Question

Explain the disadvantages of equity shares as a source of long-term finance.

Answer 1

1. No Trading on Equity: If a company issues only equity shares, it cannot obtain the benefits of trading on equity. The cost of equity shares is high.
2. Danger of Overcapitalisation: Equity share capital is not refundable during the lifetime of a company. A mistake in estimating financial requirements may, therefore, result in overcapitalisation, particularly when the company's earning capacity declines. Equity capital may remain idle and underutilized.
3. Perpetuation of Control: Any new issue of equity shares must be offered first to the existing shareholders. As a result, there is concentration of control in a few hands.
4. Take-over Bids: Equity shares have proportionate voting rights. Persons who seek to gain control over a company may indulge in undesirable practice, such as cornering of votes, formation of groups and abuse of proxy rights.
5. Speculation: During boom periods, the profits of a company and dividends on equity shares tend to increase. This leads to excessive speculation in the prices of equity shares.
6. Unsound dividend policy: During boom periods, profits tend to increase. The directors may decide to distribute higher dividends to win the cooperation of distribute higher dividends to win the cooperation of equity shareholders. They may overlook reserves for contingencies, replacements, etc.
7. Dividend Controlled by Directors: The rate of dividend is decided by the Board of Directors. Shareholders cannot demand higher dividends than those recommended by the Board. Therefore, investors may consider the equity shares unsafe and non-remunerative.
8. High Risk: Equity shareholders sink and swim with the company. During depression, they get no dividend and the market value of their holdings falls drastically. The collateral and resale value also declines. Equity shareholders lose heavily if the company fails and goes into liquidation. Therefore, equity shares do not appeal to the investors who want safety of their investment and a regular and fixed return.
9. Time Consuming: Several procedural formalities are involved in making a public issue of shares. Moreover, the issue cannot be made at any time the company wants. It depends on market conditions.