What is Capital Market?

Capital markets commonly referred to as the stock markets have been in existence for centuries. The
British East India Company was the first company to invite the public to buy shares in the company.
Since then, over the years, markets have gone through tremendous changes. The way the market works,
the asset classes, the framework of the exchanges, and everything has been evolving over time. The
changes have been brought in gradually according to the convenience of the investors and market
participants. Also in order to prevent market participants to take undue advantage of the information in
order to gain monetary benefits, the Securities Regulatory bodies over the world have surveillance
methods for mitigation of such acts. If you wish to become an active participant in the markets, having
rudimentary knowledge is of critical importance.

Elearnmarkets today will tell you how the Indian Capital Market works. We will discuss the functions
of the stock market and who are the intermediaries. Then we will move on to the structure of the capital
markets in India and finally recognize the role of the Securities Exchange Board of India (SEBI) in our
stock market scenario.
Functions of Capital Market
While from a broader perspective, Capital Markets is viewed as a market of financial assets with long
or infinite maturity, it actually plays a very important role in mobilizing resources and allocating them
to productive channels. So it can be said that the process of economic growth of a country is facilitated
by the Capital Markets. The important functions and significance of the markets have been discussed
below: –

1. Economic Growth: Capital Markets help to accelerate the process of economic growth. It reflects
the general condition of the economy. The capital Market helps in the proper allocation of resources
from the people who have surplus capital to the people who are in need of capital. So, we can say that
it helps in the expansion of industry and trade of both public and private sectors leading to balanced
economic growth in the country.
2. Promotes Saving Habits: After the development of Capital Markets, the taxation system, and the
banking institutions provide facilities and provisions to the investors to save more. In the absence of
Capital Markets, they might have invested in unproductive assets like land or gold or might have
indulged in unnecessary spending.
3. Stable and Systematic Security prices: Apart from the mobilization of funds, Capital Markets help
to stabilize the prices of stocks. Reduction in speculative activities and providing capital to borrowers
at a lower interest rate help in the stabilization of the security prices.
4. Availability of Funds: Investments are made in Capital Markets on a continuous basis. Both the
buyers and sellers interact and trade their capital and assets through an online platform. Stock
Exchanges like NSE and BSE provide the platform for this and thus the transactions in the capital
market become easy.
Types of Capital Market:
The capital market is mainly categorized into:

▪ Primary Market: The primary market mainly deals with new securities that are issued in the
stock market for the first time. Thus it is also known as the new issue market. The main function
of the primary market is to facilitate the transfer of the newly issued shared from the companies
to the public. The main investors in this type of market are financial institutions, banks, HNIs,
etc.
▪ Secondary Market: It is the market where the trading of the securities actually takes place,
thus it is also referred to as the stock market. Here the buying and selling of securities take
place, The existing investors sell the securities and new investors by the securities.
“The stock market is the story of cycles and of the human behavior that is responsible for overreactions
in both directions.”- Seth Klarman
Structure of Capital Market
The capital market in India consists of the following structure:

Capital Market Instruments

There are mainly two types of instruments that are traded in the capital market, which are:
 1. Stocks: Stocks are sold and bought over a stock exchange, They represnt ownership in the
company and the buyer of the share is referred as the shareholder.
2. Bonds: The debt securities which are traded in the capital market are known as the bonds.
Companies issue bonds for in order to raise capital foe the expansion of the business and
growth.
Features of Capital Market:
Here are the features of the Capital Market:

1. Serves as a link between Savers and Investment Opportunities:

The capital market serves as a crucial link between the saving and investment process as it transfers
money from savers to entrepreneurial borrowers.

2. Long term Investment:

It helps the investors to invest their hard-earned money in long-term investments.

3. Helps in Capital formation:

The capital market offers opportunities for those investors who have a surplus amount of money and
want to park their money in some type of investment and also take the benefit of the power of
compounding.

4. Helps Intermediaries:
While transferring shares and money from one investor to another, it takes help from intermediaries
like brokers, banks, etc. thus helping them in conducting their business.

5. Rules and Regulations:

The capital markets operate under the regulation and rules of the Government thus making it a safe
place to trade.

Difference between Capital Market and Money Market

We have provided you the answer to this question in the table below:
Role of SEBI in Capital Market
The Securities Exchange Board of India (SEBI) regulates the functions of the Securities Market in
India. It was set up in 1988 but didn’t have any legal status until May 1992, when it was granted powers
to legally enforce its control over the financial market intermediaries. With the bloom of the scale of
actions in the financial markets, there were a lot of malpractices taking place. Practices like a false issue,
delay in delivery, violation of rules and regulations of stock exchanges are on a rise. In order to curb
these malpractices, the Govt. of India decided to set up a regulatory body known as the Securities
Exchange Board of India (SEBI).
The roles and objectives of SEBI are elaborate and have been described as below:
▪ Regulation of the activities of the stock market

▪ Protecting the rights of investors

▪ Ensuring the safety of the investments.

▪ To prevent malpractices and fraudulent activities.

▪ To develop a code of conduct for the intermediaries such as brokers, mutual fund sellers etc.

Recent Developments in the Indian Capital Market

The Indian Capital Markets have been going through various developments over the years and the most
significant of them have been listed below: –

1. New Measures of Risk Management: Investments in Capital Markets are exposed to various risks.
Though some are systematic risks, others happen as a result of unsystematic market activities.
▪ Measures to reduce Price Volatility: Volatility is the fluctuation of price movements. It is the
rate of up or down movement of the stock price. Volatility is regarded as a negative factor for
the markets as it represents uncertainty and risk. After the introduction of Index futures trading
in 2000, there was a relative reduction in the volatility of the prices.

▪ Circuit Breakers: Circuit breakers were introduced to reduce large sell-offs and panic selling.
Sometimes it is also called a “collar”. If an Index or a particular stock rises or falls a certain
percentage of 10%, 15% or 20%, trading is halted by the exchange in that stock or index for a
certain period of time to curb the panic and check for market manipulations.

2. Investor Awareness Campaign: To make the markets more secure for the investors, SEBI
introduced the Investor Awareness Campaign by making an official site for this.
3. Investigations: In case of any violation of the rules and regulations of the SEBI Act 1992, the
investigation is carried out by SEBI.
4. T + 2 Settlement Cycle: Currently in the Indian Capital market, the settlement cycle is in the “T+2”
cycle. Here, ‘T’ means the trading day, and the ‘T+2’ settlement means the settlement and delivery of
the shares takes place on the 2nd trading day after the trade takes place
5. Ban on Insider Trading: Individuals possessing confidential information of a particular company
can use the information to unethically profit from the stock markets. SEBI has made it clear and
mandatory to restrict all kinds of insider trading in the Indian Capital Markets.

Sources of Finance

Sources of finance for business are equity, debt, debentures, retained earnings, term loans, working
capital loans, letter of credit, euro issue, venture funding, etc. These sources of funds are used in
different situations. They are classified based on time period, ownership and control, and their source
of generation. It is ideal to evaluate each source of capital before opting for it.

Sources of capital are the most explorable area, especially for the entrepreneurs who are about to start
a new business. It is perhaps the most challenging part of all the efforts. There are various capital sources
we can classify on the basis of different parameters.
Table of Contents

1. Long-Term Sources of Finance

2. Medium Term Sources of Finance
3. Short Term Sources of Finance
4. Owned Capital
5. Borrowed Capital
6. Internal Sources
7. External Sources
Knowing that there are many alternatives to finance or capital a company can choose from. Choosing
the right source and the right mix of finance is a crucial challenge for every finance manager. Selecting
the right source of finance involves an in-depth analysis of each source of fund. For analyzing and
comparing the sources, it needs an understanding of all the characteristics of the financing sources.
There are many characteristics on the basis of which sources of finance are classified.

On the basis of a time period, sources are classified as long-term, medium-term, and short-term.
Ownership and control classify sources of finance into owned and borrowed capital. Internal sources
and external sources are the two sources of generation of capital. All the sources have different
characteristics to suit different types of requirements. Let’s understand them in a bit of depth.
According to Time Period

Sources of financing a business are classified based on the time period for which the money is required.
The time period is commonly classified into the following three:

LONG TERM SOURCES OF MEDIUM TERM SOURCES SHORT TERM SOURCES

FINANCE / FUNDS OF FINANCE / FUNDS OF FINANCE / FUNDS

Preference Capital or Preference

Share Capital or Equity Shares Trade Credit
Shares

Preference Capital or Preference

Debenture / Bonds Factoring Services
Shares
 Retained Earnings or Internal
Lease Finance Bill Discounting etc.
Accruals

Advances received from

Debenture / Bonds Hire Purchase Finance
customers

Term Loans from Financial Medium Term Loans from Short Term Loans like
Institutes, Government, and Financial Institutes, Government, Working Capital Loans from
Commercial Banks and Commercial Banks Commercial Banks

Venture Funding Fixed Deposits (<1 Year)

Asset Securitization Receivables and Payables

International Financing by way of

Euro Issues, Euro Equity, Foreign
Currency Loans, ADR, GDR etc.

Long-Term Sources of Finance

Long-term financing means capital requirements for a period of more than 5 years to 10, 15, 20 years
or maybe more depending on other factors. Capital expenditures in fixed assets like plant and
machinery, land and building, etc of business are funded using long-term sources of finance. Part of
working capital which permanently stays with the business is also financed with long-term sources of
funds. Long-term financing sources can be in the form of any of them:

• Share Capital or Equity Shares

• Preference Capital or Preference Shares
• Retained Earnings or Internal Accruals
• Debenture / Bonds
• Term Loans from Financial Institutes, Government, and Commercial Banks
• Venture Funding
• Asset Securitization
 • International Financing by way of Euro Issue, Foreign Currency Loans, ADR, GDR,
etc.
Medium Term Sources of Finance

Medium term financing means financing for a period of 3 to 5 years and is used generally for two
reasons. One, when long-term capital is not available for the time being and second when deferred
revenue expenditures like advertisements are made which are to be written off over a period of 3 to 5
years. Medium term financing sources can in the form of one of them:

• Preference Capital or Preference Shares

• Debenture / Bonds
• Medium Term Loans from
• Financial Institutes
• Government, and
• Commercial Banks
• Medium Term Note
• Lease Finance
• Hire Purchase Finance
Short Term Sources of Finance

Short term financing means financing for a period of less than 1 year. The need for short-term finance
arises to finance the current assets of a business like an inventory of raw material and finished goods,
debtors, minimum cash and bank balance etc. Short-term financing is also named as working capital
financing. Short term finances are available in the form of:

• Trade Credit
• Short Term Loans like Working Capital Loans from Commercial Banks
• Fixed Deposits for a period of 1 year or less
• Advances received from customers
• Creditors
• Payables
• Factoring Services
• Bill Discounting etc.
According to Ownership and Control:

Sources of finances are classified based on ownership and control over the business. These two
parameters are an important consideration while selecting a source of funds for the business. Whenever
we bring in capital, there are two types of costs – one is the interest and another is sharing ownership
and control. Some entrepreneurs may not like to dilute their ownership rights in the business and others
may believe in sharing the risk.

OWNED CAPITAL BORROWED CAPITAL

Equity Financial institutions,

Preference Commercial banks or

Retained Earnings The general public in case of debentures.

Convertible Debentures

Venture Fund or Private Equity

Owned Capital

Owned capital also refers to equity. It is sourced from promoters of the company or from the general
public by issuing new equity shares. Promoters start the business by bringing in the required money for
a startup. Following are the sources of Owned Capital:

• Equity
• Preference
• Retained Earnings
• Convertible Debentures
• Venture Fund or Private Equity
Further, when the business grows and internal accruals like profits of the company are not enough to
satisfy financing requirements, the promoters have a choice of selecting ownership capital or non-
ownership capital. This decision is up to the promoters. Still, to discuss, certain advantages of equity
capital are as follows:
 • It is a long-term capital which means it stays permanently with the business.
• There is no burden of paying interest or installments like borrowed capital. So, the risk
of bankruptcy also reduces. Businesses in infancy stages prefer equity for this reason.
Borrowed Capital

Borrowed or debt capital is the finance arranged from outside sources. These sources of debt
financing include the following:

• Financial institutions,
• Commercial banks or
• The general public in case of debentures
In this type of capital, the borrower has a charge on the assets of the business which means the company
will pay the borrower by selling the assets in case of liquidation. Another feature of the borrowed fund
is a regular payment of fixed interest and repayment of capital. Certain advantages of borrowing are as
follows:

• There is no dilution in ownership and control of the business.

• The cost of borrowed funds is low since it is a deductible expense for taxation purpose
which ends up saving on taxes for the company.
• It gives the business the benefit of leverage.
ACCORDING TO SOURCE OF GENERATION:

Based on the source of generation, the following are the internal and external sources of finance:

INTERNAL SOURCES EXTERNAL SOURCES

Retained profits Equity

Reduction or controlling of working capital Debt or Debt from Banks

All others except mentioned in Internal

Sale of assets etc.
Sources
Internal Sources

The internal source of capital is the one which is generated internally by the business. These are as
follows:

• Retained profits
• Reduction or controlling of working capital
• Sale of assets etc.
The internal source of funds has the same characteristics of owned capital. The best part of the internal
sourcing of capital is that the business grows by itself and does not depend on outside parties.
Disadvantages of both equity and debt are not present in this form of financing. Neither ownership
dilutes nor fixed obligation/bankruptcy risk arises.

External Sources

An external source of finance is the capital generated from outside the business. Apart from the internal
sources of funds, all the sources are external sources.

Deciding the right source of funds is a crucial business decision taken by top-level finance managers.
The usage of the wrong source increases the cost of funds which in turn would have a direct impact on
the feasibility of the project under concern. Improper match of the type of capital with business
requirements may go against the smooth functioning of the business. For instance, if fixed assets, which
derive benefits after 2 years, are financed through short-term finances will create cash flow mismatch
after one year and the manager will again have to look for finances and pay the fee for raising capital
again.

What are Debentures?

The word debenture is derived from the Latin word ‘debere’, which means to borrow or take a loan. It
is a debt instrument that may or may not be secured by any collateral. Governments or companies use
them for raising capital by borrowing money from the public. In simple words, it is a legal certificate
that says how much the investor has invested (principal amount), the interest to be paid and the schedule
of payments. The investor receives the principal and interest at the end of maturity.
They are like unsecured loans where the investor has no claim to the company assets if a default occurs.
The repayment solely depends on the company creditworthiness of the issuing company. However,
before paying stock dividends to its shareholders, the issuing company will fix the debt interest
payments. Sometimes, companies also issue them with security, i.e. they have an asset as a mortgage.
In liquidation, the company has to preferably pay the creditors by liquidating their assets. Therefore,
investors can check the credit ratings of these instruments before investing in them.
When companies have pledged all their assets as collateral elsewhere, they can rely on debentures to
raise capital. This is because they have a longer holding period and lower interest rates. Thus, they can
be more attractive than other types of long term financing.
What are the Features of a Debenture?
The following are the key features of debenture –
Promise
It is a written promise by the issuing company that owes the specified money to the holder.
Face Value
The face value of debenture is generally the high denomination of Rs.100 or in the multiples of Rs.100
Time of Repayment
It is a debt instrument that the company issues with a maturity date mentioned in the certificate.
Basically, it provides the time of repayment of the principal amount and interest on the maturity date.
Interest rate
The holders receive a fixed rate of interest payment periodically, either half-yearly or annually. The rate
of interest of this instrument varies depending on the company, the current market conditions and the
nature of business operations.
Assurance of repayment
As per the deed, this long term debt instrument carries an assurance of repayment on the specified due
date. Also, they can be redeemed at par, premium or discount.
Parties to Debenture
Company – is the entity that borrows money.
Trustee – is the party through which the company deals with the holders. The company creates an
agreement between trustees and holders known as ‘Trust Deed’. This deed consists of company
obligations, rights of holders, etc.
Debenture Holders – are individuals or parties that provide loans to the company and receive a
‘debenture certificate’ as evidence of participation.
No Voting Rights
The holders are the creditors of the company, and they have no voting rights in the general meetings of
the company until the company asks for their opinion in exceptional circumstances.
Listing
It needs to be listed with at least one stock exchange.
What are the Types of a Debenture?
A company has the authority to issue different types of debentures that depend on their objectives and
requirements. The following are the types of debentures –
Convertible Debenture
Convertible debentures are where the holders have the right to convert their debenture holdings into
equity shares of the company. The company specifies the details about the rights of holders, trigger date
of conversion, conversion date and other terms and conditions at the time of issue. They are further
classified as –
Partly Convertible Debentures
The issuing company can partly convert them into equity shares. The company decides the conversion
ratio and the date of conversion when issuing the instrument. The holders enjoy the rights of both
creditors and shareholders of the company.
Fully Convertible Debentures
The issuing company can fully convert them into equity shares. The conversion rate and the time of
conversion are decided while issuing the instrument. Upon conversion, the holders enjoy the same status
as the company shareholders.
Optionally Convertible Debentures
The holder has an option to convert their debt into equity shares or not at a price decided by the issuing
company at the time of issue.
Non Convertible Debentures
Non Convertible Debentures are the regular debt instrument that does not allow holders to convert their
debt into equity. The interest rate is usually higher for such instruments than their regular counterparts.
Thus, these instruments retain their debt character.