EQUITYAND

DEBT MARKET(As Per the Revised Syllabus of S.Y. BMS, 2014-15, Semester IV,

University of Mumbai)

Prof. Pawan JhabakM.Com., P.G.D.Ed.M.

Ex. Vice Principal, Rustomjee Business School,Dahisar (W), Mumbai-68.

Ex. Visiting Faculty:Vivekanand Education Society, Lala Lajpatrai College,

Rajiv Gandhi Institute of Technology,Amity Business School, Narsee Monjee College,

Usha Pravin Gandhi, Bhavan’s College (Andheri),Rizvi College, S.K. Somaiya College,Akbar Peerbhoy, Bhurani College,

Poddar College, Mumbai Education Trust,Sydhnem Institute of Management, etc.

Prof. Sunil LalchandaniM.Phil., MBA, M.Com., M.A. (Economics),

PGDBM, SWE, UGC-NET, SETHead, Department of Management Studies,

Smt. Chandibai Himathmal Mansukhani College,Ulhasnagar.

MUMBAI NEW DELHI NAGPUR BENGALURU HYDERABAD CHENNAI PUNE LUCKNOW AHMEDABAD ERNAKULAM BHUBANESWAR INDORE KOLKATA GUWAHATI

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Preface

Capital market, the market for securities, where companies and governments can raise long-termfunds is an important element of any vibrant economy. Selling shares and bonds are two ways togenerate capital and long-term funds. Thus, bond markets and stock markets are considered capitalmarkets. The capital markets consist of the primary market, where new issues are distributed toinvestors, and the secondary market, where existing securities are traded. The Indian Equity marketsand the Indian Debt markets are the major constituents of Indian Financial System. The Indian EquityMarket at present is a lucrative field for investors. Indian stocks are profitable not only for long- andmedium-term investors but also the position traders, short-term swing traders and also very short-termintra-day traders. For a developing economy like India, even debt markets are crucial sources ofcapital funds. The debt market in India is amongst the largest in Asia. It includes governmentsecurities, public sector undertakings, other government bodies, financial institutions, banks andcompanies.

This book on “Equity and Debt Market” provides a conceptual framework that can be used tounderstand why such markets exist. This book has been written in line with the revised syllabus ofS.Y. BMS of Mumbai University, is an attempt to provide the basic knowledge to the learners aboutthe Equity and Debt Markets.

The book is unique in its presentation and style. Authors have tried to present the matter in asclear and simple manner as possible to make it intelligible to each and every student.

At the outset, we authors, thank the Almighty for giving us the grace to write this book. We arevery much thankful to our family, friends and well-wishers who really supported us physically andmorally in writing this book. We owe the gratitude towards our students who actually are the realinspiration for writing this book. We are very much indebted to our mentors, our teachers and ourGurus who actually are the source of guidance for us.

We would be failing in our duties if we shall not mention here about the efforts of HimalayaPublishing House Pvt. Ltd. team especially Mr. Srivastav, Ms. Archana and Mr. Pravin, without whomthis publication would not have been possible to release on time.

We hope this book would cater to the needs of all categories of learners. Still, constructivecomments and useful suggestions for the improvement of this book are always welcome.

Prof. Pawan JhabakProf. Sunil Lalchandani

Syllabus

EQUITY AND DEBT MARKET[60 Lectures: 3 Credit]

Learning Objectives:This paper will enable the students to understand the evolution of various aspects of financial

markets which in turn will help them in framing the financial policies, development of financialinstruments and processes and evolving the strategies during crisis. The teaching will be done mainlythrough materials available on internet and published research papers.

Unit Name of the Topic No. ofLectures

Unit 1 Introduction to Financial Market 151. Equity market – meaning and definitions of equity share; Growth of Corporate sector and

simultaneous growth of equity shareholders; divorce between ownership and managementin companies; Development of Equity culture in India and current position.

2. Debt market – Evolution of Debt markets in India; Money market and Debt markets inIndia; Regulatory framework in the Indian Debt market.

Unit 2 Dynamics of Equity MarketPrimary:

1. IPO – methods followed (simple numerical)2. Book building3. Role of merchant bankers in fixing the price4. Red herring prospectus – unique features5. Numerical on sweat equity, ESOP and Rights issue of shares

Secondary:1. Definition and functions of stock exchanges2. Evolution and growth of stock exchanges3. Stock exchanges in India4. NSE, BSE OTCEI and overseas stock exchanges5. Recent developments in stock exchanges6. Stock market Indices

15

Unit 3 Players in Debt Markets1. Government securities2. Public sector bonds and corporate bonds3. Open market operations4. Security Trading Corporation of India5. Primary dealers in Government securities

Bonds:1. Features of bonds2. Types of bonds

15

Unit 4 Valuation of Equity and BondsValuation of equity:

- Balance sheet valuation- Dividend discount model (zero growth, constant growth and multiple growth)- Price earning model

Valuation of bonds:- Determinants of the value of bonds- Yield to maturity- Interest rate risk- Determinants of Interest Rate Risk

15

Question Paper Pattern

Maximum Marks: 75Time: 2.5 Hours

Note: 1. All questions are compulsory subject to internal choice.

2. Figures to right indicate full marks.

Q1. Attempt any 2 questions (15 Mks)

(a) (7.5 Mks)

(b) (7.5 Mks)

(c) (7.5 Mks)

Q2. Attempt any 2 questions (15 Mks)

(a) (7.5 Mks)

(b) (7.5 Mks)

(c) (7.5 Mks)

Q3. Attempt any 2 questions (15 Mks)

(a) (7.5 Mks)

(b) (7.5 Mks)

(c) (7.5 Mks)

Q4. Attempt any 2 questions (15 Mks)

(a) (7.5 Mks)

(b) (7.5 Mks)

(c) (7.5 Mks)

Q5. Problems/Case Study (15 Mks)

Contents

ChapterNo. Name Page No.

Unit 1: Introduction to Financial Market1. Equity Shares 1 – 8

2. Indian Equity Market 9 – 15

3. Debt Market 16 – 22

4. Regulatory Framework for Debt Markets in India 23 – 27

5. Money Market 28 – 32

Unit 2: Dynamics of Equity MarketPrimary Market

6. Public Issue 33 – 41

7. Merchant Banking 42 – 47

8. Prospectus 48 – 51

9. Current Developments in Corporate Finance 52 – 59

10. Right Issue of Shares 60Secondary Market

11. Introduction to Capital Market 61 – 72

12. Stock Market Indices 73 – 81

Unit 3: Players in Debt Markets13. Bond Market 82 – 88

14. Government Securities 89 – 92

15. PSU and Corporate Bonds 93 – 97

16. STCI 98 – 99

Unit 4: Valuation of Equity and Bonds17. Valuation of Equity 100 – 115

18. Valuation of Bonds 116 – 124

Unit 1: Introduction to Financial Market

1.1 INTRODUCTION TO FINANCIAL MARKETS ● ······················································

MeaningA financial market is a market where financial assets and financial liabilities are bought and sold.

Financial markets perform the essential economic function of channelling funds from savers who havean excess of funds to spenders who have a shortage of funds. This function is shown schematically infigure below:

Financial markets can perform this basic function either through direct finance (the route at thebottom of figure), in which borrowers borrow funds directly from lenders by selling them securities orthrough indirect finance, which involves a financial intermediary who stands between the lender-savers and borrower-spenders and helps transfer funds from one to the other. This channelling of fundsimproves the economic welfare of everyone in the society because it allows funds to move frompeople who have no productive investment opportunities to those who have such opportunities,thereby contributing to increased efficiency in the economy.

EQUITY SHARESChapter

1

INDIRECT FINANCE

DIRECT FINANCE

FinancialIntermediaries

FinancialMarkets

Lender-Savers1. Households2. Business firms3. Government4. Foreigners

Borrowers-Spenders1. Business firms2. Government3. Households4. Foreigners

FUNDSFUNDS

2 Equity and Debt Market

Basis of Financial MarketBasis of Financial Markets are the Borrowers and Lenders.

Borrowers of the Financial Market can be individual persons, private companies, publiccorporations, government and other local authorities like municipalities. Individual persons generallytake short term or long term mortgage loans from banks to buy any property. Private Companies takeshort term or long term loans for expansion of business or for improvement of the businessinfrastructure. Public Corporations like railway companies and postal services also borrow fromFinancial Market to collect required money. Government also borrows from Financial Market tobridge the gap between govt. revenue and govt. spending. Local authorities like municipalitiessometimes borrow in their own name and sometimes govt. borrows in behalf of them from theFinancial Market.

Lenders in the Financial Market are actually the investors. Their invested money is used tofinance the requirements of borrowers. So, there are various types of investments which generatelending activities. Some of these types of investments are depositing money in savings bank account,paying premiums to Insurance Companies, investing in shares of different companies, investing ingovt. bonds and investing in pension funds and mutual funds.

1.2 CONSTITUENTS OF FINANCIAL MARKETS ● ·······················································The financial markets comprises of:● Capital Market, and● Money Market.

FinancialMarkets

CapitalMarket

IndustrialSecurities Market

PrimaryMarket

SecondaryMarket

GovernmentSecurities Market

Long term LoansMarket

Term LoanMarket

Market forMortgages

Market forFinancial

Guarantees

MoneyMarket

Organised

Call MoneyMarket

CommercialBills

TreasuryBills

Certificate ofDeposits

CommercialPaper

Money MarketMutual Funds

RepoMarket

UnorganisedMarkets

Money Lenders,Indigenous

Bankers, etc.

Equity Shares 3

Capital MarketThe capital market is a market for financial assets which have a long or indefinite maturity.

Generally, it deals with long-term securities which have a maturity period of above one year. Capitalmarket may be further divided into three, namely:

(a) Industrial securities market.(b) Government securities market, and(c) Long-term loans market.

(a) Industrial Securities MarketAs the very name implies, it is a market for industrial securities namely:(i) Equity shares or ordinary shares,

(ii) Preference shares, and(iii) Debentures or bonds. It is a market where industrial concerns raise their capital or debt by

issuing appropriate instruments.It can be further subdivided into two. They are:(i) Primary market or New issue market.

(ii) Secondary market or Stock exchange.(i) Primary Market

Primary market is a market for new issues or new financial claims. Hence, it is also called NewIssue Market. The primary market deals with those securities which are issued to the public for thefirst time. There are three ways by which a company may raise capital in a primary market. They are:

(i) Public issue.(ii) Rights issue.

(iii) Private placement.The most common method of raising capital by new companies is through sale of securities to the

public. It is called public issue. When an existing company wants to raise additional capital, securitiesare first offered to the existing shareholders on a pre-emptive basis. It is called rights issue. Privateplacement is a way of selling securities privately to a small group of investors.(ii) Secondary Market

Secondary market is a market for secondary sale of securities. In other words, securities whichhave already passed through the new issue market are traded in this market. Generally, such securitiesare quoted in the Stock Exchange and it provides a continuous and regular market for buying andselling of securities. This market consists of all stock exchanges recognised by the Government ofIndia. The stock exchanges in India are regulated under the Securities contracts (Regulation) Act, 1956.The Bombay Stock Exchange is the principal stock exchange in India which sets the tone of the otherstock markets.

(b) Debt MarketIt is the market where debt securities are traded. Debt securities comprises of Bonds issued by

Corporate sector, Government — Central or State, Local authorities, PSU Banks, Financial institutions,etc. It is a market where debt instruments are bought and sold and holders of the debt instrumentsenjoy fixed return with minimum risk generally.

4 Equity and Debt Market

(c) Long-term Loans MarketDevelopment banks and commercial banks play a significant role in this market by supplying

long-term loans to corporate customers. Long-term loans market may further be classified into:(i) Term loans market.

(ii) Mortgages market.(iii) Financial guarantees market.

(i) Term Loans MarketIn India, many industrial financing institutions have been created by the Government both at the

national and regional levels to supply long-term and medium-term loans to corporate customersdirectly as well as indirectly. These development banks dominate the industrial finance in India.Institutions like IRBI, IFCI, and other state financial corporations come under this category. Theseinstitutions meet the growing and varied long-term financial requirements of industries by supplyinglong-term loans.(ii) Mortgages Market

The mortgages market refers to those centres which supply mortgage loan mainly to individualcustomers. A mortgage loan is a loan against the security of immovable property like real estate. Thetransfer of interest in a specific immovable property to secure a loan is called mortgage. In India,residential mortgages are the most common ones. The Housing and Urban Development Corporation(HUDCO) and the LIC play a dominant role in financing residential projects. Besides, the LandDevelopment Banks provide cheap mortgage loans for the development of lands, purchase ofequipment, etc.(iii) Financial Guarantees Market

A guarantee Market is a centre where finance is provided against the guarantee of a reputedperson in the financial circle. Guarantee is a contract to discharge the liability of a third party in caseof his default. Guarantee acts as a security from the creditor’s point of view. In case the borrower failsto repay the loan, the liability falls on the shoulders of the guarantor. Hence, the guarantor must beknown to both the borrower and the lender and he must have the means to discharge his liability.

Money MarketMoney Market is a market where short term securities, maturity period up to 1 year are traded

generally. Money markets are covered in much detail in forthcoming chapters.

1.3 FUNCTIONS OF FINANCIAL MARKET ● ······························································The key functions of financial markets are as follows:1. Borrowing & lending: Financial market transfers fund from one economic agent

(saver/lender) to another (borrower) for the purpose of either consumption or investment.2. Determination of prices: Prices of the new assets as well as the existing stocks of financial

assets are set in financial markets. Determination of prices is major function of financialmarket.

3. Assimilation and co-ordination of information: It gathers and co-ordinates informationregarding the value of financial assets and flow of funds in the economy.

4. Liquidity: The asset holders can sell or liquidate their assets in financial market.

Equity Shares 5

5. Risk sharing: It distributes the risk associated in any transaction among several participantsin an enterprise.

6. Efficiency: It reduces the cost of transaction and acquiring information. It help to increaseefficiency in financial market.

1.4 CONCEPT OF EQUITY SHARES ● ·········································································An equity share, commonly referred to as ordinary share also represents the form of fractional or

part ownership in which a shareholder, as a fractional owner, undertakes the maximum entrepreneurialrisk associated with a business venture. The holders of these shares are the real owners of the company.They have a voting right in the meetings of holders of the company. They have a control over theworking of the company. Equity shareholders are paid dividend after paying it to the preferenceshareholders.

The rate of dividend on these shares depends upon the profits of the company. They may be paida higher rate of dividend or they may not get anything. These shareholders take more risk as comparedto 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 redeemedduring the life time of the company.

1.5 FEATURES OF EQUITY SHARES ● ·······································································Equity shares have a number of features which distinguish it from other securities. Some of the

important features of equity shares are as follows:(i) Right to income: Equity shareholders have a claim to the residual income, that is, the

income left after paying expenses, interest charges, taxes, preference dividend, if any.Usually, a part of the residual income is distributed in the form of dividend to theshareholders and other part called retained earnings is reinvested in the business. Retainedearnings ultimately benefit the shareholders in the form of firm’s enhanced value andearning power and ultimately increase dividend and capital gain of the shareholders. Thus,dividends benefit the shareholders in the form of immediate cash flows whereas the retainedearnings give them benefit in the form of capital gains but not immediately.

(ii) Claim on assets: In case of liquidation of the company, equity shares are the last ones to bepaid. They are paid after the claim of debt-holders and preference shareholders have beensatisfied. In case of liquidation due to bad financial state of affairs, the equity shareholdersgenerally remains unpaid.

(iii) Right to control: Right to control here means the power to take decisions, frame majorpolicies and power to appoint directors. Equity shareholders have the legal power to electdirectors on the board and also to replace them if the board fails to protect interest of theshareholders.

(iv) Voting rights: Each equity share carries one vote. Directors are elected in the annualgeneral meeting by the majority votes. Thus, every shareholder can participate in the vitalaffair of election of directors and cast his vote depending on the number of shares held byhim. Shareholders are entitled to vote in person or by proxy.

(v) Limited liability: In a company limited by shares, an equity shareholder’s liability is limitedto the amount of investment in his respective share. If his shares are fully paid up, he doesn’t

6 Equity and Debt Market

have to contribute anything in the event of financial stress or winding up of his company.Whereas, in case of a sole-trader concern or a partnership firm, the liability of owner/ownersis unlimited which requires them to sell their personal assets and satisfy the claims ofcreditors in the event of insolvency of these firms.

(vi) Risk capital: It is the equity shares that provide primarily the risk capital of the business.These shareholders take more risk as compared to preference shares.

(vii) Permanent capital: The capital procured by issue of equity shares is a permanent source offunds to the company as it need not be redeemed during the life time of the company. At thesame time shareholders can get money by sale of shares in the stock exchanges.

(viii) No need for security: There is no need to offer security to the shareholders. Hence, theassets of the company are free from charge.

(ix) No fixed rate of return: The rate of dividend of these shares depends upon the profits to thecompany. They may be paid a higher rate of dividend or they may not get anything.

(x) No obligation to pay dividend: The company has no obligations to pay dividend to equityshareholders even though the company get profits. Whether dividend should be paid or not,even if it is to be paid what should be the rate of dividend, etc. would be decided by theboard of directors in general body meetings.

(xi) Pre-emptive rights: Any share holder owning 2% of the existing issued capital is entitled toa preemptive rights to acquire 2% of additional shares issued by the company. He canexercise or sell or renounce this right.

(xii) Speculation: Investing public purchase equity shares with speculative motive. This ispossible because the market value of shares fluctuates depending upon the goodwill of thefirm, rate of dividend is declared.

1.6 BENEFITS AND DISADVANTAGES OF EQUITY SHARES INVESTMENT ● ··············Benefits of equity share investment are dividend entitlement, capital gains, limited liability,

control, claim over income and assets, right shares, bonus shares, liquidity etc. Disadvantages aredividend uncertainty, high risk, fluctuation in market price, limited control, residual claim etc.

Equity share is looked at from different perspectives by different stakeholders. Broadly, there aretwo major angles of looking at it – Company and Investor Angle. So, any statement about equitycapital would have different meaning for a company and an investor. We will look at the investorangle of equity share investment.

Benefits of Equity Share Investment(a) Dividend: An investor is entitled to receive dividend from the company. It is one of the two

main sources of return on his investment.(b) Capital gain: The other source of return on investment apart from dividend is the capital

gains. Gains which arise due to rise in market price of the share.(c) Limited liability: Liability of shareholder or investor is limited to the extent of the

investment made. If the company goes into losses, share of loss over and above the capitalinvestment would not be borne by the investor.

(d) Exercise control: By investing in the company, the shareholder gets ownership in thecompany and thereby he can exercise control. In official terms, he gets voting rights in thecompany.

Equity Shares 7

(e) Claim over assets and income: An investor of equity share is the owner of the companyand so is the owner of the assets of that company. He enjoys share in the incomes of thecompany. He will receive some part of that income in cash in the form of dividend andremaining capital is reinvested in the company.

(f) Rights shares: Whenever companies require further capital for expansion, they tend to issue‘rights shares’. By issuing such shares, ownership and control of existing shareholders ispreserved and the investor receives investment priority over other general investors.

(g) Bonus shares: At times, companies decide to issue bonus shares to its shareholders. It isalso a type of dividend. Bonus shares are free shares given to existing shareholders andmany a times they are given in lieu of dividends.

(h) Liquidity: The shares of the company which are listed on stock exchanges have benefit ofany time liquidity. The shares can very easily transfer ownership.

(i) Stock split: Stock split means splitting a share into parts. How should an investor bebenefited by this? By splitting of share, the per-share price reduces in the market whicheventually increases the tradability of share. At the end, stock split results in higher volumeswith more number of investors leading to high liquidity of the share.

Disadvantages of Equity Share Investment(a) No fixed dividend: The dividend which a shareholder receives is neither fixed nor

controllable by him. The management of the company decides how much dividend shouldbe given.

(b) High risk: Equity share investment is a risky share compared to any other investment likedebts etc. The money is invested based on the faith an investor has in the company. There isno collateral security attached with it.

(c) Fluctuation in market price: The market price of any equity share has a wide variation. Itis always very difficult to book profits from the market. On the contrary, there are equalchances of losses.

(d) Limited control: An equity investor is a small investor of the company, therefore, it ishardly possible to impact decision of the company using the voting rights.

(e) Residual claim: An equity shareholder has a residual claim over both the assets and theincome. Income which is available to equity shareholders is after the payment of all otherstakeholders viz. debenture holders etc.

1.7 COMMONLY USED TERMS IN SHARE CAPITAL ● ···············································

Share CapitalA joint stock company should have capital in order to finance its activities. It raises its capital by

issue of shares. The Memorandum of Association must state the amount of capital with which thecompany is desired to be registered and the number of shares into which it is to be divided. When totalcapital of a company is divided into shares, then it is called share capital. It constitutes the basis of thecapital structure of a company. In other words, the capital collected by a joint stock company for itsbusiness operation is known as share capital. Share capital is the total amount of capital collected fromits shareholders for achieving the common goal of the company as stated in Memorandum ofAssociation.

8 Equity and Debt Market

Types of Share CapitalShare capital of a company can be divided into the following different categories:1. Authorised, registered, maximum or normal capital: The maximum amount of capital,

which a company is authorised to raise from the public by the issue of shares, is known asauthorised capital. It is a capital with which a company is registered, therefore, it is alsoknown as registered capital.

2. Issued capital: Generally, a company does not issue its authorised capital to the public forsubscription, but issues a part of it. So, issued capital is a part of authorised capital, which isoffered to the public for subscription, including shares offered to the vendor forconsideration other than cash. The part of authorised capital not offered for subscription tothe public is known as ‘un-issued capital’. Such capital can be offered to the public at a laterdate.

3. Subscribed capital: It cannot be said that the entire issued capital will be taken up orsubscribed by the public. It may be subscribed in full or in part. The part of issued capital,which is subscribed by the public, is known as subscribed capital.

4. Called up capital: It is that part of subscribed capital, which is called by the company topay on shares allotted. It is not necessary for the company to call for the entire amount onshares subscribed for by shareholders. The amount, which is not called on subscribed shares,is called uncalled capital.

5. Paid-up capital: It is that part of called up capital, which actually paid by the shareholders.Therefore, it is known as real capital of the company. Whenever a particular amount iscalled and a shareholder fails to pay the amount fully or partially, it is known an unpaid callor calls in arrears.Paid-up Capital = Called up capital – calls in arrears

6. Reserve capital: It is that part of uncalled capital which has been reserved by the companyby passing a special resolution to be called only in the event of its liquidation. This capitalcannot be called up during the existence of the company. It would be available only in theevent of liquidation as an additional security to the creditors of the company.

THEORY QUESTIONS1. What are financial markets? Explain their basis.2. Explain the constituents of financial markets.3. Discuss the functions of financial markets.4. What are Equity Shares? Explain their features.5. Explain the advantages and limitations of Equity Shares.