Equity Capital

Equity Capital refers to the capital collected by a company from its owners and other shareholders in exchange for a portion of ownership in the company. The company is not liable to repay the fund raised through equity financing.

It is one of the primary sources through which businesses obtain capital to finance their operations and overall development. The most common ways to raise equity funds are through a public and private issue of shares, and accordingly, it is also classified into private and public equity capital.

• Equity capital definition portrays it as the amount of money collected from owners and other investors in exchange for a portion of ownership right in the company.
• It is exceptionally beneficial for companies since it raises large sums of money that they can use for long-term projects.
• A good equity portfolio increases credit rating.
• The company does not need to repay the fund collected through equity financing. However, they are also associated with disadvantages such as being expensive for firms to raise and a complex dividend distribution process.

The equity capital calculation method can vary based on the entity's financial context. However, the general practice is to look at the company's balance sheet or statement of profit and loss account to pick the value of total assets and total liabilities.

Total Equity = Total Assets – Total liabilities

The balance sheet portrays the value of total assets as the sum of total liabilities and equities. Hence, total equity is the difference between total assets and liabilities.

Furthermore, the Capital Asset Pricing Model (CAPM) can calculate the equity capital cost, indicating the rate of return that will flow to the shareholders. In other words, it is the cost of distribution to shareholders. The calculation considers several factors, including the status of the market and the company's overall risk. It uses historical information to come up with the pricing. The formula used to calculate the cost of equity in this model is:

E(R_i) = R_{f +} βi _*

In this formula, E(Ri) represents the anticipated return on investment, R_f is the return when risk is 0, βi is the financial Beta of the asset, and E(R_m) is the expected returns on the investment based on market analyses.

In various instances, the company may require selling a portion of itself to gain equity funds, and it creates a way for investors to own the company's share. The equity finance can be obtained through self-funding by owners, offering partnership to friends and family, private investors, stock market issuance, venture capitalists, etc. In simple terms, we can analyze that if the entity is a sole proprietorship, the equity section is referred to as owner's equity. In contrast, it is indicated as stockholders' equity for a corporation. 

The equity section of the balance sheet discloses quantitative values of components like common stock, preferred stock, additional paid-in capital, retained earnings, other comprehensive income (OCI), and treasury stock. For instance, look into the balance sheet of Apple Inc., the shareholder's equity section lists information about shares authorized, issued, outstanding, additional paid-in capital, retained earnings, and OCI. As of March 2021, Apple's stockholder equity was $69.178 billion and around 16.97 billion shares outstanding.

As with any investment, several advantages and disadvantages are associated with equity fund.

The advantages are: 

• The stocks like common stocks and preferred stocks have no maturity date. Consequently, the company does not have the right to demand back the equity shares strictly. A shareholder would therefore be more secured when holding equity shares.
• It increases the creditworthiness of a company. If it gains many equity shareholders, then they act as a form of collateral for the company. It gives the company more leverage to get more funds and negotiate better terms with lenders or other stakeholders.
• It is not obligated always to pay dividends to equity shareholders for the company. So, it will be helpful when the company faces a cash crunch. It can then use the money intended for dividend distribution to pay for other events without worrying about legal liabilities.
• For investors, equity shares are preferable in most cases since they command a higher return on investment compared to other types of securities. However, it of course, depends on the performance of the company.

It has several disadvantages as well, including: 

• The company's ownership becomes more and more diluted as it gains more equity shareholders. In some cases, this can make decision-making a slow process since it involves many shareholders. It can make the company miss out on opportunities that are tightly time-barred. 
• To a company, the cost of giving out equity shares is high. Equity shareholders usually require a high return on investment, particularly in the long run.
• Managing equity capital, in this case, costs more for the company. For instance, when paying out dividends, the money has to come out of profit after tax has been paid. In the case of other types of financing, the company would pay in interest, which would be tax-deductible, and therefore cost less for the company.
• Raising an equity fund is much more expensive than raising cash using other methods for a company.

This has been a guide to what equity capital is, and its meaning. Here we explain how to calculate equity capital along with examples, advantages and disadvantages. You may learn more about financing from the following articles -

• Equity Investment
• Optimum Capital Structure
• Market Capitalization