Analyzing Statements on Equity Financing

Equity financing involves raising funds by selling ownership stakes in a company in the form of shares. Let's examine each statement in the context of equity financing to determine its correctness.

Statement Analysis

• Statement A: Borrowing limit increases as a consequence of increase in number of shares.

  This statement is generally correct. Increasing the number of shares (and thereby raising equity capital) strengthens the company's balance sheet. A higher equity base typically leads to a lower debt-to-equity ratio, which makes the company a less risky borrower. Lenders are usually more willing to extend credit (increasing the borrowing limit) to companies with a stronger equity position, as it provides a larger buffer against potential losses.

• Statement B: Ordinary shares are generally not redeemable.

  This statement is correct. Ordinary shares (also known as common stock) represent permanent capital of the company. Unlike some types of preference shares or debt instruments, ordinary shares do not typically have a fixed redemption date by which the company must buy them back. Investors sell their ordinary shares on the stock market to exit their investment, not by having the company redeem them.

• Statement C: Issue of new shares dilutes the EPS if the profits do not increase immediately in proportion to increase in number of shares.

  This statement is correct. Earnings Per Share (EPS) is calculated as:

  \( \text{EPS} = \frac{\text{Net Profit}}{\text{Number of Outstanding Shares}} \)

  If a company issues new shares without a corresponding immediate increase in net profit, the denominator (Number of Outstanding Shares) increases while the numerator (Net Profit) remains constant or increases by a smaller proportion. This mathematical effect causes the EPS to decrease, which is known as dilution.

• Statement D: A company is not legally oblidged to pay dividend.

  This statement is correct for ordinary shares. Unlike interest payments on debt, which are contractual obligations, dividend payments on ordinary shares are generally at the discretion of the company's board of directors. The board decides whether to declare a dividend and how much to pay, based on the company's profitability, cash flow needs, future investment plans, and other factors. There is typically no legal obligation to pay dividends on ordinary shares.

• Statement E: Ordinary shares are less riskier from investor's perspective.

  This statement is incorrect. From an investor's perspective, ordinary shares are generally considered riskier than debt instruments (like bonds) or preference shares. In case of liquidation, holders of ordinary shares are the last to have a claim on the company's assets, after creditors (bondholders) and preference shareholders have been paid. Also, dividend payments are not guaranteed, unlike interest payments on debt. The value of ordinary shares can also be highly volatile.

Based on the analysis:

• Statement A is correct.
• Statement B is correct.
• Statement C is correct.
• Statement D is correct.
• Statement E is incorrect.

Therefore, the correct statements are A, B, C, and D.

Looking at the options provided, the option that lists A, B, C, and D as the only correct statements is the correct choice.

Conclusion

The statements A, B, C, and D are correct in the context of equity financing and ordinary shares. Statement E is incorrect.

The option that correctly identifies these statements is option 2.

Revision Table: Equity Financing Concepts

Additional Information: Implications of Equity Financing

Raising funds through equity financing has several implications for a company:

• Ownership Structure: Selling shares introduces new owners, potentially diluting the control of existing shareholders, especially founders or early investors.
• No Fixed Repayments: Unlike debt, equity does not require fixed principal repayments or mandatory interest payments, reducing financial risk for the company during challenging periods.
• Flexibility: Retained earnings (profits not distributed as dividends) can be reinvested back into the business for growth, R&D, or acquisitions.
• Cost: While there are no mandatory interest payments, equity financing is not free. The "cost" of equity includes expected returns by investors (dividends and capital appreciation) and the administrative costs of issuing shares. Equity can sometimes be more expensive than debt in terms of the required rate of return for investors.
• Signal to Market: Issuing new equity can be perceived positively if funds are raised for promising growth opportunities, or negatively if it signals that the company cannot obtain debt financing or is struggling with cash flow.

Understanding these aspects is crucial for comprehending the full picture of corporate finance decisions.