The Function of Stock Markets - Case Study Example

? International Financial Markets Table of Contents Part Role of Stock Markets 3 Part 2: Analysis of Capital Structure and Important Ratios 7 Part3: Concept of Rights Issue 9 Reference 11 Part 1: Role of Stock Markets The stock exchanges’ original function was to mobilise capital for long term expansion of businesses. However, over the times it has been found that this key function has been compromised as the secondary trading now accounts for a high proportion of its trading activities. Basically, stock exchange is a platform or market place that provides services for traders and stock brokers. In the broader perspective, it is a place where in the investors (who have surplus funds) and security issuers (who require funds) can meet and fulfil each others’ requirements (Bailey, 2005, p.34). Stock exchanges provide investors the opportunity to invest in a broad range of securities such as stocks, bonds, commodities, derivative instruments, and so on. These exchanges also provides conveniences for issue and redemption of financial instruments and other securities including payment of dividends and other fixed bearing returns such as coupon interest (Madura, 2012, pp.3-5). It is important to understand that the stock exchanges have multiple roles to play for the development of economy by proper channelization of capital. But one of the most important functions is raising and mobilising capital for businesses. Stock exchanges provide these services and facilities by selling ownership shares to public. The process is also known as the initial public offering or IPO that allows incorporated companies to list their shares in stock markets and allow external investors to invest in the company. The might require capital for expansion of existing facilities, launching new product or services, or diversifying products and services geographically. Whatever may be the reason for raising capital, irrespective of that the investors get the opportunity to mobilise their savings for investment (Samuel, No date, pp.26-31). For instance, when general public draw their savings and invest in shares of companies through IPO, the process actually leads to allocation of scarce resources of funds in most rational manner. This is because if the investors prefer to keep their surplus funds with them or idle deposits with banks, then the resources are stuck in the economy and is not utilised in best possible manner. But, when the investors prefer investing the funds trading in stock markets then their funds are redirected to help the management of the companies or respective finance boards of the organisations. The benefit of such investment and mobilisation of funds is not only limited to the issuing companies and the investments benefit several other sectors in the economy that are linked to each other indirectly. The mobilisation of fund to different sectors such as agriculture, industry, and commerce ultimately results into higher productivity at all level of firms and promotes stronger economic growth (Bradley and Teweles, 1998, pp.329-348). The stock markets may be broadly classified into primary market and secondary market. The main function of the primary market is facilitating issue of new securities. Organisations, both in public and private sector have the opportunity to tap the primary market where they can offer their shares to public and raise capital. The securities are not limited to ownership capital or equity capital but business entities may also issue bonds through primary. The issue of security by any business entity would depend on the business strategy and the target capital structure that the management decides in the best interest of the shareholders. If the management prefers not to dilute ownership stake and retain significant control over the key management decisions then the entity is likely to prefer bonds over equity instruments. On the other hand, if the companies prefer to increase the earnings per share of the shareholders by leveraging their existing capital structure, then it might choose to reduce the outstanding paid-up capital by issuing shares to public and thus increase the EPS. The process of issuing new security issues of business organisations to investors is also known as underwriting. The secondary market is a market where the investors has the opportunity to trade ‘already issued’ securities in lieu of the issuer. For this reason the secondary market is also known as the follow on offer (FPO) or “after-market”. Conceptually, all securities are first formed in the primary market and then they enter into secondary market. Hence, in the secondary market the shares are bought and sold from one investor to another instead of the security issuing entity. The process is unarguably beneficial for the investors who may buy the securities when they expect the prices to rise in future. This will allow them to buy the security from spot market at current market price and when the price of security rises in future then they will be able to sell it in market and earn profit in transaction process (Levinson, 2009, pp.3-14). The two possible factors that is responsible for motivating the investors to account for higher proportion of secondary trading are: The objective of profit booking – When an investor enters stock market, the primary objective remains profit making as they are not donating their hard earned surplus funds to charity. Hence, from the perspective of investor it seems very justified to follow such strategy which results into profit making. When an investor invests in a new security, whose price maybe trading at either premium, discount or even in nominal price, then the investor has to wait for the security prices to appreciate in future so that the company gets opportunity to invest the collected investment in profitable projects and return the benefits to the shareholders. But the investor will have to wait and lock in their funds when their objective is long-term capital appreciation. On the other hand the same can be achieved when the investor prefers buying and selling of stocks in secondary market using technical and fundamental analysis. Higher P/E multiple of securities – When the P/E ratio of a security is low then it is an opportunity of the investor to buy the securities as the prices generally appreciate in future. The higher P/E multiple of securities motivates the investors to trade securities whose prices are at premium especially when compared to valuation of new securities. One ways in which this trend of secondary trading in recent decades might have impacted on business growth in UK is by reducing the significant fund available for investment in primary market securities and thus compromising mobilisation of capital for long-term expansion of business. Another way by which this trend might have impact on business growth is by restricting channelization funds to new business entities. The possible implication could be that the new issuing company will have to issue security at discount or at nominal rate in order to encourage investment. This will further reduce the shareholders’ wealth by reducing the market capitalisation. Consequently, many a times when any security is trading at discount or has lower market capitalisation the investors ignore investment in those securities. Hence, the investors will prefer trading in the secondary market for securities that have high P/E ratio or securities which are undervalued so that they can profit by buying cheap and selling at higher price. The trend has the potential to damage the business growth in UK by discouraging investment in primary market and redirect funds into secondary market. Part 2: Analysis of Capital Structure and Important Ratios The following are the given information regarding the company’s capital structure and securities, Nominal share price ? 6.00 Capital Structure: 6% Debenture…. 8500 3.5 Preference Stock…. 9500 Ordinary Shares…. 185000 Net Profit for the Year…. ? 950,000.00 Profit available to Owners…. ? 475,000.00 a) To Determine Gearing Ratio Common Stockholders' Equity ? 1,110,000.00 Fixed Interest Bearing Funds ? 108,000.00 Capital Gearing Ratio 10.28 The capital gearing ratio is a very useful tool that helps analysis of capital structure of a company. It is calculated by dividing the shareholders’ equity by fixed interest bearing funds. Mathematically, In the above formula, the common stockholders’ equity consists of common stocks less preferred shares. The fixed interest bearing securities includes funds derived from bonds, debentures, long-term loans, and preferred stocks. The significance of this ratio is that it gives an idea regarding relationship between funds provided by investors who receive periodical dividend or interest at a fixed predetermined rate with the funds provided by owners’ capital. Hence, with the help of this ratio it will be possible to analyse the capital structure of an organization. The interpretation of the ratio is that if larger portion of capital is composed of owner’ equity funds then the capital structure is said to be low geared and vice-versa. In the given case, the capital structure of company is low geared and there is opportunity for investors to leverage existing capital structure. b) To Determine and Analyze Shareholders Return on Investment Net Income ? 950,000.00 Dividends ? 475,000.00 Total Debt ? 51,000.00 Total Equity ? 1,110,000.00 Return on Investment 0.41 From the above calculation it can be said that return on investment is 0.41 which is an indication that investments made by shareholders’ and bondholders’ was able to generate sufficient profit for the firm since part of capital has turned into profits. c) To Determine P/E Ratio Current Share Price (Nominal) 6.00 Earnings Per Share 5.14 P/E ratio 1.17 The Price-to-Earnings ratio gives an idea regarding the valuation of the company and also helps to determine whether share price of the firm is fairly valued, overvalued or undervalued. Mathematically, the formula to determine the P/E ratio is, Or, In this case it was count that the P/E multiple was trading at 1.17 times implying that the company is overvalued. Part 3: Concept of Rights Issue Conceptually, issue of rights implies offering of additional securities to existing shareholders’ of the company on pro-rata basis of their shareholding. When the rights are issued with respect to equity shares for a publicly traded company, then it is considered as a process of raising capital from existing owners of the company. The existing shareholders will get the opportunity to purchase specified number of ‘new’ shares at pre-determined price but before specific time frame. As the company receives owners’ funds in exchange for shares, this financial instrument is a source of capital for the company (Damodaran, 2010, pp. 357-358). Three advantages of share acquisition through rights issue are: The control of the company is retained with the existing shareholders as new shares are issued to existing shareholders proportionately on the basis of their holdings Existing shareholders remains unaffected on the account of stake dilution when fresh shares are issued. If the value of share falls when new shares are issued then owners’ will be compensated by getting new shares at lower price. It also helps to reduce ‘Gearing Ratio’. There is certainty in receiving capital when fresh shares are issued especially compared to IPO Three disadvantages of share acquisition through rights issue are: Cost – An approximate fee of Royal Bank of Scotland Rights issue was ? 216 m (including 1.50% of guaranteed issue + 0.25% of discretionary cost + 0.05% book running fee) Dilution – There is chance that investors will not take up full rights issued and sell them to external investors Risk of share buyback exists as independent research have found that 9 out of 10 investors are often rejected to buy back Reference Damodaran, A., 2010. Applied Corporate Finance. 3. United States: John Wiley & Sons. Samuel, C., No date. Stock Market and Investment the Signalling Role of the Market. United States: World Bank Publications. Bailey, R. E., 2005. The Economics of Financial Markets. United States: Cambridge University Press. Madura, J., 2012. Financial Markets and Institutions. United States: Cengage Learning. Teweles, R. J. and Bradley, E. S., 1998. The Stock Markets. 7. United States: John Wiley & Sons. Levinson, M., 2009. Guide to Financial Markets. 5. United States: John Wiley & Sons. Read More