Chapter 2 Financial Assets (Instruments) PDF

Chapter 2 Financial Assets (Instruments) 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. 1 Chapter 2 – Learning Objectives  Explain why there are...

Chapter 2 Financial Assets (Instruments) 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. 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  Treasury notes/bonds  Repurchase agreements  Municipal bonds  Federal funds  Term loans  Bankers’ acceptances  Mortgages  Commercial paper  Corporate bonds  Negotiable CDs  Preferred stock  Eurodollars  Common stock  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 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, 1990 - 2010 12 Narrow Spread 10 Corporate BBB 8 6 Corporate AAA 4 U.S. Government Wide Spread 2 0 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 The yields for the U.S. government bonds are based on bonds with 10-year maturities. Source: Federal Reserve; http://www.federalreserve.gov 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 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 (when dividend payments are missed), dividend participation, sinking funds, and/or call provisions (provides maturity) 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. 15 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 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. 16 Common Stock Classified Closely held Publicly held 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. 17 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 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. 18 Derivatives  Convertibles - 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 and at a set price 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. 19 Derivatives Swaps - an agreement to exchange cash flows or assets at a set 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. 20 Derivatives Hedge Funds- a private pool of funds constructed for the purpose of generating a specific range of returns, no matter what happens in the general stock market 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. 21 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 Different securities are popular during different economic conditions or at different times 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. 22 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 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. 23 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 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. 24 Which Financial Instrument is Best? Common Stock  no obligation of dividend payments  no maturity date for “repayment”  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 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. 25 Risk & Returns on Different Classes of Financial Instruments 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. 26 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 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. 27 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 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. 28 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 by foreign companies that is traded in the United States 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. 29 Chapter Principles Key Financial Assets Concepts  Why are there so many different types of financial institutions?  Different investors have different risk/return tradeoff preferences  Firms can raise funds more easily if they offer the types of securities that investors want  What is debt? What types of debt exist?  A debt is a loan  Two classifications of debt are short-term and long-term 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. 30 Chapter Principles Key Financial Assets Concepts  What are bond ratings and why are they important?  Bond ratings are based on both quantitative and qualitative factors; give an indication of the default risk associated with a bond  What is equity?  The value of the assets owned minus the amount of debt that is owed 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. 31 Chapter Principles Key Financial Assets Concepts  What are derivatives?  Financial assets that have values based on the values of other assets such as stocks and bonds  What are some of the more familiar types of derivatives?  Options, futures, convertibles and swaps 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. 32 End of Chapter 2 Financial Assets (Instruments) 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. 33