132 5 Equity and Shareholders’ Capital
First, the firm wants to ensure that it has assets that will not have to be repaid to
investors when the company needs them the most. Management of equity capital
is a form of corporate risk management (see Volume I).
Second, the firm wants to influence the price of debt funding in general. The
firm needs to signal to debt investors that it has a sufficient amount of assets that
will not easily be repaid to anyone else. The debt-to-equity ratio of the firm is a
way to manage the firm’s credit rating and debt investors’ perceived risk (for rat-
ings, see Volume I). The firm cannot signal that it has a favourable debt-to-equity
ratio unless it ensures that it has assets that are recognised as equity on the balance
sheet according to the applicable accounting rules (for IFRS, see below).
Third, the firm may want to influence the price of certain debts. This can be
achieved by issuing different classes of debt instruments each with different rights
to payment and different rights to collateral (for example, secured debts, unse-
cured debts, subordination, or tranching).
Fourth, the firm may want to manage the valuation of its shares. The existence
of different classes of shares enables the firm to manage the overall cost of share-
based funding (for the management of share price, see Volume I).
Fifth, as shares are equity instruments which can confer voting rights, one of
the aspects of the management of equity is the management of the firm’s share
ownership and control structure. The share ownership and control structure can be
influenced by equity instruments directly (by issuing shares or shares with differ-
ent voting rights) and indirectly (by managing the risk of the firm being taken
over).
The voting rights attaching to shares mean that whoever owns enough shares will control
the firm and the use of its assets. If the firm is so lean that it neither has assets that can be
distributed to a controlling shareholder nor can raise such funds, the firm will be less attrac-
tive as a takeover target, because buyers would not be able to refinance the takeover by us-
ing the target’s assets.
Sixth, the amount of equity can signal the quality of the firm to other stakeholders.
Sometimes the amount of equity is important for reasons of compliance. The firm
may have to comply with statutory minimum requirements on the amount of eq-
uity (minimum capital under the Second Company Law Directive, Basel II, the
minimum capital of financial institutions, and so forth).
Equity technique from the perspective of the investor. From the subjective per-
spective of the investor, equity can mean various things. Let us assume that the in-
vestor only focuses on the ranking of claims. Even in this case, the investor can
choose between two perspectives.
First, the investor may focus on whether other investors’ investments are equity
investments. In this case, equity can mean: (a) a claim that cannot be paid before
the investor’s own claims are paid (for example, an “equity” tranche when pooled
assets are securitised); (b) a claim that cannot be paid unless the company will re-
main able to pay the investor’s own claims (for example, prohibited distributions
to shareholders when applying the US type equity-insolvency test); or (c) a claim