Financial Assets (Instruments) Chapter 2

Assets uTangible asset F a physically observable, or touchable, item

Assets uFinancial asset F an asset that represents a promise to distribute cash flows some time in the future Promissory Note

Major Financial Instruments uTreasury bills uRepurchase agreements uFederal funds uBankers’ acceptances uCommercial paper uNegotiable CDs uEurodollars uMoney market funds uTreasury notes/bonds uMunicipal bonds uTerm loans uMortgages uCorporate bonds uPreferred stock uCommon stock

Financial Instruments and the Firm’s Balance Sheet uFirm issues financial instruments so it can purchase the tangible assets necessary to produce income

Balance Sheet - Equity uCommon equity F stockholder’s total investment in the firm uPar value F nominal or face value of a stock or bond uRetained earnings F earnings the firm has not paid out as dividends throughout its history uAdditional paid-in capital F difference between the value of newly issued stock and its par value

Debt uA loan to an individual, company, or government uDebt features F Principal value F Face value F Maturity value F Par value

More Debt Features uInterest payments or discounted securities uMaturity date uPriority to assets and earnings uControl of the firm (voting rights)

Short-Term Debt uTreasury Bills (T-bills) uRepurchase Agreement (Repo) uFederal Funds uBanker’s Acceptance uCommercial Paper uCertificate of Deposit uEurodollar Deposit uMoney Market Mutual Funds

Long-Term Debt uTerm Loans uBonds F Government bonds v Treasury bonds v Municipal bonds –Revenue bonds –General obligation bonds F Corporate bonds F Mortgage bonds

Bonds uDebenture uSubordinated debenture uIncome bond uPutable bond uIndexed (purchasing power) bond uFloating rate bond uZero coupon bond uJunk bond

Bond Contract Features uBond Indenture uTrustee uRestrictive covenant uCall provision uSinking fund F call for redemption by annual lottery F buy bonds on the open market uConvertible

Bond Ratings uMoody’s Investors Service (Moody’s) uStandard & Poor’s Corporation (S&P) uInvestment grade bonds F triple B or better uCriteria for rating bonds uImportance of bond ratings uChanges in ratings

Stock (Equity) uPreferred stock has preference over common stock in distribution of dividends and assets; dividend payments are fixed uPreferred stock may provide for cumulative dividends, conversion into common stock, voting rights, dividend participation, sinking funds, call provisions, and even maturity

Stock (Equity) uCommon stock F represents ownership in a corporation F common stockholders vote for members of the board of directors F has last claim on distribution of earnings and assets F may have preemptive rights to purchase any additional shares sold by the firm

Stock (Equity) uClassified stock F special purpose stock uClosely held corporations uPublicly owned corporations

Derivatives uValue depends on some underlying asset such as a stock or bond uOption - contract that gives the right to buy or sell an asset at a set price within a specified period of time F Call: holder has the right to buy F Put: holder has the right to sell F Striking price: exercise price of the option

Derivatives uCovertibles - bonds or preferred stocks that can be exchanged for common stock at the option of the holder F Conversion ratio defines the number of shares of stock the convertible holder receives upon conversion uFutures - arrangement for delivery of an item at a set future date at a set price

Derivatives uSwaps - an agreement to exchange cash flows or assets at a set time in the future

Rationale for Using Different Types of Securities uDifferences in trade-off between risk and expected after tax return uAppeal to broad market and different investment needs uDifferences in popularity through time

Which Financial Instrument is Best? uIssuer’s or investor’s viewpoint ? uBonds F fixed interest payments F does not represent ownership F may have restrictions on dividends F interest expense is deductible

uPreferred stock F fixed payment - but not obligated F no voting rights F higher after-tax cost since dividends are not deductible expenses Which Financial Instrument is Best?

uCommon Stock F no obligation of dividend payments F no maturity date for “repayment” F sales increases creditworthiness F prospects affect terms F gives control to stockholders F shares the income of the firm F higher costs of distribution than debt F dividends are not deductible

Financial Instruments in International Markets uAmerican Depository Receipts (ADRs) F represent ownership in stocks of foreign countries that are held in trust by a bank located in the country the stock is traded uForeign debt F sold by a foreign borrower but denominated in the currency of the country in which it is sold

Financial Instruments in International Markets uEurodebt F debt sold in a country other than the one in whose currency the debt is denominated F Eurobonds F Eurocredits: usually tied to London InterBank Offer Rate (LIBOR) F Euro-commercial paper (Euro-CP) F Euronotes

Financial Instruments in International Markets uEquity instruments F Euro stock is traded in countries other than the “home” country of the company, not including the United States F Yankee stock is stock issued for foreign companies that is traded in the United States

End of Chapter 2 Financial Assets (Instruments)