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CAPITAL MARKET INSTRUMENTS

MEANING:

Capital markets are markets where people, companies, and governments with more funds than
they need (because they save some of their income) transfer those funds to people, companies, or
governments who have a shortage of funds (because they spend more than their income). Stock
and bond markets are two major capital markets. Capital markets promote economic efficiency
by channelling money from those who do not have an immediate productive use for it to those
who do. Capital markets carry out the desirable economic function of directing capital to
productive uses. The savers (governments, businesses, and people who save some portion of
their income) invest their money in capital markets like stocks and bonds. The borrowers
(governments, businesses, and people who spend more than their income) borrow the savers'
investments that have been entrusted to the capital markets .For example, suppose A and B make
Rs. 50,000 in one year, but they only spend Rs.40,000 that year. They can invest the 10,000 -
their savings - in a mutual fund investing in stocks and bonds all over the world. They know that
making such an investment is riskier than keeping the 10,000 at home or in a savings account.
But they hope that over the long-term the investment will yield greater returns than cash holdings
or interest on a savings account. The borrowers in this example are the companies that issued the
stocks or bonds that are part of the mutual fund portfolio. Because the companies have spending
needs that exceeds their income, they finance their spending needs by issuing securities in the
capital markets.

CAPITAL MARKET INSTRUMENTS

Financial instruments that are used for raising capital resources in the capital market are known
as capital market instruments.

TYPES OF CAPITALMARKET INSTRUMENTS

Financial instruments (securities)


1. Ownership securities

2. Gilt edged securities

(1) OWNERSHIP SECURITIES-SHARES:


Issue of share is the best method for the procurement of fixed capital requirements because it has
not to be paid back to shareholder within the life time of the company. Funds raised through the
issue of shares provide a financial floor to the capital structure of a company.

A share may be defined as a unit of measure of a shareholders interest in the company. A share
is a right to participate in the profits made by a company while it is a going concern and in the
assets of the company when it is wound up. (Bachan Cozdar Vs. Commissioner of Income tax).
The share capital of company is divided into a large number of equal parts and each part is
individually called a share.

Under the provisions of Section 86 of the Indian Companies Act, 1956, a public company or a
private company which is subsidiary of a public company can issue only two types of shares i.e.
equity shares and preference-shares. However, an independent private company can issue
deferred shares as well.

Preference Shares:
Preference Shares are those shares which carry priority rights with regard to payment of dividend
and return of capital.

According to Sec. 85 of the Indian Companies Act, preference share is that part of the share
capital of the company which is endowed with the following preferential rights:

(1) Preference with regard to the payment of dividend at fixed rate; and

(2) Preference as to repayment of capital in the event of company being wound up.
Thus, Preference shareholders enjoy two preferential rights over the equity shares. Firstly, they
are entitled to receive a fixed rate of dividend out of the net profits of the company prior to the
declaration of dividend on equity shares.

Secondly, the assets remaining after the payment of debts of the company under liquidation are
first distributed for returning preferential capital (contributed by the preference shareholders).

Types of Preference Shares:

(i) Cumulative and non-cumulative preference shares:

The holders of cumulative preference shares are sure to receive dividend on the preference shares
held by them for all the years out of the earnings of the company. Under this the amount of
unpaid dividend is carried forward as arrears and becomes the charge on the profits of the
company.

If in any particular year they are not paid dividend, they will be paid such arrear in the next year
before any dividend can be distributed among the equity shareholders. But the non-cumulative
preference shareholders are entitled to their yearly dividend only if there is sufficient net profit in
that year. In case the earnings are not adequate, dividends are not paid and the unpaid dividend is
not carried forward for payment out of profits in subsequent years.

(ii) Participating and non-participating preference shares:

The holders of these preference shares are entitled to fixed rate of dividend and in addition they
are also granted the right to share the surplus net profits of the company, left after paying a
certain rate of dividend on equity shares. Thus, participating shareholders obtain return on their
investments in two forms (a) fixed dividend (b) share in surplus profits.

The preference shares which do not carry the right to share in the surplus profits are known as
non-participating preference shares.
(iii) Redeemable and irredeemable preference shares:

Redeemable preference shares are those which, in accordance with the terms of issue, can be
redeemed or repaid after a certain date or at the discretion of the company. The preference shares
which cannot be redeemed during the life time of the company are known as irredeemable
preference shares.

(iv) Convertible and non-convertible preference shares:

If the preference shareholders are given the option to convert their shares into equity shares
within a fixed period of time such shares will be known as convertible preference shares. The
preference shares which cannot be converted into equity shares are called non- convertible
preference shares.

(v) Guaranteed Preference Shares:

In case of conversion of a private concern into a limited company or in case of amalgamation


and absorption the seller guarantees a particular rate of dividend on preference shares for certain
years. These shares are called guaranteed preference shares.

Advantages of preference shares:

(1) Suitable to Cautious Investors:

Preference shares mobilise the funds from such investors who prefer safety of their
capital and want to earn income with greater certainty.

(2) Retention of Control:

Control of the company is vested with the management by issuing preference shares to
outsiders because such share-holders have restricted voting rights.

(3) Increase in the Income of Equity Shareholders:


Preference shares bear a fixed yield and enable the company to adopt the policy of trading
on equity to increase the rate of dividend on equities out of profits remaining after paying
fixed rate of dividend on preference shares.

(4) Flexibility in the Capital Structure:

In case of redeemable preference shares, company may feel at ease to bring flexibility in
the financial structure as they can be redeemed whenever a company desires.

(5) No charge on Assets of the Company:

The company can raise capital in the form of preference shares for a long term without
creating any charge on its assets.

Disadvantages of preference shares:

(1) Permanent Burden:

Preference Shares Impose permanent burden on the company to pay fixed dividend prior
to its disbursement among other types of shareholders.

(2) No Voting Right:

The preference shares may not be advantageous from the point of view of investors
because they do not carry voting rights.

(3) Redemption during the period of Depression:

Preference shareholders will suffer the loss, if the company exercises its discretion to
redeem the debentures during the periods of depression.
(4) Costly:

Compared to debentures and Govt., securities, the cost of raising the preference share
capital is higher.

(5) Income Tax:

Since preference dividend is not an admissible deduction for income tax purposes,
the company has to earn more, otherwise the dividend on equity shareholders will be affected.

Equity Shares:

Equity shares or ordinary shares are those ownership securities which do not carry any special
right in respect of annual dividend or the return of capital in the event of winding up of the
company.

According to Sec. 85(2) of the Indian Companies Act.

Equity shares (with reference to any company limited by shares) are those which are not
preference shares. A substantial part of risk capital of a company is raised from this source,
which is of permanent nature.

Equity shareholders are the real owners of the company. They get dividend only after the
dividend on preference shares is paid out of the profits of the company. They may not receive
any return, if there are no profits. At the time of winding up of the company equity capital can be
paid back after every claim including that of preference shareholders has been settled.

According to Hoagland, Equity shareholders are the residual claimants against the assets and
income of the corporation.The financial risk is more with equity share capital. So equity shares
are also called Risk Capital.

As the equity shareholders have higher risk, they also have a chance of getting higher dividend if
the company earns higher profits. Equity shareholders control the affairs of the company because
by possessing the voting rights they elect the directors of the company.
Advantages of Equity Shares:

(1) No Charge on Assets:

The company can raise the fixed capital without creating any charge over the assets.

(2) No-Recurring Fixed Payments:

Equity shares do not create any obligation on the part of company to pay fixed rate of dividend.

(3) Long term Funds:

Equity capital constitutes the permanent source of finance and there is no obligation for the
company to return the capital except when the company is liquidated.

(4) Right to Participate in Affairs:

Equity shareholders, being the real owners of the company, have the right to participate in the
affairs of the company.

(5) Appreciation in the value of Assets:

Investors in equity shares are rewarded by handsome dividends and appreciation in the value of
their shareholdings under boom conditions.

(6) Ownership:

Equity shareholders are the real owners of the company. They alone have voting rights. They
elect the directors to manage the company.

Disadvantages of Equity Shares:


(1) Difficulty in Trading on Equity:

The company will not be in a position to adopt the policy of trading on equity if all or most of
the capital is raised in the form of equity shares.

(2) Speculation:

During the period of boom, higher dividends on equity shares results in the appreciation of the
value of shares which in turn leads to speculation.

(3) Manipulation:

As the affairs of the company are controlled by equity shareholders on the basis of voting rights,
there are chances of manipulation by a powerful group.

(4) Concentration of Control:

Whenever the company intends to raise capital by new issues, priority is to be given to existing
shareholders. This may lead to concentration of power in few hands.

(5) Less Liquid:

Since equity shares are not refundable they are treated as illiquid.

(6) Not always Acceptable:

Because of the uncertainty of the return on the equity shares, conservative investors will hesitate
to purchase them.

Deferred Shares:
The shares which are issued to the founders or promoters are called deferred shares or founders
shares. The promoters take these shares for enabling them to control the company. These shares
have extra ordinary rights though their face value is very low.

The holders of deferred shares can get dividend only after preference and equity shareholders
shall have received their dividend.

Now-a-days, these shares have lost their popularity. At present in India public companies cannot
issue deferred shares.

Creditorship Securities or Debentures:

A company can raise finances by issuing debentures. A debenture may be defined as the
acknowledgement of debt by a company. Debentures constitute the borrowed capital of the
company and they are known as creditorship securities because debenture holders are regarded
as the creditors of the company. The debenture holders are entitled to periodical payment of
interest at a fixed rate and are also entitled to redemption of their debentures as per the terms and
conditions of the issue.

The word debenture is derived from the Latin word Lebere meaning to owe. In its simplest
sense it means a document which either creates or acknowledges a debt.

A debenture may be defined broadly, as an instrument in writing, issued by a company under its
seal and acknowledging a debt for a certain sum of money and giving an undertaking to repay
that sum on or after a fixed future date and mean while to pay interest thereon at a certain rate
per annum of stated Intervals.

As per Sec. 2 (12) debenture includes debenture stock, bonds and other securities of a company
whether constituting a charge on the assets of the company or not.

In the words of Chitty J. Debenture means a document which either creates a debt
acknowledges it, and any document which fulfills either of these conditions is a debenture.
Palmer defines a debenture as any instrument under seal of the company, evidencing a deed the
essence of it being admission of indebtedness. According to Evelyn Thomas Debenture is a
document under the companys seal which provides for the payment of the principal sum and
interest there on at regular intervals which is usually secured by a fixed or floating charge on the
companys property or undertaking and which acknowledges a company.

On the analysis of above definitions, a debenture may be defined as an instrument executed by


company under its common seal acknowledging indebtedness to some person or persons to
secure the sum advanced. Debentures are usually bonds issued by the company in series of a
fixed denomination e.g., Rs. 100, Rs. 200, Rs. 500, Rs. 1,000 of face value and are offered to the
public by means of a prospectus.

The terms and conditions of debenture issue are endorsed on the back of debenture certificate
which gives different rights to the holders.

A company may have a debenture stock which is nothing but borrowed money consolidated into
one mass for the sake of convenience. Instead of each lender having a separate bond or
mortgage, he has a certificate entitling him to a certain sum, being a portion of one large loan.

(2)Gilt edged securities

Government securities market in India is narrow and unlike other countries inactive. The general
investors do not buy these securities. The Reserve Bank of India and financial institutions are the
main investors of government securities.

The government securities market in India supports the capital market and has no negative effect
on it. The funds that it collects are mainly for minimizing the cost of servicing and for the
planned priorities of the economy.

Government securities have been employed by the Reserve Bank of India in such a way that it is
able to maintain some clear pattern of yield and a proper maturity distribution policy. It has also
been considered safe by Reserve Bank to purchase securities before maturity in order to maintain
stability.
The Reserve Bank of India has used open market operations to provide inexpensive finance for
government and has tried to maintain funds with the view of achieving stability in the future.

The Reserve Bank of India has also used the techniques of maintaining the reserve ratio and the
statutory liquid ratio and the technique of moral suasion. This it has done for controlling bank
liquidity and for achieving the objectives of debt management.

Features of Government Securities:

1. Issuing Authority
2. Government Securities and Stock Market
3. Government Securities and Commercial Banks
4. Issue Price
5. Government Securities and Rate of Interest
6. Tax Exemption
7. Government Securities and Financial Institutions
8. Government Securities and Underwriting

Issuing Authority:

Government securities can be issued only by the Central Government, State


Governments, Semi-government Authorities. The Central Government securities prevailing in
India are Gold Bonds, National Defence Bends and Rural Development Bonds.

The Central Government also issues Treasury Bills, Special Rupee Securities, Payment of Indias
Subscriptions to International Monetary Fund, I.B.R.D. and International Development Agency.

Government securities are also categorized by issues made by local Government Authorities,
City Corporations, Municipalities, Port Trusts, Improvement Trusts, State Electricity Boards,
Public Sector Undertaking and Metropolitan Authorities. These authorities usually issue bonds.
The third form of government securities are issued by the financial institutions like I.D.B.I.,
I.F.C.I., State Financial Corporations, Small Industries Development Corporation, Land
Development Banks and Housing Boards. These authorities issue bonds and debentures.

Government Securities and Stock Market:

The stock market is to a large extent influenced by the government securities in India. The
Government securities are controlled by the Reserve Bank of India which maintains the statutory
liquidity ratio and uses open market operations for control.

In India, government securities do not affect the interest rates to any great extent in the private
corporate sectors and industrial securities. Government securities operate basically for creating
funds for development and priority program of the five year plans as well as for meeting deficit
budgets for Central and State plans.

Government Securities and Commercial Banks:

In India, all commercial banks have to maintain their secondary resources through government
securities. The government securities also help them to get accommodation from the Reserve
Bank of India whenever the need arises. Government securities are also excellent means to
obtain loans. These securities are kept as collateral.

Issue Price:

Government securities are issued in denominations of Rs. 100. It has been noticed that these
securities have usually been issued at a discount but not a premium.

Government Securities and Rate of Interest:

Rate of interest on government securities is low. In fact, it is lower than any other form of
investment. This is so because government securities are considered to be the safest because at
the time of maturity government always meets its commitments and is never at default.
Tax Exemption:

Government securities offer certain tax exemptions.

Government Securities and Financial Institutions:

Financial Institutions have a legal constraint to invest certain proportion of their investible
surplus every year in government securities. This amount is usually held by them till maturity
because financial institutions find it difficult to switch from one security to another. Also, they
are not in any particular need or requirements of funds. Due to these reasons, they usually take
their funds only after the maturity of the security.

Government Securities and Underwriting:

Government securities are not underwritten. In fact, brokers also do not like to deal with these
securities. Government securities are issued by the Debt Office of the Reserve Bank of India.
This office notifies all issues and subscriptions which can be open for two to three days. The
issues are subscribed during the year and are concentrated during the slack season. Usually, the
Public Debt Office (PDO) tries to have a small portion of issues evenly spaced in the year
according to the needs of the government budget. The government securities are usually sold in
over-the-counter market and each sale is separately negotiated.

Semi government securities

The semi-government securities are issued by semi-government bodies such as Port Trust,
Improvement Trust, and Municipalities. They include port trust bonds, improvement trust bonds
and municipal bonds.