Financial Assets (Instruments)

Chapter 2Requests for permission to make

copies of any part of the work should be mailed to:

Thomson/South-Western5191 Natorp Blvd.Mason, OH 45040

Assets

Real asset a physically observable, or touchable, item

Assets

Financial asset an asset that represents a promise to

distribute cash flows some time in the future

Promissory Note

Major Financial Instruments

Treasury bills Repurchase agreements Federal funds Bankers’ acceptances Commercial paper Negotiable CDs Eurodollars Money market funds

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

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 featuresPriority to assets and earningsPrincipal value, Face value, Maturity

value, and Par value Interest payments or discounted

securitiesMaturity dateControl of the firm (voting rights)

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

Long-Term Debt

Term LoansBonds

Government Bonds

Treasury notes or bonds - issued by US government

Municipal bonds - issued by state or local governmentsRevenue bondsGeneral obligation bonds

Corporate Bonds

Mortgage 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

Yields on Selected Long-Term Bonds, 1965-2005

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 corporationsPublicly 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 timeCall: holder has the right to buyPut: holder has the right to sellStriking price: exercise price of the option

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 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

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?

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

Risk & Returns on Different Classes of Financial Instruments

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)