Diploma – Business Finance

Chapter 11: Financing Decisions: EQUITY FINANCING

CHAPTER 11: Financing Decisions: EQUITY FINANCING

Learning objectives:

Aarsheeya should be able to: -

1. Identify types of equity financing (common shares, preference shares)

2. Compare equity vs. debt financing
3. Compare common equity vs. preferred equity
4. Understand methods of raising equity (seed capital, private equity, public equity)
5. Explain advantages and disadvantages of equity financing
6. Discuss the impact of equity financing on ownership and control
7. Understand the role of equity in capital structure and financial decision-making

Section A: Theory and Concepts

1. Introduction

In Session 10, we learned about where companies can get debt finance (money they borrow) and
how borrowing affects the money shareholders earn.
In this session, we will learn about the different types of equity financing (money raised by selling
ownership in the company).
We will compare the various ways a company can raise money.
Then, we’ll look at how companies raise equity funds, like through seed money, private equity, and
public equity.
At the end, we’ll understand why having equity is important for a company.

2. Capital Structure – Equity Financing

Equity means the owner's share or ownership in a company.
There are two main types of equity financing: preference shares and ordinary shares.
In accounting, equity is also seen as the value left after subtracting what the company owes
(liabilities) from what it owns (assets).
The formula is: Equity = Assets – Liabilities (E = A – L).
3. Equity – Preference Shares
Preferred equity (or preference shares) is a type of ownership in a company that lasts as long as the
company exists — there is no fixed end date.
Preferred shareholders get paid before common (ordinary) shareholders when it comes to receiving
dividends (profits shared with owners) and assets (in case the company shuts down and sells
everything).
Preferred dividends are fixed and pre-decided, and these are paid first to preferred shareholders. If a
company is closed, it pays off all its debts first, then gives what’s left to preferred shareholders, and
only then to common shareholders. This makes preference shares less risky for investors.
However, preferred shareholders do not have voting rights in company decisions.
Preference shares are called hybrid securities because they have features of both debt and equity:
 Like debt: They pay a fixed amount regularly (like interest).

BF: Chapter 11: Financing Decision

Diploma – Business Finance
Chapter 11: Financing Decisions: EQUITY FINANCING

 Like equity: They don’t have a maturity date (the company doesn’t have to repay them by a
certain time).
4. Equity – Common Shares
Common shares (or common equity) represent the real ownership of a company. They don’t have a
fixed end date and stay active as long as the company exists.
Common shareholders are last in line when the company gives out income or assets. First, the
company pays interest to lenders, then dividends to preferred shareholders, and only after that do
common shareholders get their share — if anything is left.
Dividends for common shareholders are not guaranteed. The company may choose not to pay them,
or the amount may change depending on what the management decides.
If the company shuts down, common shareholders will only get paid after all debts and preferred
shares are settled. This means they carry the highest risk.
Because of this risk, common shareholders have voting rights. They can vote on important matters
like choosing the company’s board of directors or auditors.
Since they take more risk, common shareholders usually expect a higher return than lenders and
preferred shareholders.
Example:
If you buy common shares of Apple Inc. on the stock market, you become a small part-owner of
Apple.
4.1 Comparison with Other Financing
(a) Common Equity vs Preferred Equity
Both common shares and preferred shares are long-term (permanent) ways for a company to raise
money — they don’t have to be paid back like a loan.
But there are some key differences:
 Priority: Preferred shareholders get paid before common shareholders when it comes to
dividends or if the company shuts down.
 Dividends: Preferred shareholders get a fixed dividend (like a set amount regularly).
Common shareholders get a changing (variable) dividend, only if the company decides to
give it.
 Voting rights: Preferred shareholders don’t get to vote on company matters. Common
shareholders do have voting rights.
Example:
Suppose Coca-Cola has both preferred and common shares. If it earns profit:
 Preferred shareholders will get their fixed dividend first (e.g., $2 per share).
 Common shareholders may get a dividend — but it depends on how much profit is left and if
the management agrees to pay.
(b) Common Equity vs Debt
Debt means the company borrows money (like a loan or issuing bonds), while common equity
means selling ownership in the company.

BF: Chapter 11: Financing Decision

Diploma – Business Finance
Chapter 11: Financing Decisions: EQUITY FINANCING

 Priority: Debt holders (like banks or bond investors) are paid before both preferred and
common shareholders.
 Maturity: Debt has a due date — the company must repay the money. Common equity has
no expiry.
 Ownership: Creditors (debt holders) are not owners of the company and don’t have voting
rights.
 Interest vs Dividend:
o Companies must pay interest on debt, no matter how well they’re doing.
o Dividends to common shareholders are not mandatory and are only paid if the
company decides to.
 Tax impact: Interest on debt is tax-deductible (it reduces the company’s tax). But dividends
to common shareholders are not tax-deductible.
Example:
Let’s say Microsoft borrows $1 billion through bonds (debt) and also has common shareholders.
 Microsoft must pay interest to bondholders (even if profits are low).
 That interest payment will reduce Microsoft’s taxable income.
 Dividends to common shareholders (like you or me if we own shares) are only paid if
Microsoft chooses to — and they don’t reduce taxes.
4.2 Sources of Common Equity
Companies can raise money by selling shares. Here are the main ways they can do that:
(a) Seed Money
 This is the first money used to start a company.
 Usually comes from the founder’s personal savings and possibly from family and friends.
 The founder takes a big risk, but only loses what they invest if the company fails.
Real-World Example:
When Mark Zuckerberg started Facebook, he used his own money and help from friends. That was
seed money.
(b) Private Equity
As the company grows and needs more money, it can approach private investors (not the general
public). These include:
I. Venture Capital (VC)
 VC firms invest in startups or growing companies with potential.
 In return, they get a share of the company (equity).
 VCs also give advice and support to help the company grow.
 But: They often want some control in decision-making, and they will expect high returns
later.

BF: Chapter 11: Financing Decision

Diploma – Business Finance
Chapter 11: Financing Decisions: EQUITY FINANCING

Real-World Example:
VCs like Sequoia Capital or Accel invested in companies like Flipkart and OYO before they became
big.
ii. Angel Investors
 Angel investors are wealthy individuals who invest their personal money in new businesses.
 They usually don’t get involved in daily decisions — they invest and let the founders run the
company.
Real-World Example:
Ratan Tata has been an angel investor in Indian startups like Ola and Paytm.
Note:
Startups using VC or angel money can grow fast, but there’s also a high chance of failure. If
successful, early investors can earn huge profits when the company goes public.
(c) Public Equity
When a company becomes big enough, it can sell its shares to the public by listing on a stock
exchange.
I. Initial Public Offering (IPO)
 An IPO is when a company sells its shares to the public for the first time.
 It hires an investment bank to help sell these shares.
 Once listed, anyone (like you or me) can buy or sell its shares on the stock market.
Real-World Example:
Zomato’s IPO in 2021 let people invest in the company. Early investors made big profits, and the
company raised a lot of money to grow.
ii. Rights Issue
 When a company needs more money, it can offer its existing shareholders the chance to
buy new shares at a discount.
 It’s a way to raise funds without borrowing.
Real-World Example:
Bharti Airtel did a rights issue in 2021 to raise capital from its existing shareholders.
iii. Private Placement
 Instead of selling shares to the public, the company can sell large amounts of shares to a few
selected investors.
 This is done when the company wants to quickly raise money or bring in strategic partners.
Real-World Example:
Reliance Industries raised funds through private placements to investors like Silver Lake and
Facebook for Jio Platforms.

BF: Chapter 11: Financing Decision

Diploma – Business Finance
Chapter 11: Financing Decisions: EQUITY FINANCING

4.3 Importance of Equity Financing (Simple Version + Examples)

Why is Equity Financing More Expensive?
 Equity (shares) is costlier than debt because common shareholders take the highest risk.
 They only get returns after all others are paid (like banks and preferred shareholders).
 To reward them for this risk, companies must give higher returns (through dividends or by
increasing share prices).
Example:
If you invest in a startup as a shareholder, you take a big risk — you’ll only earn money if the business
succeeds. So, you’ll want high returns for that risk.
If Equity is Costly, Why Not Just Use More Debt?
Using only debt is dangerous. Here’s why companies must have equity too:
1. To Build a Strong Capital Structure
 A mix of equity and debt gives the best balance.
 This helps to maximize the company’s value in the market.
 To use more debt safely, a company needs to have a strong equity base.
Example:
A company like Infosys maintains a healthy mix of equity and debt. This helps it raise money at lower
interest rates because lenders feel safe.
2. Equity is More Flexible During Tough Times
 Debt must be paid back — interest and principal are mandatory.
 Equity does not require repayment — dividends are optional.
 So, if the company is going through losses or a recession, it can skip paying dividends.
 But if it has too much debt, it must pay, or it may go bankrupt.
Example:
During COVID-19, many companies with high debt struggled to survive because they had to keep
paying loans even when income dropped.
Companies with strong equity like TCS or Apple survived comfortably.
3. Bankruptcy Risk with Too Much Debt
 If a company fails to pay interest or repay debt, it is said to be in default.
 Lenders can sue the company, and it may even go bankrupt.
 But with equity, there’s no such risk — the company doesn't need to repay shareholders.
Example:
Jet Airways went bankrupt mainly due to high debt and low cash flow. It couldn't meet its debt
obligations.

BF: Chapter 11: Financing Decision

Diploma – Business Finance
Chapter 11: Financing Decisions: EQUITY FINANCING

Section B: Questions and Answers

Choose the Correct Answer

1. Bondholders are creditors of the firm, and shareholders are owners of the firm.
2. Common shareholders have voting rights because they are the owners of the firm.
3. Equity is a permanent form of financing.
4. Equity holders are the last to receive distributions in the income and assets of the firm.
5. Equity holders expect higher returns for the higher risks that they take.
6. Equity holders expect to be compensated with adequate dividends and capital gains.
7. Preferred stock is a hybrid of debt and equity because they pay fixed dividends and have no
fixed maturity dates.
8. When a company wishes to sell its shares to the general public, it does so in a/an initial public
offering.
9. When a company wishes to sell new shares to existing shareholders (in proportion to their
existing percentage), it does so with a rights issue.
10. When a company wishes to sell new shares directly to selected investors, it does so in a/an
private placement.

Multiple Choice Questions

1. ____________________ are also referred to as residual owners or residual claimants of a
company.
(A) Preferred shareholders
(B) Bondholders
(C) Warrant holders
(D) Common shareholders
2. Which of the following is TRUE?
(A) Debt and Preferred Equity are both temporary forms of financing.
(B) Debt is a permanent form of financing, while Preferred Equity is not.
(C) Debt and Equity are both permanent forms of financing
(D) Common Equity is a permanent form of financing, while Debt is not.
3. Compared to equity holders, debt holders are creditors of the company and bear
__________ risks. They are compensated with returns in the form of __________.
(A) lower, interests
(B) higher, interests
(C) lower, dividends
(D) higher, dividends
4. __________ are wealthy individual investors who do not operate as a business but invest in
early-stage companies in exchange for a portion of equity.
(A) Founders
(B) Venture capitalists

BF: Chapter 11: Financing Decision

Diploma – Business Finance
Chapter 11: Financing Decisions: EQUITY FINANCING

(C) Angel investors

(D) Investment banks
5. When a firm wishes to sell new shares to existing shareholders (in proportion to the
percentage of their existing stakes), it does so with a/an _______________.
(A) initial public offering
(B) warrant feature in a bond
(C) rights issue
(D) private placement

Section C: Activities

NA

BF: Chapter 11: Financing Decision

Diploma – Business Finance
Chapter 11: Financing Decisions: EQUITY FINANCING

Practice Again before Exams

MCQs

Multiple Choice Questions (MCQs)

1. Which of the following is not typically a benefit of equity financing?
A. No repayment obligation
B. Dilution of ownership
C. Permanent capital
D. Risk-sharing
2. In the context of equity financing, what is a major disadvantage from the founder’s
perspective?
A. Tax deductibility of dividends
B. Obligation to repay principal
C. Sharing of control and profits
D. Lower initial investment
3. Which of the following financial instruments is most closely associated with equity
financing?
A. Debentures
B. Bonds
C. Common shares
D. Commercial paper
4. The return received by equity shareholders is primarily in the form of:
A. Interest payments
B. Royalties
C. Dividends and capital gains
D. Rent income
5. Equity financing is best suited for which type of company?
A. A company with consistent cash flows
B. A company with high fixed interest obligations
C. A company in early stages of development
D. A company looking to reduce ownership dispersion
6. Which of the following is a characteristic of equity capital?
A. Fixed maturity period
B. Voting rights
C. Fixed return
D. Mandatory repayment
Short Subjective Questions
1. Differentiate between equity financing and debt financing with examples.
2. Explain the concept of retained earnings as a source of equity capital.
3. Discuss the trade-offs between ownership dilution and long-term financial flexibility in equity
financing.
4. Why might a company choose to raise funds through equity even though it is more expensive
than debt?
5. Discuss how investor expectations affect a company's equity financing strategy.

BF: Chapter 11: Financing Decision

Diploma – Business Finance
Chapter 11: Financing Decisions: EQUITY FINANCING

QP – 2024 November
Question 3 (D) - Explain why ‘preference share’ is known as a hybrid security
[4 Marks, Page Number – 4]
Solution –
Preference shares are called hybrid securities because they have features of both equity (shares)
and debt (loans).
Let’s break it down:
1. Like Debt (Loan):
 Fixed Dividend: Just like interest on loans, preference shareholders get a fixed amount as
dividend.
 Priority in Payment: They are paid before common shareholders, similar to how banks are
paid before shareholders.
Example:
If a company earns profit, preference shareholders get a fixed ₹10 dividend every year — like a loan
paying ₹10 interest.
2. Like Equity (Shares):
 No Maturity Date: The company doesn’t have to repay preference shares like a loan.
 They stay with the company for as long as the company exists.
 They are part of the ownership capital (even though they don’t have voting rights).
Example:
A preference shareholder is part-owner but can’t vote. The company doesn’t have to buy back the
shares — just like with common equity.
So, What’s the Mix?

Feature Preference Share Debt Common Equity

Fixed return? ✅ Yes ✅ Yes ❌ No

Maturity Date? ❌ No ✅ Yes ❌ No

Ownership? ✅ Partially ❌ No ✅ Full

Voting Rights? ❌ No ❌ No ✅ Yes

Priority in payment? ✅ Before common ✅ First ❌ Last

Conclusion (Simple Sentence):

Preference shares are called hybrid securities because they act like loans in how they pay fixed
returns, and act like shares because they don’t need to be repaid and stay with the company forever.

QP – 2024 November

BF: Chapter 11: Financing Decision

Diploma – Business Finance
Chapter 11: Financing Decisions: EQUITY FINANCING

Question 3 (C) - Discuss how the use of venture capitalists can be a source of financing for firms.
Explain how venture capitalists receive returns from their investments
[6 Marks, Page Number – 4]
Solution –
1. Venture Capital as a Source of Financing (3 marks)
 Venture capitalists (VCs) are companies or individuals who invest money in new or growing
businesses, especially start-ups, in exchange for ownership (equity).
 These start-ups often cannot get loans from banks because they are new and have no
proven track record. So, VCs help by providing the needed capital to grow the business.
 VCs not only invest money but also bring experience, advice, and business connections to
help the company succeed.
 However, in return, VCs usually expect a strong say in major decisions to protect their
investment.
Real-world example: Flipkart received early VC funding from Accel Partners before it became one of
India's biggest e-commerce platforms.
2. How VCs Get Their Returns (3 marks)
 Venture capitalists do not earn interest like banks. Instead, they wait for the company’s
value to grow and then sell their shares at a much higher price.
 This can happen in two ways:
o Through an Initial Public Offering (IPO) where the company is listed on the stock
market.
o Or through a private sale of their shares to another investor or company.
 Since the risk is high, they expect high returns. If the company fails, they may lose all their
money. But if it succeeds, the profits can be very large.
Real-world example: When Paytm went public, early investors like SoftBank and Alibaba sold part of
their stake and earned huge profits.
Conclusion:
Venture capitalists help businesses grow by providing funding and support. In return, they earn
profits by selling their ownership when the company becomes successful.

QP – 2025 March

BF: Chapter 11: Financing Decision

Diploma – Business Finance
Chapter 11: Financing Decisions: EQUITY FINANCING

Question 3 (B) - E-resources Inc. is a start-up that needs to raise capital funds for its business.
(i) Discuss TWO (2) differences between Debt and Common Equity as a source of capital
financing. (4 marks)
(ii) (Being a young company, E-resources Inc has not been successful in getting any debt
financing. As the finance manager, you suggest that the company should consider
seeking equity financing from venture capitalists (VCs). Explain what a venture capitalist
is. Discuss TWO (2) advantages of seeking such VC financing. (6 marks)
[10 Marks, Page Number – 4]
Solution –
(I) TWO Differences between Debt and Common Equity (4 marks)
1. Repayment and Maturity
o Debt must be repaid by the company after a certain period (it has a fixed maturity).
The company must also pay regular interest whether it makes profit or not.
o Common equity has no maturity date. It represents ownership and does not need
to be repaid. Dividends are paid only if the company chooses to and has enough
profit.
2. Ownership and Control
o Debt holders are not owners of the company. They do not get voting rights and
have no control over company decisions.
o Common shareholders are owners and have voting rights, allowing them to take
part in major decisions like electing the board of directors.

(ii) Venture Capitalists (VCs) and Their Role in Equity Financing (6 marks)
What is a Venture Capitalist? (2 marks)
A Venture Capitalist (VC) is a professional investor or investment firm that provides equity capital
(money in exchange for shares) to start-ups or early-stage companies that show high potential for
growth but may not be eligible for bank loans or debt financing.
VCs are usually willing to take more risk than traditional lenders because they believe the company
may succeed and grow rapidly. In return, they expect ownership shares and future profits.
Two Advantages of Seeking VC Financing (2 marks each)
1. Access to Capital Without Repayment Pressure
 VCs provide equity funding, which means the company does not have to repay money like a
loan.
 There’s no regular interest payment, reducing pressure on the company's cash flow, which is
very helpful for a young or loss-making firm like E-resources Inc.

2. Expertise and Strategic Support

BF: Chapter 11: Financing Decision

Diploma – Business Finance
Chapter 11: Financing Decisions: EQUITY FINANCING

 VCs often bring industry knowledge, networks, and management support to help the
business grow faster.
 They may offer advice in areas like operations, marketing, hiring, and expansion, which can
help the company succeed in the early stages.
Additional Point
 VCs earn returns by selling their shares later when the company grows or gets listed on a
stock exchange (IPO), hopefully at a higher price than they paid.
Example:
Well-known companies like Zomato, Swiggy, and OYO received VC funding in their early stages,
which helped them expand quickly and become major businesses.

BF: Chapter 11: Financing Decision