Role and Importance of Capital Market - Essay Example

Financial Management Individual assignment Table of Contents Capital Market 3 Role and Importance of capital market 3 Efficient market hypothesis 5 Sources of finance 6 Impact of Sources of finance on cost of capital 8 Dividend policy 11 Theories explaining the relevance and irrelevance of dividends in share valuation 12 Conclusion 15 Reference 17 Bibliography 21 Introduction Capital is said to be the life of business. As the size of the firm increases there arises the need for additional funds. For raising the surplus funds the business can adopt various routes. It can go for the issue of fresh equity or it can also raise debts like issue of bonds, borrowing from the financial institutions. The choice of the mode will depend on the company’s fundamentals as well as the nature of ownership desired by it. These decisions are crucial and most of the big companies seek expert financial advice in such matters. This is mainly because the funding route adopted can impact the earnings of the company thereby influencing the price of its shares in the market. The companies with a strong market position can opt for debt route as they can negotiate favorable terms from the lenders. Capital Market Crisp Plc wants to raise £250 million for financing the new projects. For this the company plans to tap the capital markets. It can either issue shares or it can raise debt. Role and Importance of capital market Capital market provides a platform to the companies for issuing new securities like debt and equity. The funds raised from the capital market are used for the long term needs of the business. It consists of primary and secondary markets. The new securities are issued in the primary markets and the trading of these securities takes place in the secondary markets. Capital market plays a major role in the economic and financial development of a country. It helps the entrepreneurs by providing them with the platform to raise capital for their business. It acts as an intermediary between the issuers and subscribers of equity. In the absence of the capital markets many of the investment opportunities would have remained untapped. Besides acting as a financial intermediary it monitors the activities of the market participants (Tadesse , n.d.). This is done to ensure that the funds raised are used for the purpose for which it has been raised. The growth of an economy depends on the presence of an efficient capital market that can mobilize the savings of individuals and also provide the opportunity of offshore financing. With the advancement in the financial markets many businesses can access the overseas markets for the issue of their shares (DUKE The Fuqua School of Business, n.d.). The financial instruments trading in the capital market include insurance instruments, equity, derivatives, bond and foreign currency. The markets satisfy the information needs of the investors by setting down rules regarding the issue of instruments. Prior to an issue, the issuer has to make necessary disclosures. The price of the securities trading on the stock exchange gives valuable information regarding the worthiness of an investment. This also leads efficiency in firm management. As the market price of a firm’s security reflects its fundamentals, the management pays special attention to business activities. By acting as a link between the investors and entrepreneurs, the capital markets facilitate the undertaking of risky projects which would have not been taken up due to scarcity of capital. Such projects require huge amount of investment which can only be mobilized through capital markets. It helps in raising capital for long gestation periods. An investor desiring to exit from an investment can do so through the active secondary markets. This caters to the liquidity problems of the investors. Efficient market hypothesis A capital market is said to be efficient when the price of the securities reflect all the available information (Massachusetts Institute of Technology, n.d.). In an efficient market there is no underpricing or overpricing of a security as all the securities trade at their intrinsic value. This eliminates the possibility of earning any supernormal profits by an investor (Malkiel, 2003). There are three forms of market efficiency- Weak Version- In a weakly efficient market, all the information about the past prices is reflected in the stock price. This makes Technical Analysis redundant. Semi-strong version- In a semi strongly efficient market the price of the security reflects all the financial information thus making Fundamental Analysis unprofitable. The Income Statements and the Balance Sheets are easily available which gives all the needed information about the financial health of the company. This means that no profits can be made with the help of certainty with the help of publicly available information. Strong Version-In a strongly efficient market no profits can be made even with the help of any insider information (KsuWeb, n.d.). Insider information refers to the information that is privy to the officials of the company. Any trading based on this kind of information is illegal and punishable. The regulators all over the world have set up strict rules to prevent this kind of trading. In efficient market, equity research does not yield any result. Since, all the stocks trade at their true vale it is not possible to cherry pick the undervalued or overvalued stocks. The booms and busts in the financial markets have disproved the efficient market theory (Vayanos, Woolley, 2009). There have been instances when the market has performed erratically. The 1987 stock market crash raised doubts about the existence of strongly efficient markets. Various studies show that the small firms earn supernormal returns in the long run. Many times the stock prices overreact to some announcements and such errors get slowly corrected. The stock prices rise abnormally in the months of December and January. So these predictable patterns suggest that the markets are yet to reach the strong form of efficiency. The markets presently are at best in the semi strong efficiency form. Sources of finance The choice of funding for Plc depends upon its existing capital structure. If the company does not have much of debt in its capital base then it can borrow externally. Currently, various sources of funding are available to the company. The choice of the source is crucial for the company. There are broadly two types of sources available to a business- internal and external. The internal sources include Retained earnings and Working capital whereas the external sources include shares, debentures, loans and overdraft facilities (BIZED-a, n.d.). Retained Earnings- Retained Profits represent that portion of business profits which remains unutilized. This can be used by the business for the purchase of new equipments or for expansion. It is said that retained profits are saved by the business for the “rainy day” (BIZED-b, n.d.). Working Capital- Working Capital is used for meeting the short term capital requirements of the business. It is expressed as the excess of current assets over current liabilities (BIZED-c, n.d.). Shares-A company can issue shares through the stock exchange. This can be issued to the new investors or it can be issued to the existing owners of the company in the form of rights issue. These shares are usually offered at a premium over the face value (NetTel@Africa, n..d.). The company can issue two types of shares –equity shares and preference shares. While the equity shareholders have the right to participate in the decision-making process of the organization, the preference shareholders do not have this right. The voting rights are denied to the preference shareholders except in the case of participating preference shareholders. But they are entitled to special preference in the distribution of profits. In the event of insufficient profits the equity shareholders may not get any dividend but the preference shareholders get a fixed payment irrespective of the earnings of the business. Debentures-Debentures are financial instruments that are issued by the company when it borrows money from the public. The debenture bears a coupon rate which is the interest that the borrower has to pay to the lenders. There can be various types of debenture- secured or unsecured debenture, fixed or floating rate debenture, convertible or non-convertible debenture etc. The company issuing the debenture has to pay an interest to the debenture holder (BIZED-d, n.d.). Bank Borrowings- the companies often borrow funds from banks for meeting their short term requirements. This can be in the form of overdraft or short term loans with a maturity of three years. Nowadays, banks also lend funds for medium term use ranging for a period of more than three years. On an overdraft facility granted by the bank interest is charged on the amount overdrawn by the business (FAO Corporate Document Repository, n.d.). Impact of Sources of finance on cost of capital From the company’s point of view the cost of capital refers to the cost of raising debt and equity. The return desired by the shareholders is the cost of equity that the enterprise has to pay to the shareholders. Similarly, the cost of debt refers to the charge that the enterprise has to pay to its debenture holders. The companies try to strike an optimal balance between the debt and equity. Debt funding is regarded as a cheap source of finance. Moreover, a company with strong fundamentals can demand for lower rates from the lenders. The interest paid on debt is allowed to be treated as a tax deductible expense. This helps the business in saving taxes. But this exposes the company to financial risk. In times of financial crisis the debt funds may become an additional burden for the company. Moreover, the business with a high debt ratio is viewed as highly risky by the investors, creditors and banks. So, they demand higher returns on their borrowings. At times the interest obligations put a pressure on the earnings. So, the company cannot make use of the growth opportunities. The equity financing may be less risky but it is more expensive. Issuing of fresh equity dilutes the ownership of the company. But still many companies rely heavily on this method of financing because it does not create any financial obligations. The amount of dividend paid to the shareholders depends upon the earnings generated by the company. If in any year the company is not able to generate surplus profits it may not pay anything to the shareholders (Washington State University, n.d.). For attracting investors the business must earn more than the cost of capital (University of Wisconsin- Whitewater, n.d.). The inclusion of higher amount of debt in the capital structure reduces the cost of capital as the cost of debt is less than the cost of equity but this increases the financial risk of the firm. There are various theories explaining the effect of a higher debt-equity ratio on the cost of capital. Net Operating Income approach- This approach states that the cost of capital remains unchanged due to any increase in financial leverage. As the firm expands it uses more debt in the capital structure. This increases the risk of the firm, so the equity shareholders ask for a higher return on their investment i.e. the cost of equity (ke) goes up. The increase in ke offsets the decrease in the cost of capital due to lower ki. Thus, the cost of capital remains constant. Source :(Kuhlemeyer, 2004). In the above figure, as the debt-equity (B/S) ratio increases from 0.25 to 2.0 the cost of capital or the capitalization rate remains constant at all the levels. This is mainly because the reduced cost of debt is offset by the rising cost of equity thus making the cost of capital constant. Traditional approach-As per this approach the equity investors can bear a moderate level of risk. So initially when the debt increases the ke does not go up i.e. the cost of capital falls. But with the increase in financial leverage the equity shareholders demand for a higher return on investment and even the cost of debt goes up, thereby pushing up the cost of capital. According to this theory there exists a point where the cost of capital is the lowest. This is the point at which the value of firm is the highest. Source :(Kuhlemeyer, 2004). Modigliani Miller approach- This approach advocates the Net Operating income approach. It states that firms in the same risk class must have the same cost of capital. If this does not hold good i.e. the value of the firms, belonging to the same risk class and having the same EBIT, is not same there arises an opportunity of arbitrage (Kuhlemeyer, 2004). Dividend policy This refers to the proportion of earnings that the company distributes among the shareholders. It is technically called dividend payout ratio. The optimal payout ratio is one that maximizes the price of the share. This is a crucial decision for the company. In this matter, Crisp Plc must take into consideration the following factors like- Availability of free cash flow- This states that the dividend declared by the firm depends on the surplus cash left after investing in projects. Type of shareholder- A particular class of shareholders like the retired individuals prefer higher amount of dividend whereas the employed individuals earning higher incomes desire lower dividends to avoid taxation. So, a firm can maximize the price of its shares and lower its cost of capital by catering to a particular class of investor. Signaling Effect- Many investors view a reduction in dividends as a negative sign leading to a fall in the share price. Similarly, increased dividend sends out a positive signal to the investors and increases the share price. They feel that the management is confident about the future prospects. This factor has a major influence on dividend decisions. To avoid the dissemination of negative signals about the firm the managers try to follow a stable and increasing dividend policy. Theories explaining the relevance and irrelevance of dividends in share valuation There are many theories explaining the impact of a higher dividend payout ratio on the share price. Gordon model- This model assumes that the value of the stock depends on the dividend declared which grows at a constant rate forever. This is given as- Po = DPS1/(r-g) where, DPS1 =Dividend expected next year r= return required by the equity investors g=Perpetual growth rate of dividend (Leonard N. Stern School of Business, n.d.). As per this model the company that pays a higher amount of dividend has a higher share price compared to a company with the same earnings but paying lower dividends. Suppose, Earning per share (EPS) =$10 Dividend payout ratio is 50% Growth rate expected next year=2% r=10% g=5% Po= (10*1.02)*0.50/(.10-.05) =$102 Traditional approach advocated by Graham and Dodd- This approach advocates that the shareholders prefer dividend over retained earnings. Thus, higher the dividend payout ratio higher is the value of the firm. This is given as- P=m(D+E/3) Where m=multiplier D=dividend R= Retained Earning per share E= Earning per share Since, E=D+R, therefore the above equation can be reframed as P=m[D+(D+R)/3] i.e. P=m(4D/3+R/3) This shows that the impact of Dividend on the share price is 4 times compared to retained earnings. Walter model- This model views that a company with an internal rate of return higher than the cost of raising equity pays lesser dividends and ploughs back most of its business profits. A firm with ample growth opportunities can maximize the wealth of its shareholders by retaining the entire profit (Mishra, Narender,1996). Irrelevance of dividend Modgliani and Miller Model- As per this model the share price of the company depends on the earnings generated i.e. PAT. It remains unaffected by the distribution of the earnings into dividend and retained earnings. This theory assumes the dividends to be irrelevant and assumes that the shareholders are indifferent to dividends. It views that the income earned by the company belongs to the stockholders so it is immaterial whether the company retains this money for further investment or passes it on to the shareholders (MoneyTerms, n.d.). This theory assumes that tax rate on dividend and capital gains is same so the investors become indifferent to getting returns in the form of price appreciation or dividends. It further assumes that- Transaction costs do not exist i.e. an investor does not have to pay any extra amount for selling off his shares. If this does not hold good then an investor needing immediate cash will prefer dividend. The companies with a low dividend payout ratio use the cash use the surplus funds effectively. The companies with a high dividend payout ratio do not have to pay any floatation costs for issuing fresh equity to undertake new projects. In this scenario the value of the firm remains unaffected by the dividend decisions of the company (Leonard N. Stern School of Business, n.d.). Rational Expectations-The investors have certain expectations regarding the dividends. In case the actual dividend is less than the expected dividend this has a signaling effect on the shareholders. They revalue the share price of the company. So, as per this approach the share price is not influenced by more or less dividend rather it is affected by the change in the expectation of the shareholders. Conclusion Crisp Plc. can raise the required amount of £250 million by issuing fresh equity or it can opt for external borrowing. The choice in this regard will be influenced by the current capital structure of the company. If the company has not used much debt in its capital then it will be benefitted by employing new debt. This is mainly because the lower cost of debt will offset the higher cost of equity thus bringing down the overall cost of capital for the company. But care must be taken here about the excess usage of debt as this may expose the company to financial risk. Reference Tadesse , S. No Date. The Allocation and Monitoring Role of Capital Markets: Theory and International Evidence. The University of South Carolina. Available at: http://fic.wharton.upenn.edu/fic/papers/05/0523.pdf [Accessed on December 15, 2009]. DUKE The Fuqua School of Business. No date. The Role of Capital Markets in economic growth. Available at: http://faculty.fuqua.duke.edu/~charvey/Research/Chapters/C6_The_role_of.pdf [Accessed on December 15, 2009]. Massachusetts Institute of Technology. No date. 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Available at: http://pages.stern.nyu.edu/~adamodar/New_Home_Page/invfables/dividirrelevance.htm [Accessed on December 15, 2009]. Bibliography Yale University School of Management. 2000. Lecture 18 The Modigliani-Miller Theorem With No Taxes. Available at: http://www.som.yale.edu/faculty/zc25/finance-core/slides/l18-new.pdf Read More