Share Capital vs. Loan Capital Overview

Study Notes

Definitions

Share Capital: Money raised by a company through the issuance of shares. Shareholders are part owners of the company.
Loan Capital: Money borrowed by a company that needs to be repaid, typically with interest. Lenders do not gain ownership.

Key Differences

Ownership
- Share Capital: Represents ownership in the company. Shareholders have a claim on profits and assets.
- Loan Capital: Represents a debt obligation. Lenders do not have ownership rights.
Nature of Investment
- Share Capital: Risk capital, as it is subject to the fortunes of the business. Dividend payouts are not guaranteed.
- Loan Capital: Fixed obligation, as it requires regular interest payments and the principal repayment regardless of business performance.
Returns on Investment
- Share Capital: Returns come in the form of dividends, which can vary or be reinvested.
- Loan Capital: Returns are in fixed interest payments, providing more predictable cash flows.
Repayment
- Share Capital: No mandatory repayment; shares can be sold by shareholders.
- Loan Capital: Must be repaid at maturity or according to scheduled terms.
Impact on Control
- Share Capital: Dilution of control if new shares are issued; shareholders can vote on important business decisions.
- Loan Capital: No dilution of control; lenders do not participate in company management.
Tax Treatment
- Share Capital: Dividends are not tax-deductible expenses; tax is paid on profits before distribution.
- Loan Capital: Interest payments are tax-deductible, which can lower the effective tax burden for the company.
Risk Level
- Share Capital: High risk for investors, especially if the company fails; potential for higher returns.
- Loan Capital: Generally lower risk for lenders, as they have priority over equity holders in the event of liquidation.

Conclusion

Understanding the differences between share capital and loan capital is crucial for evaluating a company’s financial structure and investment opportunities. Share capital involves ownership and profit-sharing while loan capital is a borrowing mechanism with fixed obligations.

Represents ownership in a company
Shareholders have a claim on profits and assets
Represents risk capital subject to the fortunes of the business
Dividends are not guaranteed
Returns are in the form of dividends
Can be sold by shareholders
Contributes to dilution of control if new shares are issued
Shareholders can vote on important business decisions
Dividends are not tax-deductible expenses
High risk for investors, especially if the company fails
Potential for higher returns

Loan Capital

Represents a debt obligation
Lenders do not have ownership rights
Represents a fixed obligation requiring regular interest payments and the principal repayment regardless of business performance
Returns are in fixed interest payments, providing more predictable cash flows
Must be repaid at maturity or according to scheduled terms
Does not dilute control
Lenders do not participate in company management
Interest payments are tax-deductible, which can lower the effective tax burden for the company.
Generally lower risk for lenders as they have priority over equity holders in the event of liquidation.

Share Capital: Issued to raise funds by selling ownership stakes in a company.
Loan Capital: Funds obtained through loans or debt instruments that have to be repaid.
Shareholders: Have equity ownership in the company.
Loan Holders (Creditors): Do not have ownership rights but are entitled to repayment.
Share Capital Repayment: Does not require repayment, but dividends may be paid based on profits.
Loan Capital Repayment: Must be repaid with interest according to the agreed terms.
Share Capital Risk: Higher risk, returns depend on company performance.
Loan Capital Risk: Generally lower risk due to legally required interest payments.
Share Capital Control: Issuing shares dilutes existing owners' control.
Loan Capital Control: Does not dilute ownership but may have covenants or restrictions.

Cost of Capital

Cost of Share Capital: Can be calculated using dividend discount models or CAPM.
- Generally higher than loan capital due to the risk taken by shareholders.
Cost of Loan Capital: The interest rate payable on loans or bonds.
- Typically lower due to lower risk and tax benefits associated with interest payments.
WACC: Combines both share capital and loan capital costs to assess overall capital costs.
- Key metric for investment decisions and financial performance evaluation.

Funding Source Risk Assessment

Share Capital Risks:
- Market Risk: Share value fluctuates with market conditions.
- Business Risk: Business performance impacts dividends and shareholder value.
Loan Capital Risks:
- Credit Risk: Borrower’s ability to repay is a concern for lenders.
- Interest Rate Risk: Changes in interest rates influence refinancing costs.
Financial Leverage:
- Utilizing loan capital can boost returns but increases vulnerability to financial strain.
- Obligations must be met regardless of company performance.
Balance: Too much loan capital increases bankruptcy risk, while too much share capital can dilute returns.

Description

This quiz explores the key differences between share capital and loan capital, highlighting their definitions, ownership implications, investment nature, and return on investment. Understand the essential concepts that distinguish these two forms of capital raising in a company.