Introduction to Securities – Equity Capital | Debt Capital

The introduction to securities, particularly focusing on equity capital and debt capital, involves understanding these two fundamental types of financial instruments used by companies to raise capital for their operations and growth. Both equity and debt capital are crucial in the financial markets, providing different risk and return profiles. Companies typically use a mix of both to optimize their capital structure, manage risks, and support their growth and investment strategies.

Table of Contents

1. Introduction to Equity and Debt
2. Features of Equity Capital and Benefits to Equity Investors
3. Features of Debt Capital and Benefits to Debt Investors
4. Hybrid Structures

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1. Introduction to Equity and Debt

A firm that requires money to conduct its operations can fund its requirements through:

• Contribution by owners (either in form of loan or equity)
• Contribution from outsiders (either in form of loan or equity)

Businesses are typically created by promoters, who bring in the initial funds, to start and nurture a business. Later as the business grows in size, the need for money can be met by additional funds brought in by the owner(s) or contributions from outsiders (public). Similarly, an investor has a choice of owning a business by contributing to equity capital or lending to a business as debt capital.

Capital used in running a business can be primarily classified based on:

• The contributors of funds
• The period for which money is contributed
• The cost of the funds to the firm
• The rights that accrue to the contributors of the funds

1.1 Contributors

Fund brought in by promoters and owners of the business is called equity capital. Equity capital can be brought in at the start of a business or at a later date as the business grows. Equity capital also can be contributed by outside investors. To enable such contribution, the business offers equity shares to outside investors, who become shareholders.

Funds brought in as loan is called debt capital. Those who contribute debt capital are called as lenders to the business. Lenders can be individuals or institutions including banks. To enable such lending, a business issues debt instruments to investors, or obtains term loans by mortgaging the assets of the company.

1.2 Time Period

The period for which capital is brought in may vary. Equity capital cannot be taken out of the firm unless the firm is liquidated. Such capital is for perpetuity.

Debt has to be repaid by the company after a certain period. The period of repayment may be short-term (less than one year) or long-term (more than one year and may go up to even 30 years or more) and is decided at the time such funds are brought in.

1.3 Cost of Capital

The business has to pay a price for using equity or debt capital. The cost may be fixed at the time the money is brought in and may constitute an obligation for the company. Debt instruments usually pay a periodic interest. The rate of interest may be pre-determined or the method by which the rate will be determined, as in the case of floating rate bonds and inflation indexed bonds, will be described upfront.

The cost of capital may vary depending on the earnings of the company, as is the case with equity capital.

Both debt capital and equity are reflected in the liability side of the balance sheet indicating “source of funds”. A company must carefully decide the mix of debt and equity to be used in the business.

1.4 Rights of the Contributors

The contributors of capital enjoy certain rights and obligations depending upon the type of capital that they have brought in. Equity investors enjoy rights such as ownership and voting rights and rights to share the profits of the company. Debt investors have the right to receive periodic interest and return of the capital on the expiry of the fixed period. The contributors of debt capital may have their rights secured against the assets of the company.

2. Features of Equity Capital and Benefits to Equity Investors

Those who contribute equity capital to the company, buy equity shares, when they are issued by the company. They are called equity shareholders of the company.
Limited Liability

Equity capital is issued with limited liability. This means, if the creditors to a business are not able to recover their dues, equity shareholders will not be asked to pay up. The liability of equity shareholders in a company is limited to their contribution made to its equity capital, or on any amount unpaid which they have agreed to pay.

2.1 Ownership Rights

Equity represents ownership of the company. Equity shareholders are owners of the company in portion of the shares held.

For example, if a company has an issued capital of Rs. 10 crore made up of 1 crore shares of Rs. 10 each, and an investor owns 10 lakh equity shares, such investor owns 10 percent of the company.

Equity shareholders have the right to participate in the management of the company. They can do this through voting rights. Each equity share carries one vote. Major decisions of the company require resolutions to be passed, which have to be voted by a majority.

Equity capital entitles its contributors to participate in the residual profits of the company. After meeting all expenses and provisions, profit that remains in the books belongs to equity shareholders. This is generally distributed to the shareholders in the form of dividends.

2.2 Liquidity

Equity shares are first issued by a company to the public through a process called the Initial Public Offer (IPO). IPOs are made in primary market. The money raised in an IPO is used by the company for its business activities and reflected in the balance sheet of the company.

After IPO, the shares are listed on the stock exchanges, where they can be traded between one investor to another. This is called the secondary market. Such transactions are between existing shareholders, and therefore do not result in change in the capital structure of the company. Secondary market provides liquidity to the investors.

2.3 Perpetuity

Equity capital is for perpetuity. It cannot be redeemed and the company does not have an obligation to repay it. In special situations, a company may buy-back its own shares from the investors. Such shares shall be extinguished by the company.

2.4 Uncertain Pay-outs

Shareholders enjoy return in the form of dividends paid by the company and may also benefit by the appreciation in share price. The investors can book capital gains by selling his shares in secondary market at a price higher than the acquisition price. If share price goes down, this may result in capital loss. However, there is no guarantee of dividends or capital appreciation on equity capital. Thus, the returns from equity are uncertain.

3. Features of Debt Capital and Benefits to Debt Investors

Debt capital refers to the borrowings of a company. Those that contribute debt capital are lenders or creditors of the company. Debt capital implies regular return and security for the investor. For the company there is an obligation to make periodic interest payments and to repay the capital on maturity.

Debt is raised by companies either by issuing securities such as debentures, bonds and commercial papers to the lenders or by taking a loan from a bank or financial institution. The terms at which the borrowing is being made, are mentioned in the document (or certificate) that represents the debt.

Debt is raised by the company for a fixed period after which it has to be repaid. The period of borrowing will vary depending upon the need of the company. The interest rate or coupon rate of a bond/debenture depends on the risk of default associated with the company issuing such securities. Thus credit rating of the debt security by SEBI registered Credit Rating Agency forms an important factor while investing in such securities.

Debt securities/loans have differential rights such as secured or unsecured. A secured loan is one where lenders have a right against the assets of the company if the company fails to pay interest and/or return the principal amount borrowed. Unsecured loan is one where such rights do not exist. Debt instruments may be listed on a stock exchange.

A bond or debenture will be defined by:

• Face value
• Interest rate (also called coupon rate) and Frequency of interest payment
• Date of Maturity/Redemption
• Other Rights of Bondholders (secured/unsecured)

A loan from a Bank or Financial Institution will be defined by:

• Amount of the Loan
• Interest Rate and Frequency of Payment
• Nature of Loan (Term Loan, overdraft limit, bill discounting etc.)
• Repayment Conditions and Time Line (As Negotiated between Borrower and Lender)
• Other Rights of Lender (secured/unsecured).

4. Hybrid Structures

Companies may raise capital in a form that combines the features of both debt and equity. These are called hybrid instruments.

4.1 Convertible Debentures

Convertible debentures pay interest like any other debt instrument till the date of maturity. On maturity, the debt is converted into equity shares. The terms of conversion, such as the number of equity shares that each debenture will be converted into and the price at which the conversion will take place are mentioned at the time of the issue of the debt instrument.

They are beneficial to a company as there is no cash outflow on maturity. The lender is benefitted if the conversion is below the prevailing market price of the share.

4.2 Preference Shares

Preference shares resemble debt instruments because they offer pre-determined rate of dividend. However, they do not have a fixed maturity period or a right over the assets of the company. They have a preference in the payment of dividend over ordinary equity shares and in the return of capital, if the company is wound up.