Capital Markets: Exchange of Funds - Research Paper Example

Capital Markets: Exchange of Funds Capital markets are an efficient and significant medium to control and organize funds to ventures and enterprises and offer a very useful resource of investing in the economies which they serve. They play a decisive function in mobilizing of savings for the purpose of investing in fruitful assets, with an outlook to enhance the state's lasting growth projection, and therefore act as a key catalyst in converting the economy into a more proficient and aggressive market. The capital markets can be classified into the primary and secondary markets; the primary being where new stocks and bonds are issued to investors, and the secondary one where already existing stocks and bonds are dealt. The government or companies or public sector organizations can get hold of funds through the sale of a new stock or bonds, in the primary market. These are usually issued by security dealers and banks that underwrite the stocks or bonds that are offered. The issuers get a commission that is inclusive in the price of the security that is being offered. Whereas in the secondary market, shares and stocks of companies that are publicly traded, are traded through stock exchanges that play the role of managed auctions. A stock exchange or share market is a company or mutual organization that presents facilities to stockbrokers and traders to buy and sell securities. Stock exchanges also present facilities for the issuing and redemption of securities, to deal with other financial instruments, and to pay income and dividends. The secondary market must be highly liquid in character, since most of the securities that are traded, are sold by investors. A capital market that has high liquidity and thus high transparency affirms a secondary market which will have the same qualities.  Over and above resource allocation, the capital markets also offer a means for managing risk by permitting the diversifying of risk within the economy (Jackson & Vitols, 2001). A capital market that is doing well, aims for improving the information quality, since it has a major part in promoting the acceptance of stronger principles of corporate governance, consequently providing support to a buy and sell setting which is established on the principles of integrity. A vital role of capital markets has been to support phases of progress in technology and development of economy all through history. Along with other things, it is possible to acquire financing for many capital intensive ventures with long growth stages, because of liquid markets. Indeed this was true in the industrial revolution of the 18th century and is applicable even in the so-called "New Economy" (Diamond, 1957). Because of the existence of dynamic bond markets, it is possible to cushion, financial systems from any shocks in future that are linked with over dependency on bank lending and short-term capital flows. This would also facilitate better diversification of risks. An advantage of capital markets is that they produce transparency in price and liquidity. They provide a safe place for diverse investors which include investment banks, commercial banks, insurance companies, pension and mutual funds, and retail investors for hedging and speculating purposes both. Furthermore, capital markets perform several decisive roles: they aggregate savings and they also allocate resources. In order to perform these functions, they have to choose not only amid competing sectors, but also among management teams, firms, that compete with each other. After distributing the funds, banks continue performing a significant job, in guaranteeing that the funds are utilized in the manner which is promised by the borrower, and that he, in response to up-to-the-minute unforeseen events, takes notice of the interests of those who provide capital (Aghion 1999). And hand in hand while providing these services, they also lessen the risks faced by savers, by giving a chance for diversifying. If any entrepreneur is aiming to start a new venture, the funds he would require, are typically beyond his reach. Banks and financial institutions add up together the savings of a pool of individuals who deposit them with these institutions, and make them available for funding of large-scale projects, such as these. This makes complete sense, since now the scale effect comes into play, that is returns would be limited if an individual was constrained by financing through his own personal investment only. This would be an essential task, even if all persons were indistinguishable, and the bank might, consequently, allot the finances merely by choosing at random, one person to take delivery of the loan. But the fact is that, all individuals are not the same. There are some who are better managers than others, while there are some who have bigger ideas. A fundamental purpose of financial institutions is to review which managers and which ventures are most to be expected to give the maximum returns (Davis & Steil, 2001). And it is a fact that it is not compulsory that the individuals that have the funds, are the ones who will use those funds in the best manner, therefore financial institutions execute an essential role in the transfer of funds to those for whom the returns will be highest. Furthermore, after the credit or loan has been given, it is really vital to monitor that the capital is spent in the promised manner, and that the project is administered in a good manner. These two roles of the financial institutions are known as the ‘screening’ and ‘monitoring’ roles. The type in which capital is supplied has costs both for the way in which these screening and monitoring functions will be executed and the performance to whom the capital has been made available. The three main types through which capital is made available are equity, long-term and short-term loans. Capital markets also offer an important foundation for external financing, as countries are maturing and beginning the conversion or transition to the New Economy. They are the best choice for High-Tech firms, which often do not have the needed collateral and cash flows to be able to secure financing through other traditional means. Furthermore, capital markets offer a variety of products and services which are linked with financial investments. In the capital markets; the stock market, the bond market, the commodities exchanges, and almost every physical or virtual service through which debt and equity securities can be bought or sold, play their part in integrating all the services. The most important purpose is to raise finances and to direct investors’ money to spots where there is a shortfall or requirement for investment. They play a role of an intermediary between governments and companies, which use them to finance innumerable projects and ventures. Capital Market: UK’s Case Illustrated UK has one of the most liquid bond and stock market in the global domain. London Stock Exchange (LSE) is a huge hub of the economy in terms of providing liquidity and exchanging funds with local and international investors. LSE has a lot of company’s shares listed with clients preferring in to trade in the most liquid shares as it allows them to exchange funds at a lower cost. There are a few shares which are not actively traded; and this absence of activity can be the basis for higher costs, through the 'spread' or at instances, no marketplace at all. Liquidity provides the simplicity because of which shares can be bought and sold and this has a very large effect on the current prices. Liquidity usually depends upon, the no. of shares that have been issued, the no. of investors that are actively trading and the no. of players in the market, who are prepared for quoting a price. As and when activity levels fall, prices become more unpredictable and thus risk levels climb up. As a general law, the bigger the company will be, the more liquidity will be in its shares. The largest companies that are listed on the LSE are traded in huge volumes. Plainly millions of numbers of shares change hands, of these companies every hour. If we see the monetary amount, then billions of pounds worth of stock market assets are traded every day. In such companies, liquidity is seldom a difficulty. On the contrary, there exist also many FTSE Fledgling corporations (those which have the least market capitalizations) that possess only one or maybe two players in the market trading in their shares. The spreads end up being large, that means higher profit for the brokers and market players, but they might be able to only implement a handful of trades each week, so in return income is much less. On the London Stock Exchange, in the quotation driven market, shares are normally quoted in expressions of the price and also in expressions of the quantity of shares that are traded at that price. This is well-known as the ‘NMS’ or the ‘Normal Market Size’. If the number of shares are more than this NMS number in any deal transaction, then the price will regularly change, and occasionally by a significant margin. Right Issues: Advantages & Disadvantages A rights or privilege issue is a method by which a company can trade new additional shares so as to raise funds. These shares are presented to shareholders of the company, in the same ratio as of their present shareholding, relating to the pre-emption right, they hold. The price at which these shares are offered is typically at some discount as compared to the present share price, because of which the investors get an incentive to purchase the new shares, but if they do not, their shareholding value is diluted. It would be a negative sign, if there is a rights issue by a highly geared company, with the intention of making its balance sheet stronger. Since, profits of such a company would already be low or might be negative, and the profits in the future seemingly weak. Changing the capital structure of such a company would not give much result unless the performance of the actual business is improved. On the other hand, it would be seen as a positive sign, if there is a rights issue to fund expansion of a company. The rights are generally a tradable sort of security themselves, that is a kind of specific time period warrant. Because of this, those shareholders who do not desire to buy new shares can trade their rights with someone else, who wants those. There are some shareholders who choose to purchase all of the rights that they are offered at the time of rights issue. Because of this, the proportion is maintained, and thus his ownership of the company is expanded, for example an x% ownership prior to the rights issue remains an x% ownership after it. Others might prefer to sell their rights, and dilute their ownership of the company, and thus reduce the value of their holding. Advantages: Because of rights issue, the company gives shareholders an option to raise their exposure to that stock, on a discounted price. Until the day, on which the new shares can be bought, the shareholders can buy and sell the rights in the same way they can trade ordinary shares. The rights issued possess a value. Companies in trouble normally use rights issues to get rid of debt, especially at times when they are being unable to borrow money from other channels.  Disadvantages: After the rights issue, the value of every share becomes diluted because of the increased number of shares that are now issued. An investor can easily be tempted to go for the rights issue, but its not necessary that it will be beneficial. So an investor needs to know the ex-rights share price and also the purpose behind this additional funding by the company, before deciding to accept or reject the rights issue. If companies want to improve the position of their balance sheet, it can be quickly done by using rights issue, but after the problem is solved then the management might not ponder over the grave issues that caused those problems, at first. Numerical Problem The cost of internal equity can be calculated from the Gordon Growth Model by changing the equation. Cost of internal Equity = Dividend Yield + Growth in Earnings Cost of internal Equity = D1/P0(1-F) + g Where D1 = Expected Dividends P0 = Current Price F = Percentage of Floatation Costs g = Growth in Earnings Cost of internal Equity = 1.18/ (41 x (1-0.12)) + 10% Cost of internal equity = 3.27% + 10% Cost of internal equity = 13.27% The cost of internal equity is a function of dividend yield and internal growth rate of the firm. Dividend Yield depends on the current stock price along with incorporating the impact of floatation costs. Higher floatation costs also increase the internal cost of equity for the firm. References Aghion, B. 1999, ‘Development Banking’, Journal of Development Economics, 58, pp. 83– 100. Davis, E. and Steil B. 2001, Institutional Investors, MIT Press. Diamond, W. 1957, Development Banks, MD: Johns Hopkins University Press. Jackson, G. and S. Vitols 2001. ‘Between financial commitment, market liquidity and corporate governance: occupational pensions in Britain, Germany, Japan and the USA’, London: Routledge Read More