Boundless: Business: "Chapter 19, Section 5: Equity Finance"

Equity Finance

Companies can use equity financing to raise money and/or increase shareholder liquidity (through an IPO).

LEARNING OBJECTIVE

  • Explain the process of financing a firm through equity

KEY POINTS

    • The equity, or capital stock (or stock) of a business entity represents the original capital paid into or invested in the business by its founders.
    • Shares represent a fraction of ownership in a business. A business may declare different types or classes of shares, each having distinctive ownership rules, privileges, or share values.
    • In finance, the cost of equity is the return (often expressed as a rate of return) a firm theoretically pays to its equity investors, (i.e., shareholders), to compensate for the risk they undertake by investing their capital.

TERMS

  • par value

    The amount or value listed on a bill, note, stamp, etc.; the stated value or amount.

  • Preferred Stock

    Stock with a dividend, usually fixed, that is paid out of profits before any dividend can be paid on common stock and that has priority to common stock in liquidation.

  • Common stock

    Shares of an ownership interest in the equity of a corporation or other entity with limited liability entitled to dividends, with financial rights junior to preferred stock and liabilities.

FULL TEXT

Equity

The equity, or capital stock (or stock) of a business entity represents the original capital paid into or invested in the business by its founders. It serves as a security for the creditors of a business since it cannot be withdrawn to the detriment of the creditors. Stock is different from the property and the assets of a business which may fluctuate in quantity and value.

The stock of a business is divided into multiple shares, the total of which must be stated at the time of business formation. Given the total amount of money invested in the business, a share has a certain declared face value, commonly known as the par value of a share. The par value is the minimum amount of money that a business may issue and sell shares for in many jurisdictions, and it is the value represented as capital in the accounting of the business.

Shares represent a fraction of ownership in a business. A business may declare different types or classes of shares, each having distinct ownership rules, privileges, or share values. Ownership of shares is documented by the issuance of a stock certificate. A stock certificate is a legal document that specifies the amount of shares owned by the shareholder, and other specifics of the shares, such as the par value, if any, or the class of the shares.

Stock typically takes the form of either common or preferred. As a unit of ownership,common stock typically carries voting rights that can be exercised in corporate decisions. Preferred stock differs from common stock in that it typically does not carry voting rights but is legally entitled to receive a certain level of dividend payments before any dividends can be issued to other shareholders.

Financing through Equity

The owners of a private company may want additional capital to invest in new projects within the company. They may also simply wish to reduce their holding, freeing up capital for their own private use. They can achieve these goals by selling shares in the company to the general public, through a sale on a stock exchange. This process is called an Initial Public Offering, or IPO.

By selling shares they can sell part or all of the company to many part-owners. The purchase of one share entitles the owner of that share to literally share in the ownership of the company, a fraction of the decision-making power, and potentially a fraction of the profits, which the company may issue as dividends.

Public companies may issue additional shares (thus diluting current equity holders) to raise money to fund operations or capital investments.

Financing a company through the sale of stock in a company is known as equity financing. Alternatively, debt financing (for example issuing bonds) can be done to avoid giving up shares of ownership of the company. Unofficial financing known as trade financing usually provides the major part of a company's working capital (day-to-day operational needs).

Cost of Equity

In finance, the cost of equity is the return, often expressed as a rate of return, a firm theoretically pays to its equity investors, (i.e., shareholders) to compensate for the risk they undertake by investing their capital. Firms need to acquire capital from others to operate and grow. Individuals and organizations who are willing to provide their funds to others naturally desire to be rewarded. Just as landlords seek rents on their property, capital providers seek returns on their funds, which must be commensurate with the risk undertaken.

Firms obtain capital from two kinds of sources: lenders and equity investors. From the perspective of capital providers, lenders seek to be rewarded with interest and equity investors seek dividends and/or appreciation in the value of their investment (capital gain). From a firm's perspective, they must pay for the capital it obtains from others, which is called its cost of capital. Such costs are separated into a firm's cost of debt and cost of equity and attributed to these two kinds of capital sources.

While a firm's present cost of debt is relatively easy to determine from observation of interest rates in the capital markets, its current cost of equity is unobservable and must be estimated. According to finance theory, as a firm's risk increases/decreases, its cost of capital increases/decreases. This theory is linked to observation of human behavior and logic: capital providers expect reward for offering their funds to others. Such providers are usually rational and prudent preferring safety over risk. They naturally require an extra reward as an incentive to place their capital in a riskier investment instead of a safer one. If an investment's risk increases, capital providers demand higher returns or they will place their capital elsewhere.



Last modified: Friday, 6 November 2015, 3:41 PM