Indian capital market

EXECUTIVE SUMMARY

The capital market is an important constituent of the financial system. It is a market for long-term funds both equity and debt and funds raised within and outside the country. The capital market aids economic growth by mobilizing the savings of the economic sectors and directing the same towards channels of productive uses. Capital market consist both primary market and secondary market.

Mangers raise fund from the capital market and investors invest their funds in the capital market. Capital market helps both manage their resources in a better way. Primary market is the market for long term funds where investors invest their funds whether it is debt or it is equity. Debt bears generally fixed rate of interest which has to be paid by the managers. It is believed that equity bears no cost but, it is a myth. Equity bears opportunity cost of capital owners have foregone to invest in the prospective firm. This is the heart of the corporate finance so, managers should always make decisions which maximize the wealth of shareholders

Managers can maximize the wealth of the shareholders either through paying dividends or appreciating the prices of shares in the market. Managers are faced with two of the strategic decisions of increasing the scale of operations or increasing the earnings in excess of expected returns.

So, here I have studied two fundamental factors scale and growth and its effects on the stock returns. I have used coefficient of correlation to measure the strength and association of these fundamental factors with stock returns.

Market Capitalization and Return on Net Worth (RONW) both have positive correlation with stock returns in almost all strata of BSE SENSEX, BSE MID CAP and BSE SMALL CAP. It is observed from the results of the analysis that market capitalization has stronger correlation in all observed cases of different firms but return on net worth has weak correlation in the cases of firms having large size i.e. market capitalization.

It is observed from the results of BSE MID CAP and BSE SMALL CAP that increase or decrease in market capitalization affect more strongly than it affects the returns of firms of BSE SENSEX. So, it is proved that firms having medium and small size are going to yield good returns if they expand and at the same time it is backed up by good return on net worth and its correlation with stock returns, that's the reason why such firms should focus over size only if they have growth potential.

INTRODUCTION

Successful, value driven organizations always aim at maximizing shareholder wealth. Mangers' quest for value helps them to achieve shareholder wealth only if, they make the right decisions at the right time. Shareholders' wealth could be maximized either through dividends they are paid or appreciation in the share prices they get over a period of time. Shareholders are paid dividends when the firm has been making profits and firm does not have the opportunity which can not earn in excess of expected market returns. If firm pay the dividends, shareholders get cash which can be invested in more profitable business. Thus, shareholders maximize their wealth. If firm doesn't give the dividends and invests in the profitable investment opportunities which has higher potential of providing returns in excess of market returns, is reflected in the share prices.

Organizations have to deal with what is significant for maximizing shareholder wealth. When it becomes the basic premise to maximize shareholder wealth, it is generally share prices which reflect the intrinsic value of the firm or value of the firm to shareholders. Share prices are affected through strong fundamental factors such as Payout ratio, dividend yield, capital structure, scale, earnings size of the firm and its growth.

If we see more or less all these factors are based on the decisions of scale or growth. If we see this in terms of share market, we can approximate market capitalization for the scale of operations and return on net worth for the growth potential. Furthermore, this can be significant to measure extent, and strength of both independent variables with approximate dependent variable share returns.

Organization which has created wealth for its shareholders has to incur low costs in terms of lower rate of expected returns while raising funds in the market, and it also has to provide good returns over time. So, it becomes very crucial to measure the correlation between scale and stock returns and growth and stock returns.

LITERATURE REVIEW

Share prices are also the most important indicator readily available to the investors for their decision to invest or not in a particular share. Theories suggest that share price changes is associated with changes in fundamental variables which are relevant for share valuation like Payout ratio, dividend yield, capital structure, earnings size of the firm and its growth,[Wilcox (1984), Rappoport (1986), Downs (1991)].

Share prices are also the most important indicator readily available to the investors for their decision to invest or not in a particular share. Theories suggest that share price changes is associated with changes in fundamental variables which are relevant for share valuation like Payout ratio, dividend yield, capital structure, earnings size of the firm and its growth,[Wilcox (1984), Rappoport (1986), Downs (1991)].

If we see, there is another relevant factor which affects the share prices is the capital structure of the firm. The level of debt financing by the firm has impact on the value of firm's assets. Hamada (1972) and Sharpe (1964) specify their theories regarding the capital structure. A high-risk firm (a firm with debt) must generate high return consistent with the investor's expected return. It follows that with higher debt firm should have greater rate of change in its share price. Hence capital structure (debt to asset ratio) changes must be directly related to the share price volatility. Modigliani and Miller (1958) emphasized that in competitive capital markets the value of a firm is independent of its financial structure. But if markets are imperfect (transaction cost, taxes, informational asymmetry, agency cost etc.) then capital structure matters and influences the share prices.

Size of a firm does have effect on the valuation of the firm assets. Smaller stocks have higher average returns. Introduction of size, as a multiplicative term to dividend, provides a significant improvement in the explanation of share prices (Karathanassis and Philiappas, 1988). The size of the firm if captured through total capital employed, is expected to influence the share prices positively as large firms are better diversified than small ones and thus are less risky (Benishy, 1961). Atiase (1985) showed that as the size of the firm increases, their share price volatility declines.

OBJECTIVE AND SCOPE OF THE STUDY

Companies, whether large or small, all over the world have one of the most common goals i.e. creating shareholder wealth. If it is not one of the prime goals, it must be one of the things in the agenda of all profit making organizations. If corporations want to defend against takeovers, it must create value for its shareholders. It will have to think over it in terms of how it can function in the best interest of owners i.e. shareholders. Shareholders' wealth is maximized when either the dividend is paid or share prices increase over the long period in the market.

Wealth for shareholders is created, if the management of the firm becomes successful in increasing long term value of the firm i.e. share prices. Senior executives have to make decisions which help them create value of the firm. Share prices are affected by many factors but two fundamental factors scale and growth have significant effect over share prices. Grand project on what matters to capital market whether is it scale or is it growth has some of the main objectives such as follows:

  1. To measure which factor out of scale and growth has greater association with share returns.
  2. To measure overall effect of scale and growth on the capital market.
  3. To check whether such factors could have implications for investment and corporate finance

RESEARCH METHODOLOGY

In this study, I have tried to assess correlation of two fundamental variables such as scale and growth with share returns over a long period. I have tried to understand whether this correlation is positive or negative. If it is positive how much correlation between these factors and share returns exist.

I have decided to assess average market of common stocks as proxy for scale and average annual return on owners' capital as proxy for growth.

RESEARCH DESIGN

I have used causal research as to find out correlation between size and share returns and earnings growth and share returns. Moreover, I will also attempt to analyze correlation of earnings growth with share returns under different average market of common stocks. Furthermore, this will be an attempt to assess the factor which will have significant effect over share returns.

RESEARCH DESIGN: CAUSAL RESEARCH

HYPOTHESIS

Share returns have positive correlation with scale i.e. average market of common stock.

Share returns have positive correlation with growth i.e. average returns on owners' capital.

SAMPLE DESIGN

Sampling Method: Stratified Random Sampling

Sampling Size: 45 Firms: BSE SENSEX (15), BSE MID CAP (15)

BSE SMALL CAP (15)

RESEARCH METHOD

In this study, I have tried to find out correlation between average market of common shares and average share returns and return on net worth and average share returns under different cases of market capitalization. Here, I have used correlation analysis to find out which factor out of scale and growth has better correlation with stock returns.

Whether market capitalization has a better correlation or return on net worth has better correlation with the stock returns? Correlation analysis is the statistical tool we can use to describe the degree to which one variable is linearly related to another. Statisticians have developed two measures for describing the correlation between two variables: the coefficient of determination and the coefficient of correlation.

COEFICIENT OF CORRRELATION

The coefficient of correlation is the primary way we can measure the extent, or strength, of the association that exists between two variables, X and Y. Here, coefficient of correlation is used to measure the extent and strength, of the association between some of the following variables.

Market capitalization (X) and its correlation with the stock returns (Y).

Return on net worth (X') and its correlation with the stock returns (Y")

Which of the two factors: market capitalization and returns on net worth has a better correlation with stock returns?

Coefficient of correlation should be used to measure degree of association between X and Y and between X' and Y'. We will measure the extent, and strength of association between market capitalization and stock returns as well as return on net worth and stock returns in the case of all sampled firms. To serve this purpose, I have collected data of 45 firms: 15 firms from each stratum such as BSE SENSEX, BSE MID CAP and BSE SMALL CAP for the period from April, 2001 to March, 2005. Thereafter the following equation has been used to measure the extent, and strength, of association among the factors for all individual firms.

Where, r = coefficient of correlation

a = Y-intercept

b = slope of the best-fitting estimating line

n = number of data points

X = values of the independent variable

Y = values of the dependent variable

Y = mean of the observed values of the dependent variable

WEIGHTED AVERAGE MEAN

If we want to measure the overall result under the sample of different strata, another statistical measure such as weighted average mean can help us to find out which of the two factors has stronger correlation with the stock returns under different strata of market capitalization such as BSE SENSEX, BSE MIDCAP and BSE SMALLCAP.

Where, C = coefficient of correlation of different firms

W = average market capitalization of a firm for the period of 5 years

EW = sum of all weights of different firms under one of the strata

EC*W = sum of products of correlation and average market capitalization of different firms

DATA COLLECTION

For the purpose of empirical research in this paper, I have collected data of 45 firms: 15 each from BSE SENSEX, BSE MID CAP and BSE SMALL CAP for the last 5 years.

  • Average annual market capitalization for the last 5 years.
  • Annual return on net worth for the last 5 years.
  • Average adjusted annualized return for the last 5 years.

Please be aware that the free essay that you were just reading was not written by us. This essay, and all of the others available to view on the website, were provided to us by students in exchange for services that we offer. This relationship helps our students to get an even better deal while also contributing to the biggest free essay resource in the UK!