finance

Financial Markets A QUALITY E-LEARNING PROGRAM BY WWW.LEARNWITHFLIP.COM

Raising Money A business can raise money through either borrowing (called debt) or through owners’ investments (called equity.)

Equity The sources of equity (owners’) funds are: 1.

Internal Reserves: Profits earned may be kept aside and used for short term or long term investment needs. This is part of the existing equity of the company.

2.

Fresh Equity: When investors buy shares of a company they increase the equity funds available to the company.

Fresh Equity is raised using specific financial instruments, which can be bought and sold. Equity instruments are of two types: 1.

2.

Common Shares: Common shares or stock represent ownership in a company. They carry voting rights for the owners. They do not guarantee any return. They exist as long as the company exists.Key features are: •

Face Value/Par Value: It is set when the share is first issued. It is an internally set value given to the share and has no relationship to the market price.

•

Selling of Shares: A publicly traded company’s shares are listed and traded on various stock exchanges.

•

Claim of Common Shareholders: Common shareholders have the last claim on profit. Only after everybody else is paid, they get their share. When the company goes into liquidation, common shareholders are the last to get their money back.

Preference Shares: Preference shareholders are a specific type of share. They carry a fixed rate of dividend, but have a claim only on profits .This means that the company will pay the dividends only in years of profit. They do not have any voting rights. Types of Preference Shares : •

Perpetual: They exist as long as the company exists, and are not repayable or redeemable, similar to common shares.

•

Redeemable: Redeemable preference shares have a fixed maturity. The face value is returned to the shareholder after maturity.

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Convertible: Convertible preference shares are convertible to common shares at a pre-defined ratio, at the option of the investor, after a certain period.

ADR or American Depository Receipt is a non-American stock that trades in American stock exchanges. It is valued in dollars, and each ADR represents a specific number of shares (one or more) in a non-American corporation. GDR or Global Depository Receipt, is used to offer Indian shares in any other country other than the US. The process for issuing an ADR/GDR:

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Financial Markets A QUALITY E-LEARNING PROGRAM BY WWW.LEARNWITHFLIP.COM

a. An Indian company deposits a large number of its shares with a bank located in the US/Other Foreign Country b. The bank issues receipts against these shares, each receipt representing a fixed number of shares. c. The receipts are sold to the people of this foreign country. They are listed on the stock exchanges and behave exactly like regular stocks.

Debt – Borrowing Money Borrowing is called ‘leveraging’ or ‘gearing’. The two ways to borrow money are: 1.

Loan from institutions: by borrowing from financial institutions such as banks. This debt must be repaid along with interest. The lender evaluates both the repayment ability of the company as well as the purpose for which the funds are proposed to be used. The Base Rate is the rate of interest at which banks lend to their most favored customers.

2.

Issuance of debt securities: When a company decides to borrow from a large pool of lenders instead of banks, it does so by issuing debt securities.

This security carries the rate of interest, date when the amount is to be repaid, and amount to be repaid. Features of debt securities: • Debt securities typically carry a fixed rate of interest committed by the issuer, called ‘Coupon’. • Maturity Period - Short term (1yr). • Company has to pay interest, whether they make profits or not. • Debt securities are tradable. • Holders of debt securities are not owners of the company, they are its creditors. • They have a ‘face value’ like common stock.

Types of Debt Securities Debt securities are of various types. The categorization is based on: 1.

Issuing a. b. c.

Authority Corporates Banks Government

2.

Maturity period a. Bonds & Debentures : A bond is a long-term debt security. The issuer can be a corporation or the government (state or central). Bonds issued by the Central Government in India are called GOI Securities or just G-secs. b. Money Market Securities: These are short term instruments and can be issued by corporates or the central Government.

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Financial Markets A QUALITY E-LEARNING PROGRAM BY WWW.LEARNWITHFLIP.COM Bonds – Key Terms Coupon - The coupon is the original interest rate committed by the issuer at the time the security is first issued. This remains constant over the life of the bond. It can be fixed or floating. The floating rate is pegged to a benchmark. LIBOR is a popular benchmark. Hence the coupon can be, for example, LIBOR+ 1.5%. AS LIBOR changes, the Coupon changes. Yield - Yield in financial terms means, rate of return. It is Income / Investment, and is expressed as a percentage. Zero Coupon Bond/Discounted Bond - A zero coupon bond is issued at a price which is at a discount to face value; it is redeemed at face value. So it doesn’t specify a coupon. The return is the difference between purchase price and redemption price. Credit ratings define the bond issuer’s ability to repay the bond amount.

Money market securities These are securities used to raise money for a short duration i.e. less than one year. •

Treasury Bills - This is a debt security issued by the Govt. of India to raise money for shorter maturities.

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Certificate of Deposits - A Certificate of Deposit (CD) is an instrument issued by a bank or Financial Institution (FI) to raise money, similar to your fixed deposit.

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Commercial Papers - Commercial paper (CP) is an unsecured debt instrument issued by a corporation to raise money.

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Repurchase Agreements – It refers to a lending transaction where the borrower uses debt securities as collateral for the borrowing.

Capital Structure The way the capital is split between debt & equity is called the capital structure of a company. Factors Affecting the Capital Structure • • • • •

Effect on Return on Equity (RoE): Raising debt helps ROE if the cost is lower than the return on the investment. Cost of raising funds: Raising equity is usually more expensive Tax Implications: Interest on debt is tax-deductible Cash flow: Debt has to be repaid, resulting in a regular claim on cash of the company Financial structure: Raising debt limits the amount of debt which can be raised in the future. Raising equity has no such issues.

Companies usually raise capital at different times using both means – debt and equity, which have different cost. They need to track their average cost, called the ‘Weighted Average Cost of Capital’ or WACC. This is got by multiplying the Amount of each capital by the weight and the cost. E.g. The Mandex company has capital of USD 100 bio, raised through different means. The firm has raised USD 55 bio. through equity,USD 4 bio through preference capital, USD 21 bio by issuing debentures and USD 20 bio. by taking a loan from a bank.

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Financial Markets A QUALITY E-LEARNING PROGRAM BY WWW.LEARNWITHFLIP.COM Source of finance

Cost (per cent)

Weight

Product of cost and weight

Equity capital

15.65

0.55 (55/100)

8.61

Preference capital

14.75

0.04 (4/100)

0.59

Debenture capital

9.04

0.21 (21/100)

1.90

Term loan

8.25

0.20 (20/100)

1.65

Weighted Average Cost of Capital (%)

12.75

The WACC is used during evaluation of projects or investments. The capital raised is used to invest in a project. That project must return more than the WACC to be feasible. -------------------

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