Q.Explain the merits and limitations of Equity Share Capital as a source of finance.

Equity capital's advantages and drawbacks are frequently tested together in AP Board Intermediate Commerce papers.

A balanced answer covers merits for the company and the limitations investors and the company both face.

Equity share capital, being an owned, permanent source of finance, offers a company several merits. It creates no fixed financial burden, since dividend is paid only when the company earns adequate profit and the board decides to distribute it, unlike interest on a loan which must be paid regardless of profit. It is a permanent source that need not be repaid during the company's life. It also improves the company's overall borrowing capacity and creditworthiness, since a larger equity base reassures lenders, and it gives shareholders a democratic voice in the company's affairs through their voting rights.

Equity share capital also has limitations. Investors who want a stable, fixed income are not attracted to equity shares, since dividend is uncertain and may not be paid at all in a poor year. Issuing further equity shares dilutes the voting control of existing shareholders. The cost of raising equity capital — through underwriting commission, brokerage, prospectus and listing expenses — tends to be higher than the cost of borrowed funds of a comparable amount, and because equity is not normally repayable, over-dependence on it alone can make it harder for a company to later change its capital structure.