In raising capital from financial markets, companies should be aware that capital markets especially international markets are usually segmented. Explain the concept of market segmentation. What are the factors which causes segmentation of capital markets?
According to Palmer (2009), market segmentation is an economy and marketing concept which is made up many factors such as people, organizations which different characteristics demanding similar goods or certain kind of service on the price or the function quality of the goods. And there are many rationales for a market to segment as follows. First, this market segmentation owns its own characteristics differing from other segmentations to meet the needs of the market. Second, it may have the same respond as other segmented market to the stimulus from the market. Third, the proper market interventions can promote the market segmentation as well. And moreover, Kotler and Armstrong (2008) also pointed out that the consumers in a certain kind of market segmentation may own the same characteristics such as the requirement on the quality, or function or price of the products or service, which may differ from consumers in other segmentation. And this kind of element in market segmentation can be viewed as either positive or negative to split up the market into many small groups.
In terms of the concept of capital market segmentation, primarily we may understand the capital market which may be made up of three components including equity, debt and foreign exchange market according to Becker (2007). Now let’s turn to the definition of the capital market segmentation in content of equity, debt and foreign exchange elements.
First, a national capital equity market is viewed as a segmented market compared to other countries’ capital market, which stems from the different rate of security in different countries on the capital market. And the capital equity market segmentation may be often promoted by the national elements such as government’s policies including tax policies, regulations, foreign exchange control and so on. Second, in the debt capital market namely the segmented money market, it is characterized by the governments’ control on interest rate ceilings, mandatory credit policies, banking reserve requirements differently in different markets. Third, the same as the above two capital market elements, the foreign exchange market segmentation also owns the characteristic of national elements such as these policies of government on this market. (Becker 2007)
According to King and Segal (2008), every capital market segment reflects the special expectation from investors on returns, the specialty in capital cost as well as different level on the access to capital. And the following discussion will analyze the factors causing segmentation of capital markets
Investor’s expectations on return
Acheson (2011) pointed out almost all of the businesses are operated in the dimension of the capital market border that the annual revenues and investors’ expectations on return become the basis of the factor for capital market segmentation for most industries. And the differences of different capital market segmentation are from the differences in the expectations on return, which is related to the earnings before interest or taxes, multiples for acquisition and other important elements. And in each capital market segment, there are often the yields for both information and liquidity on the basis of the acquisition multiples involved in the return expectations from investors. For example, in much middle size market, the return expectation of some equity investors may be among 30% to 40% compared to 10% to 20% return expectation in investment of large companies.
On the view point from Antonioua et al. (2008), the reason why capital market segmented on the basis of the return expectation from investors is that in the segmented market, players view the valuation in a relative parochial sight. Namely, greater observed risk in the capital market asks for greater return for investors to make up for the risk.
Capital Costs and Access
The capital costs and access to the market are also the factors for the forming of the capital market segment. Just as Brav (2009) said, player in different capital market segments may have a different view on the value of the same asset because the different concepts of risks and return rationale are used in these segments. Therefore, a unique capital market line namely the CML may exist in each capital market segment. And the CML illustrates the return expectation of capital investors in the capital market segment as in figure 1.0
Figure 1.0 Capital market lines
For example, form the capital market lines, players in the segment can view the proportion of their investment may bring back to them, which offers investors unique basis in each market segment to value their investment.
Moreover, the access to each capital market segment differs from each other as well according to Brav (2009). For example, for these large investors or companies, they may own the relatively free right to design their own structure in the issue of their capital compared with the middle or small investors. And for these small to middle size investors, they may have less right and have to set up timely solutions for their capital structures without any other alternatives, which shoes monumental difference with the large investors group. And that is to say, in the large capital market, the more expected structure designed by these investors themselves enables them to make plans and implement these solution to the capital with higher certainty level. In the relatively smaller market segment, the structure or these guidance from experts may be weaker compared with these larger ones.
At last, in the small to medium size capital market segment, there may be more capital alternatives for these investors, which has different institutions and mechanisms in different market segments. (Brav 2009)
By and large, the difference on viewing the value of capital and access to the different market also contribute to the capital market segmentation.
Market Mechanisms and Institutions
According to Regan and Smith (2011), the market mechanisms and institutions are also the reason for the segmentation of capital market. First, in all of the capital market, there are many commercial activity involved for players to make some exchanges to gain what they expected. It is the market mechanism that enables these players to invest or make exchange for their interests. For example, in the free market, players may make exchanges on a mutual agreed price or condition.
Second, the market mechanisms in the capital market enable players to obtain data or money into or out from the capital market so as to meet their primary expectations. And these mechanisms also promote the movement and enhance the cohesions of the market such as the exchange, allocate resources, regulations and so on. For instance, the issue of exchange may promote the trading practices between different groups of players. And the resource allocation by the mechanisms may be helpful to feed the market. And then these rules or principles provided by regulation can further standardize the operation of the market. (Regan & Smith 2011)
In short, these mechanisms are helpful for players to find out and determine which capital market is the best suitable for them to go into investment. As these mechanisms are different in different capital market as in figure 2.0, these differences bring the possibility of the capital market segmentation as well.
Figure 2.0 Comparison of capital markets
By and large, in figure 2.0, the differences of mechanisms and institution cause the further capital market segmentations. For example, in the small market, there is a lack of market mechanism and institution to guide the function of this market, which results in the little liquidity in this market. In the lower middle market, the mechanisms and institutions are relatively complex than the small ones. And in the larger market, a wider range of services for finance is promoted by these licensed providers, good regulation systems. (Regan & Smith 2011)
Behavior of Players
The last factor to cause the segmentation of the capital market is the different behaviors of player in the markets shown in figure 3.0.
Figure 3.0 Owner and Management Motives
At first, the motives for players differ in these markets. As Slee (2011) pointed out, in small market, many players prefers to have or no partners, in middle sized market, players are willing to have few partners but in the large market, players are often motivated to improve the number of the shareholders or business partners to share risks and resources, which are all due to the characteristics of the market. That is to say, players in the small market are motivated to cut down the book income in order to decrease the tax, which can help them to dilute equity. And for players in medium sized market, they are often motivated to maximize their gaining to set up the base for equity.
Second, the differences to transfer motives in the different markets are also large. According to Yeyati et al. (2008), players in large capital market often own a corporate perspective compared to a personal perspective owned by players in small markets. The basic reason is rooted from the ability of the players. For example, in the large capital markets, these players such as big companies often relatively strong economy capacity and competitiveness which enable them to last longer than players in other market. The players in small to medium size markets such as the small company may only have limited ability to make values thorough their business, which may limit their performance or return in the capital market.
Third, the motives of players in different capital markets are different because the differences in diversification, markets regulations and mechanisms. Based on this, players from large market may prefer to diversify their business or investment into some unfamiliar field while players in the small to medium size market may prefer to maintain the stability in their business and investments. (Yeyati et al. 2008)
By and large, the differences behaviors of players in different markets also cause the segmentation of capital market.
Antonioua, A., Guneya, Y. & Paudyala, K. 2008, The determinants of capital structure: Capital market-oriented versus bank-oriented institutions, Journal of Financial and Quantitative Analysis,
Adrian, T. & Shin, H.S. 2008, Liquidity and financial cycles, Social Science Electronic Publishing, New York,
Acheson, G.G. 2011, Investor behavior in a nascent capital market: Scottish bank shareholders in the nineteenth century, The Economic History Review,
Binsbergen, J.H.V., Yang, J. & Graham, J.R. 2010, The cost of debt, The Journal of Finance, vol.65,
Brav, O. 2009, Access to capital, capital structure, and the funding of the firm, The Journal of Finance,
Becker, B. 2007, Geographical segmentation of US capital markets, Journal of Financial economics,
Berger, A. 2005, Small business and debt finance, Handbook of entrepreneurship research,
Damodaran, A. n.d., The debt-equity trade off: The capital structure decision, Stern School of Business, n.p.
Dempsey, M. 2011, Consistent cash flow valuation with tax‐deductible debt: a clarification, European Financial Management,
Ehrhardt, M.C. & Brigham, E.F. 2009, Corporate finance: A focused approach, South-Western Cengage Learning, USA,
Hitchner, J.R.2011, Financial valuation: Application and methods, John Wilery & Sons, New Jersey,
Hovakimian, A. & Opler, T. 2001, The debt-equity choice, Journal of Financial and Quantitative Analysis, vol.36, pp 1-24,
King, M.R. & Segal, K. 2008, Market segmentation and equity valuation: Comparing Canada and the United States, Journal of International Financial Markets,
Kotler, P. & Armstrong, G. 2008, Principles of marketing, 12th edn, Pearson Education International, New Jersey,
Masulis, R. W. 1988, The debt / equity choice, Ballinger Pub. Co, Cambridge,
Panteghini, P. 2008, Corporate debt, hybrid securities and the effective tax rate, Social Science Research, no. 2329,
Palmer, A. 2009, Introduction to marketing theory and practice, 2nd edn, Oxford University Press, New York,
Regan, M. & Smith, J. 2011, Impact of the capital market collapse on public-private partnership infrastructure projects, Journal of Construction Engineering and management, vol.137,
Song, T. & Yong, Y. 2009, Financial development, debt governance and corporate value: evidence from Chinese listed companies, Journal of Finance and Economics,
Slee, R.T. 2011, Private capital markets: valuation, capitalization, and transfer of private business interests, John Wiley & Sons, New Jersey,
Yeyati, E.L., Schmukler, S.L. & Horen, N.V. 2008, Crises, capital controls, and financial integration, The World Bank,
Young, R.D., Nigro, P. & Glennon, D. 2008, Borrower-lender distance, credit scoring, and loan performance: Evidence from informational-opaque small business borrowers, Journal of Financial Intermediation, vol.17, issue 1, pp. 113-143,