Question

Question 2: Businesses seek to obtain funds from householders by issuing securities such as stock and bonds. What are the characteristics of an equilibrium price determined in these markets? Discuss how the issuance of these securities is related to the firm’s balance sheets and income statement. From the households perspective discuss how these securities differ in risk, maturity and claim.

Answer 1

A business operating in the society usually asks for funds from banks, cooperative society, venture capitalist and lastly from the public. Ideally the bank loans and fund raising from cooperative society is difficult and costly. Hence company issues bonds and shares through IPO/FPO. These are issued to qualified institutional buyers, retail buyers or employees. The shareholders are part of the company to an extend of the shares they hold. They may get their funds back or not, they are risky as the funds are used to run the business such as expansion, indulged into technology, basically the motive of company is to add value to the business basically value creation and shareholder’s interest is wealth maximization. The share price increases if company is doing well and wins the confidence of shareholders. If the decision making of company goes wrong, the company may also make loss and share price may go down. Hence it is a risky asset for investor and important liability of company. Since it is a risky asset, the company shares the profit if any in form of dividend with the shareholder.

Whereas bonds are not risky as such, the bond holders get fixed interest locked during the issue of bond and get the investment back after stipulated time. They don’t get share in profit but the investment is safe and interest income is also fixed even if company is not doing well and making loss.

The share price is decided by investment banker during IPO/FPO looking at the book value of stock, fundamentals of company and future perspectives. Whereas the bond coupon rate is decided as per the internal growth rate of company which means the company may grow the fund of bond holders minimum by the internal growth rate of company.

The fund raised through IPO and FPO is basically share capital are shown on liabilities side of balance sheet under the head of owner’s fund whereas the bonds are shown under unsecured liabilities.

In income statement, firstly the interest to bond holders is paid from Earnings before interest tax and depreciation. Post which the mandatory expenses are considered and later on dividend is paid to equity share holders. The dividend is paid only if company is making profits and company have sufficient reserves. But the interest has to be paid even if company is running in loss. In case of loss, the company has to carry forward the depreciation and taxes (if any) for next 8 years to set off from future profits.

Hi, hope the explainations are sufficient. pls let me know if you need any explaination.