Stock Exchange

STOCK EXCHANGE Of all modern service institutions, stock exchanges are perhaps the most crucial agents and facilitators of entrepreneurial progress. After the industrial revolution, as the size of business enterprises grew, it was no longer possible for proprietors or even partnerships to raise colossal amounts of money required for undertaking large entrepreneurial ventures. Such huge requirement of capital could only be met by the participation of a very large number of investors: their number running into hundreds, thousands and even millions, depending on the size of the business venture. In general, small-time proprietors, or partners of proprietary or partnership firm, are likely to find it rather difficult to get out of their business should they for some reason wish to do so. This is because it is not always possible to find buyers for an entire business or even a part of business, just when one wishes to sell it. Similarly, it is not easy for someone with savings, especially with a small amount of savings, to readily find an appropriate business opportunity, or a part thereof, for investment. These problems would be even more magnified in larger proprietorships and partnerships. Nobody would like to invest in such partnerships in the first place, since once invested, their savings would be very difficult to convert into cash. And most people do have a lot of reasons, such as better investment opportunity, marriage, education, death, health, and so on, for wanting to convert their savings into cash. Clearly then, big enterprises will be able to raise capital from the public at large, only if there were some mechanism by which the investors could purchase or sell their share of the business as and when they wished to do so. This implies that ownership in business has to be “broken up” into a large number of small units, such that each unit may be independently and easily bought and sold without hampering the business activity as such. Also, such breaking up of business ownership would help mobilize small savings in the economy into entrepreneurial ventures. This end is achieved in a modern business through the mechanism of Shares. A share represents the smallest recognized fraction of ownership in a publicly held business. Each such fraction of ownership is represented in the form of a certificate, known as the share certificate. The breaking up of the total ownership of a business into small fragments, each fragment represented by a share certificate, enables them to be easily bought and sold. The institution where this buying and selling of shares essentially takes place is the Stock Exchange. In the absence of stock exchanges, i.e. institutions where small chunks of businesses could be traded, there would be no modern business in the form of publicly held companies. Today, owing to the stock exchanges, we do not have to be electronics company; we can be part owners of one company today and another company tomorrow; we can be part owners in several companies at the same time; we can be part owners in a company hundreds or thousands of rhiles away: we can be all of these things, and none of them, should we for whatever

reason decide to convert all our ownership stake into cash at short notice. Thus, by enabling the convertibility of ownership in the product market into financial assets, namely shares, stock exchanges bring together buyers and sellers (or their representatives) of fractional ownerships of companies, much as buyers and sellers of vegetables come together in a vegetable market. And for that very reason, activities relating to stock exchanges (and its variations, as we shall see later) are also appropriately enough, known as Stock Market or Security Market. Also, just as a vegetable market is distinguished by a specific locality and characteristics of its own, mostly a stock exchange is also distinguished by a physical location and characteristics of its own. In fact, according to H.T. Parekh, the earliest location of the Bombay Stock Exchange, which for a long period was known as “The Native Share and Stock Broker’s Association”, was probably under a tree around 1870.

CHARACTERISTICS OF STOCK EXCHANGES: Traditionally, a stock exchange has been an association of individual members called member brokers (or simply members or brokers). Formed for the express purpose of regulating and facilitating the buying and selling of securities by the public and institutions at large. A stock exchange in India operates with due recognition from the government under the Securities & Contracts (Regulations) Act, 1956. The member brokers are essentially the middlemen, who carry out the desired transactions in severities on behalf of the public (for a commission) or on their own behalf. New membership to a stock exchange is through election by the Governing Board of that stock exchange. At present there are 21 stock exchanges in India (excluding NSE and OTCEI), the largest among them being the Bombay Stock Exchange (BSE). BSE alone accounts for over 80% of the total volume of transactions in shares. Typically, a stock exchange is governed by a board consisting of directors largely elected by the member brokers, and a few nominated by the government. Government nominees include representatives of the Ministry of Finance, as well as some public representatives, who are expected to safeguard the public interest in the functioning of the exchanges. The board is headed by a President, who is an elected member, usually nominated by the government from among the elected members. The Executive Director, who is usually appointed by the stock exchange with government approval, is the operational chief of the stock exchange, his duty is to ensure that the day to day operations of the stock exchange are carried out in accordance with the various rules and regulations governing its functioning. The overall development and regulation of the securities market has been entrusted to the Securities and Exchanges Board of India (SEBI) by an act of Parliament in 1992. All companies wishing to raise capital from the public are required to list their securities on at least one stock exchange. Thus, all ordinary shares, preference shares and debentures of publicly held companies are listed in stock exchanges.

While in the developed countries, brokers have along since graduated to rendering a whole range of consulting and advisory services to their clients based on their own research and analysis, unfortunately, the profession of brokers in India has remained a rather closed club, traditional and primitive. Their function has largely remained limited to carrying out the transaction orders on behalf of their clients (and often at prices far from satisfactory). In their role as sub-brokers and jobbers (a jobber is a broker’s broker, or one who specializes in specific securities catering to the needs of other brokers), their activities are even less organized and regulated. To be fair though, chare broking is not the only Indian institution in its primitiveness. It has plenty of company. The good news however is, things are beginning to look up. Measures are a foot for professionalizing the service through various means. For example, the BSE has set up a full-fledged training college with a view to developing the professional standards of its members as well as investors. Other institutiions like the various Indian Institutes of Management (IIM’s), Institute of Chartered Financial Analysts of India, Unit Trust of India etc. Are also beginning to play a useful part in professionalizing the discipline of investment analysis. Also there is an increasing trend to admit qualified membership to stock exchanges has already been introduced. So over a period of time, we can reasonably hope that the service would get increasingly professional.

PRIMARY AND SECONDARY MARKETS: A company cannot easily find takers for its securities (shares or debentures) from the public if they cannot subsequently trade these shares and debentures at will. In other words, a security cannot have a good primary market unless it has an active secondary market. Primary market comprises the companies making the security issues, and the public at large subscribing to them. Primary market is where a company makes its first contact with the public at large in search of capital. Therefore, if one is wondering whether or not to invest in the new issue of a company, one is contemplating whether or not to participate in the primary market. Secondary market comprises the buyers and sellers of shares and debentures subsequent to the original issue. For example, having subscribed to the share or debenture of a company, if one wishes to sell the same, it will be done in the secondary market. Similarly, one could also buy the share or debenture of a company from the secondary market (if the company is listed in the stock exchange), without having to wait for that company to come out with a new public issue. Evidently, by their very role, stock exchanges are an important constitution of the capital market.

The two markets mentioned above are not to be understood as two physically segregated institutiions. Often the same parties may be involved in both the markets. Primary market merely alludes to the first purchase of a new share or debenture by the public directly from the issuing company, whereas secondary market refers to the subsequent trading in those shares and debentures. A stock exchange is the single most important institution in the secondary market for securities.

CAPITAL AND MONEY MARKETS: Every company is in need of long-term capital as well as short-term capital. Long-term capital is required essentially for investment in land, buildings, plant and machinery and other fixed assets, which are prerequisites to the production of goods and services. Short-term capital or working capital, on the other hand, is required essentially for financing the day-to-day operations of the business, such as raw materials, work in progress, finished goods, trade debtors, etc.

Capital market is then a broad term which includes primary markets, secondary markets, term lending institutions, banks, investors, and just about anybody and everybody who is engaged in providing long-term capital (whether equity capital or debt capital) to the industrial sector. Money market however includes all the agencies providing short-term capital (or working capital), as opposed to long-term capital, to the industry at large. Just like capital market, money market also has its own primary and secondary market s. Banks, under the control of the Reserve Bank of India, play a major role in the working of money markets.

SEBI’S OVERALL ROLE IN THE SECURITIES MARKET: As was mentioned earlier, the SEBI, that is the Securities and Exchange Board of India, is the national regulatory body for the securities market, set up under the Securities and Exchange Board of India Act, 1992, to “protect the interests of investors in securities and to promote the development of, and to regulate, the securities market and for matters connected therewith or incidental to”. Well, that’s a broad canvas and SEBI has just about picked up the brush. But then, a beginning has been made. SEBI has its head office in Bombay and it is in the process of setting up regional offices in the metropolitan cities of Calcutta, madras and Delhi. The Board of SEBI comprises a Chairman, two members from the Central Government representing the Ministries of Finance and law, one member from the Reserve Bank of India and two other members appointed by the Central Government.

As per the SEBI Act, 1992, the powers and functions of the Board encompass the regulation of stock exchanges and other securities markets; registration and regulation of the working of stock brokers, sub brokers, bankers to an issue (a public offer of capital), trustees of trust deeds, registrars to an issue, merchant bankers, underwriters, portfolio managers, investment advisors and such other intermediaries who may be associated with the stock market in any way; registration and regulation of mutual funds; promotion and regulation of self regulatory organizations; prohibiting fraudulent and unfair trade practices and insider trading in securities markets; regulating substantial acquisition of shares and takeover of companies; calling for information from, undertaking inspection, conducting inquiries and audits of stock exchanges, intermediaries and self regulatory organizations of the securities market; performing such functions and exercising such powers as contained in the provisions of the Capital Issues (Control) Act, 1947 and the Securities Contracts (Regulation) Act, 1956, levying various fees and other charges, performing such other functions as may be prescribed from time to time.

STOCKS or SECURITIES: Stocks or securities are generic terms that stand for instruments of ownership like shares, as well as instruments of lending like debentures, which are issued publicly. Just as a share represents the smallest unit of ownership, a debenture or a bond represents the smallest unit of lending. Shares and debentures may be of various kinds.

ORDINARY SHARE: An ordinary share represents the form of fractional ownership in which a shareholder (one who holds ordinary shares), as a fractional owner, undertakes maximum entrepreneurial risk associated with a business venture. This risk has several dimensions. During the life of a business, in general, an ordinary shareholder receives dividends out of operating surplus. This surplus is the residual from the revenue, after subtracting all the operating expenses, the interest charges on all kinds of borrowing, various taxes, and dividends due to the nonordinary shareholders. Now, various economic factors, government policies, market conditions, the labour situation, management’s efficiency, etc. may affect revenues, expenses, interest, taxes, etc. in such a way that in any given period, there may or may not be adequate surplus left for ordinary shareholders. Again, even when a business it at the verge of closing, all other stakeholders, such as employees, creditors, lenders, government, preference shareholders, etc. must be paid their claims first and only the residual can be shared by the ordinary shareholders. Then, for various reasons, there may or may not be enough residual left for the ordinary shareholders are the last to receive their claims. In this sense, ordinary shareholders are exposed to the highest risk amongst all the stakeholders in a business. If they are lucky and times are good, a big surplus may be left for them; if not, they may

suffer a loss. It is this possibility of variation in their earnings, which constitutes the entrepreneurial risk. And since the ordinary shareholders undertake this risk, they reasonably look forward to being compensated for this risk in the long run through higher earnings. Also, in view of the entrepreneurial risk assumed by them, ordinary shareholders have a voting right in proportion to the number of shares held by them, they may exercise this right to shape the affairs of the company in a suitable manner. The vote is usually exercised on resolutions placed before the company, in their Annual General Meetings or Extraordinary General Meetings.

ISSUE OF A SHARE AT PAR AND AT A PREMIUM: In general, an ordinary share in India is said to have a par value (face value) of Rs.10, though some shares issued earlier still carry a par value of Rs.100. Par value implies the value at which a share is originally recorded in the balance sheet as equity capital. Equity capital is the same as ordinary share capital. The SEBI guidelines for public issues by new companies established by individual promoters and entrepreneurs, require all new companies to offer their shares to the public at par, i.e. at Rs.10. However, a new company set up by existing companies (and of course existing companies themselves) with a track record of at least five years of consistent profitability are allowed by the SEBI guidelines to issue shares at a premium. It should be noted that when a company issues shares at a premium, it is able to raise the required amount of capital from the public by issuing a fewer number of shares. For example, while a new company promoted by first time entrepreneurs intending to raise say, Rs. One crore, has to offer 10 lakh ordinary shares at Rs.10 each (at par), an existing company may arise the same amount by offering only 2.5 lakh shares at Rs.40 each (close to the market value of its shares). The latter is said to have issued its share at a subscription price of Rs.40 (Rs.10 in of the former case), at a premium of Rs.30 (being the excess of subscription price over par value). In such a situation in India, the company’s books of accounts will show Rs.10 towards share capital account and Rs.30 towards share premium account. It can readily be seen that the higher the premium, the fewer will be the number of shares a company will have to service. For this very reason, following the policy of free pricing of issues in 1993, many companies came out with issues at prices so high that in many cases they were higher than their market prices, lending to under-subscription of such issues. The companies are however learning fast about the pitfalls of high pricing of shares and it is only a matter of time before the issue prices become more realistic.

In India, no company is allowed to issue shares at a discount, i.e., at a price below par, again, in India, once a company has issued the shares, it cannot easily reduce its capital base, i.e., buy back or redeem its own shares. This means that ordinary share capital is a more or less permanent source of capital, which normally a company is never under an obligation to return to the investors. This is because a shareholder who wishes to disinvest (i.e., get back the invested capital) can always do so by selling the shares to other buyers in the secondary market. Also, in India, a company receives no tax benefits for the dividends distributed. In other words, dividends are paid by the companies out of the earnings left after taxes and they get taxed once again at the hands of the investors. A company cannot raise equity capital in excess of the limit authorized in its Memorandum of Association (a document detailing the terms and conditions under which a company is incorporated under the company law) at any time, without undergoing certain legal formalities. This limit is known as authorized capital. At any point of time, the actual amount of capital issued by a company may be only a part of the authorized capital, and is known as issued capital. Again, not the entire capital issued by a company is necessarily required to be fully paid up at any time. This is because a company may chose to ask for only a fraction of the value of the share initially, to call the balance in installments, calls calls. For example, a company may issue a Rs.10 share, and require the investors to pay up only Rs.5 initially. The remaining Rs.5 may be called in one or more calls. The amount of capital paid up at any point in time is known as the paid-up capital. Again, while an investor may apply for, say, 100 shares at a subscription price of Rs.20 fully paid up, he may be allotted only, say, 10 shares by the company. The application money of the investor on the 100 shares applied is Rs.2000 (100 x Rs.20). The company would refund the balance of Rs.1800 (Rs.2000 - 200) to the investor, since he is allotted shares only worth Rs.200 (10 x Rs.20).

IS FREE PRICING OF PUBLIC ISSUES “BAD NEWS” FOR INVESTORS? The answer depends upon whom we mean by “investors”? Is investor the one who is already holding a share, that is, an existing shareholder, or one who is going to become a shareholder? Unfortunately there has been some confusion in this regard. To any reasonable person, it should be clear that is the existing shareholder who is the true investor since he has already invested. Whenever a company makes a public issue of shares at a price, which is lower than the market value of the share, some part of the wealth gets transferred from the existing shareholder to the new shareholder. It happens like this. Consider a company with 1lakh shares outstanding, quoted in the market at Rs.50 each. The total wealth of the existing shareholders can be said to be Rs.50 lakh. If this company raises another Rs.10 lakh by issuing 50,000 shares at Rs.20 each, as used to

be the case before free pricing, the share price of the company roughly falls down to Rs.40 (being (50 lakh + 10 lakh) / 105 lakh shares). This means a loss of Rs.10 per share to the existing shareholders, amounting in all to Rs.10 lakh. At the same time, this represents a gain to the new shareholders,. Since their holding of 50,000 shares at the rate of Rs.40 each is now worth Rs.20 lakh and their investment was only Rs.10 lakh, the loss of 10 lakh to the existing shareholders becomes the gain to the new shareholders. However, under free pricing regime, when a public issue of shares is made at the market price, say, Rs.40 in the above case, the existing shareholders suffer no net loss. Nor do the new shareholders make any unreasonable gain at the cost of the former. The advent of free pricing, needless to say is obviously good news to existing shareholders, though it may not appear as such to the new shareholders. It is understandable if everybody likes an eldorado where one could buy a share for Rs.20 today and sell it a month later for Rs.50, as was the case earlier. It is simply that no sensible and sustainable economy can work that way. It is a wonder that w worked that way at all, all these years. However, even a new shareholder must realize that before free pricing, precisely on account lf the bumper profit through the allotment of a share at a very low price, his probability of being allotted a share was also very low, since the extent of over subscription was very high. As a result, used to be a very small fraction of the actual number of having gone down significantly, the probability of allotment has gone up, and an average new shareholder can expect a much larger fraction of the shares applied for being allotted. Thus on the balance even he may not be so badly off.

WHY SHOULD A COMPANY TRY TO PRICE ITS PUBLIC ISSUE OF SHARES AS HIGH AS POSSIBLE In fact, any company trying to price its public issue higher than its market price is being silly. For that matter any company trying to price any of its products higher than the market price is being silly. It should be obvious, that in such a case the investor (or the customer) will eject the offered share (or the product) outright, unless the higher price is qualitatively justified or he is ill informed. True, there have been many instances following the free pricing policy where companies have priced their issues higher than the market price. But these are errors of judgment, which a company soon comes to learn and learns to correct. However, one important reason for the propensity of companies to price their shares unduly high may be attributed to their mistaken notion that the higher the price at which a company issues its shares, the lower its cost of capital.

Men who should know better, for example, our chief executives of companies and development banks, have frequently gone on record saying that under free pricing it is cheaper to raise equity than debt. Such statements are made on the argument that while a debenture issue involves a cost of around 18% to 19%, the cost of raising equity can be as low as 3% (for example, when a company paying 30% dividend on a share with a par value of Rs.10 is issued at Rs.100, that is at or near the market price of the share). According to this notion, the abolition Controller of Capital Issues (CCI – an official of the Ministry of Finance, a position now abolished) has reduced the cost of raising capital significantly. Hence the abolition of CCI is considered welcome. This is one reason why some companies have issued shares at prices higher than their prevailing market prices. Let us see if this view is tenable. Let us consider a situation where a share of par value of Rs.10 has been issued at Rs.100 (the market value of the share being close to Rs.100). if the company has been paying a dividend of Rs.3 per share, implying a 30% dividend, the dividend yield translates to a mere 3% (being dividend / market price). Is the cost of equity 30%? The answer is NO. The concept of cost of equity has to be understood properly. If the cost of equity is interpreted as 3%, this implies that the equity holders investing in the company’s shares are prepared to accept a return of 3% on their investment. This is clearly absurd. If the debenture holders receive a return of 17% or 18% on their investment, clearly the shareholders must be expecting a higher return, to compensate for their higher level of risk on their investment. Let us say that the shareholders expect a return of 24% on their investment. However, they receive a dividend yield of mere 3%. So how do they receive their remaining 21% return? Obviously this must come in the form of capital appreciation on their share. In other words, if a Rs.100 share were worth Rs.121 at the end of a year after paying Rs.3 as dividend, then together with the dividend, they earn a return of 24%. But then under what circumstances would a share worth Rs.100 in the market appreciate to Rs.121 a year later, after paying a dividend of appreciate to Rs.121 a year later, after paying a dividend of Rs.3. Alternatively put, when will the value of a share appreciate from Rs.100 to Rs.124 (including the dividend worth Rs.3). This would be the case only if the company has been able to earn a return of 24% on the original investment of Rs.100. Thus, in an on-going system, if the shareholder continues to receive a 3% yield as dividend, he must continue to receive a capital appreciation of 21% annually to earn an overall expected return of 24%. This would be feasible only if the company continued to earn a minimum return of 24&% on shareholder’s funds (though paying out only 3% as dividend and pumping back the rest into the business). Thus the cost of equity in this case is said to be 24%, which is the expected return of the shareholder. And the expected return of the shareholders is quite independent of the price at which a company may make its public issue.

Let us consider another company identical to the one above, but paying 50% dividend, i.e., Rs.5 per share. In this case, since the shareholder still expects a return of 24%, but only 5% (Rs, 5 dividend on a share with a market value of Rs.100) is being received as dividend, the remaining 19% return will have to come in the form of capital appreciation of the share, so that once again, the overall return the company will have to earn on its investments will be 24%, which constitutes the cost of capital. In case you are wondering how two companies paying 30% and 50% dividends will have the same cost of capital, just remember that the two firms are assumed to be otherwise identical. Thus, the second firm in order to remain identical to the first will have to resort to external funds to compensate for the higher dividend payout for its investment schemes, so that their earning streams are identical. What happens, if, a company raises capital from the public at Rs.100 per share and deploys the capital in operations earning a return of, say, only 15%, while the shareholders expect a return of 24%. The situation implies that the company earns a stream of only Rs.15 per share. This stream of earnings per share capitalized at 24% implies a market value per share of only Ra.62.50 (being 15/0.24). in other words, an investor who wants 24% return form his investment in this company’s share will be prepared to pay only Rs.62.50 for the share, since the company earns a stream of only Rs.15 per share. Thus, if shareholder who desires a return of 24% on his investment subscribes to a share at Rs.100 in a company, which earns a return of mere 15% on the investment, he will find the value of the share dropping to about Rs.62.50, so that he would have suffered a major loss on his investment. Clearly then, in the above situation, no matter at what price the public issue is made, the cost of capital, that is the return the company is obliged to earn on its investments remains 24%. It is just that when an issue is made below the market price of a share, there is transfer of wealth from the existing shareholders to new shareholders. But there is no change in the cost of capital. It is in the interest of the companies not to price their issues too high and thereby risk erosion of investors confidence should the price of the share fall steeply later. After all a company is a going concern which needs to come back to the capital market again and again. Irrespective of how a company prices its issue, an investor must develop the ability to assess the reasonableness of the price for himself.

KINDS OF SHARES There are basically two other kinds of shares, namely preference shares and savings shares.

PREFERENCE SHARE: The most characteristic feature of a Preference share is that both in the payment of dividends during the life of the business, and in sharing the residual on its termination, a preference shareholder get a preference over the ordinary shareholder. Unless the preference shares – holder has received his piece of the pie, the ordinary shareholder cannot hope to receive his own piece. On account of this preference over the ordinary shareholder, the preference shareholder assumes lower risk than the former. It is, therefore, reasonable that in the long run, the preference shareholder should normally expect to earn less than the ordinary shareholder. Usually, the rate of dividend for the preference shares is fixed at the time of issue. Alternatively, the preference shareholder may be guaranteed a minimum fixed dividend on the share with an additional variable component depending upon the extent of profits made in a given year. Also, preference shares may be cumulative or non-cumulative. In the case of a cumulative preference share, if the dividend in a particular year is skipped on account of paucity of profits, it is cumulatively made good in the following year or years, thereby providing such preference shareholders extra assurance on their dividend earnings. In the case of a non-cumulative preference share, on the other hand, there is no such provision. Thus, the former is less risky than the latter. Again, a preference share may or may not have voting rights. Further, a preferences share may be irredeemable or redeemable. These mean respectively that the preference share capital may either be permanent like the ordinary shares, or such shares may be repurchased by the company by paying back the capital. However, in India, preference shares are not very popular and they are largely on their way out. Occasionally, an investor may also encounter such shares as convertible preference shares: These are preference shares, which are converted into ordinary shares at some time in future at terms and conditions specified in advance. Recently, many companies have issued cumulative convertible preference shares, often known as CCPs. As the name implied, these are cumulative preference shares, which are converted into ordinary shares at a suitable conversion price in due course.

SAVINGS SHARE: A Saving share is an ordinary share without voting rights. They are also known as non-voting shares. In many countries, such shares co-exist with ordinary shares, and usually earn higher dividends than the latter as compensation for the loss of voting right. Similarly, there are other kinds of savings shares, which may have much more than one right each. Golden share is an example. In Sweden, for example, there are shares with 1000 voting rights each, which enable the promoters to wield control over their companies with relatively smaller financial stakes. We so not have savants shares in India at present, and nor is there a likelihood of their being introduced in the foreseeable future.

PARTLY PAID UP SHARES One may occasionally encounter partly paid up shares, so that such a share quotes differently from a fully paid up share. An investor should learn to distinguish a fully paid up share from a partly paid up share. Often, a company issues a share against which the investor is not required to pay up the entire capital at the time of application, so that the share remains a partly paid share. A part, say 50%, may be paid up at the time of application while the remaining 50% may be called by the company in due course in one or more installments. When a company makes a call on a partly paid up share. it specifies the date by which the call must be responded to. Depending upon this date, the stock exchange authorities specify the date after which the shares not having paid up the call money will be deemed bad deliveries. Thus, after this date, all transactions in that share takes place only if the shares are paid up to the extent of the latest call. MARKET LOTS AND ODD LOTS An important aspect of trading in securities is the notion of lot size. Each company specifies the minimum number of securities which makes an even or a market lot. All transactions have to be done in integral number of market lots. In general, for Rs.10 paid up shares the lot size is 100 and for Rs.100 paid up shares it is 10. However, lot sizes of 50 and 5, for the two categories respectively, are also prevalent in the market. To facilitate transactions, stock exchanges allow a lot to be made up of share certificates from up to five different folios. The stock exchanges also hold special trading sessions for dealing in odd lot shares. In general shares in odd lots fetch a price which is much lower (often up to 15% less) than the price shares in market lots. An investor is sometimes unable to avoid holding odd lot shares because they are created by awkward proportion n which “rights” are given to the shareholders by the companies. SHARE WARRANT A Share warrant is an option to buy a specified number of a firm’s shares at a specified price over a specified period of time. Warrants are issued by companies for cash to investors who may exercise the inherent option (to buy the shares) or may resell the warrants to other investors. Typically, a warrant holder has to surrender the warrant and pay some additional cash, known as exercise price of the warrant, in order to buy the shares. In general, warrants expire by a given date. Once the option on the warrant has been exercised, the warrant holder

becomes a shareholder. In India, warrants have appeared in the capital market only recently and are beginning to attain some popularity. DEBENTURES A debenture represents the smallest unit of public lending to a company. Like shares, they are represented in the form of a certificate. The common face value for a debenture in India is Rs.100, and they are always issued at par. Unlike an ordinary shareholder, a debenture holder assumes very little risk on his investment. Unlike the uncertain stream o dividends, which a shareholder receives, a debenture holder receives a fixed stream of interest. Payment of such interest is a legal obligation on the part of the company. Further, in general, a debenture is required to be secured against the assets of the company. Thus, a debenture is also a form of a secured loan. Secured debenture implies that should a company default in its obligations towards debenture holders in the repayment of their interest and principal, in law, the charged assets can be sold off for meeting such obligations. Thus, debenture holders are investors who assume relatively little risk on their investment and accordingly the returns they can expect to earn are lower than that of ordinary shareholders. Debenture holders, since they are lenders of capital and not owners, do not have voting rights, except under exceptional circumstances. Unlike dividend, interest on debentures is deductible form the corporate profits. This means that interest payments are made from the pretax operating profits of a company. KINDS OF DEBENTURES IN THE CORPORATE SECTOR Debentures are essentially of three kinds, fully convertible(FCD), partly convertible (PCD) and non-convertible (NCD).

Fully Convertible debentures (FCD) :- A fully convertible debenture is a debenture which, at a specified time after the issue, is fully converted to equity at the option of the holder.

Partly Convertible Debenture (PCD) :- As the name wuggests, a partly convertible debenture is a debenture only a part of which is convertible into an ordinary share. For example, a debenture priced at Rs.100 may have two components, namely, (A) - a convertible component (B) - a non-convertible component priced at Rs.30 and Rs.70 respectively. Here only component (A) priced at Rs.30 is convertible into an ordinary share, while the non-convertible component (B) priced at Rs.70 is allowed to remain intact.

Non-convertible Debentures (NCDs) : - These debentures cannot be converted into ordinary shares. Frequently, these debentures may redeemable with a small premium (usually 5% of the principal). They may also be irredeemable or

perpetual. In India, the interest rate on non-convertible debentures paid by the companies is usually 2 to 2.5% higher than that for convertible debentures. Under the SEBI guidelines, conversion must take place at or after 18 months at the option of the debenture holder. The guidelines also require that all debentures with conversion or maturity over 18 months be credit rated and that the premium amount at the time of conversion, the period of conversion, the redemption amount, period of maturity and yield on redemption be indicated in the prospectus. Ordinarily, a convertible debenture is converted into the shares of the company issuing the debenture. However, in principle, there is no reason why the debentures of a company cannot be converted into the shares of another company. In many countries, such a practice does exist. Such innovations are bound to enter our own market before long. BONDS : A bond is more or less the same as a debenture. In India, the terms bonds and debentures are mostly used interchangeable. There is virtually no distinction between the two, and the difference if any is subtle enough to be disregarded for all practical purposes. Some, however, regard a bond as an American term for a debenture. Others prefer to reserve the term ‘bonds’ for public debt securities belonging to the government and public sector undertakings. ZERO COUPON or A DEEP DISCOUNT BOND : A zero coupon bond or a deep discount bond is a loan instrument slightly different from an ordinary debenture. Unlike an ordinary debenture, which is usually offered at its face value (say Rs.100) and earns a stream of interest till redemption (say 15% per annum) and is redeemed with or without premium, fiveyear zero coupon bond may be offered at a discount (say at Rs.50), and fetches no periodic interest and is redeemed at the face value (say Rs.100). a little computation revels that the yield to maturity or YTM of such a zero coupon bond when subscribed to at Rs.50 is about 15%, which is similar to that of an ordinary debenture subscribed to at face value, which is redeemed without premium. It is simply; that instead of receiving the interest periodically, the bondholder receives the principal as well as compounded interest together at the time of maturity of the bond. In other words, the interest is automatically reinvested at 15% per annum till maturity. The implication of such an instrument in India may be of significance to the investors in the high-tax brackets, depending upon whether or not they can treat the implicit interest accrued at the time of redemption as capital gains. Since the interest on the bond is received only at the time of redemption, if it is allowed to be accounted for as premium at redemption attracting capital gains tax rather than income tax, the bond may have a special attraction (since the capital gains tax rate is in general lower than the income tax rate). In the developed countries, however,

investors must pay income tax on the implicit coupon interest every year, even though they do not actually receive the interest. SECURED PRIMIUM NOTE The terminology is not a standard one. The term became current when TISCO made its issue in 1992. Notwithstanding the formidable sounding terminology, it was nothing but a close cousin of a zero coupon bond, along with some warrants attached. Moreover, the redemption was not in one period, but spread over several periods. Usually, any security will turn out to be a mere permutation or combination of the various characteristics. And there are likely to be as many names for securities as there are permutations and combinations of their characteristics. WHY SHOULD THE INTEREST BE TAX DECUCTIBLE FOR COMPANIES, WHILE THE DIVIDENDS ARE NOT It is difficult to provide any logical reason why this should be so. But the fact that it is so implies that for some reasons the governments all over wish to favour debt over equity. Whether this encourages companies to prefer debt over equity and how such a preference affects entrepreneurship in an economy are points to ponder. Certain countries do have tax shields for dividends also under certain circumstances. Similarly, in other countries interest on loans are not always fully tax deductible. For example, in India, in the mid-seventies, the interest on corporate fixed deposits were tax-exempt only to a tune of 85%. Also, till recently, in the case of partnership firms, the interest on loan from a partner to the firm was not tax exempt. Again, the favourable treatment of interest vis-à-vis dividend in law is by no means a universal phenomenon. In many Islamic countries, interest is viewed with considerable disfavour even in law. BONUS ISSUE When we invest the share capital in a business, we do so with the expectation of getting back not only our invested capital, but also a proportionate share of the surplus generated from operations, after all the other stakeholders have been paid their dues. Thus, collectively the business owes its shareholders, their invested capital as well as the surplus generated from operations. But in reality, while the business may pay us annual dividends, seldom is this surplus fully distributed away as dividends. Thus, the surplus which is retained in the business is still owed to us. This retained surplus is also reflected as retained earnings or reserves in the Balance sheet of a company. Together, share capital and reserves are known as equity or the net worth of a company. Over a period of time, the retained earnings of a firm can become quite large: often several times the original share capital. And when this happens, the management of the firm may decide to transfer some amount from the reserves

account to the share capital account by a mere book entry. This has the effect of decreasing or debiting the reserves in the balance sheet of the firm and increasing or crediting the share capital (and hence the number of shares outstanding). In such a case, the firm is said to have made a bonus issue.

THE BENEFIT OF A BONUS ISSUE TO A SHAREHOLDER: Let us assume that a company makes a 1: 2 bonus issue. In other words, for every two shares held, the shareholders receive one additional share. For example, if this company’s original share capital was Rs.10 crore(with one crore shares of par value Rs.10 outstanding), the bonus issue has the effect of increasing the share capital to Rs.15 crore(implying 1.5 crore shares or Rs.10 each), so that the reserves go down accordingly by Rs.5 crore. This has been shown in the partial balance sheet of a hypothetical company in the box below: Balance sheet of XYZ Before Bonus Issue (Rs. In Crore) Liabilities Share capital (1 crore shares of Rs.10 each) Reserves

10

Assets --

20

--

------

--------

Balance Sheet of XYZ After Bonus Issue (Rs. In Crore) Liabilities Share capital (1.5 crore shares of Rs.10 each) Reserves

15 15 ------

Assets ----------

Thus, the shareholder of the firm who previously held two shares is now in possession of three shares, i.e., one extra share. Henceforth, the shareholders would begin to receive dividends on three shares held by them earlier. The same effect could have been achieved by the company by increasing its dividend payments by 50% on the earlier two shares, without making the bonus issue. Since a bonus issue implies no real change in the fortunes of the business, the ex-bonus price (the market price after the bonus issue) of the three shares including the bonus share, will be equal to the cum-bonus price (the price before the bonus issue) of the original two shares. Hence, following this bonus issue, the market price per share must fall by 33.33% (assuming that everything else remains unchanged). In other words, now the market price of the ex-bonus share will be only two thirds of the price of the cum-bonus share. The bonus issue enthusiasts may argue that this fall in market price is likely to be much less than 33.33%, so that the ex-bonus value of the three shares would be greater than the cum-bonus value of the two shares, implying an increase in the wealth position of the shareholder as a consequence of the bonus issue. If this were indeed so, it would imply creation of wealth through book entry, for a bonus issue is nothing but just that. In a logical world, there is no reason to believe that the

shareholders would not have achieved the same increase in wealth if the company had decided to merely enhance the dividend by 50%, rather than issue a bonus of 1:2 (assuming that the company maintained its DPS following the bonus issue). Thus, strictly speaking, bonus issue implies absolutely no change in the fortunes of either the issuing company or its shareholders.

IF THE BONUS ISSUE IS MERELY A BOOK ENTRY, THEN WHY DO COMPANIES ISSUE BONUS SHARES AT ALL: Perhaps the only rational reason for a firm to do so is that by not issuing bonus shares, the market price of a firm may increase to extremely high levels over a period of time (remember that regular bonus issues have the effect of keeping the market price per share low on account of the enlarged share capital base). Such high share prices may make it difficult for the shareholders to trade in the shares. For example, over the 1982-1992 period Colgate-Palmolive India Ltd made four bonus issues of 1:1 and one of 3:5. This means, that a shareholder who held one share prior to 1982, held about twenty-five shares in 1992. The average market price of a Colgate share was around 400 in 1992 (par value being Rs.10). This means that if Colgate had made no bonus issues between 1982 and 1992, the market price of its share would have been about Rs.10000 (Rs.400 x 25) by 1992. Small and medium investors may find it difficult to trade a share at such a price. Thus when a bonus issue is made, the share may become relatively more liquid. The resulting increase in the liquidity of the ex-bonus shares may, to some extent, explain why following a bonus issue of, say, 1:1, the price of the share falls less than 50%. However, there is no strong empirical evidence to support this hypothesis. There may possibly be other reasons why firms may choose to make bonus issues periodically. It may be that when the retained earnings of a firm grow very large in relation to its share capital, the firm feels exposed to the charge of making enormous profits at the cost of the consumer, and may be apprehensive about attracting close public scrutiny. For the same reason they may be reluctant to announce very high rates of dividends and hence choose to make bonus issues instead. However, such a reason hardly appears to be elegant. It is also argued that, by issuing bonus shares, a firm indirectly discloses to the market its continued ability to pay dividends on the enlarged capital base in future, so that the investors expect a stable increase in the company’s profits in future and the share price goes up. There is some empirical evidence to support this view. But the catch is that there is no reason why the same information cannot be imparted to the market through an appropriate increase in dividends or through a straight and simple announcement by the management to that effect. Thus, as we said earlier, it is in fact difficult to see how by making an accounting entry in the books of accounts can create any wealth through increase in share prices.

RIGHTS ISSUE Normally, whenever an existing company makes a fresh issue of equity capital or convertible debentures the existing shareholders or convertible debenture holders have the first right to subscribe to the issue in proportion to their existing holdings. Only what is not subscribed to by the existing shareholders can be issued to the public. Thus, an issue offered to the existing shareholders or convertible debenture holders as their right is known as rights issue, as opposed to an issue open to the public at large, in which case we call it a public issue. An investor may exercise this right to subscribe to the offered issue, or he may sell the rights separately in the market. The rights have a market value only when the issue is made below the market value of the security. When this happens, as can be expected, the market price drops a little. The price of the security before the rights issue is known as the cum-rights price. The difference between the cum-rights and ex-rights price is a measure of the market value of a right, through increase in shares prices.

IS THE PRICE AT WHICH THE IMPORTANT:

RIGHTS ARE

ISSUED

The price at which a rights issue is made is irrelevant. In order to understand this, consider the example of a company, which has 100000 ordinary shares outstanding with a market price of Rs.40 per share. This is the cum-rights price. The total market value of the shares (also known as market capitalization) at this stage is Rs.4000000 (Rs.40 x 100000). Let us assume that this company needs to raise another Rs.500000 for sustaining its operations and so makes a rights issue of 25000 shares, i.e., at a ratio of 1:4, at Rs.20 each. Thus, after the rights issue is made, the number of shares outstanding increases to 125000. Assuming that the purpose for which the additional capital is being raised is not likely to affect the overall profits of the company significantly (in other words, everything else remains the same), the ex-rights price of the share should drop to about Rs.36 { Rs. (4000000 + 500000) / 125000). In this case, the value of a right is Rs.4 and one requires four rights in order to procure one share at Rs.20, and the ex-rights wealth of the shareholders works out to about Rs.4500000 (Rs.36 x 125000). If on the other hand the company were to decide to raise the additional Rs.500000 by issuing 12500 shares at Rs.40 each, the ex-rights price of the share would remain unchanged at Rs.40 (4500000 / 112500). Also, one who buys four rights for Rs.16, and acquires one share at the issue price of Rs.20, eventually ends up paying Rs.36, which is the same as the ex-rights price. In this case once again, the ex-rights wealth of the shareholders is about Rs.4500000 (Rs.40 x 112500). Thus, it can be seen that no matter at what price the rights issue is made; the ex-rights wealth of the shareholders subscribing to the rights issue (ex-rights price multiplied by the number of shares outstanding including the rights issue) remains

more or less the same. This was not so in the case of public issues. A public issue made blow the market price, we noticed, resulted in a transfer of wealth form the existing shareholders to the new shareholders. Needless to say, no issue, whether rights or public, will be subscribed to by a rational investor at a price higher than the prevailing market price, as the investor can always buy that the share from the secondary market rather than subscribe to the issue.