The Role and Importance of Capital Markets - Dissertation Example

The Role and Importance of Capital Markets   Part A Introduction A share represents the ownership interest in the company having dividends rights and other rights like right to attend the meeting. The two types of shares are - equity shares and preference shares. Unlike the equity shares, the preference shareholders are entitled to special privileges with regard to payment of capital and profit sharing. The businesses deploy a mix of debt and equity in their capital base. The firms have a finance department that looks after the funding needs. The financing policy should be designed in a way that it maximizes the wealth of the shareholders while minimizing the overall cost of capital. Equity The equity shares are also referred to as ‘ordinary shares’. The equity shareholders also referred to as ‘ordinary shareholders’ who share the risk as well as reward associated with the corporate ownership. Unlike preference shares the equity shares do not carry any preference with respect to redemption and income. As the equity shareholders are exposed to greater risks and do not enjoy any specified preferential rights, the equity holders are entitled to a higher share in the business profits in the form of high dividends as compared to the payments made to the preferential shareholders. However, the declaration of dividend is at the discretion of the directors’. Types of equity shares The equity shares are of the following types- With voting rights Without voting rights With differential voting rights with respect to dividend payments or voting, as per any prescribed rules and conditions. The shares with the feature of “differential voting rights” cannot be more than 25% of the company’s Total Issued Share Capital. The corporate can raise additional funds, without diluting the ownership interest of the existing shareholders through the issue of “non-voting equity shares”. These shares are inclusive of all benefits that are due to the normal shareholders except the “right to vote” in the company’s annual general meetings. Like the ordinary shares, the non-voting class of shares is entitled to bonus and rights issue as well as preferential share offers. In order to compensate the loss of voting rights this class of shares carry a high rate of dividend as compared to the voting shares. In the event of dividend failure, the non-voting class of shares will automatically get pro-rata voting rights until there is resumption in dividend payments (Guruswamy, p.51). Merits & demerits of equity An important benefit arising from the issue of equity is that it does not create any fixed obligations. The dividends paid on the equity shares are at the discretion of the management and therefore it does not create any legal bindings. In the initial stages, the company may not be in a position to withstand fixed contractual obligations. For this reason, the equity issue is the most preferred route of issuing funds as it does not create any financial burden on the company. However, a high level of equity can dilute the ‘ownership’. It is argued that the equity shareholders interfere in the business affairs thereby delaying crucial business decisions. Moreover, the managers have to seek approval of the majority shareholders at the time of making important business decisions. This leads to excessive delays. Benefits & Risks of voting & non-voting equity The main advantage of non-voting shares is that it overcomes the problem of dilution of ownership as these classes of shares do not have any voting rights. This class of shares tackles the problems related with other class of shares such as the ordinary shares or voting shares. The latter class of shareholders seeks high returns on their invested funds both in the form of high dividends and capital appreciation. Due to this, the non-voting shares are said to have a popular and ready market. In fact, this class of shares is similar to preference shares in terms of absence of voting rights but unlike preference shares this class of shareholders enjoys the benefit of high rates of dividends as well as capital appreciation in the form of bonus issue. The limitation of the non-voting shares is that if the company fails to pay dividends at the stipulated rate, these shareholders are entitled to voting rights on a pro-rata basis. The other limitation of this class of shares is high dividend rates. Debt The debt holders are the creditors of the business. Debt refers to the loans raised by the business from external sources. These sources include banks, financial institutions and the general public. On the debt raised, the company has to make fixed interest payments. Based on the tenure of the debt, it can be short term as well as long term. The short term sources of debt include bank overdraft & trade credit and the long term sources of debt include debentures, term loans. Types of debt Debentures- The debenture is a type of bond by way of which the company raises money from the public for long term purposes. A debenture is payable at par or at premium on the date of maturity and carries fixed coupon payments. There can be various classes of debentures. Based on convertibility, the debentures can be classified as convertible and non-convertible debentures. Based on redemption, the shares can be classified as redeemable and irredeemable debentures. Again depending on ‘security,’ the debentures can be classified as secured debentures and unsecured debentures. Term Loan- The term loan is taken for a specific purpose from the banks and financial institutions like financing of equipments and is generally secured against the firm’s assets. This form of loan is inexpensive and is also not very time consuming. Bank Overdraft- It is a type of short term loan by which the bank allows the firm certain credit limit, enabling it to withdraw from its current account to the extent of this limit. This limit is set by the bank based on the anticipated cash flows of the firm. Trade Credit- Trade Credit is a type of short term financing that does not involve any interest payments. In fact, it is a type of contract between two parties namely the business and the supplier. Here the supplier grants the goods to the business on credit. Benefits and risks of debt The main advantage of issue of debt is that there is no dilution of ownership interests. The cost of debt is also lower as compared to equity, making it the most sought after financing mode by the managers. Unlike dividends, the interest paid on debt is a tax deductible expense. The risk of debt issue is that it creates fixed obligations that have to be honored irrespective of the company’s liquidity position. An excessive debt exposure is not in the financial interest of the company as it endangers the solvency of the business. The high costs of servicing debt often come in the way of business growth. Benefits and risks of various forms of debt The debenture is a type of financial instrument that helps in raising funds for long term business needs. A company with a high credit rating can issue debentures at low rates and vice versa. The risk of this form of investment is that fixed interest costs often exert pressure on the earnings of the company. Term loans are inexpensive as well as less time consuming (Stoltz, p.118). The main advantage of bank overdraft is that it meets the immediate funding requirements of the business. However, the limitation of this form financing is that the bank can demand repayments at a short notice. Trade Credit is beneficial in the sense that it gives the business the time to sell the goods and repay for the material acquisitions at a later date. However, the limitation is that a high accounts payable period does not convey a good message to the potential investors. Gearing and cost of capital The gearing of the business refers to the amount of debt in the capital base. A high level of gearing is not in the financial interest of the company. The managers must try to maintain an ideal gearing position so as to minimize the cost of capital and maximize the value of the firm. Part B Role and importance of capital markets A capital market refers to the market where a company or government raises funds for financing their operational activities generally for long time periods. The short term funding needs can be met from other markets such as money market. The capital market comprises of stock markets for the issue of equity securities and bond markets for raising debt. The new issues relating to stocks and bonds are done in the primary markets in the form of underwriting of securities. The money raised from underwriting goes in meeting the investment needs of the company. The stocks and bonds issued in the primary markets are traded in the secondary markets which includes stock exchange, over-the-counter (OTC) etc. The securities prices in the secondary markets reflect a company’s real price. This serves as a good benchmark in the issue of additional bonds or stocks that are required for further business expansion (Borowski, p.3). In short, capital markets are the markets by which the companies, government or people having surplus funds transfer the same to companies, government or people in need of it. The capital markets are said to enhance market efficiency by transferring the resources from those without any productive use for the same to those who require it for productive purposes. In other words, the capital market acts as a link between the ‘suppliers’ and ‘borrowers’ of funds (Woepking, “International Capital Markets & Their Importance”). Efficient market hypotheses An efficient market is one where the price of an asset reflects its true economic value. In other words, a market is said to be efficient when the asset prices contain all the information relating to value. The price of the asset changes so as to reflect any new information. As a result, it is not possible to outperform the market on a consistent basis. Types of market efficiency There are three types of market efficiency- Weak Form- The markets are said to be weakly efficient when the price of the assets reflects all the past data. Therefore, it is not possible to predict future prices using the past information. So an investor cannot make permanent profits based on past prices. This makes technical analysis redundant. Any extra normal return can be earned using fundamental analysis or with the help of insider information. Semi-strong form- The semi-strong form of efficiency states that the price of securities reflects all the publicly available information. The price of shares adjusts rapidly to any new information. This makes both technical analysis and fundamental analysis redundant in the long run. Strong form- The markets are said to be strongly efficient if supernormal profits cannot be made even with the help of insider information. Implications of capital market efficiency for companies, managers and shareholders In the case of strong form of market efficiency, the firm’s value reflects the present value of the anticipated net cash flows. So the strong form of market efficiency has strong implications for the company, shareholders and managers. As long as the decisions of the firm impacts the consumption opportunities of the shareholders through changes in wealth, the managers can work towards maximizing the firm’s market value. The managers have no incentive in manipulating the firm’s earnings. If the firm issues new securities at the prevailing market price then the concerns relating to dilution are eliminated. Moreover, the returns on the security are meaningful estimates of the performance of the firm (Shanken & Smith, “Corporate Finance Implications”). The implication of EMH is that the market price reflects all information. Therefore, the purchase and sale of assets do not involve any positive cash flows generating returns adjusted for the risk. For the valuation of a project, the market prices serve as the best estimate. When the managers issue any new securities, the price of the securities is the best estimate of the firm value to avoid any possibility of over valuation or undervaluation. The price of the securities contains all the possible information. There is no possibility of financial illusions. The price reflects the value based on the anticipated pay-off of the asset. So, it is not possible for the company to mislead the market. If the markets are strongly efficient then the timing of equity or debt issues is of no significance to the manager as the security’s price is ‘fair’. The entity cannot trick the participants in the market by resorting to techniques like “creative accounting”. The price of the firm’s stock is a reflection of the NPV of the estimated cash flows and therefore the manager just need to make sure that the investments yield returns in excess of cost of capital (Ogilvie, p.70). Empirical evidences show that the market reaction to any new information is relatively accurate and quick. So the market prices are on an average correct. Even if the market is not perfectly efficient, it is relatively efficient. Both technical and fundamental analysis is not likely to yield abnormal profits. The focus of the investors should be on good investments defined in terms of acceptable risk level and expected return. The active strategies cannot outperform the passive strategies or buy and hold strategy. The managers must keep a watch over the stock price to check whether the price changes are due to some new information or market overreaction or due to some momentum in short run (Hartviksen, “Implications of Market Efficiency”). Practical Issues- There have been evidences to show that the managers possess more information that what is reflected in the stock price. The investors know that the managers have more superior information. The managers can initiate certain actions by which they can exploit the advantages from information. Suppose the existing market price of the security is $25. The investors perceive that if they have access to the same information as the managers, the price would be higher at $27 or low at $23. A manager wishing to raise funds will prefer the equity mode if they feel that value of the share is less say $23. Again if they feel that the real value is worth $27, they would prefer debt over issue of equity. Therefore, in the case of a fresh equity issue the investors reassess the existing price taking this new information into account. This increases the likelihood of a lower share value and decreases the likelihood of a higher value resulting in a price drop. This eliminates the possibility of any gain from the exploitation of superior information by the manager. There might also be problems when the company makes announcement for repurchase of shares. The investors are of the view that the managers would optfor buying of shares when the shares are underpriced (Shanken & Smith, “Corporate Finance Implications”). Reference Borowski, A. Financial Management: The Role and Importance of Capital Markets and EMH. GRIN Verlag. 2010. Guruswamy, S. Capital Markets, 2E. Tata McGraw-Hill. 2009. Hartviksen, K. Implications of Market Efficiency. No Date. INTRODUCTION TO CORPORATE FINANCE. March 15, 2011. . Mathur, B.S. Trans Auto Engines Systems. Tata McGraw-Hill. 1974. Ogilvie, J. Management Accounting - Financial Strategy. 2007. Elsevier. Woepking, J. International Capital Markets & Their Importance. 2007. The University of IOWA Center for International Finance and Development. March 15, 2011. . Shanken, J. Smith, W.C. Corporate Finance Implications. 1996. Implications of Capital Market Research for Corporate Finance. March 15, 2011. < http://www.bus.emory.edu/jshanken/published/Implications%20Corp%20Fin.pdf>. Stoltz, A. Financial Management. Pearson South Africa. 2007. Read More