Financial Management Foundations - Essay Example

Differentiate between various financial securities including common and preferred stock, convertible debt, warrants and derivatives By: October 2008 TABLE OF CONTENTS 1.0 Introduction 2.0 Forms of Financial Securities 2.1.1 Common Stock 2.1.2 Preference Stock 2.1.3 Convertible Debts 2.1.4 Warrants 2.1.5 Derivatives 3.0 Uses of Financial Securities 4.0 Conclusion Executive Summary In this paper, we compare five different financing alternatives available to investors in the financial market. Capital constrained investors can adapt either of these financing methods as each of them is dependent on the client's needs. However, some of these financing alternatives are common only to a few industries. Today, however due to the opportunistic gains associated with some of these instruments, some firms do not only use it as a risk minimization strategy, but however as an investment. The various instruments are examined, followed by their uses which include raising capital, risk reduction, and to take advantage of arbitrage pricing. 1.0 Introduction Capital management is essential in that it has an effect on a firm's risk and profitability as well as the firm's value. (Garcia-Terul and Martinez-Solano, 2000: p. 164). Investments in working capital constitute a tradeoff between risk and profitability because decisions that increase profitability also increase risk and vice versa. This is obvious even in capital markets where a tradeoff exists between risk and profitability. For example, investments in equities tend to be riskier than investments in savings accounts and bonds but equities tend to pay higher returns that savings accounts and bonds. (Bodie et al, 2005). A company that has a negative net working capital therefore faces higher risks than a company that has a positive net working capital irrespective of the profitability of the company. This is so because, the company with higher current liabilities may have high levels of debts that may be uncollectible, but which must have been included in the sales figure used in calculating profit. Debtors may default on the payment of debt and inventories may go obsolete. Finance literature has long recognized that market imperfection and information asymmetry affect finance. Thus, corporations must choose from the various financing options appropriate for them. These include, warrants issuance, derivatives instruments, common stocks and Preferred stocks etc. (Ambarish, John &Williams 1987). The purpose of this paper is to differentiate between the various financing securities and derivatives instruments. The remainder of the paper is organized as follows. Section 2 describes the various financial securities. In Section 3, differences e different financing securities are highlighted. Section 4 comments on the result and presents te conclusion. 2.0 Forms of Financing Securities Securities are often referred to as fungible, negotiable instrument representing financial values (Bodie, Kane, Marcus 2005). These instruments are broadly classified into debts securities (e.g., banknotes, bonds and debentures), and equity securities for example common stocks (Ross,Westerfield & Jaffe 1999). According to DeAngelo DeAngelo & Stulzb (2006) company or other entity issuing the security is called the issuer. What specifically qualifies as a security is dependent on the regulatory structure in a country. For example private investment pools may have some features of securities, but they may not be registered or regulated as such if they meet various restrictions (Ross, Westerfield & Jaffe 1999). Issuers include individuals, commercial banks, mortgage institutions and other international institution like the World bank. 2.1 Common stocks A common stock is an example of equity security. It represents the principal capital stock of a company. In most cases, Brealey & Myers (2005) state that a common stock security is a share in the capital stock of a company .According to Elliot & Elliot (2005) the holder of a common stock certificate is entitle to a share of the company, and in the event of bankruptcy the risk is limited to the capital contributed. Unlike the other security instruments, which typically require regular payments (interest) to the holder, equity securities are not entitled to any payment. Owners of these breeds of securities further share only the residual interest of the issuer after all obligations have been paid out to other creditors (Garcia-Terul & Martinez-Solano 2007). 2.2 Preferred Stock Owners of preference stocks are preference shareholders. They are the shareholders in the company entitled to receive payments in the case of bankruptcy before equity shareholders. Their shares hold a conversion option. That is can be converted into common stock status (Eliot & Eliot 2005). Unlike common stocks and derivatives,the convertibility may be forced if the convertible is a callable bond, and the issuer calls the bond. 2.1. 3 Convertible Debts These are bonds or other debts instruments that is converted in to a specified number of common stock at the option of the holder. According to Ambarish, John, & Williams (1987), convertible holders are entitled to a fixed return interest or dividend and the option the options to convert the bond or preference stock. Companies does this at a lower yield. This is the only instrument with a call price given the company in questions powers to force conversion. 2.1.4 Warrants According to Bodie, Kane &Marcus 2005, Ross (2005), warrants are debt convertible instruments with relatively long term option to purchase a common stock at a specified exercise price within a specified period of time. Brealey & Myers (2002) refer to warrants as sweeteners companies used to obtain lower interest rates, to raise additional funds in the case of marginal credit risk and to appreciate the activities of underwriters and venture capitalist when founding a company. Common features include, specified dates, number of shares, and price (DeAngelo DeAngelo & Stulzb 2006). 2.1.5 Derivatives Derivatives are financial instruments frequently used by companies to help reduce the risks of fluctuations in interests rates, currency exchange rates, commodity prices and equity market (Bodie, Kane &Marcus 2005, Ross 2005, and Brealey & Myers 2005). For example, a company that owes a large amount of debt at a floating or variable exchange or interest rate may take up a derivative to insulate itself from interest rates hikes (Brealey & Myers 2005). According to DeAngelo DeAngelo & Stulzb (2006) this involves future contracts, that will include swaps and options. Bodie, Kane & Marcus (2005) state that, derivatives are not considered equity and as such, are classified as either assets or liabilities and measured at fair value. 3.0 Uses of Financial securities. Most often these instruments outline above are used to gauge against risk, raise capital and as an investment vehicle. Here, the diverse range of potential underlying assets and pay-off alternatives leads to a wide range of benefits, including risk minimisation, investment options and raising new capital. One use of these instruments is the transfer of risk by taking the opposite position in the underlying asset. Hedging is commonly referred to in this direction. Conclusion To conclude, if investment in one of these instrument must be done, then we will propose that the investment be done taking into consideration the investors objective. This should however, be on a precondition that other relevant information on the firm like financial and management data for the past years be obtained and a time series analysis made to see how it has progressed within this period. References Ambarish, R., John, K., Williams, J., 1987. Efficient signaling with dividends and investments. Journal of Finance 42, 321- 344. Bodie Z. Kane A., Marcus A. J. (2005). Investments. 6th Edition. McGraw-Hill Elliot. B., Elliot J. (2005). Financial Accounting and Reporting. Ninth Edition. Prentice Hall Financial Times. Garcia-Terul P. J., Martinez-Solano P. (2007). Effects of working capital management on SME profitability. International Journal of Managerial Finance, vol. 3, No. 2, pp. 164-177 DeAngelo H., DeAngelo L., Stulzb R. M. (2006). Dividend Policy and the earned/Contributed Capital mix: a test of the life-cycle theory. Journal of Financial Economics, vol. 18, pp. 227-254. Gottesman A. A., Jacoby G. (2006). Payout policy, taxes, and the relation between returns and the bid-ask spread. Journal of Banking and Finance, vol. 30, pp. 37-58. Myers S.C., Brealey R. A. (2002). Principles of Corporate Finance, Seventh Edition. McGraw-Hill Irwin. Ross S.A., Westerfield R.W., Jaffe J. (1999). Corporate Finance. Fifth Edition. McGraw-Hill Irwin. Read More