4.11 Stocks and Shares:

Introduction:

A legal entity is required to be established to carry out activities like :

Manufacturing of Products such as: food products, TVs, Refrigerators, Soaps and detergents…

Sale of goods such as: Cycles, Bikes, Cars

Providing of services such as: courier services, computer services, banks . . .

In order to start a commercial activity what do we need?

1. Name for the company which carries the activity

2. People who can invest money in the company

3. Money

As per the Indian Companies act of 1956, it is necessary to register the company in India, before it commences its operations. After registration, the commercial activity can take place in the name of the company.

How do companies get the money?

Will any one give money unless the people who established the organisation put their money first in the company?

Unless the people who start the organisation (called Promoters)   invest money, no financial organisation including Banks will provide money. Later, one can ask friends and relatives and general public to invest money in the organisation.

People who put their money in the company are called shareholders (Owners) of the company.

With this introduction let us define some terms

‘Joint stock company’ is a business organisation (company) formed under the Indian companies act 1956.   After this the company needs to follow guidelines rules of Indian Income tax and other company rules.

‘Share capital’ is the amount put in by promoters, public to help the company to start and operate the business. This consists of money invested by promoters, friends and public.

Share capital can vary from few Lakhs to few Crores.

The share capital is divided in to number of equal parts each having a fixed value called face value. Each of this is called a share. The people who invest money in the company  and have share are called share holders.

If  the share capital of a company is Rs 1,00,000. It can be divided in to

·         1,00,000 shares of each face value of Rs. 1(1,00,000 = 1,00,000*1)

·         20,000 shares of each face value of Rs. 5(1,00,000 = 20,000*5)

·         10,000 shares of each face value of Rs. 10(1,00,000 = 10,000*10)

·         1000 shares of each face value of Rs 100(1,00,000 = 1,000*100)

Whichever way the shares are split we notice that

Share capital = Number of shares * Face value of each share

Since company is not like bank, what do share holders get from the company on the investment made by them?

They do not get any financial benefit till the company makes profit. Once the company starts making profit, the share holders get part of the profit in proportion to the investment (Number of shares) made by them. The profit sharing among investors is distributed by way of  ‘dividend’. It is paid as % on the face value of the share.  Unlike a fixed interest % in the case of fixed deposits with Banks and Post offices, there is no limit on the dividend %.  There are examples of companies declaring dividend in excess of 500%.This is possible when good companies make huge profits.  Similarly there are companies who may not declare dividend for years together (10, 20 years).In such cases investors do not get any return on their investment.

Category of share holders

1. ‘Preference share holders’.

These types of share holders get dividend at a fixed rate (not more) when company makes profit, before dividend is paid to other category (‘Equity share holders’) of share holders. In case of company closing down, preference share holders get their capital (the amount of money they invested in the company) first before other category of share holders get their investment back

2. ‘Equity share holders’

a) These types of share holders get dividend only after divided is paid to Preference share holders. The dividend % is not fixed nor it has a limit .When the company is closed down, their investment amount in the company is returned last after repayment to preference share holders.

(We can say that they get high returns (good dividend) on their investment by taking a small risk (Lose money on closure of company)

1.  Some times companies call for application (Public offerings) asking investors to invest in their companies. In response to that, public make applications to become share holders of the companies

2.  The shares could be bought from existing share holders. In such cases, the shares are sold and bought through ‘middlemen’. These middlemen are called ‘share brokers’. They charge certain % as commission (‘brokerage’) from both sellers and buyers as service charges on the value of the sale/purchase.

‘Stock exchange’ is a registered organization through which shares are bought and sold. Bombay Stock Exchange (BSE) and National Stock Exchange (NSE) are two examples.The shares of good companies are always listed(registered) with a recognized Stock Exchange. We have learnt that each share has a face value. If the company is doing very well then there will be people who would like to be share holders of that company so that they can get good dividends. In case of such companies there are few people who would like to sell their shares, but there are many people who want to buy these shares. Since demand is more than the supply, people who want to sell, will ask much more price than the face value.  This is called ‘market price’. This price is determined by sellers and buyers on a particular day and hence changes from day to day.  When the company is doing well, normally its market price is more than its face value (In such cases we pay ‘premium’  over and above its face value. If a company is not doing good and is making losses for several years its market price is normally less than its face value (Market value is at ‘discount’)

Number of shares bought = Investment/(Market value of one share)

Examples:

Though the face value of State Bank Of India’ s  share is Rs  5 there are days when it’s market price was in the range of 100 to 600Rs.

Similarly we have case of ‘Infosys Ltd’ whose market price was in the range of  2000 to 3000 when the share’s face value was Rs 5.

The market conditions, growth prospects of the company and economic conditions of the country together determine the market value of share of any company.

Note : Since the market price of a  company’s share does not remain same, people earn/lose money depending upon fluctuations in the market

(If the market price goes up, investors make money; if it goes down they lose money)

Debenentures

When companies need money for their growth/expansion they can borrow money from Banks as loan. On the loan they pay interest to Banks. Alternatively, Companies can also borrow money from public by issuing what is called debenture certificates. The value of each debenture certificate is normally in multiples of  Rs 1000.Companies pay interest at a fixed rate to holders of debentures on this value . The company returns the debenture amount at the end of a fixed period (for ex. 5 years, 10 years…)

This way of borrowing is advantageous to the company as  normally they get money  at lesser interest rate compared what banks charge to them on loans. It is beneficial to public also as public get higher interest rate than what they may get from Banks. This way Companies can avoid banks acting as ‘middleman’ between depositors.  If the company closes down the debenture holder may lose their money. Like shares, debentures also can be bought through Stock Exchanges through share brokers. Like shares, debentures also have market value.

4.11 Problem 1: Ram purchases 200 shares of a company of Rs, 25 each at Rs 5 premium. The company declares a dividend of 8%. Find out the amount invested and the dividend received by Ram and also find out the rate of return

Return % is defined as

(Income/Investment)*100

Solution :÷

Face value of 1 share = Rs 25

Premium for 1 share = Rs 5

Total value of 1 share paid by Ram= Rs 30(=25+5)

Total cost of 200 shares (Ram’s Investment) = No of shares* cost of one share = 200*30 = Rs 6000

Dividend rate per share = 8%

Dividend amount per one share of face value of Rs 25 = 25*8/100 = Rs 2(Note dividend is always paid on the Face value and not on the market value)

Dividend on 200 shares = Number of shares * dividend per one share=200*2 = Rs 400

Return % = (Income/Investment)*100

= (400/6000)*100 = 6.67%

Note that though the company declared dividend of 8% Ram got a return of only 6.67%

(Why? : Because for a share of Rs 25, Ram paid Rs 30 a premium of Rs 5 extra)

4.11 Problem 2:  Share capital of a company is Rs 3, 00,000 divided in to 3000 shares. At the end of a year the company distributes Rs 56,000 as dividend to all its share holders. How much a share holder will receive as dividend if he holds 36 shares?

Solution :

Face value of one share = ==100

Dividend per share = = =18.667

Dividend on 36 shares = 36*Dividend  per share = 36*18.667 = Rs 672

4.11 Summary of learning

 No Points learnt 1 Share capital, Preference shares, equity shares, Stock exchanges, Market price, dividend, debentures