Unit 5

CAPITAL MARKET EFFICIENCY AND CAPITAL MARKETS IN INDIA

 Capital markets facilitate the buying and selling of securities, such as shares and bonds or
debentures. They perform two valuable functions:
1. Liquidity
2. Pricing securities
Capital Market Efficiency
 Capital Market Efficiency may be defined as the ability of securities to reflect and incorporate all
relevant information in their prices. Three forms of capital market efficiency may be
distinguished
 Weak form of efficiency - The security prices reflect all past information about the price
movements.
 Semi-strong form of efficiency - The security prices reflect all public ally available information
about the price movements.
 Strong form of efficiency - The security prices reflect all published and unpublished public and
private information about the price movements.
Attributes of a Perfect Capital Market
1. No entry Barriers.
2. Large Number of Buyers and Sellers.
3. Divisibility of financial assets.
4. Absence of transaction costs.
5. No tax differences.
6. Free Trading.
Three significant imperfections of Capital markets
 Tax asymmetries
 Information asymmetries
 Transaction costs
CAPITAL MARKETS IN INDIA
 Primary market
 Secondary market
PRIMARY CAPITAL MARKET IN INDIA
 Primary capital market is a conduit for the sale of new securities.
 Listed (existing or new) companies may make the public issues of shares.
 The initial public offerings (IPOs) are the public issues of securities by new companies
for the first time.
Financial Instruments
 Equity and debt are the two basic instruments of raising capital from the primary markets.
 Ordinary shares
 Preference shares
 Debentures
 Convertible debentures
 Warrants
 Cumulative convertible preference shares (CCPS)
 Derivative securities
 Borrowings from financial institutions
 Private Placement
 Instead of a public issue of securities, a company may offer them privately, only to a few
investors; that is, less than 50 in number. This is referred to as private placement of
securities.
Reasons for the development of Private Placement:
 Private placement of securities is subject to much less compliance than the public issues
 Private placement is cost effective as compared to public issues
 Private placement is time effective as deals can be easily and directly negotiated with a few
investors
 Private placement helps to tailoring the issues according to the needs of the companies
Euro Issues
 Companies in India have started raising funds via euro issues in the foreign capital markets.
 Euro issues include foreign currency convertible bonds (FCCBs), global depository receipts
(GDRs) and American depository receipts (ADRs).
Government Securities
 Both the central and state governments borrow large sums of money from the primary market by
issuing dated securities (long-term securities) and Treasury bills (T-Bills).
 T-Bills in India are issued for short duration.
Pricing of New Issues:
 Companies in India can freely price share issues, subject to the SEBI guidelines.
 In the case of the listed companies, the current market price provides a basis for pricing the new
issue of securities.
 A company is required to issue a prospectus when it issues shares to the public.
Book Building and Price Discovery:
 Book building is an alternative to the traditional fixed-price method of security issue.
 In book building the issue price is not fixed.
 Book building is a process of offering securities at various bid prices from investors.
 There is a price band with the floor price (lower price) and the ceiling price (higher price).
 The demand for the security is assessed and the price is discovered based on bids made by
investors.
 Price discovery, therefore, depends on the demand for the shares at different prices.
Book building involves the following steps:
1. The company plans an IPO via the book building route.
2. It appoints an issue manager (usually a merchant banker) as book-runner.
3. It issues a draft prospectus containing all required disclosure.
4. The draft prospectus is filed with SEBI.
5. The issue manager (book-runner) appoints syndicate members and other registered
intermediaries to garner subscription.
6. Price discovery begins through the bidding process.
7. At the close of bidding, book-runner and the company decide upon the allocation and allotments.
SECONDARY MARKETS IN INDIA
 Secondary capital markets deal in the second-hand issued securities.
Stock exchanges are secondary markets where buyers and sellers trade in already issued
securities
A stock exchange provides the following useful economic functions:
 a) Help in determining fair prices based on demand and supply forces and all-available
information
b) Providing easy marketability and liquidity for investors
c) Facilitation in capital allocations in primary markets through price signalling
d) Enabling investors to adjusting portfolios of securities
In terms of business activities, the two most prominent all-India stock exchanges are the
Bombay Stock Exchange (BSE) and the National Stock Exchange (NSE).
Securities and Exchange Board of India (SEBI)
 SEBI is required to regulate and promote the securities market by:

Government Securities Market

 The government debt market constitutes about three-fourths of the debt market in India.
 Commercial banks and financial institutions in India own a large proportion of the
government debt securities due to statutory liquidity and other investment requirements.
Derivatives Market
 Derivatives are securities derived from other securities (called underlying securities) like
equity, debt, or any other type of security.
 They also include contracts that derive their values from prices or index of prices.
 In India, the OTC derivatives are not allowed; the legal derivatives must trade on
recognised stock exchanges only.
Trading and Settlement
 Dematerialization of shares
 Trading
 Rolling settlement
 Circuit breaker
MERCHANT BANKING: ROLE IN CAPITAL MARKETS:
 Merchant bankers play the role of intermediaries in the capital market in India.
 They help companies in the total management of issues of securities.
 Therefore, they are called issue managers.
 As members of stock exchange, underwriters of new issues and book builders, they help to make
market, and hence, are known as market makers also.
 Merchant bankers cannot undertake the pure fund-based activities.
MUTUAL FUNDS AND CAPITAL MARKETS
 Indian investors started investing through mutual funds since 1964 when the government set up
the Unit Trust of India (UTI).
 UTI’s objective was to mobilize the savings of the public, and invest them in securities and other
assets, enabling the investors to earn good returns.
Broad categories of Mutual Funds
 Closed-ended mutual funds
 Open-ended fund
Various kinds of funds possible:
 Income funds
 Growth funds
 Balanced funds
 Tax saving funds
 Sector-based funds
Benefits of Mutual Funds
 Simplicity
 Diversification
 Professional management
 Affordability
 Flexibility
Drawbacks of Mutual Funds
 High fees and expenses
 Brokerage fees
 Hidden costs
 Cost of diversification
 Risks of ownership
Index Fund
 In an index fund, the funds manager creates the fund by buying shares included in a stock market
index such as the BSE Sensex or the NSE Nifty or a sector specific stock index.
 Sector funds are index funds as they are based on stock market indices.
 Stock market indices keep track of all types of companies.
Advantages: Index Funds
 Less expenses
 Low research cost
 Regular follow-up
Limitations: Index Funds
 Index funds can never outperform the market.
 The small investors may not be able to invest in index funds as several funds require a large
initial investment.
Hedge Fund
 A hedge fund does varieties of things than merely buying and selling securities.
 It takes both long and short positions, uses arbitrage, buys and sells undervalued securities,
trades options or bonds, and invest in almost any opportunity in any market where it foresees
impressive gains at reduced risk.
 Most hedge funds aim at reducing volatility and risk, while offering high returns under different
market conditions.
Advantages: Hedge Fund
 Positive returns
 Risk reduction
 Wide choices
 High returns
 Ideal investment
 Better diversification

LONG TERM FINANCE: SHARES, DEBENTURES AND TERM LOANS

 Ordinary shares provide ownership rights to investors.
 Debentures or bonds provide loan capital to the company, and investors get the status of
lenders.
 Loan capital is also directly available from the financial institutions to the companies.
Ordinary Shares–Features:
 Claim on Income
 Claim on Assets
 Right to Control
 Voting Rights
 Pre-Emptive Rights
 Limited Liability
Ordinary Shares–Pros and Cons:
 Advantages
 Permanent Capital
 Borrowing Base
 Dividend Payment Discretion
 Disadvantages
 Cost
 Risk
 Earnings Dilution
 Ownership Dilution
Public Issue of Equity:
 Public issue of equity means raising of share capital directly from the public.
 As per the existing norms, a company with a track record is free to determine the issue
price for its shares.
Underwriting of Issues:
 It is legally obligatory to underwrite a public and a rights issue.
 In an underwriting, the underwriters—generally banks, financial institution, brokers,
etc.—guarantee to buy the shares if the issue is not fully subscribed by the public.
 The agreement may provide for a firm buying by the underwriters.
 The company has to pay an underwriting commission to the underwriter for their
services.
Private Placement:
 Private placement involves sale of shares (or other securities) by the company to few
selected investors, particularly the institutional investors.
 Private placement has the following advantages:
 Size
 Cost
 Speed
Right Issue of Equity Shares:
 Selling of Ordinary Shares to the existing shareholders of the company.
 Value of Right
Effect on Shareholders’ Wealth:
 The shareholder has three options:
 (i) he exercises his rights,
 (ii) he sells his rights, or
 (iii) he does not exercise or sell his rights.
 He will lose under the third option.
Is the Subscription Price of any Significance?
 It is irrelevant in terms of the impact on the shareholders’ wealth.
 It can be fixed at any level below the current market price.
 The primary objective in setting the subscription price low is that after the rights offering,
the market price should not fall below it.
Right Shares – Pros and Cons:
 Advantages
1. Control is maintained
2. Less flotation cost
3. Issue more likely to be successful
 Disadvantages
1. Shareholders lose if fail to exercise their right
2. If shareholding concentrated in hands of FI
Preference Shares:
 Similarity to Ordinary Shares:
1. Non payment of dividends does not force company to insolvency.
2. Dividends are not deductible for tax purposes.
3. In some cases, it has no fixed maturity dates.
 Similarity to Debentures:
1. Dividend rate is fixed.
2. Do not share in residual earnings.
3. Preference shareholders have claims on income and assets prior to ordinary
shareholders.
4. Usually do not have voting rights.
Preference Shares–Features:
1. Claims on Income and Assets
2. Fixed Dividend
3. Cumulative Dividend
4. Redemption
5. Sinking Fund
 6. Call Feature
7. Participation Feature
8. Voting Rights
9. Convertibility
Preference Shares–Pros and Cons:
 Advantages:
 Risk less leverage advantage
 Dividend postponability
 Fixed dividend
 Limited Voting Rights
 Disadvantages:
 Non-deductibility of Dividends
 Commitment to pay dividends
DEBENTURES:
 A debenture is a long-term promissory note for raising loan capital.
 The firm promises to pay interest and principal as stipulated.
 The purchasers of debentures are called debenture holders.
 An alternative form of debenture in India is a bond.
 Mostly public sector companies in India issue bonds.
Debentures–Features:
 Interest Rate
 Maturity
 Redemption
 Sinking Fund
 Buy-back (call) provisions
 Indenture
 Security
 Yield
 Claims on Assets and Income
Types of Debentures:
1. Non – Convertible Debentures
2. Fully – Convertible Debentures
3. Partly – Convertible Debentures
Debentures–Pros and Cons:
 Advantages:
 Less Costly
 No ownership Dilution
 Fixed payment of interest
 Reduced real obligation
 Disadvantages:
 Obligatory Payment
 Financial Risk
 Cash outflows
 Restricted Covenants
Term Loans–Features:
 Maturity
  Direct Negotiations
 Security
 Restrictive Covenants
1. Asset related covenants
2. Liability related covenants
3. Cash flow related covenants
4. Control related covenants
 Convertibility
 Repayment Schedule
Lease Defined: Lease is a contract under which a lessor, the owner of the assets, gives right
to use the asset to a lessee, the user of the assets, for an agreed period of time for a
consideration called the lease rentals.
 In up-fronted leases, more rentals are charged in the initial years and less in the later
years of the contract. The opposite happens in back ended leases.
 Primary lease provides for the recovery of the cost of the assets and profit through lease
rentals during a period of about 4 or 5 years. It may be followed by a perpetual,
secondary lease on nominal lease rentals.
Types of Leases:
1. Operating Lease
2. Financial Lease
3. Sale-and-lease-back
Operating Lease: Short-term, cancelable lease agreements are called operating lease.
 Tourist renting a car, lease contracts for computers, office equipments and hotel rooms.
 The Lessor is generally responsible for maintenance and insurance.
 Risk of obsolescence remains with the lessor.
Financial Lease: Long-term, non-cancelable lease contracts are known as financial lease.

 Examples are plant, machinery, land, building, ships and aircrafts.

 Amortise the cost of the asset over the terms of the lease–Capital or Full pay-out leases.
Sale and Lease Back:
 Sometimes, a user may sell an (existing) asset owned by him to the lessor (leasing
company) and lease it back from him. Such sale and lease back arrangements may
provide substantial tax benefits.
 In April 1989, Shipping Credit and Investment Corporation of India purchased Great
Eastern Shipping Company bulk carrier, Jag Lata, for Rs 12.5 Cr and then leased it back
to GESC on a 5 years lease, the rentals being Rs 28.13 Lakh per month. The ships WDV
was Rs 2.5 Cr.
Cash Flow Consequences of a Financial Lease
 Avoidance of the purchase price
 Loss of depreciation tax shield
 After–tax payments of lease rentals
Commonly Used Lease Terminology:
1. Leveraged Lease
2. Cross-border lease
3. Closed and open ended lease
 4. Direct lease
5. Master lease
6. Percentage lease
7. Wet and dry lease
8. Net net net lease
9. Update lease
Myths about Leasing:
 Leasing Provides 100% Financing
 Leasing Provides Off-the-Balance-Sheet Financing
 Leasing Improves Performance
 Leasing Avoids Control of Capital Spending
Advantages of Leasing:
1. Convenience and Flexibility
2. Shifting of Risk of Obsolescence
3. Maintenance and Specialized Services
Evaluating a Lease:
 Equivalent Loan Method
 Net Advantage of a Lease Method
 IRR Approach
Equivalent Loan Method:
 EL is that amount of loan which commits a firm to exactly the same stream of fixed
obligations as does the lease liability.
 Method—
1. Find out incremental cash flows from leasing.
2. Determine the amount of equivalent loan such cash flow can service.
3. Compare the equivalent loan so found with lease finance.
Net Present Value and Net Advantage of Leasing:
 The direct cash flow consequences are:
1. The purchase price of the asset is avoided.
2. The depreciation tax shield Is lost.
3. The after tax lease rentals are paid.
 The net present value of these cash flows at after tax cost of debt should be calculated. If
it is positive, lease is beneficial.
Combination of Net Present Value of Investment and Net Advantage of Leasing:
Lease Benefits to Lessor and Lessee:
 A lease can benefit both when their tax rate differs.
 Leasing pays if the lessee’s marginal tax rate is less than that of the lessor. In fact in a
lease, the lessee sells his depreciation tax shield to the lessor.
 In the absence of taxes it is hard to believe that leasing would be advantageous if the
capital markets are reasonably well functioning.
 Gain of both is loss to the government in form of taxes.
Leasing Benefits Come from…
 Both, lessor and lessee, gain at government’s expense because of the difference in their
tax rates.
 The government gains from the tax on lease rentals while it loses on depreciation and
interest tax shields.
 The implicit principal payments in a lease rental are shielded by depreciation, while
interest deductions provide for implicit return on the lessee’s capital.
Internal Rate of Return Approach:
 IRR of a lease is that rate which makes NAL equal to zero.
1. Ao = Purchase Price.
2. L = Lease Rentals.
3. DEP = Depreciation
4. T = Tax Rate
5. OC = Operating Cost
6. SV = Salvage Value
DEPRECIATION TAX SHIELD AND SALVAGE VALUE UNDER INDIAN TAX LAWS:
 Once the firm sells an asset, it will know the salvage value on which it will lose the
depreciation tax shield.
 Thus, the lost depreciation tax shield on salvage value should be treated as safe cash
flows and it would be discounted at the after-tax cost of borrowing.
LEVERAGED LEASE
Hire Purchase–Conditions:
 The owner of the asset (the Hirer or the manufacturer) gives the possession of the asset to
the Hirer with an understanding that the Hirer will pay agreed instalments over a
specified period of time.
 The ownership of the asset will transfer to the hirer on the payment of all instalments.
 The Hirer will have the option of terminating the agreement any time before the transfer
of ownership of assets. ( Cancellable Lease)

Difference between Leasing and Hire Purchase Financing:

Instalment Sale:
 Instalment Sale is a credit sale and the legal ownership of the asset passes immediately to
the buyer as soon as the agreement is made between the buyer and the seller.
 Except for the timing of the transfer of ownership, instalment sale and hire purchase are
similar in nature.
Evaluation of Hire Purchase Financing:
 The hiree charges interest at a flat rate, and he requires the hirer to pay equal instalments
at each period.
 The sum-of-years-digit (SYD) method is the most commonly used methods for
calculating interest over a period of time.
Project Financing:
 Scheme of financing a particular economic unit in which a lender is satisfied in looking at
the cash flows and the earnings of that economic unit as a source of funds, from which a
loan can be repaid and to the assets of the economic unit as a collateral for the loan.
 It is different from the traditional form of financing, i.e., the corporate financing or the
balance sheet financing.
Balance sheet financing vs. Project financi

Characteristics:
1. Separate project entity
2. Leveraged financing
3. Cash flows separated
4. Collateral
5. Sponsor’s guarantees
6. Risk sharing
Project financing allows sponsors to:
 Finance projects larger than what the company’s credit and financial capability would
permit,
 Insulate the company’s balance sheet from the impact of the project,
 Use high degree of leverage to benefit the equity owners.
Financing Arrangements for Infrastructure Projects:
1. The Build Own Operate Transfer (BOOT) Structure.
2. The Build Own Operate (BOO) Structure.
3. The Build Lease Transfer (BLT) Structure.
Project Financing Risk and their Allocation:
 Risks
1. Project Completion Risk
2. Market Risk
3. Foreign Currency Risk
4. Inputs Supply Risk
 Risk Mitigation
 1. By Government
1. Country Risk
2. Sector Policy Risk
3. Commercial Risk
Financial Structure of Infrastructure Projects:
 Debt
 Bonds
 Equity
Appropriate Return to Equity and Financial Structure in Infrastructure Project Financing:
 Return on equity
 Risk measurement
 Impact of guarantees
 Financial structure
 Taxes
 Financial distress
 Government restrictions
VENTURE CAPITAL FINANCING

NOTION OF VENTURE CAPITAL:

 Venture capital (VC) is a significant financial innovation of the twentieth century.
 Venture capital is the investment of long-term equity finance where the venture capitalist
earns his return primarily in the form of capital gains.
 The underlying assumption is that the entrepreneur and the venture capitalist would act
together in the interest of the enterprise as ‘partners’.
Features of Venture Capital
 Equity Participation.
 Long-term Investments.
 Participation in Management.
Venture capitalist combines the qualities of bankers, stock market investors and entrepreneur in
one.

Stages in Venture Financing:

THE BUSINESS PLAN:
 The first step for a company (or an entrepreneur) proposing a new venture in obtaining
venture capital is to prepare a business plan for the consideration of a venture capitalist.
 The business plan should explain the nature of the proposed venture’s business, what it
wants to achieve and how it is going to do it.
 The length of the business plan depends on the particular circumstances.
 It should use simple language and all technical details should be explained without
jargons.
Essential Elements of a Business plan:
1. Executive summary
2. Background on the venture
3. The product or service
4. Market analysis
5. Marketing
6. Business operations
7. The management team
 8. Financial projections
9. Amount and use of finance required and exit opportunities
What does a Venture Capitalist Look for in a Venture?
 Superior businesses
 Quality and depth of management
 Corporate governance and structure
 Appropriate investment structure
 Exit plan
THE PROCESS OF VENTURE CAPITAL FINANCING
• Deal origination
• Screening
• Evaluation (due diligence)
• Deal structuring
• Post-investment activity
• Exit plan
Venture Capital Investment Process

Methods of Venture Financing:

 Equity
 Conditional Loan
 Income Note
 Other Financing Methods
1. Participating Debentures
2. Partially Convertible Debentures
3. Cumulative Convertible Preference Shares
 4. Deferred Shares
5. Convertible Loan Stock
6. Special Ordinary Shares
7. Preferred Ordinary Shares
Disinvestment Mechanisms:
 Buyback by Promoters
 Initial Public Offerings
 Secondary Stock Market
 Management Buyouts
DEVELOPMENT OF VENTURE CAPITAL IN INDIA
 The concept of venture capital was formally introduced in India in 1987, when the
government announced the creation of a venture fund, to be operated by the Industrial
Development Bank of India (IDBI).
 VCFs in India can be categorized into the following four groups:
1. VCFs promoted by the central (federal) government-controlled development
finance institutions
2. VCFs promoted by the central (federal) government-controlled development
finance institutions
3. VCFs promoted by the public sector banks
4. VCFs promoted by the foreign banks and private sector companies and financial
institutions
Future Prospects of Venture Financing:
 Rehabilitation of sick units.
 Assist small ancillary units to upgrade their technologies.
 Provide financial assistance to people coming out of universities etc.
 VCFs can play a significant role in the service sector including tourism, publishing,
health care, etc.
Success of Venture Capital:
 Entrepreneurial Tradition
 Unregulated Economic Environment
 Disinvestment Avenues
 Fiscal Incentives
 Broad Based Education
 Venture Capital Managers
 Promotion Efforts
 Institute Industry Linkage
 R&D Activities