Question

explain using payoff diagram the extent to which the following corporate securities exhibit like features
convertable debt
callable debt
levered equity
warrants

Answer 1

Categories for Classification of Corporate Securities (With Diagram)

Category # 1. Ownership Securities:

The term ‘ownership securities,’ also known as ‘capital stock’ represents shares. Shares are the most universal form of raising long-term funds from the market. Every company, except a company limited by guarantee, has a statutory right to issue shares. The capital of a company is divided into a number of equal parts known as shares.

According to Farewel, J., a share is, “the interest of a shareholder in the company, measured by a sum of money, for the purpose of liability in the first place, and of interest in the second, but also consisting a series of mutual covenants entered into by all the shareholders interest.”

Section 2(46) of the companies Act, 1956 defines it as “a share in the share capital of a company, and includes stock except where a distinction between stock and shares is expressed or implied”.

Kinds of Ownership Securities or Shares:

Companies issue different types of shares to mop up funds from various investors. Before Companies Act, 1956 public companies used to issue three types of shares, i.e. Preference Shares, Ordinary Shares and Deferred Shares. The Companies Act, 1956 has limited the type of shares to only two-Preference shares and Equity Shares.

In some countries like U.S.A. and Canada certain companies issue another type of shares called ‘no par stock’. But these shares, having no face value, cannot be issued in India.

Different types of shares are issued to suit the requirements of investors. Some investors prefer regular income though it may be low, others may prefer higher returns and they will be prepared to take risk. So, different types of shares suit different types of investors. If only one type of shares is issued, the company may not be able to mop up sufficient funds.

The various kinds of shares are discussed as follows:

i. Equity Shares:

Equity shares, also known as ordinary shares or common shares represent the owners’ capital in a company. The holders of these shares are the real owners of the company. They have a control over the working of the company. Equity shareholders are paid dividend after paying it to the preference shareholders. The rate of dividend on these shares depends upon the profits of the company.

They may be paid a higher rate of dividend or they may not get anything. These shareholders take more risk as compared to preference shareholders. Equity capital is paid after meeting all other claims including that of preference shareholders. They take risk both regarding dividend and return of capital. Equity share capital cannot be redeemed during the time of the company.

ii. Preference Shares:

As the name suggests, these shares have certain preferences as compared to other types of shares. These shares are given two preferences. There is a preference for payment of dividend. Whenever the company has distributable profits, the dividend is first paid on preference share capital.

Other shareholders are paid dividend only out of the remaining profits, if any. The second preference for these shares is the repayment of capital at the time of liquidation of company. After paying outside creditors, preference share capital is returned. Equity shareholders will be paid only when preference share capital is returned in full.

A fixed rate of dividend is paid on preference share capital. Preference shareholders do not have voting rights; so they have no say in the management of the company. However, they can vote if their own interests are affected. Those persons who want their money to fetch a constant rate of return even if the earning is less will prefer to purchase preference shares.

iii. Deferred Shares:

These shares were earlier issued to promoters or founders for services rendered to the company. These shares were known as Founders Shares because they were normally issued to founders. These shares rank last so far as payment of dividend and return of capital is concerned. Preference shares and equity shares have priority as to payment of dividend.

These shares were generally of a small denomination and the management of the company remained in their hands by virtue of their voting rights. These shareholders tried to manage the company with efficiency and economy because they got dividend only at last.

Now, of course, these cannot be issued and these are only of historical importance. According to Companies Act, 1956 no public limited company or which is a subsidiary of a public company can issue deferred shares.

iv. No Par Stock/Shares:

No par stock means shares having no face value. The capital of a company issuing such shares is divided into a number of specified shares without any specific denomination. The share certificate of the company simply states the number of shares held by its owner without mentioning any face value.

The value of a share can be determined by dividing the real net worth of the company with the total number of shares of the company. Dividend on such shares is paid per share and not as a percentage of fixed nominal value of shares.

The issue of no par stock offers a number of advantages such as:

(i) It enable a company to present the balance sheet depicting its true and correct position,

(ii) There is no need to reconstruct the balance sheet by way of capital reduction;

(iii) There is no need to manipulate or window dress the accounts;

(iv) Marketing of shares becomes easier, and

(v) It induces investors to study the financial position of the company to know the value of their holdings, etc.

However, no par stock suffers from many limitations also. No par shares provide no standards for valuation of holdings. In many cases dividends have been paid out of capital. The balance sheet of the company becomes difficult to understand and there is more scope of tax evasion.

Such shares are issued in certain countries like U.K., U.S.A. and Canada and are gaining popularity there. But in India, no such shares can be issued as the companies Act, 1956 provides for the issue of only two types of shares (i) equity and (ii) preference.

v. Shares with Differential Rights:

‘Shares with differential rights’ means shares issued with differential rights in accordance with section 86 of the Companies Act.

Section 86 of the Act, as amended by the Companies (Amendment) Act, 2000, provides that the new issue of share capital of a company limited by shares shall be of two kinds namely:

(a) Equity Share Capital:

(i) With voting rights; or

(ii) With differential rights as to dividend, voting or otherwise in accordance with such rules and subject to such conditions as may be prescribed.

(b) Preference Share Capital:

Sub-clauses (i) and (ii) in clause (a) above were inserted by the Companies (Amendment) Act, 2000 which came into effect on 13th December, 2000. Consequently, section 88 of the Companies Act was omitted which prohibited issue of equity shares with disproportionate rights.

However, it must be noted that the issue of shares with differential rights as permitted by Companies (Amendment) Act, 2000 is connected with equity shares only and not the preference shares.

As per Companies (Issue of Share Capital with Differential Voting Rights) Rules, 2001, any company limited by shares can issue equity shares with differential rights as to voting, dividend or otherwise subject to the fulfillment of following conditions at the time of issue of such equity shares:

(i) The company should have distributed profits in terms of Section 205 of the Companies Act for preceding three financial years preceding the year in which it is decided to issue such shares.

(ii) The company has not defaulted in filing annual accounts and annual returns for three financial years immediately preceding the year in which it is decided to issue such shares.

(iii) The company has not failed to repay its deposits or interest thereon on due date or redeem its debentures on due date or pay dividend.

(iv) The Articles of Association of the company authorise such issue; otherwise, a special resolution shall be passed in the general meeting to suitably alter the Articles.

(v) The company has not been convicted of any offence arising under Securities Exchange Board of India Act, 1992; Securities Contracts (Regulation) Act, 1956 or Foreign Exchange Management Act, 1999.

(vi) The company has not defaulted in meeting investors’ grievances.

(vii) The shares with differential voting rights shall not exceed 25% of the total share capital issued.

(viii) The company shall not convert its equity capital with voting rights into equity share capital with differential voting rights and the shares with differential voting rights into equity share capital with voting rights.

(ix) A member of the company holding any equity share with differential right shall be entitled to bonus shares, right shares of the same class.

(x) The holders of the equity shares with differential right shall enjoy all other rights to which the holder is entitled to excepting the differential right.

(xi) The company has to obtain the approval of shareholders in general meeting by passing resolution as required under section 94 (1) (a) and 94 (2) for increase in share capital by issuing new shares.

(xii) The listed public company has to obtain the approval of shareholders through postal ballot.

(xiii) The notice of the meeting at which resolution is proposed to be passed should be accompanied by an explanatory statement stating (a) the rate of voting right which the equity share capital with differential voting right shall carry, and (b) the scale or proportion to which the rights of such class or type of shares will vary.

The concept of differential rights is new to the Indian corporates and it will require experience to ascertain its effectiveness. However, the issue of shares with differential rights may protect companies from hostile takeovers and may also benefit the shareholders by way of higher dividend than those having voting rights.

But, at the same time, the disadvantage of non-voting shares in case of a takeover bid may be that the price of voting shares may rise and the price of non-voting shares shall not increase. Otherwise also, the price of voting shares may be higher in the market as compared to non-voting shares.

vi. Sweat Equity:

The term ‘sweat equity’ means equity shares issued by a company to its employees or directors at a discount or for consideration other than cash for providing know-how or making available rights in the nature of intellectual property rights (say, patents or copyright) or value additions, by whatever name called.

The idea behind the issue of sweat equity is that an employee or director works best when he has ‘sense of belongingness’ and is amply rewarded.

One of the ways of rewarding him is by offering him shares of the company at low prices, where he is working. It is termed as ‘sweat equity’ as it is earned by hard work (sweat) of employees and it is also referred to as ‘sweet equity’ as employees become happy on the issue of such shares. The purpose of sweat equity is to ensure more loyalty and participation of employees.

Section 79A of the Companies Act, 1956 (inserted w.e.f. 31st October, 1998) allows companies to issue sweat equity shares subject to the following conditions:

(a) ‘Sweat equity shares’ must be of a class of shares already issued by the company.

(b) The issue of sweat equity shares must be authorised by a special resolution passed by the company in general meeting. The resolution must specify the number of shares, current market price, consideration, if any and class or classes of directors or employees to whom the sweat equity shares are to be issued.

(c) The sweat shares can be issued only one year after the company is entitled to commence business.

(d) The sweat equity shares of a company, whose equity shares are listed on a recognised stock exchange, shall be issued in accordance with the regulations made by the Securities and Exchange Board of India. However, in the case of a company whose equity shares are not listed on stock exchange, sweat equity shares will be issued in accordance with guidelines as may be prescribed by the Central Government.

(e) A subsidiary of an Indian company can issue sweat equity to Indian employees even if the subsidiary is incorporated out of India.

(f) All the limitations, restrictions and provisions relating to equity shares shall be applicable to the sweat equity shares.

Category # 2. Creditor-ship Securities:

The term ‘creditor-ship securities’, also known as ‘debt capital’, represents debentures and bonds. They occupy a very significant place in the financial plan of the company. A debentures or a bond is an acknowledgement of a debt. It is a certificate issued by a company under its seal acknowledging a debt due by it to its holders.

In the U.S.A., bonds are secured by tangible physical assets of the company and debentures are secured only by the general creditworthiness of the company. But, in India and U.K., no such distinction is made between debentures and bonds.

According to the Companies Act, 1956, the term debentures includes, “debentures stock, bonds and many other securities of a company whether contributing a charge on the assets of the company or not”.

Hence, in our study, we have not made any distinction between the two terms, debentures and bonds and the two have been used interchangeably. The use of such creditor-ship securities in financing of a company generally tends to reduce the cost of capital and consequently helps it to improve the earnings for its shareholders.

Debentures or Bonds:

A company may raise long-term finance through public borrowings. These loans are raised by the issue of debentures. A debenture is an acknowledgement of a debt. According to Thomas Evelyn.

“A debenture is a document under the company’s seal which provides for the payment of a principal sum and interest thereon at regular intervals, which is usually secured by a fixed or floating charge on the company’s property or undertaking and which acknowledges a loan to the company’s property or undertaking and which acknowledges a loan to the company”.

A debenture-holder is a creditor of the company. A fixed rate of interest is paid on debentures. The interest on debentures is a charge on the profit and loss account of the company. The debentures are generally given a floating charge over the assets of the company. When the debentures are secured, they are paid on priority in comparison to all other creditors.