Capital markets are financial markets where instruments such as stocks, bonds, currencies, and other financial assets are traded.
Corporate Ownership
At the outset, a company can be financed by DEBT or EQUITY (common stock (shares). Once a company is established, it may need further financing for additional projects. This too can come from issuing more DEBT or EQUITY (common stock (shares), as well as using existing retained profits.
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A corporation is owned by its common stockholders. – The shareholders
The shareholders are entitled to all the company profits after the debt holders have been paid their interest. They also have voting rights. Shareholders exercise control over the firm by voting for its board of directors and on all major issues.
Most voting is done on a majority basis with each common share representing one vote.
Where a company is voting on being taken over or other substantial issues, individual or groups of shareholders try to influence the vote by either buying a majority of the issued and outstanding shares or persuading the majority of existing shareholders to vote with them.
In rare cases, defense companies or companies of national strategic importance the government may have a blocking vote without a majority.
Authorized Share Capital – is the maximum number of shares that the company is permitted to issue under its rules without additional shareholder approval. There may be rules that limit the amount that can be issued in any financial year.
Issued shares and Outstanding Shares – are the number of shares actually issued by the company and held by shareholders.
Share repurchases – Treasury stock are shares that have been repurchased by the company and held in its treasury. A company may choose to buy back its own shares because of a lack of potential growth opportunities.
Shareholders demand returns on their investments in the form of dividends – the cost of equity. Buying back shares can reduce the overall cost of capital i.e. future dividend payments. Another major reason is to take advantage of perceived undervaluation. This may prove wrong, many companies bought back shares before the price collapsed during the financial crisis. This has been the case in the recent collapse in share prices, many companies bought back their own shares at higher prices prior to the coronavirus rout of the share markets.
Companies are often measured by the growth in earnings per share. By reducing the number of outstanding shares, a company’s earnings per share ratio is automatically increased. NOTE Donald Trump has stated that companies will not be able to buy back their own shares until any bailout money they receive has been paid back.
The term fully-diluted includes shares that could be issued as part of employee share option schemes, or any instruments issued by the company such as convertibles bonds or warrants, that allow the holder to convert these instruments into shares in the future.
Common Stock (Ordinary shares) – All companies have common stock, (some corporations have preferred stock in addition to their common stock.)
Shares of common stock provide evidence of ownership of a corporation. Holders of common stock elect the corporation’s directors and share the profits of the company via dividends.
Common shareholders bear the highest risk as in bankruptcy, the secured lenders (debt owners) would be paid first, followed by unsecured lenders, preferred stockholders (if any), and lastly the common stockholders. The greater the risk the higher the investors required rate of return. Hence the cost of debt is lower than the cost of equity and government bonds (risk-free) have the lowest cost (required rate of return) of all instruments.
Additional Paid in Capital
When a firm issues new equity, it records each new share in its books at par value.
If the price at which new equity is issued is above the par value, the difference between the issue price and the par value of a stock is known as the Additional Paid-in Capital. In some cases equity finance can be raised at a value below the face value.
If a firm has recently issued 10 million new shares at $15 per share; when the par value of each is $1.50.
What is the value of additional paid-in capital (APIC)? $135,000,000
APIC = (10,000,000x$15) – (10,000,000x$1.5)
Treasury Stock / Retained Earnings
Treasury stock – A corporation’s own shares that have been repurchased from shareholders. The cash value of the shares purchased is recorded in a shareholders account (treasury stock account) as a negative number.
Retained earnings – A shareholders’ equity account that records the net profit (income) of a company from its formation until the most recent company year end, (balance sheet date) less the dividends paid to shareholders/ declared (to be paid to shareholders) from the company’s formation to that balance sheet date.
A company’s share capital is the total amount contributed directly by shareholders when the firm issues new stock, and the NET PROFIT (earnings) plowed back into the company.
It should be noted, that buying shares in stock markets above (or below) the face value of a share , DOES NOT INCREASE / (DECREASE) THE SHARE CAPITAL. That is simply a transaction between a BUYER and a SELLER of the share. The profit or loss goes to the SELLER and not the company.
Shareholders (Common) Equity = Par Value + Additional Paid-in Capital + Retained Earnings – Share Repurchases
A firm has 150 million authorized shares.
120 million shares are currently in issue and 115 million shares are currently trading on the NYSE (outstanding shares).
As at 31 December 2015, the company’s share price was $5.25.
Shareholders Equity Account ($)
- Common Stock: 1,200,000
- Additional paid-in capital: 55,500,000
- Retained Earnings: 210,800,000
- Treasury Shares: (15,000,000)
- Shareholder’s Equity: 252,500,000
Questions
Calculate the par value of each share?
Par value is $0.10 per share, which is computed as follows:
$1,200,000 (Common Stock A/C) /120,000,000 issued shares = $0.01 per share
Estimate the average price at which shares were sold?
The shares were sold at an average price of:
[$1,200,000 + $55,500,000 (Additional Paid in Capital)]/ 120,000,000 shares = $0.4725
Calculate the number of shares that were repurchased?
The company has repurchased: 120,000,000 issued shares – 115,000,000 outstanding shares= 5,000,000 shares
PRICE / BOOK RATIO (P/B Ratio)
Estimate the average price at which the shares were repurchased?
The average repurchase price: $15,000,000 (Treasury Stock Account)/ 5,000,000 shares = $3.00 per share.
What is net book value of the company? Calculate the market value to book ratio for the company
Book Value = Is the total shareholder’s equity $252,500,000
Shareholders Equity = Assets – Liabilities
Share price / Book Value per share (P/B ratio)
= $5.25 / ($252,500,000 / 120,000,000 shares) = $5.25 /$2.1041 =2.495
Price to book ratio
Comment on the Market Value to Book Value (Price / Book Value) ratio.
The book value of equity is the value of a company’s net assets (assets minus liabilities) recorded on the balance sheet.
The company is trading at 2.495 times its book value. A book value of more than 1, indicates the market believes asset values are understated in the balance sheet or the company is or will be earning a high return on its assets. Technology and service companies have few assets, the lawyers, accountants and geeks generate the profits and not buildings/machinery. Employees are not assets in the financial statements. Manufacturing companies have lower P/B ratios.Investors are attracted to businesses trading with a book value below 1, if they believe a new management or better market conditions will improve the returns. Alternatively, the sale of all the assets would be at more than the price paid for the shares.
Book value has several limitations. Principally, the balance sheet records assets based on historic cost and not the cost of replacement, which would result in a much higher ratio for companies with very old assets bought at lower prices than their current cost.
Why do companies repurchase shares? Discuss the share repurchase scheme.
Companies purchase their own shares, when they have surplus funds and the management have no potential investments or projects that meet their cost of capital. (remember NPV calculations).
Companies may also purchase their own shares to achieve a more optimal capital structure. The cost of equity (shares) is higher than the cost of debt. Issuing debt or using surplus cash to repurchase shares will reduce the weighted average cost of capital (WACC).
Finally, the management may be measured (and incentivised) by the share price performance. By reducing the number of outstanding shares, future profits will be shared by fewer shareholders, potentially increasing the share price.
The repurchase of shares is like dividends, a way of returning money to shareholders (part of their required rate of return). The shareholder sells part or all of their shares to the company. The sale of shares is subject to capital gains tax and dividends to income tax. Depending on an investors tax status, they may prefer share repurchases or dividends.
The company repurchased shares at an average price of $3.00, which is lower than the current share price. The decision was good for the company; shareholders would have made $5.25 per share, if they held on and sold them on the stock market not $3.00. The time value of money is relevant here, when were the shares repurchased, what was the share price then?
Corporate Debt
When issuing debt, companies are legally bound to make payments and repay the principal. But in the case of bankruptcy ; debt is not always repaid. Corporate debt is therefore more risky than GOVERNMENT DEBT / TREASURY BILLS and has a higher required rate of return than the RISK FREE RATE. The interest rate on a bond reflects the risk associated with the issuing company.
Zero-coupon Bonds – a bond that is issued at a deep discount to its face value but pays no interest. The difference between the amount you receive at maturity and the amount you paid represents the interest payment. The advantage to the company is cash flow, it delays interest payments and to the investor there is certainty and the chance that if interest rates fall the price of the bond will rise.
Debt Characteristics
Seniority – Debt can vary in seniority, i.e. some debt is paid back before other debt, usually in the order in which it was issued ..the more senior the less the risk and so this debt has a lower coupon. – Subordinated Debt
Security – some debt can be secured against company assets and in the event of bankruptcy when the company assets are sold. Secured Debt will be paid from the sale of the assets, this can be against general assets or a specific asset. Leases are an example, where the lender provides Long-term rental agreements for business assets. If the company doesn’t pay the rental, the lender can take the assets back.
Debt can be issued in a foreign currency such as Eurodollars or Eurobonds, which will then have currency risk.. The Nigerian Naira could fall 40% against these currencies, making it more difficult for the company to make repayments.
Debt is often issued with PROTECTIVE COVENANTS i.e a company must always have an operating profit of 2x its interest payments . These restrictions on a firm protect the debtholders
Preferred Stock
A preferred share entitles the holder to a fixed dividend, whose payment takes priority over that of ordinary share dividends.
Preferred shares usually do not carry voting rights. But can appreciate in value like common stock.
Preferred shares is technically equity, but is similar to a bond issue and in some cases can act as debt from a tax perspective.
Preferred shareholders may have the right to receive payment in arrears before the dividend can be resumed for common shareholders.
In short, preferred shares have less risk than common stock and can be more flexible than debt for the company in terms of legal interest and principal payments.
Key Areas
The single most important factor will be the company’s future sales – this will be driven by your expectations of the economies where the company has sales. How long and by how much you expect COVID-19 to impact sales. Unemployment is important, if you predict a longer term for people’s income to recover. Personal debt levels and rising interest rates will reduce people’s spending power. (ask friends from different countries, your parents and do some research).
Remember companies are valued until infinity, the impact of COVID-19 may have a small impact on the long term value, unless the lack of cashflow will result in serious financial distress.
Also consider your expectations for the cost of producing or purchasing what they sell. Tariffs push prices higher and reduce sales.
Academic Questions
Academic questions, projects, assignment questions on this topic.
- When using a DISCOUNTED CASH FLOW VALUATION (actually most valuation methods), the calculated equity value must be divided by the NUMBER OF OUTSTANDING SHARES.
- Students must use the latest available financial report. The last SEC 10K report for the year.
- Make sure you use the correct number as this will impact your valuation.
Cost of Equity
In finance, the cost of equity refers to the return a company theoretically pays to its equity investors (shareholders( in lieu of the risk they undertake by investing their company (capital).
The most common formula used to calculate cost of equity is the CAPM method:
As per CAPM formula, Cost of Equity = (Risk-Free Rate of Return) + (Beta * (Market Rate of Return – Risk-Free Rate of Return)).
Management / MBA question on this topic:
Q) Alpha Limited has a debt equity ratio of 3:2. The pre-tax cost of debt is 12%. Effective tax rate for the company is 30%. The equity beta of Alpha is 1.5. Market risk premium is 8% and the risk-free rate is 7%.
a) Discuss and Compute the cost of equity of Alpha Limited
b) Discuss WACC and determine the WACC based on after tax cost of debt and cost of equity?
Q. The risk free Rate of return is 6 %, Return on market is 11% and the Beta of Michelllo Private limited is 1.1. Estimate the cost of Equity and also mention the steps to calculate the opportunity cost of capital as per the CAPM Model.
Intrinsic Value of Stocks
Intrinsic value of a stock is its true value. This is calculated on the basis of the monetary benefit you expect to receive from it in the future.
A stock is a financial asset that generates cash flows. Thus, intrinsic value of any asset can be defined as the present value of all the distributable cash flows the asset generates during its lifetime.
When using “present value”, all cash flows in the future have to be discounted by an appropriate discount rate or an interest rate.
There are different variations of the intrinsic value formula, but the most “standard” approach is similar to the net present value formula.
Popular valuation methods:
- Dividend Discount Model (DDM): This is an absolute valuation model that derives the “true” value of a company based on the dividends it pays to the shareholders.
- Discounted Cash Flow Model (DCF): Instead of dividends, the DCF model uses a company’s discounted future cash flows to value the business.
- The Comparables Model: Instead of finding an intrinsic value for the stock, this model compares the stock’s price multiples to a benchmark to determine if the stock is undervalued or overvalued.
Questions on this topic:
Q) Fusion Limited’s dividend is growing at a rate of 12% per annum. This growth rate is expected to continue for 3 years. Thereafter, the growth rate will decline to 8% for the next 2 years. After that, the year on year growth in dividends is expected to be a stable 6% rate forever. If the last dividend was Rs 6 per share and the required rate of return on equity is 20%, what is the fair value per share.
Q) Alpha limited is investing $500 million in a new project. The present values of the future after tax cash flows resulting from the project is $750 million. The company has 100 million shares outstanding, having market price of $45 per share. Assuming, the project being independent of other expectations about the company, Calculate the effect of – The new project on the value of the company on the company’s stock.
Sensex, BSE, NSE and Nifty Explained
BSE is short for the ‘Bombay Stock Exchange’. Founded in 1875, BSE is the first and one of the largest securities markets based out of Mumbai in India. NSE is short for the ‘National Stock Exchange’. Founded in 1972, it offers a country-wide stock market similar to BSE. While BSE is older, NSE is larger with greater daily trades and a higher turnover rate.
While BSE and NSE are stock Markets, both Sensex and Nifty are stock market indices. A stock market index summarises the movements of the market in real[1]time. A stock market index is created by grouping together similar kinds of stock. Sensex, which stands for ‘Stock Exchange Sensitive Index’, is the stock market index for the Bombay Stock Exchange. Nifty stands for ‘National Stock Exchange Fifty’ and is the index for the National Stock Exchange.
What is a debt buyback?
What is a debt buyback? Why was a program of debt buybacks not sufficient to resolve the Debt Crisis of 1980s?
Debt buyback refers to the repurchase by a debtor of its own debt, usually at a substantial discount, from the secondary market.
Situations like the COVID-19 pandemic affect markets, and in the short term, many loans get priced at a significant discount. As a result, borrowers consider such opportunities to buy back their own outstanding loans at significantly reduced prices.
Debt Crisis of 1980s: In the 1980s, highly indebted Latin American and other developing regions were unable to repay the debt, pushing the world into a debt crisis, because of which financial rescue operations became necessary.
There were several years of rescheduling and restructuring of sovereign and private sector debt, it was hoped that these countries would carry out economic reforms that would lead to economic growth which would help them to pay of their debt. However, it did not happen; on the contrary, these countries cut down spending on infrastructure, health, and education, leading to stagnant or negative growth.
In 1989, the Brady Plan was launched which allowed countries to buy back their own debt at discount in the secondary market. The success of this plan was mixed as some countries still defaulted on its Brady bonds. These bonds also exposed investors to interest rate risk, sovereign risk, and credit risk.
The period is also referred to as the “lost decade”, the crisis required a decade of negotiations and multiple attempts at debt rescheduling to resolve, which came at significant cost to America and other less-developed countries.
Useful Links
Debt Crisis of the 1980s explained.
Academic Questions on Capital Markets
Q) Nishant is a fresh MBA Graduate who got placed in a wealth advisory firm. On his first day of his induction, his manager asks him to prepare assignment any two each from money market and capital market instrument that he would advise his client to invest in. Help Nishant with his assignment.
Q) XYZ Private Limited company wants to raise fresh capital from the primary market. As a financial advisor to the firm advise the various techniques which the company
can use in order to raise fresh capital from the primary market?
Q) “In 2008 the world economy faced its most dangerous Crisis since the Great Depression of the 1930s and brought back to light the role of state intervention in
regulating regulatory market”.
a. In regard to the above statement discuss some of the reasons for state intervention in
regulation of the financial market?
b. Highlight the benefits of state intervention wrt Indian Context
Question: LTCG tax on equity shares
The Budget 2018 proposes to change how LTCG on equity shares and units of equity-oriented MFs are taxed in your (an individual’s hands).
If you sell after 31.3.2018 the LTCG will be taxed as follows: (Also refer to tables at the bottom)
1. The cost of acquisition of the share or unit bought before Feb 1, 2018, will be the higher of :
a) the actual cost of acquisition of the asset
b) The lower of : (i) The fair market value of this asset(highest price of share on stock exchange on 31.1.2018 or when share was last traded. NAV of unit in case of a mutual fund unit) and (ii) The sale value received/accrued when the share/unit is sold.
Effective financial year 2018-19, long term capital gain arising from sale of equity share is proposed to be taxed at the rate of 10% on a gain exceeding 100,000 without allowing any benefit of indexation. However, all gains up to 31st January, 2018 will be exempt. Similarly, distribution by the equity oriented mutual fund shall attract tax @ 10%. This shall act as major dampener for the investors.
MBA assignment question (NMIMS and other colleges):
Mr. Fernandez has a portfolio of equity shares worth Rs. 2 crores by current market valuation. He had inherited the shares from his father 10 years ago. He has become extremely concerned about the introduction of 10% LTCG tax on equity shares in this year’s Union Budget. Not sure about the impact of this newly introduced tax, he is contemplating selling of all the shares before 31st March 2018, and escaping the taxation. He has sought your opinion on this. Prepare a detailed report citing the implications of the LTCG tax, and guide Mr. Fernandez in his decision making.
Forex Exchange Market
The foreign exchange market is where one currency is traded for another. Its participants include large banks, central banks, currency speculators, multinational corporations, governments, and other financial markets and institutions.
Forex, also referred to as Foreign Exchange is a worldwide trading financial market. It is considered to be the largest market in the world leading to high liquidity. Forex Trading is where trading is done between different currencies of the world against each other. It determines the value of currencies.
- It is the most liquid and the largest financial market in the world.
- Currency trading is done over the counter, rather than being centralized like in case of stock market.
- The Forex market has low trading costs.
Currency Calculations
Trading involves any two currencies that can be traded over the counter. Forex currencies are always traded in pairs i.e. you buy one and sell the other currency simultaneously.
Cross Rate Calculations
Q.) 1 USD = CHF 0.9405 – 15
1 USD = CAD 1.0397 – 07
Calculate value of 1 CAD in terms of CHF
Q) USD 1.5235 – 45 per GBP
EUR 1.1790 – 00 per GBP
Calculate USD per EUR quotation.
Q) USD / INR 53.8325 – 75
USD / SEK 6.4745 – 45
Calculate 100 INR / SEK quotation.
Q) 100 INR / USD 1.8513 – 18
USD / JPY 93.1875 – 75
Calculate 100 JPY / INR quotation.
Q) 100 INR / USD 1.8595 – 00
100 JPY / INR 58.2335 – 35
Calculate USD / JPY quotation.
Q)EUR 0.7692 – 02 per USD USD
1.5390 – 00 per GBP
Calculate GBP per EUR quotation.
Q)AUD 0.9898 – 08 / USD
SGD 1.2400 – 10 / USD
Calculate AUD per SGD quotation.
Q)SEK 9.7575 – 75 = 1 GBP
GBP 0.6494 – 04 = 1 USD
Calculate value of 1 SEK in terms of USD.
Q) USD / INR 52.9885 – 35
EUR / USD 1.2870 – 80
Calculate INR/EUR quotation.
Q)1 USD = CAD 1.0530 – 40
1 USD = INR 54.1365 – 15
Calculate value of 1 CAD in terms of INR.
Percentage Spread Calculations
Q) 1 USD = CAD 1.1290 – 00 Calculate %age spread.
Q) 100 INR = USD 2.1605 – 10 Calculate %age spread.
Q) USD / SGD 1.4395 – 05 GBP / SGD 2.6865 – 75
Calculate GBP / USD quotation. Establish relationship between the three quotations in terms of %age spread.
Q) Mean rate GBP / INR 78.6500 AND SPREAD = 0.0030. Calculate %age spread and GBP / INR quotation.
Q) Flat rate USD / NZD 1.1785 and spread = 10 points. Calculate %age spread and USD / NZD quotation.
Q) Average rate EUR / SEK 8.3590 and spread = 80 points. Calculate %age spread and EUR / SEK quotation.
Q) Ask rate USD / CHF 0.9406 and spread = 12 points. Calculate USD / CHF quotation and % age spread.
Q) Bid rate EUR / CHF 1.2096 and spread = 0.0014. Calculate EUR / CHF quotation and % age spread.
Q) Mid rate USD / EUR 0.7752 Percentage spread = 0.1290%. Calculate spread and USD / EUR quotation.
Q) Spread = 0.0014 and % spread = 0.0810%. Calculate mid rate and the quotation.
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