Concepts Behind Equity Financing
Equity Financing refers to raising capital for a company by issuing company stock to investors. In this process, the company is selling its equity, i.e. ownership rights to the shareholders.
Equity financing is useful for a company when it has less assets and when it has just started and wants to use a safer way of raising capital. In equity financing, the returns offered to the investors depends on the profitability of the company. In case the company does not make any profits, the shareholder so not receives any returns. This also serves as an obstacle in raising capital by equity financing as the company needs to have such a reputation that people are willing to invest their money. No one wants to put their money on a sinking ship and thus, equity financing can be only done by companies with a good rapport or position in the market.
The main disadvantage of raising capital by equity financing is that the investors get a part of ownership in the company. Although they are not involved in decision making, they have a share in the profits of the company. Many companies keep high amounts as retained earnings in case they make a huge profit in order to not pay high returns to their investors.
For the investors, the equity financing investments are the riskiest. In case the company fails to perform, their money goes down the drain. At the same time, it can give them a very high yield as well. It is risky but very profitable in case the company does well.
For equity financing, IPOs (Initial Public Offer) are issued to the public. Interested people can apply and if they get selected, they become a shareholder of the company. The market value of the share keeps changing as and when the company performs good or bad. This also gives the investors a chance of earning capital gain which is the most looked forward return while investing in equity.
Equity Financing is generally governed by regulations as a company might try to manipulate investors. The local governing authority of an area has rules set which have to be followed by the companies who want to issue equity to the public. Most important regulation is transparency which demands all the financial information of the company to be made public so that the investor can judge the performance of the company and decide whether he or she wants to invest in that company of not.
For a company, deciding the amount to be raised by equity financing is crucial. The company is selling its ownership rights and thus, the decision of the extent of raising equity financing is crucial as a company cannot return the amount to investors till the end of the company's life even if the company is doing well. The company has to create a balance between its debt capital and equity capital in order to maximize their returns and reduce their risk as well.
Difficulties Encountered In Equity Financing
While doing equity financing problems, it mainly includes calculating the returns to the investors and the amount of equity capital to be raised. In order to do any, there has to be knot of logic and calculations involved to find the most optimum point.
Students find it difficult to solve the problem and determining what is best for the investor and what is best for the company. Also, there are limitations to how much a company can raise and the process it can follow. For the investors, you have to select the one with the maximum return and hence, that requires calculating returns from different companies.
The problems also involves calculating the financial ratios which is it a very difficult topic and requires learning of a lot of formulas and calculations. Thus, equity financing is a broad topic which includes a variety of subtopics.
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