International Financial Markets - Case Study Example

INTERNAITONAL FINANCIAL MARKETS The role of a stock exchange and how it has taken new dimensions is discussed along with the ratios and the phenomenon behind the right share issue and how it can be carried out. STOCK EXCHANGE The main function for which the stock exchanges came into being was to mobilize the capital and to raise enough funds where the company can fulfill its needs and acquire assets or pay liabilities. The stock exchanges provided a motive and platform to the companies to raise capital by issuing shares and debentures which can be utilized on a long term basis. As time has passed, this motive has been gradually dissolved and the stock markets are now the arena for secondary trading where the brokers intend to trade shares for commission and the investors are least interested in long term investments, rather they are intended to make short term trading for quick profit generation. (Jeffry A. Timmons n.d.) Secondary Trading Secondary trading refers to the trading activities which are performed in the stock exchange after the company has already issued the stocks such as the shares and debentures. These trading activities involve speculations where the investor sells the already purchased securities to a speculator through a broker. The reason for which these kinds of markets came in to being was to create the liquidity in the markets and not to get the money of the investor tied up for a long period of time. After the listed companies have issued the shares in the market, these shares can be readily traded in the stock exchange for making a quick gain, for which the brokers charge a partial commission. Factors responsible for Secondary Trading There are many factors that account for the Secondary trading activities that have caused to be the uplift of secondary trading. Liquidity ease One of the main benefits that has lead to secondary trading in place of long-term investment is the investor can recover the amount of its investment to an extent in a short period, whenever he needs it. (Finance 2008) The investor is blessed with this comfort that he can sell his part of the interest, whenever he thinks fit, if the investment lies in fragmented proportions. This facilitates the market entry and exit, allowing new investors to explore and invest in the market. (ICT Regulation 2010) In short, it can be said that the secondary markets provide a much liquid environment for the trading activities to be held. Speculation and rapid profit making Another important cause of this new face of stock exchange is that the speculation business has gained new heights and the traders can make a quick profit by selling the shares that they hold at a price which is greater than the dividend that they will receive over a period of time. Secondary trading can also be done without the physical transfer of shares and even the money, as a gain can be made by selling the shares before the actual transfer is made. Business growth in United Kingdom Secondary trading has also helped the business growth in the UK, which is explained in detail below: The secondary market is proving beneficial for the business in the United Kingdom as it has enabled the primary investor to gain an understanding of the exit rates through recycling their capital. (Euro Money 2010) This also enhances the investments in the markets. Due to the secondary trading, people are more willing to purchase shares and opt for an IPO as even thought they do not want to invest on a long term, they can always trade those shares in the market and make a gain which helps the business point view to flourish and the company gets a good response whenever it wants to issue the shares. RATIOS Different ratios, including the gearing ratio, price earnings ratio and return on investment ratio are calculated and their affects on the company are examined. Gearing Ratio: It is the financial ratio which compares the equity of the owner with the funds borrowed. (Investopedia 2009) Long term debts (Debenture Stock) = £ 1,600,000 Preference Shares = £ 2,400,000 Ordinary Shares = £ 4,000,000 Gearing Ratio = Long term debts + Preference Shares Ordinary Share Holders Equity Gearing Ratio = 1,600,000 + 2,400,000 4,000,000 Gearing Ratio = 4,000,000 4,000,000 Gearing Ratio = 1 Dividend declared and Return on Investment The dividend is declared after a profit of £800,000 and only 40% has been decided to be distributed among the shareholders. The dividend will be calculated as per following formula: Dividend/ share = Dividend declared Outstanding Shares Profit = £800,000 Dividend declared: £800,000 x 40% Dividend declared = £320,000 Firstly, dividend will be paid on the preference shares and then on the ordinary shares. (Bized n.d.) Since the company has issued 600,000 shares @ £4 each with then the dividend will be paid on £2,400,000 (600,000 x £4) Dividend of Preference Shares = Preference Shares x Fixed dividend Dividend of Preference Shares = 600,000 x 4 x 2.5% Dividend of Preference Shares = £ 60,000 The dividend declared of Ordinary shares can be calculated by subtracting the Dividend on preference shares from the total declared dividend. Dividend on Ordinary shares = £320,000- £60,000 Dividend on Ordinary shares = £260,000 Dividend per ordinary share = £260,000/£ 4,000,000 Dividend per ordinary share = £0.065 The return on investment can be calculated to determine the efficiency of the investment, which can be calculated by the following: Return on Investment = Gain on Investment – Cost of Investment Cost of Investment The return on investment on the above mentioned company is very healthy as the company is giving a £0.065 on every ordinary share to its shareholders. Price/Earnings ratio The price earnings ratio refers to the ratio between the market value of the share with the Earning per share (EPS). (Stocks 2010)The price earnings ratio can be calculated by the following formula: Price/Earnings Ratio = Market Value per share Earnings per share In order to calculate the price/earnings ratio, first we would have to calculate the Earnings per share. Earnings per share = Net Income – Dividend on proffered stock Average Outstanding shares Earnings per share = 800,000 – 60,000 1,000,000 Earnings per share = 720,000 1,000,000 Earnings per share = 0.72 Price/Earnings Ratio = Market Value per share Earnings per share Price/Earnings Ratio = £ 4.0 £0.72 Price/Earnings Ratio = 5.56 It is the relationship between the companys earning and the stock price. There is immense importance of the Price/Earnings ratio for the investors as it shows the amount that the investors are eager to pay for their earnings per unit of currency, which is why it is also termed as "multiple" (Investopedia 2010) It is one of the most important determiners for the investors where they are willing to invest because a low P/E would render low investment chances for the company. A high Price/Earnings ratio would mean that the company is eager to give a high return on the investment made. (Stocks 2010) It also compares the market price of the shares with the share of possible dividend out of the net profit which the company gives to the existing share holders of the company. There also lies an argument that some of the investors would not regard the Price/Earnings ratio as significant because the numerator is a market driven determiner while the denominator, earnings per share, is calculated by the accounting ratios which is why the relationship does not give the investor an exact idea if the investment would render the same returns for the future as the Market price may fluctuate at any time. RIGHT ISSUE The right issue of shares is that issue of the share capital by the company in which the company offers its shares to its existing shareholders in the fraction of their existing shareholding. (Money Terms 2010) Usually, the price at which these shares are offered to the share holders is a discounted share price compared to the current share price, this also gives an extra incentive to the share holders to purchase these shares. This, however, does not create an obligation on the share holders to purchase the shares as they have the right to reject the shares. The existing share holders are more inclined to buy these shares because if they do not buy these shares, this will be presented as an option to the public due to which the existing share holders will lose the holding strength on the company. Since these shares are usually sold at a cheaper price than the market, the shareholders who do not intend to purchase the shares and get their investment blocked, the shareholders purchase the shares at that cheaper price and then trade those shares in the market at the prevailing price to make a quic profit out of that issue of shares. Advantages to the shareholders of Right Issue There are many advantages to the share holders for this option which are explained below: The existing share holders get the right to more shares without seeking to trade in the market. The shareholders get this option at a relatively low price than that of the market, which is why they get the opportunity to increase their holding on the company at a relatively lesser compensation than the ordinary people. (Stock Market Guide 2006) The shareholders can also trade the shares immediately in the market at market price to make an immediate gain. Disadvantages to the shareholders of Right Issue One of the disadvantages of a right issue is that the value of the shares will be diluted along with the increase in the issue of shares which may be disturbing to the share holders in the long term. In case the share holder is not willing to purchase the shares or does not have enough funds, those shares will be offered to the public and the shareholder will lose the proportionate holding on the company. The share holder, in consequence of not opting to purchase the shares of the company, will lose the voting rights that he previously held in the company giving him a disadvantage. Conclusion It can be understood that the right issue has both the advantages and the disadvantages to both the company and the shareholders as the company can incline its share holders to purchase the shares and the shareholders can be benefitted by getting the shares at a much lesser price than that of the market. References Bized. http://www.bized.co.uk/learn/accounting/financial/sources/prefshares.htm. Euro Money. 2010. http://www.euromoney.com/Article/1001377/BackIssue/50018/Secondary-market-for-UK-PFI-takes-off.html. Finance. 2008. http://finance.mapsofworld.com/capital-market/secondary/trading.html. ICT Regulation. 2010. http://www.ictregulationtoolkit.org/en/practicenote.aspx?id=3075. Investopedia. 2009. http://www.investopedia.com/terms/g/gearingratio.asp. Investopedia. 2010. http://www.investopedia.com/terms/p/price-earningsratio.asp. Jeffry A. Timmons, Stephen Spinelli, Andrew Zacharakis. Techniques and strategies for financing and valuing. Money Terms. 2010. http://moneyterms.co.uk/rights-issue/. Stock Market Guide. 2006. http://www.stockmarketguide.org/rights_issue.asp. Stocks. 2010. http://stocks.about.com/od/evaluatingstocks/a/pe.htm. Stocks. 2010. http://stocks.about.com/od/evaluatingstocks/a/pe.htm. Read More