How They Generate Economic Wealth

Published Date: 02 Nov 2017

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Introduction

When a company is established and incorporated, as a public company, the shares are offered to the applications for some money. This amount of money accumulated through the sale of shares forms the capital of the company. For the general understanding of the business in any economy, Capital is a very important determining factor of the business, because the initial investment for the view of earning profit, the initial capital, is too high and the risk is associated with it. As compared to the employment, the self employed or an entrepreneur in general, have to invest some amount, which is said capital, and it is the fate of the self employed that it may succeed or fail, whereas in the employment there is no risk for the investment, as there is no investment required, all the employee has just to do is to fulfill the job requirement and to get a an earning at fixed rate.

The amount to be invested in business has risk, as above mentioned, but the business has too much attraction, because it has good returns, and if comparable by the employment, the investor may receive many multiples of the salary in a single period. A return on money received from the business, that is the profit in general determines the business efficiency. But the question is that, is it necessary to invest money into a company and purchasing the shares? Can’t it be invested in the bank to get the interest income on that? This question has been evaluated in the context of the given topic, and will help in determining the criticalness of various securities in the financial markets.

Ordinary shares

Ordinary shares are the main source of capital for any public company, the other sources of capital is the debt etc. Ordinary shares provide the money that the shareholders pay to the company and in return receive the dividend, and the rate of dividend depends on the performance of the company. The stock market is the market of corporate securities, but the corporations may issue stock; it is the stock that provides initial capital for a company and the limited liability is the key factor in the corporate sector (J Richard, 1998). A company with healthy profits will probably go for good dividend yield, whereas the company suffering from loss may not issue dividends to the shareholders. It should be kept into consideration that the company will only share the profit, and the shareholders are not supposed to compensate on the behalf of the loss of the company.

How it generates the economic wealth

A person may have en economic role in terms of economics, he may be dependant or independent, he may be a surplus unit or deficit unit. A deficit unit is anyone who has more money than he spends, and hence he can utilize the money to get more money. This money can be given to those who are deficit unit, or those who may need it, which is the function of stock exchanges and the credit unions. So those who have more money can spend their money into the stock markets and can receive the return on it. This rate of return depends on the performance of the company.

When a person receive an income from the shares, that is called the dividend, the person has more to spend, which can be given to deficit units at a certain rate of return, and the deficit unit may start his/her own economic activity, that may be any businesses, but without this extra money given by surplus unit to the deficit unit through purchasing shares or purchasing government securities to the deficit unit, helps the deficit unit to pass some threshold, for the entrepreneur it may be the heavy capital required to start a business, or the government which want the people savings in their reserves which is going to be discussed later. Since the more economic activity can be generated by this security, economy can developed and the employment rate may increase, and the more the volume of economic activity, the more the taxes are accumulated, which in turn provide good infrastructure to the general public at the broader level.

Proposed Method

The Capital Asset Pricing Model has been used for assessing the risk return relationship for the ordinary shares. CAPM provides the analysis of market returns and the risk free return and shows the co variance between them for reaching the required rate of returns or the rate required for estimating the present value of future outflows. In CAPM theory, risk free investment is the choice available to the investors, the other option is the shares, and the investor may reduce the risk of by increasing the amount of risk free investment in the given portfolio (Harrington, 1987)

Risk Return Relationship

The risk is associated with several factors, which may be weak liquidity situation, low profit trends, any technological change in the industry, any lawsuit filed against the company, or any other significant event reported in the audited reports of the company. Financially the company has a risk return relationship associated with the leverage. The more the company has debt, the more the company will have to pay the interest costs, but in comparison the debt capital is cheap, so the company reaches at the point where it can strike the balance between them.

Ideally the company should have a debt ratio of 50% or less than it, but going for higher ratio, the company will have to pay the interest rate for the borrowed money, more. Creditors will feel the risk and will increase the interest rates and compounding them, the companies costs will mount, resulting in low profits, and in these circumstances, the company needs to perform surprisingly well to stay consistent with good profits.

Is it a good Investment for current Year?

According to the Standard and Poor’s the market returns for the year 2012 were 13.4 and it was the fourth largest return in US (NASDAQ, 2013)

Debentures

Debentures are the certificates for the amount borrowed by the company from the creditors. Company pays the interest on the debentures and it is the second source of the capital for the company, the first one being the shares issue. Debentures provide the company a cheap capital, which is required by the company for the business extensions programs, and/or for setting up a new business. A debenture is the promissory note which is supported by the general creditworthiness of the firm (Goyal, O., 1988).

The interest is paid on the debentures and these are given to the creditors. Creditors not only receive the interests but at last they also receive redemption, which is the returning of the actual amount to the creditor. Debentures portion in any certain company depends on its policies, and the company may go with higher rates. The actual dividend is only paid to the ordinary shareholders, whereas the preference shareholders receive the fixed flat rate for their investments which is deducted to reach the profit available to the shareholders. So the preference shares and debentures can be treated in the class different from the ordinary shareholders and they may be grouped in one category due to their substance, in accordance with the Generally Accepted Accounting Practices.

How they Generate Economic Wealth

Debentures can be obtained from different creditors, which may include the credit unions and microfinance institutions. The money given to the deficit unit by the surplus unit is the underlying concept in the case of unions and by exploiting this principles; the debentures can be explained thoroughly. The creditor’s institutions do help the economy to grow. The businesses are not easy to start, on may need sufficient capital, and for the capital, one may need the source of income, and the source of income may not be present as the business is not present to raise the enough capital, So to break this deadlock, the creditors unions provide the facility to borrow capital and to invest for the entrepreneurship. This is quite useful where the economy is not developed and the small businessman can take the benefit, and even the big companies may need to borrow.

Is it Good Investment for Current Year

The interest rate has varied from 0.25 to 20 % in the last 30 years in the US (Trading Economies, 2013). The fluctuation of the interest rates has many aspects. The low interest rates allow the investors to borrow money on very easy terms. Those who have mortgages and have to pay the interest, they will have to pay very low interest expenses and this reduction is termed as discretionary income, in terms of economics.

Bonds

Bonds are the risk free Government securities. The reason why they are termed as the risk free securities is because their return rate is given guarantee by the Government, which is the strongest stakeholder of the economies. The amount on the bonds is paid back to the investor. The bonds have low interest rates as compared to the market returns, and these low interest rates are compensated at the risk, because these interest rates do not varies according to the change in market returns, but may have affect on the market returns.

How They Generate Economic Wealth

Bonds appreciate savings, and they propose that the extra money should be spent on purchasing bonds as they provide risk free rate of returns. These returns are fixed by the Governments for certain time frame. A well functioning market supports the bond market by increasing its liquidity and it makes easy for the financial institutions to cover short term liquidity needs and makes it less risky (World Bank, International Monetary Fund, 2001)

Risk Return Relationship

Bonds and the Government securities have very important aspects with respect to the risk return relationship. When the market returns are low, a person may invest the money into the bonds and can receive the interest (Goyal, 1998). So why is the Need to invest in the company and to take the risk? The reason behind this risk is that the return is more as the risk is more as mentioned above in the Capital Asset Pricing Model. This also affects on the required rate of return for any company, because the required returns would be high, if the Bonds returns would be high and in this case the market returns will have the balanced attractiveness (Richard et al, 1998)

Is it Good Year for Investment

The interest rates are quite low and are 0.25 % which is not rally attractive for any kind of investment. Although it may provide the risk free returns, but from the investing point of view, they return rates are quite less.