Financial Assets (Instruments) Chapter 2 Requests for permission to make copies of any part of the work should be mailed to: Thomson/South-Western 5191 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 features Priority to assets and earnings Principal value, Face value, Maturity value, and Par value Interest payments or discounted securities Maturity date Control 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 Loans Bonds

Government Bonds Treasury notes or bonds - issued by US government Municipal bonds - issued by state or local governments Revenue bonds General 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,

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 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?

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)