Chapter 3: Terminology In Equity And Debt Markets

Chapter 3: Terminology In Equity And Debt Markets – NISM-Series-XV Research Analyst Exam Study Notes Download PDF Book

Understanding Security Markets: Equity and Debt Instruments

Security markets enable investors to deploy surplus funds into investment instruments that are pre-defined, regulated, and typically liquid in secondary markets. These instruments are primarily categorised into two types: Equity and Debt. Equity capital is used indefinitely by a company, whereas debt capital is borrowed for a specific period. Equity investors are business owners and participate in its management without guaranteed returns, while debt investors are lenders with fixed returns and no management role.

Topic Pointers:

  1. Equity Securities:
    • Nature: Long-term capital available for indefinite use.
    • Returns: No fixed return or guarantee of principal return. Earnings depend on business performance.
    • Role in Business: Investors are owners and partake in management.
    • Risks and Rewards: High volatility, higher potential returns, benefit from residual profits.
  2. Debt Securities:
    • Nature: Short-term, borrowed capital with a set repayment time.
    • Returns: Fixed interest rate and principal repayment at maturity.
    • Role in Business: Investors are lenders without a management role.
    • Risks and Rewards: Lower risk, steady income, preference in claims over business assets but limited to fixed returns.
  3. Comparative Analysis:
    • Risk Profile: Equity is riskier but offers growth potential; Debt is safer with steady returns.
    • Return Potential: Equity can yield higher returns but is uncertain; Debt offers lower but stable returns.
    • Investor Preference: Choice depends on risk tolerance, investment horizon, and return expectations.
  4. Investment Strategies:
    • Diversification: Balancing between equity and debt based on individual financial goals and risk appetite.

Example: A business borrows funds at 12% interest and earns a 14% return on assets. Debt investors receive a fixed 12% return, whereas equity investors benefit from the additional 2% profit. Conversely, if returns fall below borrowing costs, equity investors bear the loss, illustrating the higher risk and reward nature of equity investment compared to debt.

What are Equity and Debt Securities

Security markets enable investors to invest surplus funds in pre-defined investment instruments issued under regulatory supervision. There are two types of securities – equity and debt. Equity represents ownership in a business, while debt represents lending to a business.

Topic Pointers:

  1. Equity Capital
    • Ownership capital, available as long as needed
    • No fixed returns, residual profits belong to equity investors
    • Higher potential returns but higher risk
    • Participate in management
  2. Debt Capital
    • Borrowed capital, needs to be returned after specified time
    • Earn fixed interest rate (coupons) and return of principal at maturity
    • Lower risk than equity
    • Do not participate in management
  3. Investor Choice
    • Debt – lower risk, stable but lower returns
    • Equity – higher risk, volatile but potential for higher returns
    • Investors allocate between debt and equity based on risk appetite, time horizon etc.

Example: If a business borrows at 12% and earns 14% return on assets, debt investors get 12% as promised and equity investors get the excess 2% returns. But equity investors also bear losses if returns are under 12%.

What is Face Value (FV)

The nominal price assigned to a share by the company is its face value. The equity capital is calculated by multiplying the total number of shares by the face value per share.

Topic Pointers:

Face Value and Share Capital

  • Face value is the nominal value assigned to each share
  • Share capital = Number of shares x Face value per share

Issuance of Shares

  • Shares may be issued to investors at face value or at a premium or discount to face value

Change in Face Value

  • Face value remains same unless company decides to split or consolidate shares
  • In a split, face value reduces and number of shares rise
  • In a consolidation, face value rises and number of shares fall

Importance of Face Value

  • Face value is used to calculate dividend amount
  • Dividend percentage is applied on the face value

Example: A company has 1 lakh shares with Rs 10 Face Value. Equity capital is 1 lakh x Rs 10 = Rs 10 lakhs. If it declares 30% dividend, dividend per share is 30% of Rs 10 Face Value i.e. Rs 3 per share.

What is Book Value

Book value is the net worth of a company, i.e. assets minus liabilities. Book value per share is calculated by dividing the net worth by total number of outstanding shares.

Topic Pointers:

Net Worth

  • Assets (at book value) minus Liabilities
  • Book value is the recorded value in books, may differ from market value

Book Value per share

  • Book Value / Number of outstanding shares

Significance

  • Theoretical value per share if company is liquidated
  • Depends on company’s ability to realise book value of assets to pay off liabilities

Example: A company has assets worth Rs 100 cr, liabilities of Rs 40 cr, and 20 lakh outstanding shares Net worth = Assets – Liabilities = Rs 100 cr – Rs 40cr = Rs 60 cr Book value per share = Net worth / No. of shares = Rs 60 cr / 20 lakh = Rs 30

So the book value per share is Rs 30. This is the theoretical value per share if it is liquidated by realising asset values.

What is Market Value

Market value is the current market price of a company’s share. Market capitalization is the market value of all outstanding shares and is calculated as market price per share * total outstanding shares.

Topic Pointers:

Market Price : Current price at which share trades in the market

Market Capitalization : Number of outstanding shares * Market price per share

What affects market price?

  • Expected future performance
  • Market sentiments
  • Liquidity
  • Demand/Supply

Example: A company has 50 lakh outstanding shares trading at Rs 100 per share. Market capitalization = 50 lakh x Rs 100 = Rs 500 crores

This means the market value of all its shares based on current market price is Rs 500 crores.

What is Replacement Value

Replacement value refers to the market value of all assets that an existing company owns, if a new company were to set up the same infrastructure and plants.

Topic Pointers:

  1. Replacement Value
    • Cost of setting up the same assets and infrastructure from scratch
    • Applicable to plant, property, and equipment
  2. Difference from Book Value
    • Book value: Historical cost less depreciation
    • Replacement value: Current market value of assets
  3. Significance
    • Indicates current worth of company’s assets
    • Useful for investors and analysts

Example: If a company has machinery that has a book value of Rs 50 lakhs (cost minus depreciation),. The current market value of similar new machinery is Rs 80 lakhs. The replacement value of the machinery is Rs 80 lakhs.”

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