Role and Importance of Capital Market
1.1 Capital Market plays an important role in long-term 'financial securities', which are in two different forms, Equity and Debt Securities.
Equity consists of ordinary and preference shares, while debt securities consist of debentures, unsecured & convertible loans. These securities are traded in a capital market by the Companies, Government or any other individual to maximise shareholder's wealth. Capital market practices economic efficiency by giving securities to those companies who need funds for their investment. In a capital market investors invest their money in the form of stock and bonds, on the other hand companies issue their securities to the investor, through this cycle capital market promotes economic efficiency.
There are two types of capital markets:
Capital Market acts as a Primary Market when the new securities are issued in the form of equity and debt by the companies, which is funded by the private investors and financial insititutions. Primary market is restricted to issue the new equities and debt, so therefore secondary market plays a more important role than the primary market.
Secondary Market consists of stock exchange, bond markets and in the form of future and options markets. In this type of market investors can sell their shares and bonds as well as being able to buy new ones but if they face difficulty to buy or sell new shares than the investors will not hire in the market place. There are different stock exchanges working around the world allowing investors to buy or sell, if they meet certain requirements set by the regulatory authorities such as LSE and AIM in the U.K.
A market can be efficient where the trading of shares is consistent because of fair price. Any company in the capital market likes to find their finance cheap but the investor wants high returns so the market efficiency is based on the connection between the stock prices and in the formation. According to the FAMA(1970) 'A securities market is efficient if security prices fully reflect the information available', this practice allows the investor to have confidence before entering the market. According to Dixon and holmes(1992) efficient market have these three features:
DIFFERENT FORM OF EFFICIENCY
WEAK-FORM EFFICIENCY: if the share price fully reflect information regarding the historical sequence of share price. In such kind of market the abnormal returns cannot be made according to the historical movements of share price. So the empirical evidence shows that capital markets are weak form of efficiency. Weak-form test include serial correlation test, run test and filter tests. Filter test try to identify any significant long-term relationship in a security price movements by filtering out any short-term price changes. So previous study shows abnormal returns can appear due to the filter test. (Alexander 1961).
SEMI-STRONG EFFICIENCY:
If the market is semi strong efficient then the share price reflect all post information and all publicly available information, including financial data. Test for semi strong form of efficiency involve the fundamental analysis which measure the stock market reaction to the new information. (MANGANELLI 2002) if the share price is traded commonly the time value required for its return to equilibrium to will be shorter.
STRONG-FORM EFFICIENCY:
If the share prices reflect all the information which contains inside information as well it is known as strong form of efficiency. In this form of efficiency abnormal returns cannot happen but in reality some investors do make abnormal returns. Capital markets do not meet the strong form of efficiency as research states that stock markets in the UK are highly efficient. It's the responsibility of the managers to carefully analyse the accounts historical movements and returns to assist their sells when making decisions.
'The financial manager should therefore focus on making good financial decisions which increase the shareholder wealth as the market will interpret these decisions correctly and the share price will adjust accordingly'. *1
Watson d. , Corporate finance, 4th ed. 2007 London Prentice Hall
SOURCES OF CAPITAL
A company requires finance for any investment. There are different kind of sources of finance available in the capital market in the form of equity and debt finance. A company have a choice of raising capital but during taking decision company needs to consider the following general factor:
If the purpose is to acquire assets that are the permanent part of the company capital then the funding will be long term finance.
Types of long term finance
The external long term finance consist of ordinary shares, preference shares, loans and debentures, convertible loans, euro bonds, lease and grants. The internal long term finance consist of retained profit of the company.
Equity Finance
Equity finance also known as ordinary shares which belong to the owners of the company. Ordinary shares sales to the new issues to the public or to the existing share holders. The ordinary shares must have the nominal value and the shares cannot be issued less than this value. And the new issues, which is issued to the existing shareholders or the new owners are always issued at the premium to their nominal value. Ordinary shareholders are in a greater risk than any other provider in long term finance because they expect higher return in compensation. This means the cost of the preference shares or cost of the debt is always lower than the cost of the equity.
RIGHT ISSUES
There are however some limitations to this method of raising the finance where the new shares are offered to the existing shareholders on a pro rata basis as a regulation being implemented, It's known as the Rights Issue. This is not a suitable method to raise money though as existing shareholder might not have an abundance of cash and new customers would be easily tempted to buy the new floating shares.
BONUS ISSUES
A trend in which a company increase the number of shares in issues without raising the additional finance. The bonus issues are also known as scrip issues or share splits. These shares are not issued for issued. ACCORDING TO GRINBLATT ET AL (1984) the bonus have a positive effect on shareholder wealth and might be interpreted by investor as a favourable signal concerning a company's future cash flow.
SCRIP DIVIDEND
SHARE REPURCHASES
PREFERENCE SHARES:
Preference shares are traded in a stock exchange like ordinary shares but are different in following aspects;
Preference shares may be in the form of cumulative. If the profit is unsufficient then dividend will not be paid but they allow to accure and have right to receive dividend when profit become available. But if the preference shares lost their dividend then called non-cumulative preference shares.
The company can buy preference shares from the shareholders in prescribed circumstances to satisfy the company's financing needs. This trend is known as Convertible preference shares or Redeemable preference shares.
If the profit of the company increases from an agreed amount than additional dividend will be paid to the preference shares this trend known as Participating preference shares.
RETAINED EARNINGS;
The part of the company's profit which is not divided to the shareholders but is reserve for the future business of the company is called retained earnings. Following are the benefits for the company of retained earnings;
Following are the limitations of the retained earnings;
