Detailed analysis of Capital market. Explain the terms- Right Issue and Right Shares.

 

Capital Market

The meaning of capital market is not the same as or similar to that of a market place where goods are bought and sold. Capital market actually denotes the arrangements whereby transactions of money capital (not capital goods) are facilitated. In other words, transactions involving procurement of funds and supply of funds which take place among individuals and various organisations may be regarded as the capital market. Thus, the capital market is not located in a particular place. Nor there are fixed categories of investors and dealers in the capital market, that is, those who supply funds and those who procure funds for investment.

You may have heard or read about another type of market in connection with business finance, known as the money market. Money market refers to transactions involving borrowing and lending of money for short periods for which again there is not definite place set aside in a town. Thus, we can say that money market is the market for short-term funds.

Sometimes the term `money market' is used in a broad sense to include the markets for short-term as well as long-term funds. Strictly speaking, money market refers only to the market for short-term funds. This distinction helps us in understanding the nature of money transactions which take place for financing business activities. But there is a close relation between the capital market and the money market. The same institutions often deal in both the markets. Companies borrow money for capital purposes. Many financial institutions lend money for short periods as also long periods. Apart from having common links, the two markets are mutually interdependent. The relative demand and supply of funds in the two markets are determined by changes in the rates of interest on short-term funds compared to the expected yield on long-term funds. Thus, if there is increase in interest rate in the money market, one expects an increase in demand for funds in the capital market. Or, a rise in the expected yield in the capital market may lead to a rise in demand for funds in the money market.

You have learnt that transactions involving the procurement and supply of long-term funds take place in the capital market. You also know that companies raise funds by issuing shares and debentures of different types. Individuals and institutions which contribute to the share capital of a company become its shareholders. They are also known as members of the company. Share certificates are issued to them by the company bearing the company's seal and indicating the number of shares allotted to the holders of the certificates. Similarly, debentures are issued by companies to raise long-term loans. Debenture bonds are issued to those who subscribe to the loans.

When long-term capital is initially raised by new companies or by existing companies by issuing additional shares or debentures, the transactions are said to have taken place in the market for new capital. Those who deal in newly floated shares or debentures of companies become a part of the capital market known as the market for new capital or New Issue Market. As you know, shares and debentures issued by public limited companies are freely transferable. Buying and selling of shares and debentures already issued by companies take place in another type of market, known as the stock exchange, which is also a part of the capital market.

The New Issue Market for raising capital consists of arrangements which facilitate the procurement of long-term finance by companies issuing shares and debentures. Shares are issued by companies before the commencement of business and, if necessary, subsequently for expansion of business. Before shares are issued, the directors of the company have to decide on the following matters: the amount of capital which is to be raised by issue of shares, the types of shares (preference shares, equity shares, or both) which will be issued, and the time of issuing shares. No company can raise share capital exceeding the amount of authorised capital mentioned in the Memorandum of Association. What part of the authorised capital should be raised initially or at any other point of time depends upon the purpose for which funds are needed and the alternative sources of raising capital which may be available (like borrowing, for instance). Next, the directors must decide the type or types of shares to be issued. If both equity and preference shares are to be issued, decisions have to be made as to the proportion in which they will be issued, number and the face value of shares in each category and the rate of dividend on preference shares. The relative attractiveness of equity shares and is generally taken into account while deciding the above matters. The time of issue is decided by the directors taking into account the likely demand for shares in the capital market, the investors' mood, government policies with regard to money and credit control and taxation, as well as the prevailing business conditions. If it is desired that the shares to be issued should be listed in the stock exchange for official quotation, the directors must fulfil the conditions for that purpose.

Sometimes, the directors of a company along with their friends and relatives agree to take up a certain proportion of the shares. Similarly, the promoters may privately negotiate with Non-Resident Indians (Indians living abroad) and financial institutions to raise a part of the share capital. The arrangement whereby shares are, thus, decided to be allotted is known as private placement of shares. At the same time, the general public may be invited to subscribe to the share capital through advertisement and issue of prospectus. This is known as public issue of shares.

Where a company decides to issue additional shares at any time after two years of its formation or after one year of the first allotment of shares, whichever is earlier, it is required under law that such shares must be first offered to the existing shareholders of the company. If the offer is declined by the existing shareholders, only then the shares can be issued to the public. Such an issue is called 'rights Issue' and these shares are known as 'right shares'.

 Besides issuing shares, most companies also raise long-term loans by issuing debentures to the public. A public company can simultaneously issue shares and debentures immediately after its incorporation. The company's indebtedness is acknowledged in the debenture bonds issued to the subscribers. The terms and conditions relating to the issue are also specified in the debenture bond. Debentures are usually repayable after a specified period and carry a fixed rate of interest payable at regular intervals. The company creates a mortgage or charge on its assets to secure the issue of debentures. Although debentures are usually repayable after a fixed period, companies may also issue debentures which are convertible into equity shares after a certain period. Such debentures are known as 'convertible debentures'.

The issue of convertible debentures by a company, which has bright prospects, makes it more attractive for investors. The reason is that, investors as debenture holders enjoy a fixed interest income during the initial stage and, later on, as equity shareholders they become entitled to share in the prosperity of the company through high dividend income as well as increase in share prices. However, approval of the Central Government is required where the holders of debentures are given the option to convert or not to convert the debentures into shares.

Control of Capital Issues:

To ensure that investment made by companies are in accordance with the national development plans, and not used for wasteful purposes, Government controls the issues of shares and debentures under the Capital Issues (Control) Act, 1947. Let us study the main points in this connection.

1- A company making public offer of shares and debentures must obtain the consent of the Controller of Capital Issues if the amount to be raised during a period of 12 months exceeds Rs. one crore. But public limited companies issuing shares knot debentures) are exempt from seeking consent provided the following conditions are fulfilled:

a)       The amount of debt (borrowings) of the company does not exceed twice that the owners' investment (in the form of share capital and retained profits) i.e. the debt to equity ratio does not exceed 2:1.

b)      The amount of equity (owners' investment) is less than three times that of preference share capital i.e. the equity-preference ratio is less than 3.1.

c)       The rate of dividend on preference shares and interest on debentures do not exceed the maximum limit fixed from time to time by the Controller

d)      The shares issued to the public are eligible for being officially quoted on' recognised stock exchange.

2- Companies making fresh issue of shares (not debentures) are to file a statement of proposals for capital issue with the Controller at least 30 days before the date of the proposed offer of shares. The companies must also obtain a letter of acknowledgement from the Controller before making the public offer and make a statement to that effect in the prospectus or statement in lieu of prospectus.

3- Loans raised by companies from financial institutions do not require the Controller's approval.

4- Private limited companies are also subject to control over their capital issues if more than 20% of the amount is subscribed by one or more public limited companies, and the amount of capital issue involved exceeds Rs. one crore during a period of 12 months.

5- Companies must seek the consent of the Controller of Capital Issues for issue of debentures to the public.

6- The amount of debenture issue for working capital purposes is not to exceed 20% of the gross current assets, loans and advances. For long-term investment projects, the amount will be considered on the basis of approval of the scheme of finance by the financial institutions or Government.

7- The debt-equity ratio, including the proposed debenture issue, must not exceed 2:1. But this requirement may be relaxed in the case of industries like fertilisers, petrochemicals, cement, paper, shipping, etc., which require heavy investments.

8- The debentures shall carry rate of interest not exceeding the rate which may be prescribed from time to time by the Controller.

 

Normally debentures shall not be redeemable before the expiry of the period of seven years. A company may have the option of redeeming the debentures from the fifth to the ninth year from the date of issue in such a way that the average period of redemption continues to be seven years. However, investors holding debentures of the face value of Rs. 5,000 or less must be paid in one instalment.