Importance Of Capital Markets And Efficiency Market Hypothesis
Capital markets are market where companies, government or people with extra fund then transfer the funds to other people, companies or government who spend more than their income, means shortage funds. It is very important to every company because capital markets provide a way to help the companies to collect finance so that they can continue operate their business. Capital markets contain two major markets which are stock market and bond market. Besides that, these markets also promote economic efficiency by providing the liquidity to the shareholders to pay back the shares to take money out of the market. Capital markets encourage investors to invest by purchasing the stocks and bonds. That is because there have provide an exit mechanism to sell the investment when the investors need the money back from their investment. It have two main functions, the primary markets is dues with newly issued securities and raise long-term funds for the company. The secondary markets are dealing with the existing securities. The secondary markets are the sources of pricing information for the primary markets so that can help the investors to allocated new funds to their best use in the primary markets. (Denzil Watson & Antony Head, 2007)
Efficiency markets hypothesis (EMH) is the traded asset's prices already incorporate and all the relevant information was reflect to the market and instantly changes to reflect new information. There have three forms of market efficiency. (Moorad Choudhry, 2001)
The Three Forms of Market Hypothesis
Weak Form Market Hypothesis
The weak form of market efficiency hypothesis stated that security prices is reflect the information contain the past history of the stock price itself. Investors cannot find any future predicted in this form of market hypothesis. (Carlos Correia et al, 2007)
Semi-strong Market Hypothesis
It asserts that stock prices reflect all the past history and also include the current publicly available information. Any new information entering the public domain was absorbed by the market and almost instantaneously incorporated into the current prices. Once the new information absorbed by the market, there will not have any price change on it anymore. (Carlos Correia et al, 2007)
Strong Form Market Hypothesis
It stated that stock prices reflect all relevant information in privately and publicly held. Under this form, the investors who's buying or selling the stock will affect the price of the stock and the price will quickly adjusts to reflect the insider information.
(Carlos Correia et al, 2007)
Finance Sources
There have two types of finance sources which are equity finance and debt finance. The major source of finance is to gain back the profit from sales to customer which means to raise the fund of the company. Each source has its own merits and risk, choosing the correct sources can let the company to earn more profit. Spry plc is a large company which mostly using the long-term sources of finance.
Equity Finance
Equity finance is an act of selling the common stock or preference stock to the individual or institutional investors in order to raising the money for the company. The advantages of equity finance is the funding is committed to the project that the company planning. When the business is doing well, the investors just will realize their investment. The disadvantages are rising the equity finance will consume the time, costly, demanding and risk.
Ordinary Share Capital
Ordinary share is also known as "common stock" and it represent to the ownership of a limited company. The company can issues as many as of the authorized shares they like but it also depends on the authorized number of the shares. The issue price must be equal to or more than the nominal values of the shares if the ordinary shares are issues for cash. When the company first issuing the shares in the market, they won't issues all of the share as the nominal price, the company will issues some of the shares to the market while the other shares is store up for further use.
Ordinary shareholders put their fund in the company is to buy a new issue of shares and want to retained the company profit. The company can choose whether want to pay the dividend to the shareholders or not. If still have any profit after the companies pay all the expenses, the company will using it to pay for the shareholders as dividend. The dividend pay to shareholders is not a fixed amount but is rely on the company's earning. The ordinary share is a high risk high return method, because it will facing many risk like market risk, liquidity risk and interest rate risk. Besides that, there also have a risk like the investors didn't like the investment. If the companies go bankrupt and liquidity, the shareholders will not receive any money until the creditors paid for the lost.
Ordinary shareholders have some special right in the company like they can change the decision making by the company through voting, attend general meeting receive the annual account of the company and participate in a new issue of shares in company. (Denzil Watson & Antony Head, 2007)
Preference Share Capital
Preference shares are higher ranking and less risky than ordinary shares. The company will pay the dividend to the preference shareholders before they pay to the ordinary shareholders. Preference shareholders are receiving a fixed amount of dividend annually and will be paid when the company declares a dividend. If the company didn't make any profit in a year, the preference shareholder's dividend will added to next year's dividend until the company can pay it. This is known as cumulative preference shares. (Denzil Watson & Antony Head, 2007)The preference shareholders normally are does not have the voting right but in certain condition, the company will give some of the shareholders voting power. For an example, if the preference shareholder's dividends are arrears for a substantial time, they will give the voting right to the shareholders to vote for their benefit. (Moorad Choudhry, 2001) Besides that, the preference shares can be convertible into ordinary shares which known as convertible preference shares. Using this method, the shareholders can get higher return when the company is doing well.
Retained Earning
Retained earning is the earning that the company did not pay out to the shareholders as dividend or using it to pay off the debt. The company retained the earning is used to acquire additional income-earning assets which can raise the company profit. The company must have the retained earning in their accounts because company can use it to invest in other project which is good profit returns and growth potential. (TheFreeDictionary) Although company can get benefit from retained earning methods, but they still will facing some risk. If the retained earning can not cover the net loss of the company, the company will facing deficit.
Cost of capital
Cost of capital defined as the weighted average of the costs of the different components of financing which including debt, equity and hybrid securities which used by a firm to fund its investment. It is important to use the correct cost of capital as a discount rate. (Aswath Damodaran, 2006)
Weighted Average Cost of Capital
WACC is a weighted average of the component costs of debt, preferred stock and common equity.
Cost of Equity
The cost of equity is the rate of return that investors require to invest in the equity of a company. The company must achieve the rate of return to maximize shareholders wealth, if the company fails to achieve the rate of return to match investor's opportunity cost, the company will feel difficult to attract new funds and if the situation becomes serious, it can cause the company liquidation or easily take over by other company. (Glen Arnold, 2008)
Cost of Debt
The cost of debt measures the current cost to the firm of borrowing funds to finance projects. It is the effective rate that company pays to current loans, bonds and various other forms of debt. It can be measure as two form which are before-tax or after-tax. The after-tax cost is more often using because the interest expense is deductible. Cost of debt can be divided to two types which are irredeemable and redeemable. (TheFreeDictionary, no date)
Importance of Cost of Capital
The concept of cost of capital is crucial in financial management of a company because it can be use to appropriate long-term finance and compare different projects so that the company can choose to invest in the project which will earns more and less risky. It's playing a key role in decision making by the company like making decision for an investment proposal before the management and also is an important methods in other areas such as dividend decision, working capital policy etc. The rate of interest on loans and normal dividend rates in the market were always changing, so the cost of capital plays an important role in controlling the company to avoid risk and searching for the finance sources which can bear the minimum cost of capital and to evaluate top executives financial performances. (TheFreeMBAResource)
