November 20, 2020

Pros and Cons of Capital Stock

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Pros and Cons of Capital Stock

Capital stock (share capital) emerged in the middle of the 19th century with the emergence of a joint-stock form of ownership, when the need for the implementation of investment projects that were beyond the power of sole ownership or partnership arose. Basically, you can find the following accounting and financial definition of this term: the common and preferred stock a company is authorized to issue, representing the size of the equity position of a company.

Capital stock can only be formed by issuing shares, nothing else. Therefore, the amount of capital stock will always be equal to the number of outstanding common shares x the nominal value of one common share. Why are we talking about “nominal”? Because the actual price of the shares may be higher.

Here are the basic terms you will need to know when talking about capital stock. Our capital stock is:

  • Authorized – the maximum number of shares that a company can issue in accordance with its charter;
  • Outstanding – shares already issues, which is usually less than authorized;
  • Paid-in – the total amount of cash or other assets that investors have given a company in exchange for its stock.

The shares themselves are:

  • Common – determined by dividing all the distributable earnings for the year by the number of common shares;
  • Preferred – give the right to a fixed rate of dividend, which does not depend on how much the company made during the year. 

Another difference between common and preferred shares is that the holders of the latter receive their money first, and the remaining amount is distributed among common shares, holders of which also have voting rights.

Pros and Cons of Capital Stock

Advantages and Disadvantages

The basis of the corporation’s capital is common shares. They make the stockholders the true owner of the corporation. Sometimes investors are attracted to common shares, but when it is not possible to sell common stock at reasonable prices, then bonds and/or preferred stock are issued instead. From the point of view of the issuer, the issue of common shares has the following pros and cons. 

Pros:

  • You don’t have to pay dividends. 
  • Dividends can be paid in the form of additional shares, which saves working capital and company resources. 
  • There is no need to return capital. 
  • Assets are not burdened with obligations to creditors.
  • The capital increase has a positive effect on the issuer’s credit rating.
  • If shares are sold on the open market, then their liquidity (and investors’ interest) increases. 
  • If sold on the open market, then the stock has a market value that is of great importance in corporate finance. 

Cons:

  • Deposits of the previous shareholders are “diluted”, i.e. their share in the corporation’s capital stock decreases. 
  • If the shares are voting shares, then the voting power of the previous shareholders is reduced. 
  • Issuing shares is more expensive than issuing bonds if the interest on the bonds is considered a cost of doing business.
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Author: Charles Lutwidge

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