to time.
- For that we need to comply with some formalities also have to pay some fees to the legal bodies.
2. Issued Share Capital:
- It is that part of the authorized capital that the company offers to the investors.
3. Subscribed Share Capital:
- It is that part of the issued capital that an investor accepts and agrees upon.
4. Paid-up Capital:
- It is the part of the subscribed capital, which the investors pay. Normally, all companies accept complete money in one shot and therefore issued, subscribed and paid capital becomes the same.
- Conceptually, paid-up capital is the amount of money that a company invests in the business.
5. Right Shares:
- These shares are those which a company issues to its existing shareholders.
- The company issues such kinds of shares to protect the ownership rights of the existing investors.
6. Bonus Shares:
- When the company issues shares to its shareholders in the form of a dividend, we shall call them bonus shares.
- There are various advantages and disadvantages of bonus shares like a dividend, capital gain, limited liability, high risk, fluctuation in the market, etc.
7. Sweat Equity Share:
- They issue it to employees or directors of a company at a discounted rate.
- Issued for consideration other than cash. These are the types of equity share classifications.
We can classify types of preference shares under the following categories:
1. According to Redeemability:
Redeemable Preference shares
- Shares that a company may repay after a fixed period or earlier.
- As per the Companies (Amendment) Act, 1988, a company can issue redeemable preference shares redeemable within 10 years from the date of issue.
Irredeemable Preference Shares
- It does not carry the arrangement for redemption.
- Shares are repayable only at winding up.
2. According to the Right of Receiving Dividend:
Cumulative Preference Shares
- A fixed-rate of dividend is guaranteed.
- At the time of inadequate profit, they will lose nothing.
- Arrear will get in subsequent years.
Non Cumulative Preference Shares
- Fixed-rate of dividend is guaranteed.
- At the time of inadequate profit, they will get nothing.
3. According to Participation:
Participating Preference shares
- Fixed-rate of dividend is guaranteed.
- Entitled to share the surplus profit.
Non-Participating Preference Shares
- A fixed-rate of dividend is guaranteed.
- It does not share the surplus profit.
4. According to Convertibility:
Convertibility Preference Shares
It gives the holders of convertible preference shares an option to convert whole or part of their holding into equity shares after a specific period.
Non Convertibility Preference Shares
The holders of non-convertible preference shares do not have the option to convert their holding into equity shares; i.e., they remain as preference share until their redemption. These are the types of Preference shares classifications.