Generally, the personal savings of an entrepreneur along with contributions from friends and relatives are the source of fund to start new or to expand existing business. This may not be feasible in case of large projects. In this case, promoters have the option of raising money from the public across the country by selling (issuing) shares of the company. For this purpose, the promoter can invite investment to his or her venture by issuing offer document which gives full details about track record, the company, the nature of the project, the business model, the expected profitability etc.
If you are comfortable with this proposed venture, you may invest; this mechanism by which corporates raise money from public is called the primary markets. Importantly, when you, as a shareholder, need your money back, you can sell these shares to other or new investors. Such trades do not reduce or alter the company’s capital. Stock exchanges bring such sellers and buyers together and facilitate trading. Therefore, companies raising money from public are required to list their shares on the stock exchange. This mechanism of buying and selling shares through stock exchange is known as the secondary markets.
Apart from shares, there are many other financial instruments (securities) used for raising capital. Debentures or bonds are debt instruments which pay interest over their life time and are used by corporates to raise medium or long term debt capital. If you prefer fixed income, you may invest in these instruments which may give you higher rate of interest than bank fixed deposit, because of the higher risk. Besides, equity and debt, a combination of these instruments, like convertible debentures, preference shares are also issued to raise capital.
The institutions, players and mechanism that bring suppliers and users of capital together, is known as capital market. Thus capital market mobilizes savings and channelizes it, through securities, into preferred entrepreneurs.
Products available in capital market
1. Equity (instrument of ownership)
Equity shares are instruments issued by companies to raise capital and it represents the title to the ownership of a company. As a shareholder, you bear the entrepreneurial risk of the business venture and are entitled to benefits of ownership like share in the distributed profit
(Dividend) etc. The returns earned in equity depend upon the profits made by the company. Company’s future growth etc.
2. Debt (loan instruments)
A) Corporate debt
a) Debentures are instrument issued by companies to raise debt capital. As an investor, you lend you money to the company, in return for its promise to pay you interest at a fixed rate (usually payable half yearly on specific dates) and to repay the loan amount on a specified maturity date.Normally specific asset(s) of the company are held (secured) in favour of debenture holders. This can be liquidated, if the company is unable to pay the interest or principal amount. Unlike loans, you can buy or sell these instruments in the market.
Types of debentures that are offered are as follows:
- Non convertible debentures (NCD) – Total amount is redeemed by the Issuer
- Partially convertible debentures (PCD) – Part of it is redeemed and the remaining is converted to equity shares as per the specified terms
- Fully convertible debentures (FCD) – Whole value is converted into equity at a specified price
b) Bonds are broadly similar to debentures. They are issued by companies, financial institutions, municipalities or government companies and are normally not secured by any assets of the company (unsecured).
Types of bonds
- Regular Income Bonds provide a stable source of income at regular, predetermined intervals
- Tax-Saving Bonds offer tax exemption up to a specified amount of investment, depending on the scheme and the Government notification.
Examples is Infrastructure Bonds under Section 88 of the Income Tax Act, 1961
B) Government debt:
Government securities (G-Secs) are instruments issued by Government of India to raise money. G Secs pays interest at fixed rate on specific dates on half-yearly basis. It is available in wide range of maturity, from short dated (one year) to long dated (up to thirty years). Since it is sovereign borrowing, it is free from risk of default (credit risk). You can subscribe to these bonds through RBI or buy it in stock exchange.
C) Money Market instruments (loan instruments up to one year tenure)
- Treasury Bills (T-bills) are short term instruments issued by the Government for its cash management. It is issued at discount to face value and has maturity ranging from 14 to 365 days
- Commercial Papers (CPs) are short term unsecured instruments issued by the companies for their cash management. It is issued at discount to face value and has maturity ranging from 90 to 365 days.
- Certificate of Deposits (CDs) are short term unsecured instruments issued by the banks for their cash management. It is issued at discount to face value and has maturity ranging from 90 to 365 days.
3. Hybrid instruments (combination of ownership and loan instruments)
Preferred Stock / Preference shares entitle you to receive dividend at a fixed rate. Importantly, this dividend had to be paid to you before dividend can be paid to equity shareholders. In the event of liquidation of the company, your claim to the company’s surplus will be higher than that of the equity holders, but however, below the claims of the company’screditors, bondholders / debenture holders.
- Cumulative Preference Shares: A type of preference shares on which dividend accumulates if remains unpaid. All arrears of preference dividend have to be paid out before paying dividend on equity shares.
- Cumulative Convertible Preference Shares: A type of preference shares where the dividend payable on the same accumulates, if not paid. After a specified date, these shares will be converted into equity capital ofthe company.
- Participating Preference Shares gives you the right to participate in profits of the company after the specified fixed dividend is paid. Participation right is linked with the quantum of dividend paid on the equity shares over and above a particular specified level.
4. Mutual Funds
Mutual funds collect money from many investors and invest this corpus in equity, debt or a combination of both, in a professional and transparent manner. In return for your investment, you receive units of mutual funds which entitle you to the benefit of the collective return earned by the fund, after reduction of management fees. Mutual funds offer different schemes to cater to the needs of the investor are regulated by securities and Exchange board of India (SEBI)
Types of Mutual Funds
At the fundamental level, there are three types of mutual funds:
- Equity funds (stocks)
- Fixed-income funds (bonds)
- Money market funds