Capital Market Instruments

Capital Market Instruments1Lecture OutlineCapital Market meaningCapital Market Instruments - Equity sharesPreference share Non voting shares Convertible Cumulative Debentures(CCD) Fixed DepositsWarrantsDebentures and BondsADR and GDR2Capital Market Capital market deals with medium term and long term funds. Its focus is on financing of fixed investment Main participants in capital market are mutual funds, insurance organization, foreign institutional investors, corporates and individuals The capital/securities market has two segments :i. Primary/new issue market andii. Secondary market/stock exchange(s)/market(s)Primary/new issue market It is that market in which shares, debentures and other securities are sold for the first time for collecting long-term capital. In the primary market, securities are offered to the public for subscription for the purpose of raising capital or fund.

Features of Primary Market It Is Related With New Issues It Has No Particular Place It Has Various Methods Of Float Capital: Following are the methods of raising capital in the primary market: i) Public Issue ii) Offer For Sale iii) Private Placement iv) Right Issue v) Electronic-Initial Public Offer

Secondary market/stock exchange(s)/market(s) Market for old/existing securities It plays an indirect role in industrial financing by providing liquidity to investment already made The SE three vital function for the orderly growth of capital formation are1. Nexus between saving and investment2. Liquidity to investors by offering place of transaction in securities3. continuous price formation.Capital Market Instruments - The capital market generally consists of the following long term period i.e., more than one year period, financial instruments; In the equity segment - Equity shares, preference shares,convertible preference shares, non-convertible preference shares etc and In the debt segment debentures, zero coupon bonds, deep discount bonds etc.

Hybrid Instruments have both the features of equity and debenture. This kind of instruments is called as hybrid instruments. Examples are convertible debentures, warrants etc.

Equity Shares Equity shares represents ownership capital and its owner ordinary shareholders/equity holders share the reward and risk associated with ownership of the corporate enterprises. Authorized equity/share capital represents the maximum amount that a company can raise from the ordinary shares Ordinary/Equity shares typically have par/face value in terms of the price of each share. The most popular denomination being Rs.10

Equity shares also known as Ordinary shares. Equity shares represent the ownership position in a company. The shareholders of equity shares are the legal owner of the company.Equity shares are the source of the permanent capital since they do not have a maturity date. shareholders are entitled for dividend.The amount or rate of dividend is not fixed: the companys board of directors decides it.An ordinary share is known as variable income security

Authorized Share Capital represents the maximum amount of capital, which a company can raise from shareholders. The portion of the authorized share capital, which has been offered to shareholders, is called Issued Share Capital.Subscribed Share Capital represents that part of the issued share capital, which has been accepted by shareholders. The amount of subscribed share capital actually paid up by shareholders to the company is called Paid-Up Share Capital. The companys earnings, which have not been distributed to shareholders and have been retained in the business, are called Reserves and Surplus.

1. Maturity: Equity shares provide permanent capital to the company and cannot be redeemed during the life time of the company

2. Claims on Income: Equity shareholders have a residual claim on the income of a company. They have a claim on income left after paying dividend to preference shareholders.

Features of Equity Shares3. Claim on Assets: Ordinary shareholders have a residual claim on the companys assets in the case of liquidation.

4. Right to control: Ordinary shareholders have the legal power to elect directors on the board. Ordinary shareholders are able to control management of the company through their voting rights and right to maintain proportionate ownership.

5. Voting rights: Ordinary shareholders are required to vote for election of directors and change in the memorandum of association. An ordinary share holder has votes equal to the number of shares held by him.

Shareholders may vote in person or by proxy. A proxy gives a designated person right to vote on behalf of a shareholder at the companys annual general meeting. 6. Pre-emptive Right: The law grants shareholders the right to purchase new shares in the same proportion as their current ownership.

7. Limited Liability: Ordinary shareholders are the true owners of the company, but their liability is limited to the amount of their investment in shares.

Advantages of equity sharesAdvantages to company:

1. Long-term and Permanent Capital2. No Fixed Burden on the company's resources3. Credit worthiness4. Risk Capital5. Dividend Policy

Advantages to Investors:

1. More Income2. Right to Participate in the Control and Management3. Capital profits4. An Attraction of Persons having Limited Income

Disadvantages of equity shares

Disadvantages to company

1. Dilution in control2. Trading on equity not possible3. Over-capitalization4. No flexibility in capital structure5. High cost6. Speculation

Disadvantages to investors

1. Uncertain and Irregular Income2. Capital loss During Depression Period3. Loss on Liquidation

A rights issue is a way in which a company cansell new sharesin order to raise capital. The law in India requires that the new ordinary shares must be first issued to the existing share holder. RIGHT ISSUE OF EQUITY SHARESAdvantages of Right IssueIt gives existing shareholders securities called "rights", which give the shareholders the right to purchase new shares at a discount to the market price.

Issue involves less flotation cost as the company can avoid the underwriting commission.

3. In the case of profitable companies, the issue is more likely to be successful since the subscription price is set much below the current market price.

DisadvantagesShare holders who fail to exercise their rights may lose in terms of decline in their wealth. The value of each share will be diluted as a result of the increased number of shares issued. Another disadvantage is for those companies whose share holding is concentrated in the hands of financial institutions, because of the conversion of loan into equity. They would prefer public issue of shares rather than the right issue.

Preference Shares It is a unique type of long term capital market instrument. It combines some features of equity shares as well as some of debentures it carries a fixed rate of dividend ranks higher than equity as a claimant to the income/assets normally does not have a voting right dividend paid out are not taxable payment of dividend depend upon discretion of management irredeemable preference shares have no fixed maturity dateNote types of preference shares22

Cont. .Preference shares are a long term source of finance for a company. They are neither completely similar to equity nor equivalent to debt. The law treats them as shares but they have elements of both equity shares and debt.

For this reason, they are also called hybrid financing instruments. These are also known as preferred stock, preferred shares, or only preferred in different part of the world.

Features of Preference Shares 1. Fixed Dividends Preference shares have fixed dividends. Also preference dividends are not tax deductible.

2. Preference over Equity Preference share dividend has to be paid before any dividend payment to ordinary equity shares & at the time of liquidation also, these shares would be paid before equity shares.

3. No Share in Earnings Preference shareholders can not claim on the residual earnings and residual assets.

4. Fixed Maturity - Like debt, preference shares also have fixed maturity date.

5. Cumulative dividend - It requires that all past unpaid preference dividend be paid before any ordinary dividends are paid.

6. Dividend from PAT - Preference share dividend is paid out of the profits left after all expenses and even taxes.

Advantages of Preference Shares Advantages from Company point of view

1. Fixed Return2. No Voting Right 3. Flexibility in Capital Structure 4. No Charge on Assets 5. Widens Capital Market

Advantages from Investors point of view:

1. Regular Fixed Income2. Preferential Rights 3. Voting Right for Safety of Interest 4. Lesser Capital Losses5. Fair Security

Disadvantages of Preference Shares Disadvantages for companies

1. Higher Rate of Dividend 2. Financial Burden3. Dilution of Claim over Assets 4. Adverse effect on credit-worthiness 5. Tax disadvantage

Disadvantages for Investors

1. No Voting Right 2. Fixed Income 3. No claim over surplus4. No Guarantee of Assets

Classification of Preference Share1.Cumulative and Non-cumulative Preference sharesIn the case of Cumulative preference shares, dividend in arrears for the years in which company earned no profits or insufficient profits receives the dividend in the year in which company earns profits.But, If company does not have any profits in a year, no dividend will be paid to non-cumulative preference shareholders.2. Redeemable and Irredeemable Preference SharesRedeemable preference shares can be redeemed on or after a fixed period after giving a proper notice of redemption to preference shareholders. while Irredeemable preference shares are those shares which cannot be redeemed during the lifetime of the company.

3.Convertible and Non-convertible preference sharesPreference shareholders are given a right to covert their holding into ordinary shares such shares are known as convertible preference shares. The holders of non-convertible preference shares have no such right of conversion.

4. Participating and Non-participating Preference SharesThe holders of participating preference shares have a right to participate in the surplus profits of the company remained after paying dividend to the ordinary & preference shareholders at a fixed rate. The preference shares which do not have such right to participate in surplus profits, are known as non-participating preference shares.

DEBENTURESA debenture or a bond is long-term promissory note for raising loan capital. The firm promises to pay interest and principal as stipulated. The purchaser of debenture is called lender or debenture-holder. Although the money raised by the debentures becomes a part of the company's capital structure, it does not becomeshare capital.Features of Debentures1.Interest rate: The interest rate on a debenture is fixed and known. Debenture interest is tax deductible.

2.Maturity: Debentures are issued for a specific period of time.

3.Redemption: Debentures are mostly redeemable, they are generally redeemed on maturity.4. Sinking fund: A sinking fund is cash set aside periodically for retiring debentures. Periodic retirement of debt through sinking fund reduces the amount required to redeem the remaining debt at maturity.

5. Buy-back (call) provision: Buy-back provisions enable the company to redeem debenture at a specified price before the maturity date. Buy-back price may be more than par value.6. Indenture or debenture trust deed: An indenture is a legal agreement between the company issuing debentures and the debenture trustee who represents the debenture holders. Trustee ensures that the company will fulfill the contractual obligations.

7. Security: Debentures are either secured or unsecured. A secured debenture is secured by a lien on the companys specific assets. When debentures are not protected by any security, they are known as unsecured debenture.

378. YieldThe yield is related to its market price; Two types of yield:The current yield on a debenture is the ratio of the annual interest payment to the debentures market price.

The yield-to-maturity takes into account the payments of interest and principal, over the life of the debenture.

9. Claims on assets and incomeDebenture holders have a claim on the companys earning, prior to that of the shareholders.

Types of DebenturesNon-convertible debentures (NCDs): NCDs are pure debentures without a feature of conversion. They are repayable on maturity. The investor is entitled for interest and repayment of principal.

2. Fully-convertible debentures (FCDs): FCDs are converted into shares as per the terms of the issue, with regard to the price and time of conversion.

3. Partly-convertible debenture (PCDs): The investor has advantages of both convertible and non-convertible debenture blended into single debenture.

Advantages of Debentures

1. Less costly 2. No ownership dilution3. Fixed payment of interest4. Reduced real obligation

Disadvantages of Debenture

1. Obligatory payments2. Financial risk3. Cash outflows4. Restricted covenantsNon Voting SharesNon-voting shares is shares that provides the shareholder very little or no vote on corporate matters, such as election of the board of directors or mergers.

This type of share is usually implemented for individuals who want to invest in the companys profitability and success at the expense of voting rights in the direction of the company. Preference shares typically has nonvoting qualities.DebenturesDebenture/bonds represents creditor ship securities and debenture holders are ling-term creditors to the companyAs a secured instrument, it is a promise to pay interest and repay principal at stipulated times.Types of Debentures:Debentures are divided into different categories on the basis of: (1)convertibility of the instrument (2) SecurityConvertibilityDebentures can be classified on the basis of convertibility into:A. Non Convertible Debentures (NCD)B. Partly Convertible Debentures (PCD)C. Fully convertible Debentures (FCD)D. Optionally Convertible Debentures (OCD)CLASSIFICATION OF DEBEBTURES From security point of view On the basis of redemption On the basis of Negotiability On the basis of convertibility On the basis of priority From coupon or interest rate point of view

TYPES OF DEBEBTURES From security point of viewSecured or Mortgage debenturesUnsecured debentures On the basis of redemptionRedeemable debenturesNon-redeemable debentures On the basis of NegotiabilityRegistered debenturesBearer debenturesOn the basis of convertibilityConvertible debenturesNon-convertible debentures

On the basis of priorityFirst debenturesSecond debentures

From coupon or interest rate point of viewCoupon rate pointZero coupon Rate

TYPES OF DEBEBTURESFrom security point of viewSecured or Mortgage debenturessecured by a charge on the assets of the company.debenture holders have the right to recover their principal amount with the unpaid amount of interest on such debentures out of the assets mortgaged by the company.

Unsecured debenturessuch debentures do not carry any security with regard to the principal amount or unpaid interest.

TYPES OF DEBEBTURESOn the basis of redemptionRedeemable debenturesdebentures are issued for a fixed period.principal amount of such debentures is paid off to the debenture holders on the expiry of such period.such debentures can be redeemed by annual drawings or by purchasing from the open market.

Non-redeemable debenturesdebentures which are not redeemed in the life time of the company.such debentures are paid back only when the company goes into liquidation.TYPES OF DEBEBTURESOn the basis of NegotiabilityRegistered debenturesdebentures that are registered with the company.amount of such debentures is payable only to those debenture holders whose name appears in the register of the company.

Bearer debenturesdebentures which are not recorded in a register of the company. such debentures are transferrable merely by delivery.holder of these debentures is entitled to get the interest.TYPES OF DEBEBTURESOn the basis of convertibilityConvertible debenturesdebentures that can be converted into shares of the company on the expiry of pre-decided period.the term and conditions of conversion are generally announced at the time of issue of debentures.

Non-convertible debenturesdebentures that can not be converted into shares of the company.TYPES OF DEBEBTURESOn the basis of priorityFirst debenturesdebentures are redeemed before other debentures.

Second debenturesdebentures are redeemed after the redemption of first debentures.TYPES OF DEBEBTURES From coupon rate or interest rate point of view Coupon rate pointUsually debentures are issued with a coupon rate, that is annual interest rate on the face value of debentures.This rate may be fixed or floating with the market interest rate.

Zero coupon rateSuch debentures does not carry coupon rate or specified interest rate with itself.These debentures are issued with substantial discount to compensate the investor for interest.BondsBond is a debt security, in which the authorized issuer owes the holders a debt and, depending on the terms of the bond, is obliged to pay interest (the coupon) to use and/or to repay the principal at a later date, termed maturity. A bond is a formal contract to repay borrowed money with interest at fixed intervals (ex semi annual, annual, sometimes monthly).Fixed DepositsThe deposit placed by investors with companies for a fixed term carrying a prescribed rate of interest is called Company Fixed Deposit.Financial institutions and Non-Banking Finance Companies (NBFCs) also accept such deposits. Deposits thus mobilized are governed by the Companies Act under Section 58A.These deposits are unsecured, i.e., if the company defaults, the investor cannot sell the documents to recover his capital, thus making them a risky investment option.WarrantsA warrant entitles its holder to subscribe to the equity capital of the company during a specified period at a stated/particular/certain price. The holder acquires only right (option) but he has no obligation to acquire the equity shares.

Warrants are generally issued in conjunction with/tied to other instrument.Depositary Receipts (DR)Type of negotiable (transferable) financial security.Traded on a local stock exchange.Physical certificate allowing investors to hold shares in equity of other countries.BenefitsFor the CompanyRaise capital from foreign markets.Increases the share liquidity.

For the InvestorInvestors gain the benefits of diversification.Investors will be able to reap the benefits of foreign (emerging) markets.Parties to a Depository ReceiptbrokersdepositaryCustodianIssuerInvestment bankerlawyersAccountantsAmerican Depository Receipt (ADR)The first ADR was introduced by J.P. Morgan in 1927 for the British retailer Selfridges.

Shares of many non-US companies trade on US stock exchanges.

ADRs are denominated and pay dividends in US dollars and may be traded like regular shares of stock.

Types of ADR programsWORKING OF ADR MARKETSponsored ADR programINVESTORUS EXCHANGEBROKE/ DEALER3 LEVELS OF SPONSORED PROGRAMSUnder the sponsored program there are 3 levels and they are ;

Level 1- Level 1 depositary receipts are the lowest level of sponsored ADRs that can be issued. When a company issues sponsored ADRs, it has one designated depositary who also acts as its transfer agent.

Level 1 shares can only be traded on the OTC market and the company has minimal reporting requirements with the U.S. Securities and Exchange Commission [SEC]

Level 2 depositary receipt programs are more complicated for a foreign company. When a foreign company wants to set up a Level 2 program, it must file a registration statement with the U.S. SEC and is under SEC regulation.

The advantage that the company has by upgrading their program to Level 2 is that the shares can be listed on a U.S. stock exchange. These exchanges include the New York Stock Exchange (NYSE), NASDAQ, and the American Stock Exchange (AMEX).

A Level 3 American Depositary Receipt program is the highest level a foreign company can sponsor. Because of this distinction, the company is required to adhere to stricter rules that are similar to those followed by U.S. companies.

Foreign companies with Level 3 programs will often issue materials that are more informative and are more accommodating to their U.S. shareholders because they rely on them for capitalUnsponsored Programme:

Unsponsored shares trade on theover-the- counter(OTC) market

Unsponsored ADRs are often issued by more than one depositary bank Restricted Programme

Foreign companies that want their stock to be limited to being traded by only certain individuals may set up a restricted program

ADR programs operating under one of these 2 rules make up approximately 30% of all issued ADRs

Privately placed (SEC Rule 144A) ADRs

ADR program underSEC Rule 144A

private placement

restricted stockand may only be issued to or traded byQualified Institutional Buyers(QIBs)Offshore (SEC Regulation S) ADRs

SEC Regulation S

Shares are not, and will not be registered with any United States securities regulation authority

The shares are registered and issued to offshore, non-US residentsGLOBAL DEPOSITORY RECEIPTSGlobal Depository Receipt (GDR)Certificate issued by a depository bank, which purchases shares of foreign companies.

Several international banks issue GDRs, such as JPMorgan Chase, Citigroup, Deutsche Bank, Bank of New York.

GDRs are often listed in the Frankfurt Stock Exchange, Luxembourg Stock Exchange and in the London Stock Exchange.ProcessCo/- deposits large no of shares located in country where it wants to list.The bank then issues receipts underlying the shares (2-4)Behaves exactly like regular stocks- price fluctuation according to demand & supplyIs receipts are sold to people of that countryThis receipt is then listed on local stock exchanges.