Understanding Instrument of Equities

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MBARendezvous.com -India's content lead MBA website  has started series of articles to equip MBA aspirants with general awareness with the hope that you would get success in various MBA entrance exams

 
Following article on”Understanding Instrument of Equities” is part of our series on general awareness:
 
Financial markets are of two types, long term and short term. The markets dealing with short term financial markets are called as money market while the long term are called as capital market which deals with financial securities of more than 364 days of maturity. The government securities as well as corporate securities are the part of capital market and equities are part of corporate securities along with other instruments like bonds and debentures.
 
An equity or share is an instrument through which the holder of that instrument claims share in the assets and profit of the company whose share it holds. Thus equities don’t assure fix returns but gives a share in profit. The equities are tradable instrument, traded at stock exchange like Bombay Stock Exchange (BSE), National Stock Exchange (NSE). When a company releases its new share to garner funds, they are called as initial public offering (IPO). 
 
Through IPOs, company offers its shares for sale to the public. The shares are sold in the market at a price (offer price) determined by the company along with investment bankers or underwriters who also promote the offer. These days, public issues are targeted at various sectors of investing fraternity. Companies now allot certain portions of their offers to different segments. Traditionally there are three segments viz; qualified institutional buyers (QIB), high net worth individuals and retail investors (general public).
 
The funds raised by the company through equity are available to the company on unsecured basis i.e. the company does not offer any of its assets as a security to the investors. Returns paid by company on the shares are in the form of dividends. Dividends are paid at the face value of the shares, not at the market value.
 
Advantages of equity over other instruments :
 
• There is no compulsion to pay dividends. If the firm has insufficiency of cash it can skip equity dividends without suffering any legal consequences.
 
• Equity capital has no maturity date and hence the firm has no obligation to redeem.
 
• Because equity capital provides a cushion to lenders it enhances the creditworthiness of the company. In general others things being equal the larger the equity base the greater the ability of the firm to raise debt finance on favorable terms
 
However, there are some disadvantages also:
 
• Sale of equity shares to outsiders dilutes the control of existing owners.
 
• The cost of equity capital in high usually the highest. The rate of return required by equity shareholders is generally higher than the rate of return required by other investors.
 
• Equity dividends are paid out of profit after tax whereas interest payments are tax deductable expenses and this enhances the relative cost of equity. Partially offsetting this advantage is the fact that equity dividends are tax exempted whereas interest income is taxable in the hands of investors.
 
• The cost of issuing equity shares is generally higher than the cost of issuing other types of securities. Underwriting commission brokerage costs and other issue expenses are high for equity issues.
 
 
Equity market is further divided into primary and secondary market. The primary market or the new issue market refers to the raising of new capital in the form of equity shares or debentures. It is not necessary that company must be entirely new enterprise but a company already in business may ‘go public’ to expand its capital base. ‘Going public’ means becoming a public limited company and thus to be entitled to raise funds from general public in the form of IPO. For inducing public to invest their savings in new issues, service of specialized institutions (underwriters and stock brokers) is required.
 
The secondary market or old issue market deals in securities or equities already issued by the companies. The main purpose of such a market is to provide liquidity (easy convertibility into cash) to such securities.
 
The stock exchange is an institution for orderly buying and selling of listed shares. Listed shares are those shares that appear on the approved list of a stock exchange. India has more than 20 stock exchanges five of which are of national stature while rest regional ones. 
 
Market capitalization (often called M-cap) is another important concept which refers to the total value of the tradable shares of a publicly traded company. It is equal to the share price times the number of shares outstanding. 
 
For example, if XYZ company has 100 shares outstanding and a share price of Rs.20 per share then the market capitalization is 100 xRs.20 = Rs.2000. Markets capitalization could be used as a proxy for the public opinion of a company's net worth and is a determining factor in some forms of stock valuation. The concept of M-cap is used for the formulation of indices like Sensex, Nifty etc. Sensex is weighted index shares of 30 companies listed at BSE with largest M-cap. Similarly, Nifty is the index of top 50 companies at NSE. 
 
The movement of Nifty and Sensex manifest the macroeconomic sentiments of the economy. As a part of the process of economic liberalization, the stock market has been assigned an important place in financing the Indian corporate sector. Besides enabling mobilizing resources for investment, directly from the investors, providing liquidity for the investors and monitoring and disciplining company management company managements are the principal functions of the stock markets.
 
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