Question

Question 3

1. “Capital market instruments are fixed-income obligations that trade in the secondary market, which means you can buy and sell them to other individuals or institutions.” – Expound the types of securities.

Answer 1

CAPITAL MARKET INSTRUMENTS

                        Financial instruments that are used for raising capital resources in the capital market are known as Capital Market Instruments. The changes that are sweeping across the Indian capital market especially in the recent past are something phenomenal.

It has been experiencing metamorphic in the last decade, thanks to a host of measures of liberalization, globalization, and privatization that have been initiated by the Government. Pronounced changes have occurred in the realm of industrial policy. Licensing policy, financial services industry, interest rates. The competition has become very intense and real in both industrial sector and financial services industry.

Types of Capital Market Instruments

            The various capital market instruments used by corporate entities for raising resources are as follows: 1. Preference shares 2. Equity shares 3. Non-voting equity shares 4. Cumulative convertible preference shares 5. Company fixed deposits 6. Warrants 7. Debentures and Bonds.

PREFERENCE SHARES:            

            Shares that carry preferential rights in comparison with ordinary shares are called ‘Preference Shares’arding payment. of The pr dividend and the distribution of the assets of the company in the event of its winding up, in preference to equity shares.

Types of Preference Shares

1. Cumulative preference shares:

            Shares where the arrears of dividends in times of no and/or lean profits can be accumulated and paid in the year in which the company earns good profits.

2. Non-cumulative

            Preference shares: Shares where the carry forward of the arrears of dividends is not possible.

3. Participating preference shares:

            Shares that enjoy the right to participate in surplus profits or surplus assets on the liquidation of a company or in both, if the Articles of Association provides for it.

4. Redeemable preference shares:

            Shares that are to be repaid at the end of the term of issue, the maximum period of a redemption being 20 years with effect from 1.3.1997 under the Companies amendment Act 1996. Since they are repayable, they are similar to debentures. Only fully paid shares are redeemed. Where redemption is made out of profits, a Capital Redemption Reserve Account is opened to which a sum equal to the nominal value of the shares redeemed is transferred. It is treated as paid-up share capital of the company.

5. Fully convertible cumulative preference shares:

                        Shares comprise two parts viz., Part A and B. Part A is convertible into equity shares automatically and compulsorily on the date of allotment. Part B will be redeemed at par/converted into equity shares after a lock-in period at the option of the investor, conversion into equity shares taking place after the lock-in period, at a price, which would be 30 percent lower than the average market price. The average market price shall be the average of the monthly high and low price of the shares in a stock exchange over a period of 6 months including the month in which the conversion takes place.

6. Preference shares with warrants attached:

            The attached warrants entitle the holder to apply for equity shares for cash, at a ‘premium’, at any time, i and fifth year from the date of allotment. If the warrant holder fails to exercise his option, the unsubscribed portion will lapse. The holders of warrants would be entitled to all rights/bonus shares that may be issued by the company. The preference shares with warrants attached would not be transferred/sold for a period of 3 years from the date of allotment.

2. EQUITY SHARES:

Equity shares, also known as „ordinary shares are the shares held by the owners of a corporate entity. Since equity shareholders face greater risks and have no specified preferential rights they are given larger share in profits through higher dividends than those given to preference shareholders, provided the company’s performance is ex dividends in case there are no profits or the profits do not justify dividend for previous years even when the company makes substantial profits in subsequent years.

            Equity shareholders also enjoy the benefit of ploughing back of undistributed profits kept as reserves and surplus for the purposes of business expansion. Often, part of these is distributed to them, as bonus shares. Such bonus shares are entitled to a proportionate or full dividend in the succeeding year.

Capital

            Equity shares are of different types. The maximum value of shares as specified in the Memorandum of Association of the company is called the authorized or registered or nominal capital. Issued capital is the nominal value of shares offered for public subscription. In case shares offered for public subscription are not taken up, the portion of capital subscribed is called subscribed capital. This is less than the issued capital Paid-up capital is the share capital paid-up by shareowners which is credited as paid-up on the shares.

Par Value and Book Value

The face value of a share is called its Par value. Although shares can be sold below the par value, it is possible that shares can be issued below the par value. The financial institutions that convert their unpaid principal and interest into equity in sick companies are compelled to do if at a minimum of Rs.10 because of the par value concept even though the market price might be much less than Rs.10.

Par value can also lead to unhealthy practices like price rigging by promoters of sick companies to take market prices above Rs.10 to get their new offers subscribed. Par value is of use to the regulatory agency and the stock exchange. It can be used to control the number of shares that can be issued by the company. The par value of Rs.10 per share serves as a floor price for issue of shares.

Book value is the intrinsic value of a share that is calculated to reflect the net worth of the shareholders of a corporate entity. Cash Dividends These are dividends paid in cash. A stable payment of cash dividend is the hallmark of stability of share prices.

Stock Dividends These are the dividends distributed as shares and issued by capitalizing reserves. While net worth remains the same in the balance sheet, its distribution between shares and surplus is altered.

3. NON-VOTING EQUITY SHARES

Consequent to the recommendations of the Abi amendment to the Companies Act, corporate managements are permitted to mobilize additional capital without diluting the interest of existing shareholders with the help of a new instrument called non-voting equity shares’. Such shares will be entitled to all the benefits except the right to vote in general meetings. Such non-voting equity share is being considered as a possible addition to the two classes of share capital currently in vogue.

            This class of shares has been included by an amendment to the Companies Act as a third category of shares. Corporate will be permitted to issue such share up to a certain percentage of the total share capital. Non-voting equity shares will be entitled to rights and bonus issues and preferential offer of shares on the same lines as that of ordinary shares.

            The objective will be to compensate the sacrifice made for the voting rights. For this purpose, these shares will carry higher dividend rate than that of voting shares. If a company fails to pay dividend, non-voting shareholders will automatically be entitled to voting rights on a prorate basis until the company resumes paying dividend

4. CONVERTIBLE CUMULATIVE PREFERENCE SHARES (CCPS)

These are the shares that have the twin advantage of accumulation of arrears of dividends and the conversion into equity shares. Such shares would have to be the face value of Rs.100 each. The shares have to be listed on one or more stock exchanges in the country.

  1.  Debt-equity ratio: For the purpose of calculation of debt-equity ratio as may be applicable CCPS is be deemed to be an equity issue.

2.  Compulsory conversion: The conversion into equity shares must be for the entire issue of CCP shares and shall be done between the periods at the end of three years and five years as may be decided by the company. This implies that the conversion of the CCP into equity shares would be compulsory at the end of five years and the aforesaid preference shares would not be redeemable at any stage.

3.   Fresh issue: The conversion of CCP shares into equity would be deemed as being one resulting from the process of redemption of the preference shares out of the proceeds of a fresh issue of shares made for the purposes of redemption.

4.  Preference dividend: The rate of preference dividend payable on CCP shares would be 10 percent.

5.  Guideline ratio: The guideline ratio of 1:3 as between preference shares and equity shares would not be applicable to these shares.

6. Arrears of dividend: The right to receive arrears of dividend up to the date of conversion, if any, shall devolve on the holder of the equity shares on such conversion. The holder of the equity shares shall be entitled to receive the arrears of dividend as and when the company makes profit and is able to declare such dividend.

7.  Voting right: CCPS would have voting rights as applicable to preference shares under the companies Act, 1956.

8. Quantum: The amount of the issue of CCP shares would be to the extent the company would be offering equity shares to the public for subscription.

5. COMPANY FIXED DEPOSITS:

Fixed deposits are the attractive source of short-term capital both for the companies and investors as well. Corporate favour fixed deposits as an ideal form of working capital mobilization without going through the process of mortgaging assets.

            Investors find fixed deposits a simple avenue for investment in popular companies at attractively reasonable and safe interest rates. Moreover, investors are relieved of the problem of the hassles of market value fluctuation to which instruments such as shares and debentures are exposed.

            There are no transfer formalities either. In addition, it is quite possible for investors to have the option of premature repayment after 6 months, although such an option entails some interest loss.

Regulations Since these instruments are unsecured; there is a lot of uncertainty about the repayment of deposits and regular payment of interest. The issue of fixed deposits is subject to the provisions of the Companies Act and the Companies (Acceptance of Deposits) Rules introduced in February 1975. Some of the important regulations are:

1.  Advertisement: Issue of an advertisement as approved by the Board of Directors in dailies circulating in the state of incorporation.

2.  Liquid assets : Maintenance of liquid assets equal to 15 percent (substituted for 10% by Amendment Rules, 1992) of deposits (maturing during the year ending March 31) in the form of bank deposits, unencumbered securities of State and Central Governments or unencumbered approved securities.

3.  Disclosure: Disclosure in the newspaper advertisement the quantum of deposits remaining unpaid after maturity. This would help highlight the defaults, if any, by the company and caution the depositors.

4. Deemed public Company : Private company would become a deemed public company (from June 1998, Section 43A of the Act) where such a private company, after inviting public deposits through a statutory advertisement, accepts or renews deposits from the public other than its members, directors or their relatives. This provision, to a certain extent, enjoins better accountability on the part of the management and auditors.

5.  Default: Penalty under the law for default by companies in repaying deposits as and when they mature for payment where deposits were accepted in accordance with the Reserve Bank directions.

6.  CLB : Empowerment to the Company Law Board to direct companies to repay deposits, which have not been repaid as per the terms and conditions governing such deposits, within a time frame and according to the terms and conditions of the order.

6. WARRANTS

An option issued by a company whereby the buyer is granted the right to purchase a number of shares of its equity share capital at a given exercise price during a given period is called a ‘warrant’. Although trading Sock markets for more in warred than 6 to 7 decades, they are being issued to meet a range of financial requirements by the Indian corporate.

            A security issued by a company, granting its holder the right to purchase a specified the Indian context are called ‘sweeteners ‘and were issued by a few Indian companies since 1993. Both warrants and rights entitle a buyer to acquire equity shares of the issuing company. However, they are different in the sense that warrants have a life span of three to five years whereas; rights have a life span of only four to twelve weeks (duration between the opening and closing date of subscription list).

            Moreover, rights are normally issued to affect current financing, and warrants are sold to facilitate future financing. Similarly, the exercise price of warrant, i.e. The price at which it can be exchanged for share, is usually above the market price of the share so as to encourage existing shareholders to purchase it.

            On the other hand, one warrant buys one equity share generally, whereas more than one right may be needed to buy one share. The detachable warrant attached to each share provides a right to the warrant holder to apply for additional equity share against each warrant.

7. DEBENTURES AND BONDS

A document that either creates a debt or acknowledges it is known as a debenture. Accordingly, any document that fulfils either of these conditions is a debenture. A debenture, issued under the common seal of the company, usually takes the form of a certificate that acknowledges indebtedness of the company. A document that shows on the face of it that a company has borrowed a sum of money from the holder thereof upon certain terms and conditions is called a debenture. Debentures may be secured by way of fixed or floating charges on the assets of the company. These are the instruments that are generally used for raising long-term debt capital

Secondary Market

Ø A secondary market is a platform wherein the shares of companies are traded among investors. It means that investors can freely buy and sell shares without the intervention of the issuing company.

Ø In these transactions among investors, the issuing company does not participate in income generation, and share valuation is rather based on its performance in the market. Income in this market is thus generated via the sale of the shares from one investor to another.

Types of Securities

1. Equity securities

Ø Equity almost always refers to stocks and a share of ownership in a company (which is possessed by the shareholder). Equity securities usually generate regular earnings for shareholders in the form of dividends. An equity security does, however, rise and fall in value in accord with the financial markets and the company’s fortunes.

2. Debt securities

Ø Debt securities differ from equity securities in an important way; they involve borrowed money and the selling of a security. They are issued by an individual, company, or government and sold to another party for a certain amount, with a promise of repayment plus interest. They include a fixed amount (that must be repaid), a specified rate of interest, and a maturity date (the date when the total amount of the security must be paid by).

Ø Bonds, bank notes (or promissory notes), and Treasury notes are all examples of debt securities. They all are agreements made between two parties for an amount to be borrowed and paid back – with interest – at a previously-established time.

3. Derivatives

Ø Derivatives are a slightly different type of security because their value is based on an underlying asset that is then purchased and repaid, with the price, interest, and maturity date all specified at the time of the initial transaction.

Ø The individual selling the derivative doesn’t need to own the underlying asset outright. The seller can simply pay the buyer back with enough cash to purchase the underlying asset or by offering another derivative that satisfies the debt owed on the first.

Ø A derivative often derives its value from commodities such as gas or precious metals such as gold and silver. Currencies are another underlying asset a derivative can be structured on, as well as interest rates, Treasury notes, bonds, and stocks.

Ø Derivatives are most often traded by hedge funds to offset risk from other investments. As mentioned above, they don’t require the seller to own the underlying asset and may only require a relatively small down payment, which makes them favourable because they are easier to trade.