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Explore various financial assets such as tangible assets, promissory notes, bonds, stocks, and derivative instruments in the context of firm balance sheets. Learn about debt features, bond contracts, stock classifications, and the rationale for using different securities. Delve into the best financial instruments from both issuer and investor viewpoints.
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Financial Assets (Instruments) Chapter 2
Assets • Tangible asset • a physically observable, or touchable, item
Promissory Note Assets • Financial asset • an asset that represents a promise to distribute cash flows some time in the future
Treasury notes/bonds Municipal bonds Term loans Mortgages Corporate bonds Preferred stock Common stock Major Financial Instruments • Treasury bills • Repurchase agreements • Federal funds • Bankers’ acceptances • Commercial paper • Negotiable CDs • Eurodollars • Money market funds
Financial Instruments and the Firm’s Balance Sheet • Firm issues financial instruments so it can purchase the tangible assets necessary to produce income
Balance Sheet - Equity • Common equity • stockholder’s total investment in the firm • Par value • nominal or face value of a stock or bond • Retained earnings • earnings the firm has not paid out as dividends throughout its history • Additional paid-in capital • difference between the value of newly issued stock and its par value
Debt • A loan to an individual, company, or government • Debt features • Principal value • Face value • Maturity value • Par value
More Debt Features • Interest payments or discounted securities • Maturity date • Priority to assets and earnings • Control of the firm (voting rights)
Short-Term Debt • Treasury Bills (T-bills) • Repurchase Agreement (Repo) • Federal Funds • Banker’s Acceptance • Commercial Paper • Certificate of Deposit • Eurodollar Deposit • Money Market Mutual Funds
Long-Term Debt • Term Loans • Bonds • Government bonds • Treasury bonds • Municipal bonds • Revenue bonds • General obligation bonds • Corporate bonds • Mortgage bonds
Bonds • Debenture • Subordinated debenture • Income bond • Putable bond • Indexed (purchasing power) bond • Floating rate bond • Zero coupon bond • Junk bond
Bond Contract Features • Bond Indenture • Trustee • Restrictive covenant • Call provision • Sinking fund • call for redemption by annual lottery • buy bonds on the open market • Convertible
Bond Ratings • Moody’s Investors Service (Moody’s) • Standard & Poor’s Corporation (S&P) • Investment grade bonds • triple B or better • Criteria for rating bonds • Importance of bond ratings • Changes in ratings
Stock (Equity) • Preferred stock has preference over common stock in distribution of dividends and assets; dividend payments are fixed • Preferred stock may provide for cumulative dividends, conversion into common stock, voting rights, dividend participation, sinking funds, call provisions, and even maturity
Stock (Equity) • Common stock • represents ownership in a corporation • common stockholders vote for members of the board of directors • has last claim on distribution of earnings and assets • may have preemptive rights to purchase any additional shares sold by the firm
Stock (Equity) • Classified stock • special purpose stock • Closely held corporations • Publicly owned corporations
Derivatives • Value depends on some underlying asset such as a stock or bond • Option - contract that gives the right to buy or sell an asset at a set price within a specified period of time • Call: holder has the right to buy • Put: holder has the right to sell • Striking price: exercise price of the option
Derivatives • Covertibles - bonds or preferred stocks that can be exchanged for common stock at the option of the holder • Conversion ratio defines the number of shares of stock the convertible holder receives upon conversion • Futures - arrangement for delivery of an item at a set future date at a set price
Derivatives • Swaps - an agreement to exchange cash flows or assets at a set time in the future
Rationale for Using Different Types of Securities • Differences in trade-off between risk and expected after tax return • Appeal to broad market and different investment needs • Differences in popularity through time
Which Financial Instrument is Best? • Issuer’s or investor’s viewpoint ? • Bonds • fixed interest payments • does not represent ownership • may have restrictions on dividends • interest expense is deductible
Which Financial Instrument is Best? • Preferred stock • fixed payment - but not obligated • no voting rights • higher after-tax cost since dividends are not deductible expenses
Which Financial Instrument is Best? • Common Stock • no obligation of dividend payments • no maturity date for “repayment” • sales increases creditworthiness • prospects affect terms • gives control to stockholders • shares the income of the firm • higher costs of distribution than debt • dividends are not deductible
Financial Instruments in International Markets • American Depository Receipts (ADRs) • represent ownership in stocks of foreign countries that are held in trust by a bank located in the country the stock is traded • Foreign debt • sold by a foreign borrower but denominated in the currency of the country in which it is sold
Financial Instruments in International Markets • Eurodebt • debt sold in a country other than the one in whose currency the debt is denominated • Eurobonds • Eurocredits: usually tied to London InterBank Offer Rate (LIBOR) • Euro-commercial paper (Euro-CP) • Euronotes
Financial Instruments in International Markets • Equity instruments • Euro stock is traded in countries other than the “home” country of the company, not including the United States • Yankee stock is stock issued for foreign companies that is traded in the United States
End of Chapter 2 Financial Assets(Instruments)