There are two types of funds that a firm can raise: equity funds and borrowed funds. A firm sells shares to acquire equity funds. Shares represent ownership rights of their holders. Buyers of shares are called shareholders, and they are the legal owners of the firm whose shares they hold. Shareholders invest their money in the shares of a company in the expectation of a return on their invested capital. The return on the shareholders’ capital consists of dividend and capital gain. Shareholders make capital gains by selling their shares.
Shareholders can be of two types: ordinary (or common) and preference. Preference shareholders receive dividend at a fixed rate, and they have a priority over ordinary shareholders. The dividend rate for ordinary shareholders is not fixed, and it can vary from year to year depending on the decision of the board of directors. The payment of dividends to shareholders is not a legal obligation; it depends on the discretion of the board of directors. Since ordinary shareholders receive dividend (or re-payment of invested capital, only when the company is wound up) after meeting the obligations of others, they are generally called owners of residue. Dividends paid by a company are not deductible charges for calculating corporate income taxes.
Equity funds can also be obtained by a company by retaining a portion of earnings available for shareholders. This method of acquiring funds internally is called earnings retention. Retained earnings are undistributed profits of equity capital; they are, therefore, rightfully a part of the equity capital. The retention of earnings can be considered as a form of raising new capital. If a company distributes all earnings to shareholders, then, it can reacquire new capital from the same sources (existing shareholders) by issuing new shares called a rights issue. Also, a public issue of shares may be made to attract new shareholders.
Another important source of securing capital is creditors or lenders. Lenders are not the owners of the company. They make money available to the firm on a lending basis and retain title to the funds lent. The return on loans or borrowed funds is called interest. Loans are furnished for a specified period at a fixed rate of interest. Payment of interest is a legal obligation. The amount of interest is allowed to be treated as expense for computing corporate income taxes. Thus the payment of interest on borrowing provides tax shield to a firm. The firm may borrow funds from a large number of sources, such as banks, financial institutions, public or by issuing bonds or debentures.
A bond or a debenture is a certificate acknowledging the money lent by a bondholder to the company. It states the amount, the rate of interest and the maturity of the bond or debenture.