Equity capital has some disadvantages to the firm as compared to other long-term sources of finance. They are :
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(i) Cost. The cost of equity capital is high, usually the highest. The rate of return required by equity shareholders is generally higher, than the rate of return required by other investors. While the cost of debt and preference can be determined fairly easily, the cost of equity capital is rather difficult to estimate. Cost of equity capital is highest because of two reasons :
• Dividends paid by the firm to equity shareholders are not tax deductible as are interest payments.
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• Floatation cost on equity shares are higher than those of debts. Underwriting commission, brokerage costs, and other issue expenses are higher for equity issues.
(ii) Risk. As already explained, equity shareholders are the last to be paid, for payment of divided during the life time of the company and payment of capital at the event of liquidation of the company. As a result, they are facing the maximum risk from investor’s point of view.
(iii) Earnings Dilution. Whenever new equity shares are issued, it dilutes the existing shareholders’ earnings per share (EPS) if the profits don’t increase immediately in proportion to the increase in the number of equity shares.
(iv) Product Ownership Dilution. Whenever new equity shares are to be issued, these are first offered to the existing shareholders because Companies Act gives them a pre-emptive right to retain their proportionate ownership. This right is called right snares. But if existing shareholders don’t have funds to invest in additional shares, the issue of new share will reduce the ownership and control of the existing shareholders. The ownership may change hands which assumes great significance specially in case of closely held companies.