Capital Market: Meaning, Functions & Instruments

While the money market satisfies working capital requirements for a few months, no industrial empire can be constructed on 90-day loans. Building semiconductor fabrication plants, laying optical fiber networks, and manufacturing automobiles require permanent and long-term capital lasting 5, 10, or 25 years. This is the domain of the Capital Market.

1. What is the Capital Market?

The Capital Market is the organized financial market that deals in long-term debt and equity securities with maturity periods exceeding one year. It channels medium- and long-term funds from household savers, institutional funds, and foreign investors into corporate enterprises, municipalities, and central governments.

Two Wings of the Capital Market

Primary Market (New Issue Market - NIM): Where companies, governments, or public sector bodies issue brand new securities to raise fresh capital (e.g., IPOs, rights issues).
Secondary Market (Stock Exchange): Where previously issued securities are continuously bought and sold among investors (e.g., trading on NSE and BSE).

2. Vital Functions of Capital Markets

┌────────────────────────────────────────────────────────────────────────┐
│                      FUNCTIONS OF CAPITAL MARKET                       │
├──────────────────────────┬─────────────────────────────────────────────┤
│ 1. Capital Formation     │ Pools small household savings across the    │
│                          │ nation to build giant industrial plants.    │
├──────────────────────────┼─────────────────────────────────────────────┤
│ 2. Continuous Liquidity  │ Allows an investor who bought shares years  │
│                          │ ago to cash out instantly on an exchange.   │
├──────────────────────────┼─────────────────────────────────────────────┤
│ 3. Price Discovery       │ Prices reflect corporate earnings, balance  │
│                          │ sheet health, and future growth prospects.  │
├──────────────────────────┼─────────────────────────────────────────────┤
│ 4. Allocation Efficiency │ Scarce capital naturally flows to dynamic,  │
│                          │ innovative, and well-managed enterprises.   │
├──────────────────────────┼─────────────────────────────────────────────┤
│ 5. Wealth Creation       │ Enables ordinary citizens to participate in │
│                          │ the prosperity of leading corporations.     │
└──────────────────────────┴─────────────────────────────────────────────┘

3. Major Capital Market Instruments

Capital market instruments represent either an ownership stake (equity) or a creditor relationship (debt).

1. Equity Shares (Ordinary Shares)

Nature: Represents fractional ownership in the company.
Voting Rights: Every equity shareholder holds voting rights proportional to their shareholding and participates in major corporate decisions at Annual General Meetings (AGMs).
Dividend: No guaranteed fixed dividend; payout depends on profits and board discretion.
Residual Claim: Equity holders are paid last in the event of company liquidation (highest risk, but unlimited upside potential through capital appreciation).

2. Preference Shares

Nature: Hybrid security carrying features of both equity and debt.
Preferential Rights:
1. Priority in Dividend: Paid a fixed rate of dividend before any dividend is paid to equity shareholders.
2. Priority in Capital Repayment: In the event of winding up, capital is returned to preference shareholders before equity shareholders.
Voting Rights: Generally do not have voting rights (unless their fixed dividends remain unpaid for 2 consecutive years or on matters directly affecting their rights).
Types of Preference Shares:
- Cumulative vs Non-Cumulative: Unpaid dividends accumulate and carry forward to future years or lapse.
- Participating vs Non-Participating: Entitled to share in surplus profits after equity dividend or limited to the fixed rate.
- Convertible vs Non-Convertible: Can be converted into equity shares after a fixed tenure.
- Redeemable vs Irredeemable: Companies in India can only issue redeemable preference shares (maximum period 20 years under Companies Act 2013).

3. Debentures & Bonds

Nature: A long-term debt instrument issued under the common seal of a company acknowledging a debt obligation.
Creditor Status: A debenture holder is a creditor of the company, not an owner.
Fixed Interest (Coupon): The company is legally bound to pay fixed interest regardless of whether it makes a profit or a loss.
Classification of Debentures:
- Secured (Mortgage) vs Unsecured (Naked): Backed by a charge on company assets or issued purely on company reputation.
- Convertible vs Non-Convertible (NCD): Can be converted into equity shares (Fully Convertible Debentures - FCD, or Partially Convertible Debentures - PCD).
- Zero-Coupon Bonds (Deep Discount Bonds): Sold at steep discount to face value with no periodic coupon; full face value paid at maturity.

4. Key Differences: Equity Shares vs Preference Shares vs Debentures

Feature	Equity Shares	Preference Shares	Debentures
Legal Status	Owners / Proprietors	Preferred Owners	Creditors / Lenders
Return	Fluctuating Dividend	Fixed Dividend Rate	Fixed Interest Rate (Coupon)
Payment Obligation	Discretionary (if profit exists)	Discretionary (before equity)	Mandatory charge against profits
Voting Rights	Full voting rights	No voting rights (normally)	No voting rights
Tax Deductibility	Paid from post-tax profits	Paid from post-tax profits	Interest is tax-deductible expense
Risk to Investor	Highest risk	Moderate risk	Lowest risk (especially if secured)
Repayment on Winding Up	Last priority (Residual claim)	Paid before equity	First priority before all shareholders

5. Modern International Capital Market Instruments

Indian multinational corporations also raise foreign capital using specialized global instruments:

American Depository Receipts (ADRs): Negotiable certificates issued by a US bank representing shares of an Indian company, traded on US stock exchanges like NYSE or NASDAQ (e.g., Infosys, HDFC Bank).
Global Depository Receipts (GDRs): Depository receipts traded on European exchanges such as London or Luxembourg.
Masala Bonds: Rupee-denominated bonds issued in overseas markets. Currency risk is borne by foreign investors rather than the Indian corporate issuer.
Foreign Currency Convertible Bonds (FCCBs): Bonds issued in foreign currency that can be converted into equity shares at a pre-agreed conversion price.

6. Summary for BBA Exams

Capital Market: Handles long-term capital (over 1 year) for capital expenditure, infrastructure, and expansions.
Equity Shares: Ownership, full voting rights, fluctuating dividends, residual claim, highest risk/return.
Preference Shares: Fixed dividend, priority on repayment, non-voting, redeemable within 20 years.
Debentures: Creditor instrument, guaranteed fixed interest (charge on profit, tax-deductible), secured or unsecured.
Global variants: ADRs (US markets), GDRs (European markets), and Masala Bonds (overseas rupee debt).

Capital Market: Meaning, Functions & Instruments | BBA DAVV Notes