Week 5: Financial instruments

What is a financial instrument

Any contract that gives rise to a financial asset for one entity and a financial liability/equity instrument for another entity

For example: You (company A) lend your friend (company B) $100.

You have a financial asset because your friend owes you $100.

Your friend has a financial liability because they owe you $100.

purchaser of debenture(gives money): one with financial asset

issuer of debenture(takes money): one with financial liability

What is a financial asset

• finanical asset is something that gives you cash/ a right to receive cash

  • includes cash

  • equity instrument (shares) of another company (ie. you bought shares for cash)

  • contractual right to receive cash or another financial asset from another entity

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Financial liability

• contractual obligation to deliver cash or another financial asset

• or exchange financial instruments under potentially unfavourable conditions

What is an equity instrument

any contract that evidences a residual interest in the assets of an entity after subtracting liabilities

• holders of equity=business owners

  • they share business profit and risk, investment returns depends on performance, value they get is uncertain

How can a company raise finance

Through borrowing or through equity(shares)

is it debt or equity

A

• get a fixed number of shares

• how much holder gets depends on share price

• holder bears equity risk

• no obligation to deliver fixed financial value therefore equity

B:

• fixed value of 100k

• number of shares adjusts

• therefore financial liability

debt vs equity pros and cons

• Debt: doesn’t reduce ownership, but repayment obligation and financial risk

• Equity: no contractual requirement to pay back, but dilutes ownership

forms of financial instruments

Basic (Non-derivative) financial instruments

• instruments that derive value from market: Cash, accounts receivable/payable, loans, debentures, ordinary shares

Derivative financial instruments

• derive value from underlying item and needs very little or no initial investment that is settled at future date

• eg. Forward contracts, call & put options, interest rates/currency swaps

• call option: option to buy at certain price

• put option: option to sell at certain price

Preference shares and why do companies prefern them

• mix of debt and equity

• Higher preference than ordinary shares.

• Limited voting rights

• Offer more predictable returns (cumulative)

• Non participating

WHY DO THEY PREFER THEM

• Can raise funds without diluting control (cuz don’t have voting rights)

• More flexible than debt

• Can attract different investors

Ordinary notes: compound financial instrument (contain both equity and liability componenet)

• Ordinary note: a debt instrument under which the issuer borrows funds and has a contractual obligation to pay interest and repay the principal in cash. 

Convertible note and why companies and investors prefer them

• gives the holder the option to convert the debt into the issuer's ordinary shares at end of contract period. 

• Allows company to raise finance without diluting ownership cuz don’t have to issue ordinary shares immeditably

• Company needs to pay a lower interest rate than straight debt 

• May reduce need for future cash repayment (ie. can just convert to shares rather than paying principal)

WHY INVESTORS PREFER:

• Receive interest while holding notes like debtholders

• Has ability to participate in share price growth in future

• Can convert into shares if conversion becomes attractive

How to treat compound financial instrument

• handle liability first then equity

• liability is pv of future interest payments and principal (discount at market interest rate for similar debt with no conversion feature)

• equity: total issue proceeds-financial liability component.

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Recognising financial assets and libailities

initial measurement: generally fair value

• There could be transactions costs when purchasing financial assets:

  o Fair value through P&L (FVTPL): transacƟon costs → expense

  o Other categories (i.e. amorƟsed cost, FVOCI): transacƟon costs → added to iniƟal carrying

  amount

Subsequent measurement

• Amortised cost

• Fair value through oci

• Fair value through p&l

how to determine subsequent measurement of asset

1) ask why does the entity hold the financial asset

• Hold to collect contractual cash flows

• Hold to collect AND sell

• Other (e.g. trading)

2) Ask what cash flow does the asset generate does it pass SPPI test (solely payments of principal and interest)

then the subsequent measurment method u use depends on these things

amortised cost method

subsequent measurment for equity instruments

• dont need test

• if its held for trading use FVTPL

If not held for trading : Entity may make an irrevocable election at initial recognition to

present changes in FV in OCI

Impairment

• if you hold it for long term there can be impairment

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measurement of liabilities

initial measurment: generally at fair value

• FVTPL: FV of consideration received

• Amortised cost: FV of consideration received minus transaction costs when issue the financial liability