Principles of Finance 5e, Ch. 2 Financial Assets © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Chapter 2 Financial Assets (Instruments) 1

Chapter 2 – Learning Objectives Explain why there are so many different types of financial instruments. Describe the types of debt that exist and their characteristics Explain what bond ratings are and why they are important Describe equity and some of the features/characteristics of equity. Describe what derivatives are and some of the more familiar types of derivatives. Principles of Finance 5e, Ch. 2 Financial Assets © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 2

Assets Real asset a physically observable, or touchable, item Financial asset an asset that represents a promise to distribute cash flows some time in the future Principles of Finance 5e, Ch. 2 Financial Assets © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 3

Major Financial Instruments Treasury bills Repurchase agreements Federal funds Bankers’ acceptances Commercial paper Negotiable CDs Eurodollars Money market funds Principles of Finance 5e, Ch. 2 Financial Assets © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 4 Treasury notes/bonds Municipal bonds Term loans Mortgages Corporate bonds Preferred stock Common stock

Financial Instruments and the Firm’s Balance Sheet Firm issues financial instruments so it can purchase the tangible assets necessary to produce income Principles of Finance 5e, Ch. 2 Financial Assets © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 5

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 Principles of Finance 5e, Ch. 2 Financial Assets © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 6

Debt - A loan to an individual, company, or government Debt features Priority to assets and earnings Principal value, Face value, Maturity value, and Par value Interest payments Discounted securities Maturity date Control of the firm (voting rights) Principles of Finance 5e, Ch. 2 Financial Assets © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 7

Short-Term Debt Treasury Bill (T-bill) Repurchase Agreement (Repo) Federal Funds Banker’s Acceptance Commercial Paper Certificate of Deposit Eurodollar Deposit Money Market Mutual Fund Principles of Finance 5e, Ch. 2 Financial Assets © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 8

Long-Term Debt Term Loans Speed Flexibility Low issuance costs Bonds Principles of Finance 5e, Ch. 2 Financial Assets © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 9

Government Bonds Treasury notes or bonds - issued by US government Municipal bonds - issued by state or local governments Revenue bonds General obligation bonds Principles of Finance 5e, Ch. 2 Financial Assets © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 10

Corporate Bonds Mortgage bonds Debenture Subordinated debenture Income bond Putable bond Indexed (purchasing power) bond Floating rate bond Zero coupon bond Junk bond Principles of Finance 5e, Ch. 2 Financial Assets © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 11

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 Principles of Finance 5e, Ch. 2 Financial Assets © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 12

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 Principles of Finance 5e, Ch. 2 Financial Assets © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 13

Yields on Selected Long-Term Bonds, Principles of Finance 5e, Ch. 2 Financial Assets © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 14 The yields for the U.S. government bonds are based on bonds with 10-year maturities. Source: Federal Reserve; Narrow Spread Wide Spread Corporate BBB Corporate AAA U.S. Government