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4. Primary market

4.1. Learning outcomes

After studying this text the learner should / should be able to:

• Understand the organizational structure of the equity market.

• Explain the differences between the primary and secondary equity market.

• Evaluate the economic function of the primary market.

• Comprehend the motivation and advantages or the listing of share capital.

• Explain the disadvantages of being listed.

• Know of the existence of listing requirements.

• Identify the types of companies that list.

• Describe the listed products other than shares.

• Explain the methods of listing.

• Provide an exposition of the steps involved in a listing.

• Comprehend the contents of the prospectus.

• Evaluate the arguments for and against underwriting a share issue.

• Describe the other sources of primary market issue of listed equity.

• Appreciate the role played by the exchange in terms of capital raised.

4.2. Introduction

Organisational structure of spot financial markets

Figure 1: Organisational structure of spot financial markets

Figure 1 serves as an introduction to this section. All financial markets have primary markets, but not all have secondary markets. For example, there is a primary market for savings deposits, but the holders are not able to sell these financial instruments. Marketable securities have secondary markets.

Listed equities are marketable and the equity market therefore has a primary market and a secondary market. The primary equity market is the market for the issue of newly created equities, and the secondary market the market for the trading of existing securities. Thus, in the case of primary market issues the issuing companies are funded to the extent of the number of shares issued times the price of the shares (see Figure 2).

exchange of value in primary equity market

Figure 2: exchange of value in primary equity market

In the secondary market the companies whose shares are being traded are not additionally funded. The seller of the (existing) shares (an investor) is merely paid for the shares by the buyer (an investor), via a broker, and the consideration paid is the number of shares times the price negotiated for the shares (see Figure 3).

exchange of value in secondary equity market

Figure 3: exchange of value in secondary equity market

The primary market for unlisted shares is straightforward. In the case of a new company, the owners would simply have the shares created by an accountant/lawyer and the funds (par value of shares) placed in a bank account opened for the company. If the unlisted company requires additional funding, it will approach investors, armed with a prospectus, and if successful, place the shares with them, and place the funds raised in the bank account.

However, in the case of a listed company, the primary market is not uncomplicated. In the pages that follow, the primary market is covered in some detail under the following sections:

• Economic function of primary market.

• Motivation for listing (advantages).

• Disadvantages of being listed.

• Listing requirements.

• Types of companies that list.

• Listed products other than shares.

• Methods of listing.

• Steps involved in a listing.

• The prospectus.

• Underwriting a share issue.

• Other sources of primary market issue of listed equity.

• Capital raising.

4.3. Economic function of primary market

The economic benefit / function of the primary equity market is to channel surplus funds into productive investment at a price that is commensurate with the risk assumed by the buyer of the equity. The issue price paid is a function not only of the perceived risk and expected return, but also of the fact that a secondary market exists for the trading of the equities, i.e. a means of exit from the investment exists. For this reason, the primary and secondary markets are inextricably linked.

It will be apparent that most companies have their shares listed on an exchange with the intention of utilizing the acquired (permanent) capital for long-term investment (additions to a production facility and/or equipment) that will yield a respectable return for the company and therefore for its shareholders. However, this capital will not be readily available if no secondary market for equities exists.

The secondary market not only provides an exit mechanism for the investment (many investors invest only for the short term), but also provides real clues as to the correct pricing. The large investors in the equity market are the professional investors (called the "institutions"), and smaller investors take comfort from the fact that the market is usually priced correctly, and that the professionals have brought this about.

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