a) Equity Shares vs. Preference Shares
| Point of Difference | Equity Shares | Preference Shares |
|---|---|---|
| Ownership | Represents ownership in the company with voting rights | No ownership rights; generally no voting rights |
| Dividend | Paid after preference shareholders; not fixed | Fixed rate of dividend paid before equity holders |
| Repayment | Repaid after all liabilities in case of liquidation | Priority in repayment over equity shareholders |
| Voting Rights | Have voting rights in company meetings | No voting rights, except in exceptional circumstances |
| Risk | Higher risk, higher return potential | Lower risk, but limited return |
b) Net Income Approach vs. Net Operating Income Approach
These are two capital structure theories used to evaluate the impact of debt on the value of the firm.
Net Income (NI) Approach
Developed by: David Durand
Assumptions:
- The cost of debt is less than the cost of equity
- Increasing debt will reduce the Weighted Average Cost of Capital (WACC)
- Overall firm value increases with more debt
Implication:
Capital structure is relevant; firms can increase value and lower WACC by increasing debt proportion.
Net Operating Income (NOI) Approach
Developed by: David Durand
Assumptions:
- The overall cost of capital remains constant regardless of the capital structure
- The market value of the firm is not affected by changes in the debt-equity ratio
- The benefit of cheaper debt is offset by higher cost of equity
Implication:
Capital structure is irrelevant; value of the firm is based on operating income alone.
Comparison Table
| Aspect | Net Income Approach | Net Operating Income Approach |
|---|---|---|
| Capital Structure Relevance | Relevant | Irrelevant |
| WACC | Varies with capital structure | Remains constant |
| Firm Value | Can be maximized with more debt | Unchanged regardless of debt |
Conclusion
Understanding the distinction between equity and preference shares helps investors and financial managers assess investment options and capital planning. Similarly, comparing NI and NOI approaches aids in understanding how capital structure may or may not influence the value and cost of capital of a firm.