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COMPUTER ORIENTED ACCOUNTING SYSTEM EQUITY
EQUITY
1. Introduction and Meaning
In accounting and finance, equity represents the owners’ claim on the assets of a business. It is the residual interest in the assets of the entity after deducting all liabilities. In simpler terms, equity is what belongs to the owners – it is the amount that would be returned to them if all assets were sold and all debts were paid.
Equity is also known as:
- Shareholders’ equity (for companies)
- Owners’ equity (for sole proprietorships and partnerships)
- Capital (in a general sense)
- Net worth or Net assets
Accounting Equation: Assets = Liabilities + Equity
Therefore, Equity = Assets – Liabilities
2. Features of Equity
- Residual claim – Equity holders are paid last, after all creditors and lenders have been satisfied.
- No fixed return – Unlike debt (which pays fixed interest), equity does not guarantee a fixed dividend. Returns depend on profitability.
- Permanent capital – Equity capital is not required to be repaid during the life of the business (except in case of liquidation or buyback).
- Voting rights – Equity shareholders usually have voting rights in company decisions.
- Risk capital – In case of losses or bankruptcy, equity holders may lose their entire investment.
- Control – Equity holders own the business and have the right to elect the board of directors.
3. Types of Equity
A. Based on Source
| Type | Description |
|---|---|
| Contributed capital | Funds directly invested by owners (share capital). |
| Retained earnings | Profits reinvested in the business instead of being distributed as dividends. |
B. Based on Ownership Rights (in a company)
| Type | Description |
|---|---|
| Equity share capital (Common stock) | Ordinary shares with voting rights; dividend is not fixed; residual claim. |
| Preference share capital (Preferred stock) | Shares with a fixed dividend rate; priority over equity shares for dividend and repayment; usually no voting rights. |
| Retained earnings | Accumulated profits not distributed. |
| Other reserves | Capital reserve, revaluation reserve, securities premium, etc. |
4. Equity in Different Business Structures
| Business Type | Equity Components |
|---|---|
| Sole proprietorship | Capital account (owner’s investment + profits – drawings). |
| Partnership | Capital accounts of each partner + current accounts + reserves. |
| Company (Private/Public) | Share capital (equity + preference), reserves and surplus (retained earnings, securities premium, general reserve, etc.). |
5. Components of Shareholders’ Equity (Company Balance Sheet)
| Component | Explanation |
|---|---|
| Equity share capital | Face value of shares issued multiplied by number of shares. |
| Preference share capital | Face value of preference shares issued. |
| Securities premium reserve | Excess over face value received from shareholders. |
| General reserve | Profits set aside for future needs. |
| Retained earnings | Accumulated profits not distributed as dividends. |
| Revaluation reserve | Increase in asset value on revaluation (cannot be distributed as dividend). |
| Capital redemption reserve | Created when shares are bought back. |
| Less: Treasury shares | Company’s own shares bought back (negative equity). |
| Less: Accumulated losses | Losses that reduce equity. |
6. Equity vs Debt
| Basis | Equity | Debt |
|---|---|---|
| Return | Dividend (variable, not guaranteed) | Interest (fixed, mandatory) |
| Repayment | Permanent (no repayment date) | Fixed maturity date |
| Tax treatment | Dividend not tax‑deductible | Interest is tax‑deductible |
| Risk | Higher risk (last claim) | Lower risk (priority claim) |
| Control | Voting rights | No voting rights |
| Cost | Usually higher than debt | Usually lower than equity |
| Impact on leverage | Reduces financial risk | Increases financial risk |
7. Cost of Equity (Ke)
The cost of equity is the minimum rate of return that a company must earn on its equity‑financed portion to satisfy its equity shareholders. Unlike debt, the cost of equity is not directly observable.
Common Methods to Calculate Cost of Equity
A. Dividend Discount Model (Dividend Growth Model)
Ke = (D1 / P0) + g
Where:
- D1 = Expected dividend per share next year
- P0 = Current market price per share
- g = Constant growth rate of dividends
Example:
- Current market price = ₹ 100
- Expected dividend next year = ₹ 5
- Growth rate = 6%
- Ke = (5/100) + 0.06 = 0.05 + 0.06 = 11%
B. Capital Asset Pricing Model (CAPM)
Ke = Rf + β × (Rm – Rf)
Where:
- Rf = Risk‑free rate (e.g., government bond yield)
- β = Beta (measure of systematic risk)
- Rm = Expected market return
Example:
- Rf = 7%
- β = 1.2
- Rm = 15%
- Ke = 7 + 1.2 × (15 – 7) = 7 + 1.2 × 8 = 7 + 9.6 = 16.6%
8. Book Value vs Market Value of Equity
| Basis | Book Value | Market Value |
|---|---|---|
| Meaning | Equity as per balance sheet (historical cost) | Current price of shares × number of shares |
| Calculation | Assets – Liabilities | Share price × outstanding shares |
| Reliability | Based on accounting records | Based on market perception |
| Use | For accounting purposes | For investment decisions, valuation |
Example:
- Company has 10,000 shares of ₹ 10 each (face value)
- Reserves = ₹ 2,00,000
- Book value = (10,000 × 10) + 2,00,000 = ₹ 3,00,000 → Book value per share = ₹ 30
- Market price per share = ₹ 80 → Market value of equity = ₹ 8,00,000
9. Advantages of Equity Financing
- No fixed obligation – No mandatory dividend or repayment.
- Permanent capital – Strengthens the balance sheet.
- Improves creditworthiness – Lenders prefer companies with higher equity.
- No charge on assets – Equity does not require collateral.
- Flexibility – No restrictive covenants as in debt agreements.
- Risk absorption – Equity absorbs losses, protecting creditors.
10. Disadvantages of Equity Financing
- Dilution of control – Issuing new equity shares reduces existing owners’ control.
- Higher cost – Cost of equity is generally higher than cost of debt.
- Dividends not tax‑deductible – Interest on debt saves tax; dividends do not.
- Expectations of high returns – Shareholders expect higher returns compared to lenders.
- Time‑consuming and expensive – Issuing shares involves legal formalities, underwriting fees, etc.
11. Retained Earnings – A Special Form of Equity
Retained earnings are profits that have been reinvested in the business rather than paid out as dividends. They belong to equity shareholders.
Features:
- No cost of issuance (no underwriting fees, legal costs).
- Does not dilute control.
- Opportunity cost – shareholders could have earned returns elsewhere.
- Cost of retained earnings (Kr) is usually equal to cost of equity (Ke).
Formula for growth using retained earnings:
Growth rate (g) = Retention ratio × Return on equity (ROE)
Example:
- Retention ratio = 60%
- ROE = 15%
- g = 0.60 × 0.15 = 9%
12. Illustrative Problems
Problem 1: Calculation of Equity (Balance Sheet)
Question: From the following, calculate shareholders’ equity:
- Equity share capital: ₹ 50,00,000
- Preference share capital: ₹ 10,00,000
- General reserve: ₹ 8,00,000
- Securities premium: ₹ 2,00,000
- Retained earnings: ₹ 5,00,000
- Revaluation reserve: ₹ 1,00,000
Solution:
Shareholders’ equity = Equity share capital + Preference share capital + Reserves + Retained earnings
= 50,00,000 + 10,00,000 + 8,00,000 + 2,00,000 + 5,00,000 + 1,00,000
= ₹ 76,00,000
Problem 2: Cost of Equity (Dividend Growth Model)
Question: A company’s share is currently trading at ₹ 250. It paid a dividend of ₹ 12 per share last year. Dividends are expected to grow at 5% annually. Calculate the cost of equity.
Solution:
- D0 = ₹ 12
- D1 = D0 × (1 + g) = 12 × 1.05 = ₹ 12.60
- P0 = ₹ 250
- g = 5% = 0.05
- Ke = (D1 / P0) + g = (12.60 / 250) + 0.05 = 0.0504 + 0.05 = 10.04%
Problem 3: Book Value per Share
Question: A company has equity share capital of ₹ 20,00,000 (2,00,000 shares of ₹ 10 each). Reserves and surplus total ₹ 15,00,000. Calculate book value per share.
Solution:
- Total equity = 20,00,000 + 15,00,000 = ₹ 35,00,000
- Number of shares = 2,00,000
- Book value per share = 35,00,000 / 2,00,000 = ₹ 17.50
Problem 4: Effect of New Equity Issue on EPS
Question: A company has 1,00,000 shares outstanding. Net profit after tax is ₹ 15,00,000. It plans to raise ₹ 20,00,000 by issuing new equity shares at ₹ 100 each. The new funds will generate an additional profit of ₹ 3,00,000 per year. Calculate the old EPS and new EPS.
Solution:
- Old EPS = 15,00,000 / 1,00,000 = ₹ 15
- New shares issued = 20,00,000 / 100 = 20,000 shares
- Total shares after issue = 1,00,000 + 20,000 = 1,20,000
- New net profit = 15,00,000 + 3,00,000 = ₹ 18,00,000
- New EPS = 18,00,000 / 1,20,000 = ₹ 15
- Note: EPS remains the same – the new investment earns the same rate as the existing return on equity (15%).
13. Practice Problems
Problem 1
Calculate shareholders’ equity from: Share capital ₹ 30,00,000; General reserve ₹ 6,00,000; Securities premium ₹ 1,50,000; Revaluation reserve ₹ 80,000; Profit & loss (credit) ₹ 2,70,000.
Problem 2
A share has current market price ₹ 180. Expected dividend next year ₹ 9. Growth rate 4%. Find cost of equity.
Problem 3
A company has 5,00,000 shares of ₹ 10 each. Reserves = ₹ 25,00,000. Calculate book value per share.
Problem 4
A company currently has 2,00,000 shares earning EPS of ₹ 8. It wants to raise ₹ 50,00,000 by issuing new shares at ₹ 125 each. The new funds will earn 12% return. Calculate the new EPS. (Assume tax rate 30% and existing profit after tax is given by old EPS × shares.)
14. Summary – Key Points
- Equity = Owners’ claim = Assets – Liabilities.
- Includes share capital, reserves, retained earnings.
- Equity shares have voting rights, variable dividends, residual claim.
- Preference shares have fixed dividends, priority over equity, usually no voting rights.
- Cost of equity is higher than cost of debt and is calculated via dividend model or CAPM.
- Retained earnings are an internal source of equity with opportunity cost.
- Book value differs from market value; market value is usually higher for profitable companies.
Practice Lab
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