NISM Series II-B · Chapter 1: Introduction to Securities

L1 · Foundation

Introduction to Securities

How a business is funded, the four bases on which capital is classified, the features of equity capital — limited liability, ownership, liquidity, perpetuity and uncertain pay-outs — the features of debt capital and what defines a bond or a bank loan, and the two hybrid structures.

16 min read · Worth 4% of the paper · Written from pages 13–18 of the official NISM workbook · Updated 18 September 2026

What this chapter covers

Units 1 to 5 together carry 20 marks out of 100. Spread evenly, this chapter is worth about 4 marks.

LEARNING OBJECTIVES: After studying this chapter, you should know about: Concept of Equity and Debt · Features and Benefits of Equity Capital · Features and Benefits of Debt Capital · Features of Hybrid Instruments

1.1 Introduction to equity and debt

A firm that requires money to conduct its operations can fund its requirements through:

Contribution by owners (either in form of loan or equity)

Contribution from outsiders (either in form of loan or equity)

Note that both owners and outsiders can give either kind of money.

Businesses are typically created by promoters, who bring in the initial funds to start and nurture a business. Later as the business grows in size, the need for money can be met by additional funds brought in by the owner(s) or contributions from outsiders (public). Similarly, an investor has a choice of owning a business by contributing to equity capital or lending to a business as debt capital.

Owning or lending — the whole chapter turns on that choice.

The four bases of classification

Capital used in running a business can be primarily classified based on:

The contributors of funds · The period for which money is contributed · The cost of the funds to the firm · The rights that accrue to the contributors of the funds

Four bases.

Contributors

Funds brought in by promoters and owners of the business are called equity capital. Equity capital can be brought in at the start of a business or at a later date as the business grows. Equity capital also can be contributed by outside investors. To enable such contribution, the business offers equity shares to outside investors, who become shareholders.

Funds brought in as loan is called debt capital. Those that contribute debt capital are called lenders to the business. Lenders can be individuals or institutions including banks. To enable such lending, a business issues debt instruments to investors, or obtains term loans by mortgaging the assets of the company.

Two routes for debt — issue instruments, or take a term loan against mortgaged assets.

Time period

The period for which capital is brought in may vary. Equity capital cannot be taken out of the firm unless the firm is liquidated. Such capital is for perpetuity.

The first sample question tests this — equity capital is for perpetuity from the company's point of view.

Debt has to be repaid by the company after a certain period. The period of repayment may be short-term (less than one year) or long-term (more than one year and may go up to even 30 years or more) and is decided at the time such funds are brought in.

Short-term is under one year; long-term is over one year and may run to 30 years or more.

Cost of capital

The business has to pay a price for using equity or debt capital. The cost may be fixed at the time the money is brought in and may constitute an obligation for the company. Debt instruments usually pay a periodic interest. The rate of interest may be pre-determined or the method by which the rate will be determined, as in the case of floating rate bonds and inflation indexed bonds, will be described upfront.

Either the rate itself or the method of arriving at it must be stated upfront.

The cost of capital may vary depending on the earnings of the company, as is the case with equity capital.

Both debt and equity are reflected in the liability side of the balance sheet indicating "source of funds". A company must carefully decide the mix of debt and equity to be used in the business.

Both sit on the liabilities side — a point candidates often get wrong, since equity feels like something the company owns rather than owes.

Rights of the contributors

The contributors of capital enjoy certain rights and obligations depending upon the type of capital that they have brought in. Equity investors enjoy rights such as ownership and voting rights and rights to share the profits of the company. Debt investors have the right to receive periodic interest and return of the capital on the expiry of the fixed period. The contributors of debt capital may have their rights secured against the assets of the company.

1.2 Features of equity capital

Those who contribute equity capital to the company, buy equity shares, when they are issued by the company. They are called equity shareholders of the company.

Limited liability

Equity capital is issued with limited liability. This means, if the creditors to a business are not able to recover their dues, equity shareholders will not be asked to pay up. The liability of equity shareholders in a company is limited to their contribution made to its equity capital, or on any amount unpaid which they have agreed to pay.

The most a shareholder can lose is what he put in, plus anything still unpaid on his shares.

Ownership rights

Equity represents ownership of the company. Equity shareholders are owners of the company in proportion of the shares held.

For example, if a company has an issued and paid-up capital of Rs.10 crore made up of 1 crore shares of Rs.10 each, and an investor owns 10 lakh equity shares, such investor owns 10% of the company.

10 lakh out of 1 crore is one-tenth.

Equity shareholders have the right to participate in the management of the company. They can do this through voting rights. Each equity share carries one vote. Major decisions of the company require resolutions to be passed, which have to be voted by a majority.

One share, one vote.

Equity capital entitles its contributors to participate in the residual profits of the company. After meeting all expenses and provisions, profit that remains in the books belongs to equity shareholders. This is generally distributed to the shareholders in the form of dividends.

"Residual" — the shareholder is paid last, out of what remains.

Liquidity

Equity shares are first issued by a company to the public through a process called the Initial Public Offer (IPO). IPOs are made in primary market. The money raised in an IPO is used by the company for its business activities and reflected in the balance sheet of the company.

After IPO, the shares are listed on the stock exchanges, where they can be traded between investors. This is called the secondary market. Such transactions do not result in change in the capital structure of the company. Secondary market provides liquidity to the investors.

Secondary trades change owners, not capital.

Perpetuity

Equity capital is for perpetuity. It cannot be redeemed and the company does not have an obligation to repay it. In special situations, a company may buy-back its own shares from the shareholders. Such shares shall be extinguished by the company.

Extinguished — bought-back shares are cancelled, not held.

Uncertain pay-outs

Shareholders enjoy return in the form of dividends paid by the company and may also benefit by the appreciation in share price. The investors can book capital gains by selling their shares in secondary market at a price higher than the acquisition price. If share price goes down, this may result in capital loss. However, there is no guarantee of dividends or capital appreciation on equity capital. Thus, the returns from equity are uncertain.

The second sample question asks how equity gives returns — both dividend and capital appreciation.

1.3 Features of debt capital

Debt capital refers to the borrowings of a company. The return to an investor from debt securities is primarily in the form of interest. Those that contribute debt capital are lenders or creditors of the company. Debt capital implies regular return and security for the investor. For the company there is an obligation to make periodic interest payments and to repay the capital on maturity.

A debt instrument pays interest as a percentage of its face value. The tenor of a debt instrument is fixed in advance.

The fourth sample question tests this — interest is a percentage of face value, not market value.

Debt is raised by companies either by issuing securities such as debentures, bonds and commercial papers to the lenders or by taking a loan from a bank or financial institution. The terms at which the borrowing is being made, are mentioned in the document (or certificate) that represents the debt.

Debt is raised by the company for a fixed period after which it has to be repaid. The period of borrowing will vary depending upon the need of the company.

Credit risk

The interest rate or coupon rate of a bond/ debenture depends on the risk of default associated with the company issuing such securities. The risk that a debt instrument may default on its interest payments is called credit risk. Credit rating of the debt security by SEBI registered Credit Rating Agency forms an important factor while investing in such securities.

The third sample question tests this — the interest a company must pay depends on its default risk.

Secured and unsecured

Debt securities/ loans have differential rights such as secured or unsecured. A secured loan is one where lenders have a right against the assets of the company if the company fails to pay interest and/or return the principal amount borrowed. Unsecured loan is one where such rights do not exist. Debt instruments may be listed on a stock exchange.

What defines each

A bond or debenture will be defined by:

Face value · Interest rate (also called coupon rate) and Frequency of interest payment · Date of Maturity/ Redemption · Other Rights of Bondholders (secured / unsecured)

A loan from a Bank or Financial Institution will be defined by:

Amount of the Loan · Interest Rate and Frequency of Payment · Nature of Loan (Term Loan, overdraft limit, bill discounting etc.) · Repayment Conditions and Time Line (As Negotiated between Borrower and Lender) · Other Rights of Lender (secured / unsecured)

Four items for a bond; five for a loan — and note that a loan's repayment terms are as negotiated between borrower and lender, while a bond's are fixed in the issue.

1.4 Hybrid structures

Companies may raise capital in a form that combines the features of both debt and equity. These are called hybrid instruments.

Convertible debentures

Convertible debentures pay interest like any other debt instrument till the date of maturity. On maturity, the debt is converted into equity shares. The terms of conversion, such as the number of equity shares that each debenture will be converted into and the price at which the conversion will take place are mentioned at the time of the issue of the debt instrument.

They are beneficial to a company as there is no cash outflow on maturity. The lender is benefitted if the conversion is below the prevailing market price of the share.

No cash goes out for the company; the lender gains if he converts below market.

Preference shares

Preference shares resemble debt instruments because they offer pre-determined rate of dividend. However, they do not have a fixed maturity period or a right over the assets of the company. They have a preference in the payment of dividend over ordinary equity shares and in the return of capital, if the company is wound up.

The fifth sample question asks which is a hybrid security — preference shares.

Feature	Like debt	Like equity
Preference shares	Pre-determined rate of dividend; preference in dividend and in return of capital	No fixed maturity period or a right over the assets of the company
Convertible debentures	Pay interest like any other debt instrument till the date of maturity	On maturity, the debt is converted into equity shares

The chapter's sample questions confirm that equity capital is for perpetuity from the company's point of view; that equity gives returns as both dividend and capital appreciation; that the interest a company pays on debt depends on its default risk; that a debt instrument pays interest as a percentage of its face value; and that preference shares are a hybrid security.

Think of it like this

Owning a shop or lending to it

Suppose a friend opens a sweet shop and needs Rs. 10 lakh. You can give the money in two quite different ways.

Buy a share of the shop. You become part-owner. Equity represents ownership of the company. Equity shareholders are owners of the company in proportion of the shares held. If the shop prospers you share the profit; if it fails you may get nothing back.

Or lend the money. Funds brought in as loan is called debt capital. Those that contribute debt capital are called lenders to the business. You get interest whether the shop does well or badly, and your money back on the agreed date.

The workbook lists the four differences to look for: the contributors of funds · the period for which money is contributed · the cost of the funds to the firm · the rights that accrue to the contributors of the funds.

On period: equity capital cannot be taken out of the firm unless the firm is liquidated. Such capital is for perpetuity, whereas debt has to be repaid by the company after a certain period — short-term (less than one year) or long-term (more than one year and may go up to even 30 years or more).

On cost: debt usually pay a periodic interest, while for equity the cost of capital may vary depending on the earnings of the company.

On rights: equity investors enjoy rights such as ownership and voting rights and rights to share the profits of the company. Debt investors have the right to receive periodic interest and return of the capital on the expiry of the fixed period.

And a point that catches candidates out: both debt and equity are reflected in the liability side of the balance sheet indicating "source of funds". Even the owner's money is something the company owes to somebody — just not on any fixed date.

Limited liability: the wall around your wallet

This single feature is why ordinary people are willing to buy shares in companies they will never visit.

Two components — what you have paid, and what you have agreed to pay but not yet paid. Nothing beyond.

Suppose a company owes its suppliers Rs. 500 crore and its assets fetch only Rs. 200 crore on winding up. The suppliers bear the shortfall. No one comes to a shareholder who bought 100 shares and asks him to contribute.

Contrast the shareholder's upside, which is unlimited but uncertain. Equity capital entitles its contributors to participate in the residual profits of the company. After meeting all expenses and provisions, profit that remains in the books belongs to equity shareholders.

"Residual" cuts both ways — last in line for profits, but everything left over is his.

And nothing is promised: there is no guarantee of dividends or capital appreciation on equity capital. Thus, the returns from equity are uncertain.

The two sources of return: shareholders enjoy return in the form of dividends paid by the company and may also benefit by the appreciation in share price, capital gains being booked by selling their shares in secondary market at a price higher than the acquisition price — and if share price goes down, this may result in capital loss.

Which is exactly what the second sample question asks — the answer is both.

Face value is the base for interest, whatever the market says

A bond's coupon never changes because its price moved.

A debt instrument pays interest as a percentage of its face value. The tenor of a debt instrument is fixed in advance.

Take a Rs. 1,000 face value bond paying 8%. It pays Rs. 80 a year — whether the bond is quoted at Rs. 1,100 or Rs. 900 on the exchange. The buyer at Rs. 900 gets a better yield on his money, but the coupon is still 8% of Rs. 1,000.

That is why the fourth sample question rejects current value, market value and future value.

What decides the coupon in the first place is the borrower's creditworthiness. The interest rate or coupon rate of a bond/ debenture depends on the risk of default associated with the company issuing such securities. The risk that a debt instrument may default on its interest payments is called credit risk.

And an outside opinion is sought: credit rating of the debt security by SEBI registered Credit Rating Agency forms an important factor while investing in such securities.

A weak borrower must offer more — which is the third sample question, answered by default risk.

Security is the other lever. A secured loan is one where lenders have a right against the assets of the company if the company fails to pay interest and/or return the principal amount borrowed. Unsecured loan is one where such rights do not exist.

Four things define a bond: face value · interest rate (also called coupon rate) and frequency of interest payment · date of maturity/ redemption · other rights of bondholders (secured / unsecured).

A bank loan adds a fifth — the nature of loan (Term Loan, overdraft limit, bill discounting etc.) — and its repayment conditions and time line are as negotiated between borrower and lender, not fixed by an issue document.

Hybrids: instruments that change costume

Between pure debt and pure equity sit instruments that borrow features from both.

Companies may raise capital in a form that combines the features of both debt and equity. These are called hybrid instruments.

A convertible debenture starts as debt and ends as equity. Convertible debentures pay interest like any other debt instrument till the date of maturity. On maturity, the debt is converted into equity shares.

Nothing is left vague: the terms of conversion, such as the number of equity shares that each debenture will be converted into and the price at which the conversion will take place are mentioned at the time of the issue of the debt instrument.

Who gains what. They are beneficial to a company as there is no cash outflow on maturity — the debt is settled in its own shares rather than in money. The lender is benefitted if the conversion is below the prevailing market price of the share — he receives shares worth more than the debt he gave up.

A preference share never changes costume; it wears both at once. Preference shares resemble debt instruments because they offer pre-determined rate of dividend. However, they do not have a fixed maturity period or a right over the assets of the company.

Debt-like in its return, equity-like in its permanence and its lack of security.

And the "preference" is exactly what the name says: they have a preference in the payment of dividend over ordinary equity shares and in the return of capital, if the company is wound up.

Paid before the ordinary shareholder, but after every creditor.

The fifth sample question offers equity shares and non-convertible debentures as distractors — the first is pure equity, the second pure debt. Only preference shares straddle the two.

Key terms in this chapter

Convertible debentures: Instruments that pay interest like any other debt instrument until maturity, when the debt is converted into equity shares on terms — the number of shares per debenture and the conversion price — stated at the time of issue. The company gains from having no cash outflow on maturity; the lender gains if conversion is below the prevailing market price.
Credit risk: The risk that a debt instrument may default on its interest payments. The coupon rate of a bond or debenture depends on the issuer's default risk, and credit rating by a SEBI registered credit rating agency is an important factor in investing.
Debt capital: Funds brought in as loan. Contributors are lenders — individuals or institutions including banks — and the business either issues debt instruments to them or obtains term loans by mortgaging its assets.
Equity capital: Funds brought in by promoters and owners of the business, and by outside investors to whom the business offers equity shares. It is for perpetuity, cannot be taken out unless the firm is liquidated, and carries ownership, voting and profit-sharing rights.
Face value: The value on which a debt instrument pays interest, expressed as a percentage of it. The tenor of a debt instrument is fixed in advance.
Four bases of classifying capital: The contributors of funds, the period for which money is contributed, the cost of the funds to the firm, and the rights that accrue to the contributors.
Hybrid instruments: Capital raised in a form combining features of both debt and equity — convertible debentures and preference shares.
Limited liability: Where creditors cannot recover their dues, equity shareholders are not asked to pay up. Their liability is limited to the contribution made to the equity capital, or to any amount unpaid which they have agreed to pay.
Ownership rights: Equity shareholders own the company in proportion to the shares held, participate in management through voting rights with each share carrying one vote, and are entitled to the residual profits remaining after all expenses and provisions, generally distributed as dividends.
Perpetuity: Equity capital cannot be redeemed and the company has no obligation to repay it. In special situations a company may buy back its own shares, and such shares are extinguished by the company.
Preference shares: Shares resembling debt in offering a pre-determined rate of dividend, but having no fixed maturity period and no right over the company's assets. They carry preference over ordinary equity shares in the payment of dividend and in the return of capital on winding up.
Primary and secondary market: Equity shares are first issued to the public through an initial public offer in the primary market, the money raised being used by the company for its business. After the IPO the shares are listed and traded between investors in the secondary market, which provides liquidity without changing the company's capital structure.
Secured and unsecured: A secured loan gives lenders a right against the assets of the company if it fails to pay interest or return the principal; an unsecured loan carries no such right.
Short-term and long-term debt: Short-term is repayable in less than one year; long-term in more than one year, and may extend to 30 years or more. The period is decided when the funds are brought in.
Terms defining a bank loan: Amount of the loan; interest rate and frequency of payment; nature of loan such as term loan, overdraft limit or bill discounting; repayment conditions and time line as negotiated between borrower and lender; and other rights of the lender, secured or unsecured.
Terms defining a bond: Face value; interest rate — also called coupon rate — and frequency of interest payment; date of maturity or redemption; and other rights of bondholders, secured or unsecured.
Uncertain pay-outs: Shareholders earn dividends and may gain from appreciation in share price, booking capital gains by selling above the acquisition price, but a falling price causes capital loss and neither dividends nor appreciation is guaranteed.

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Original explanatory writing based on the official NISM workbook for Series II-B, which is published and copyrighted by NISM. Check figures against the current edition at nism.ac.in.

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