Chapter 8 • Sources of long-term finance
Servicing costs
Equity holders expect relatively high returns in terms of capital appreciation and divi-
dends. Dividends represent an explicit cost. The capital appreciation results from the
fact that profits not paid out as dividends still belong to the shareholders, even if they
have to wait until they sell their shares or the business is liquidated before they can
turn retained profit into cash. Thus, one way or another, the entire profits will even-
tually be paid out to shareholders.Obligation to pay dividends
Dividend payment levels are a question of the discretion of directors and financial
managers. As we saw under ‘Servicing costs’ above, ultimately the shareholders will
receive their money, but they cannot directly force payment of a particular level of
dividend in a particular year.Obligation to redeem the investment
There is no such obligation unless (or until) the business is liquidated. Because of this,
and to some extent because of the flexibility on dividend levels, finance provided by
ordinary shareholders does not normally impose a legally enforceable cash flow obliga-
tion on the business.Tax deductibility of dividends
In contrast to the servicing of virtually all other types of finance, dividends are not
tax deductible in arriving at the business’s corporation tax liability. This tends to make
dividends more expensive than a similar gross equivalent loan interest rate.Effect on control and freedom of action
Where new equity finance is raised other than from the existing shareholders in the
same proportions as their original investment, voting power will shift to some extent,
perhaps to a large extent, and possibly with it control of the business. This is not nec-
essarily a feature of all increases in equity financing. In fact, the two most important
means of raising equity finance for most businesses, retained profits and rights issues
(each discussed below), generally avoid this problem.
Until recently, it was doubtful whether this shift in power was really of much con-
cern to typical ordinary shareholders, since they seemed not to use their votes in any
case. The annual general meetings of most businesses were characterised by a distinct
absence of most of those entitled to be present and to vote. More recently, however,
the institutional investors have taken a much more active role as shareholders.
Sometimes this can mean applying pressure directly on boards of directors. Control is
a factor that has always tended to be of concern to ordinary shareholders in small busi-
nesses, a point that we shall discuss in Chapter 16.Factors for the potential investor to consider on equity financing
Level of return
The level of return on equity financing would be expected to be higher than the level
of return associated with ‘safe’ investments such as UK government securities. This
has historically been the case, with real returns from UK equities averaging around
6.5 per cent p.a. from 1900 to 2001 (Dimson, Marsh and Staunton 2002), contrasting
with an average real return from government securities of about 3 per cent p.a. over