NISM Series IIA Study Notes — Chapter 1: Introduction to Securities

1. Core Framework of Corporate Capitalization

The Evolution of Business Funding

In the corporate lifecycle, businesses are typically initiated and created by promoters. These promoters bring in the initial funds required to establish, nurture, and support the business in its early stages. As the business expands and grows larger, the requirement for additional funds increases. This growing need for capital is met by inviting financial contributions from outsiders who are not related to the promoters.

Classification Matrix of Capital

The capital used to run a business is primarily classified based on four key dimensions:

• Contributors of Capital: Capital can be categorised by who provides the funds. Funds brought in by the promoters and owners of the business constitute equity capital. This capital can be introduced at the very start of the business or at a subsequent date as the business expands. Equity capital can also be contributed by external investors who have no relationship with the promoters.
• Time Period / Tenor: The duration for which capital is provided varies significantly. Equity capital is perpetual and cannot be taken out of the firm unless the company is liquidated. Conversely, debt capital is raised for a temporary, pre-defined period, after which the principal must be repaid by the company.
• Cost of Capital: A business must pay a price for utilizing either equity or debt capital. This cost can be fixed at the time the money is brought in, creating a binding obligation. Debt instruments typically pay periodic interest at a pre-determined rate.
• Rights of the Contributors: Different types of capital confer specific rights and obligations upon the contributors. For instance, equity investors enjoy rights such as company ownership, voting rights, and the right to share in the residual profits of the company.

Comparison of Equity and Debt Capital

2. Comprehensive Analysis of Equity Capital

Key Structural Features of Equity

Equity capital is the fundamental risk capital of a company. It features several distinct legal and financial attributes:

Limited Liability

Equity capital is issued with limited liability. This means that if the business's creditors are unable to recover their outstanding dues from the company, the equity shareholders cannot be asked to pay up or use their personal assets to cover the shortfall.

Face Value

The total equity capital required by a company is divided into smaller units of equal denomination called the face value or par value of the equity shares.

Authorized Capital

The maximum limit of equity capital that a company is legally permitted to have is defined in its Memorandum of Association (MOA). This maximum limit is known as the authorized capital of the company.

Issued Capital

A company does not need to issue all of its authorized capital at once. It may issue a portion of its authorized capital as and when it requires funds. This capital can be issued to promoters, the general public, or specified private investors. The portion of authorized capital that has been allocated to investors is called the issued capital.

Paid-up Capital

When investors subscribe to the capital issued by a company, they are not always required to pay the entire price immediately. The company may call for payment in tranches (installments):

1. Application Money: Paid at the time of applying for the shares.
2. Allotment Money: Paid when the shares are formally allotted to the investor.
3. Call Money: Paid subsequently in installments as demanded by the company.

The total amount actually paid by the investors against the issued capital is known as the paid-up capital.

Ownership Rights and Liquidity

Ownership Proportion

Equity represents the actual ownership of the company. Equity shareholders are part-owners, and the exact extent of their ownership is defined by the proportion of shares they hold in the company's issued capital.

This relationship can be represented by the following formula:

Ownership Proportion = (Number of Shares Held by Investor / Total Issued Capital) * 100

Liquidity and Return Mechanics

Equity shares are initially issued by the company to investors. Subsequently, these shares are listed on a stock exchange, providing secondary market liquidity.

On the stock exchange, shares can be freely transferred from one investor to another. Because these transactions occur directly between existing shareholders, they do not result in any change to the capital structure or total capital of the company.

Equity capital is held for perpetuity and does not have a redemption or maturity date.

3. Comprehensive Analysis of Debt Capital

Key Characteristics of Debt Instruments

Debt capital refers to the structured borrowings of a company. Unlike equity investors, those who contribute debt capital are lenders or creditors of the company, not owners.

The primary characteristics of debt capital include:

• Debt Instruments: Debt is raised by companies through the issuance of various debt securities such as debentures, bonds, and commercial paper to lenders.
• Fixed Tenor: Debt is raised for a fixed, pre-determined period. Upon reaching the end of this period (the maturity date), the borrowed principal amount must be fully repaid by the company. The specific borrowing period varies depending on the funding needs of the company.
• Security and Charge on Assets: Lending can be secured or unsecured. In a secured debt structure, lenders have a legal claim or right against the assets of the company. If the company fails to pay the periodic interest or return the principal amount borrowed, the lenders can exercise their rights against these assets. In unsecured lending, no such asset-backed rights exist.
• Listing and Secondary Market Trading: Debt instruments may be listed on a stock exchange. Listing allows investors to buy or sell these instruments in the secondary market, providing liquidity prior to maturity.
• Structured Cash Flows: Debt instruments provide a pre-defined income stream to investors at specific, pre-determined intervals (known as interest or coupon payments) along with the repayment of the principal (redemption proceeds) upon maturity.

4. Hybrid Capital Structures: Bridging Equity and Debt

Companies often raise capital using hybrid instruments, which combine the characteristics of both debt and equity capital. The two most prominent hybrid structures are convertible debentures and preference shares.

Convertible Debentures

Convertible debentures function as a debt instrument in their initial phase but contain an option to convert into equity shares at a future date.

• Dual Nature: They pay a periodic coupon interest to the investor, exactly like a standard debt instrument, until the pre-specified conversion date.
• Conversion Terms: The exact terms of the conversion are explicitly defined at the time of the debenture's issue. These terms specify:
  1. The exact number of equity shares that each debenture will be converted into.
  2. The specific conversion price at which the transaction will occur.

Preference Shares

Preference shares occupy a unique space in a company's capital structure. While they are technically shares, they resemble debt instruments in several ways.

• Pre-determined Dividend: Preference shares offer a pre-determined, fixed rate of dividend, which resembles the fixed interest payments of a bond.
• Priority Status: Preference shares are given priority over ordinary equity shares on two occasions:
  1. Payment of Dividends: Preference dividends must be paid out of profits before any dividend can be distributed to ordinary equity shareholders.
  2. Repayment of Capital: If the company is wound up or liquidated, preference shareholders are repaid their capital before ordinary equity shareholders receive any residual assets.
• Key Differences from Debt:
  • Unlike debt, preference shares do not typically have a fixed maturity period.
  • Preference shareholders do not possess a charge or legal right over the assets of the company if the company defaults.
  • Dividends are paid to preference shareholders only if the company has generated sufficient profits. If there are no profits, the company is under no absolute obligation to pay a dividend for that period.
• Varying Rights: To balance these special benefits, certain rights enjoyed by ordinary equity investors, such as active voting rights on general company decisions, are typically not available to preference shareholders.

5. Glossary of Key Terms

• Promoter: The individual or group of individuals who conceive a business idea, bring in the initial risk capital, and nurture the company during its starting phases.
• Authorized Capital: The maximum limit of equity share capital that a company is authorized to issue, as registered in its Memorandum of Association (MOA).
• Issued Capital: The portion of authorized capital that the company offers to promoters, the public, or specific investors to meet its funding needs.
• Paid-up Capital: The actual amount of money paid by shareholders in response to the company's calls for capital.
• Perpetuity: A state of infinite duration; in finance, equity capital is considered perpetual because it cannot be redeemed or taken out of the company unless the firm is liquidated.
• Debentures: Long-term debt instruments issued by a company acknowledging its debt, which can be secured or unsecured, and may be convertible or non-convertible.
• Hybrid Instruments: Financial securities that integrate features of both debt (like fixed payouts) and equity (like ownership conversion or profit dependency).
• Memorandum of Association (MOA): The constitutional document of a company that defines its core purpose, operating limits, and authorized capital structure.

6. Exam-Focused Key Takeaways

• Perpetual vs. Temporary Capital: Equity capital is perpetual and can only be returned upon liquidation. Debt capital is temporary and must be repaid by the company after a fixed, pre-specified period.
• The Residual Claim of Equity: Equity shareholders are the ultimate risk-bearers. In the event of liquidation, their claims on the cash and assets of the company rank last, behind all creditors and preference shareholders.
• Dividend Yield Relationship: The dividend yield of a share is inversely related to its market price. If the market price of an equity share increases, its dividend yield decreases, and vice versa.
• No Capital Structure Impact in Secondary Market: Trading of listed shares on a stock exchange is a transaction between existing shareholders. This transfer of ownership does not alter the total capital structure of the issuing company.
• Preference Share Dividend Dependency: Unlike bond interest, which is an absolute obligation, preference dividends are paid only if the company has generated sufficient profits.