INVESTMENT IN EQUITY

Prof. Raman Kumar

 What is equity?
• Corporations are businesses whose liability is limited for
owners.
• It means owners can not be asked money even if a
company gets bankrupt, provided they have paid full
money when purchasing shares.
• Owners in a company is called “Share Holders”.
• Equity refers to owners capital or share holders’ capital.
Share capital is part ownership in a company because total
capital of a company is divided into several parts.
• Share capital may be of following types:
(1) Preference share capital (also called Preferred Stock), or
(2) Equity share capital (also called Common Stock or
Ordinary Share). (For details see class notes).
 How to Invest in Equity?
• Investment in Equity is possible through
following means:
(1) Primary market,
(2) Secondary market,
(3) Mutual Funds,
(4) Index Fund

First two are collectively called ‘capital market’.

 Primary Market
• It is market where issuer of shares directly interact with investors.
• Companies issue (technically Selling) shares through a process called “Initial Public
Offering (IPO)”.
• Investors who desire to buy shares may apply in IPO.
• If total number of applications is more than the number of shares issued by company
then this situation is called “Over Subscription”.
• In this case shareholders may get shares in “Pro-Rata” allotment. Pro-rata means
Proportionate Allotment in certain ratio.
• Even in Pro-Rata allotment some shareholders may not get any share and their
advanced money is returned.
• Those who get shares under pro-rata , excess money paid by them is either adjusted for
any future payment or returned back.
• If total number of applications is less than the number of shares issued by company
then this situation is called “Under Subscription”.
• In this case all applicants get full shares that they applied.
 Secondary Market
• Any share issued through primary market can be traded
(means purchased and sold) in secondary market.
• Stock Exchange (SE) mainly comes under secondary market
for equity.
• Stock exchanges are organised exchanges governed
through law of the country.
• Such exchanges have physical presence.
• Only members (also called Brokers) can trade in stock
exchange.
• Membership of SE is available through a stringent process.
• Hence an average investor can trade in stock exchange only
indirectly through a member who charge some commission
and do the trade as instructed by the investor.
 Mutual Fund
• A Mutual Fund (MF) is a type of investment vehicle.
• Investors who can not analyse themselves which equity stock to be
traded can indirectly reach to equity through contribution in MF
Scheme.
• MF are managed by Professional Investment Managers.
• MF pools (collects) money from many people who desire to invest
and then collected money is invested in shares or other assets.
• Collected money is divided into several equal units in the same way
as share capital is divided into many shares and given to investors
according to money contributed by them.
• Annual income coming from the said investment is distributed to
investors of MF according to units held by them after deducting
management expenses.
• Risk in MF investment is same like shares but reduced due to
portfolio investment made by MF Managers.
• A MF scheme can either be Open Ended or Close Ended.
• An open ended MF can be purchased or sold anytime. It has
no maturity period.
• A close ended MF can only be purchased at the beginning
when fund was created and sold back only when its maturity
comes. Hence it has fixed maturity period.
• MF schemes are purchased and sold at the NAV ( Net Asset
Value)
• NAV is calculated by dividing “Total Value of Asset of MF” by
“Total Number of Units of MF Scheme”.
 Index Fund
• For understanding Index Fund Investment you have
to first understand Index of the Market.
• A separate material is being given on this topic. Go
through that.
• Index Fund are also MF Scheme, dedicated to invest
the money in shares included in the creation of the
Index of the Market in the same proportion or
weight.
(See Class Note for Example).
 What Investors Get in Equity?
• An investor in equity gets following as a re-
ward:
1. Dividend (Interim and Final),
2. Rights shares,
3. Bonus Shares,
4. Capital Gain
 Dividend
• Dividend is distribution of profit to shareholders.
• It can either be Interim Dividend or Final Dividend.
• Interim dividend is dividend given to shareholders before the
end of accounting year.
• Final dividend is given after the end of accounting year.
• Dividends are not at a fixed rate. It varies according to the
profit earned by company.
• Decision of dividend is taken by board of directors and has to
be approved by Shareholders’ general meeting.
 Rights Shares
• Rights shares or simply Rights are shares issued by a company after the
first issue of shares. It means any share issued by the company after the
first issue in its life are Rights Shares.
• These shares are first offered to existing shareholders of the company.
• These shares are offered for purchase at a price lower than the market
price.
• If a shareholder does not want to buy these shares, he may ask his family
or friends or any one to buy them if they like so.
• Rights offered to shareholders is in some ratio of their present holding of
shares. For example: If a company is offering rights in the ratio of 5:1 and
Mr.Z presently holds 4000 equity shares of that company. It means Mr.Z
will get offer of 4000/5*1=800 Shares.
• Rights not taken by existing shareholders is issued by company to general
public.
 Bonus Shares
• Bonus Shares are shares given to existing equity
shareholders free of any cost.
• When a company has big amount of Reserves and
Surplus lying in its Balance Sheet, it may distribute Bonus
Shares to existing shareholders by capitalising the
Reserves and Surplus.
• Capitalization of Reserves and Surplus mean transferring
the amount of money to Equity Share capital from
Reserves and Surplus equal to the value of Bonus shares.
• Bonus shares are also distributed in fixed ratio just like
Rights.
 Capital Gains
• Capital Gain is profit earned when shares are
sold by shareholders. In case of Loss on sale it
is called “Capital Loss”
• Capital Gain is taxable just like dividend is
taxed.
• In some countries tax rate of capital gain is
lower than the general rate of tax.
 Valuation of Equity
• Theoretical value of share can be calculated by
getting present value of future cash flows in the form
of dividend and capital gain.
• Some authorities consider “Free Cash Flows” of the
future for getting Present Value.
• Taken discount rate is Cost of Equity.
• Since dividend of equity is not fixed hence valuation
becomes difficult.
• However some valuation models have been
considered for valuation.
• They are:
A. When Dividend Rate is Constant:
1. Single Period Valuation Model (When shareholder wants to keep share
for one year only):
PV = D1/(1+Ke)+P1/(1+Ke)
Here,
D1 = Dividend to be received at the end of the year 1.
P1 = Market price of share at the end of the year 1.
Ke = Cost of Equity
Note: This formula can be extended if shareholder want to keep shares for
more than one year.
2. Multi Period Valuation Model (When shareholder do
not intend to sale share in near future):
PV = D/Ke
B. When Dividend Rate has a Growth:
PV = D1/(Ke-g)
Here,
g = Fixed Growth Rate in Dividend.
Assumption: Ke>g
NOTE: Preference Shares are valued like Bonds.
• END……..