Today, investments are something that everyone looks forward to in order to make good money. However, it becomes extremely crucial for a firm to choose the right kind of instruments that it can offer to its investors. For investments, there are many financial instruments that are available in India where the investor can invest to get the best returns. According to the definitions in Accounting Standard 31, ‘A financial instrument is any contract that gives rise to a financial asset of one entity and a financial liability or equity instrument of another entity’.
A company can offer potential investors various types of financial instruments available in India.
For each of the above instrument, detailed analysis has been presented below. For any further queries, you can talk to the experts at Starters’ CFO.
Equity Investment Instrument
Companies can issue stock to raise capital for various needs. Stocks trade on regulated exchanges, such as the National Stock Exchange or Bombay Stock Exchange, or on over-the-counter markets. Investment portfolios can derive good benefits from rising stock prices but can also suffer during periods of market volatility. Even companies offering can pay dividends, which are cash distributions to shareholders from after-tax profits. The main risk of equity investments is that deteriorating business conditions can lead to falling profits and stock prices.
To get your company listed, contact Starters’ CFO. They define an equity instrument as any contract that evidences a residual interest in the assets of an entity after deducting all of its liabilities.
Types of Equity Instruments
Here’s the description of the three basic forms of equity instruments:
- Common Stock: A share of common stock provides an ownership interest in the company, along with voting rights and possible dividends. Classes on the stock market designate common stock into different numbers of votes per share, such as Class A, Class B, Class C, etc. The company may suspend dividends if it faces financial difficulties, and it doesn’t guarantee them. In case of company liquidation, common stockholders are the last to receive payment. To account for this risk, the dividend yield is at times higher than the rate paid on preferred shares. In the event of liquidation, common shareholders have rights to a company’s assets only after fully paying bondholders, preferred shareholders, and other debt holders.
- Preferred Stock: Preferred stock also gives ownership but does not include voting rights. Holders of preferred stock are the second to be paid in company liquidation; bond holders are first. If the stock is convertible, the shareholder has the option of converting his shares to common stock. This has been further dealt in a separate section on Convertible Preference Stock. Participating preferred stock pays an increased dividend when the company is profitable. Preferred stock generally does not have voting rights, but has a higher claim on assets and earnings than the common shares.
- Warrants: They offer the right to purchase common stock at a certain price. They are valid only for a limited period of time. The warrant expires if you do not purchase the stock within the specified time frame. Existing shareholders or new purchasers of stock or bonds may be offered warrants. Warrants give the holder the right but not the obligation to buy an underlying security at a certain price, quantity and future time.
Merits and Demerits
Convertible Preference Shares
Convertible preference shares are shares that shareholders can convert into equity shares within a certain period, based on agreed-upon terms and conditions. In most cases, shareholders initiate the conversion, but occasionally, the company or issuer can compel conversion. The value of convertible common stock is ultimately based on the performance, or lack thereof, of the common stock.
In the event of bankruptcy or other corporate restructuring, preferred stockholders take priority over common shareholders when it comes to paying dividends and liquidating the company’s assets. These securities are a way to increase yields and lower risk. Investors should weigh the higher yield of convertible preferred against the increased equity risk.
Convertible debentures are hybrid securities which offer advantages of both bonds and equities. Like ordinary bonds – they offer regular interest income through coupon payments and a degree of downside protection not found in equity. Similar to equities, they also offer generally unlimited upside potential for capital appreciation in rising equity markets.
They are an attractive financing vehicle for an issuer as they provide a cheaper way to raise permanent capital. The benefit to selling convertible bonds is a reduced cash interest payment. A convertible bond’s issuer is effectively selling a call option on their common stock to allow for a cheaper cost of funding. Exercising the conversion feature potentially dilutes shareholder’s equity, resulting in a lower interest expense cost.
Therefore, investors must weigh the loss in yield against the opportunity to convert into equity and benefit from capital appreciation. They are an attractive financing vehicle for an issuer as they provide a cheaper way to raise permanent capital. The benefit to selling convertible bonds is a reduced cash interest payment. A convertible bond’s issuer is effectively selling a call option on their common stock to allow for a cheaper cost of funding. Exercising the conversion feature potentially dilutes shareholders’ equity, resulting in a lower interest expense.
Therefore, investors must weigh the loss in yield against the opportunity to convert into equity and benefit from capital appreciation. Convertibles also offer tax advantages to the issuer as fixed interest payments are tax deductible.
- Fixed income potential is provided by income from regular coupon payments and re-payment of principal at maturity. The equity component has historically provided a better total return potential than a plain nonconvertible bond.
- Convertible debentures offer diversification benefits as their performance does not directly correlate to either that of equities or bonds. Therefore, adding convertible bonds to a portfolio would reduce overall portfolio volatility. They are a better diversifier than a comparable equity and bond mix without any optional obligation. This diversification benefit is pronounced during periods of market turmoil.
- Convertible debentures also offer relatively cheap optionality and have had attractive risk/return characteristics in the past.
Futures and Options
Futures and Options form part of the derivatives market. The most significant event in finance during the past decade has been the extraordinary development and expansion of financial derivatives. These instruments enhance the ability to differentiate risk and allocate it to those investors who are most able and willing to take it. This is a process that has undoubtedly improved national productivity, growth and standards of living.
Derivatives markets generally are an integral part of capital markets in developed as well as in emerging market economies. These instruments assist business growth by disseminating effective price signals concerning exchange rates, indices and reference rates. Derivative products provide benefits such as risk management or redistribution of risk away from risk-averse investors.
Hence, one should choose wisely among different instruments that it can offer to its investors. A wrong choice can affect your business badly. To assist you, we at Starters’ CFO aim to provide you the best quality services and proper guidance in all sorts. You can contact us for further details.