Let us compare the merits and demerits of equity shares and debentures for the anp any before advising the directors about the most appropriate source of finance.
(a) Equity Shares:
The merits of raising funds through issuing equity shares are given below:
(i) Payment of dividend to the equity shareholders is not compulsory. Therefore, there is no burden on the company.
(ii) Equity capital is a permanent source of capital as it is to be repaid only at the time of liquidation of a company.
(iii) Funds can be raised through equity issue without creating any charge on the assets of the company. The assets of a company are, therefore, free to be mortgaged for the purpose of borrowings.
The major limitations of raising funds through issue of equity shares are as follows:
(i) The cost of equity shares is generally more as compared to the cost of raising funds through other sources.
(ii) Issue of additional equity shares dilutes the voting power, and earnings of existing equity shareholders.
(b) Debentures:The merits of raising funds through debentures are as follows:
(i) Debentures are fixed charge funds and do not participate in profits of the company.
(ii) As debentures do not carry voting rights, financing through debentures does not dilute control of equity shareholders on management.
(iii) Financing through debentures is less costly as compared to cost of preference or equity capital as the interest payment on debentures is tax deductible.
The demerits of raising funds through debentures are as follows:
(i) As fixed charge instruments, debentures put a permanent burden on the earnings of a company. There is a greater risk when earnings of the company fluctuate.
(ii) With the issue of debentures, the capacity of a company to further borrow funds reduces.
The decision of the directors to install a new water based paint plant in South India at an estimated cost of rupees five crore is not a risky project. So the company should issue debentures for raising the funds due to the relative advantages of this source over equity shares.