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’.
Different types of Financial Instruments available in India which a company can offer to the potential investors are depicted below:
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.
Equity instrument is defined as ‘An equity instrument is any contract that evidences a residual interest in the assets of an entity after deducting all of its liabilities’. In order to get your company listed, you can contact Starters’ CFO.
Types of Equity Instruments
The three basic forms of equity instruments are described below:
- Common Stock: A share of common stock provides an ownership interest in the company, along with voting rights and possible dividends. Common stock may be divided into classes with different number of votes per share. These classes are designated as Class A, Class B, Class C, etc. on the stock market. Dividends are not guaranteed and may sometimes be suspended if the company struggles financially. Holders of common stock are the last to be paid if the company liquidates. To account for this risk, the dividend yield is at times higher than the rate paid on preferred shares. Common stockholders are on the bottom of the priority ladder for ownership structure; in the event of liquidation, common shareholders have rights to a company’s assets only after bondholders, preferred shareholders and other debt holders are paid fully.
- 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. Warrants may be offered to existing shareholders or packaged with a new purchase of stock or bonds. 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 those shares which can be converted into equity shares within a certain period at some agreed terms and conditions. Most convertible preferred stock is exchanged at the request of the shareholder, but sometimes there is a provision that allows the company, or issuer, to force conversion. The value of convertible common stock is ultimately based on the performance, or lack thereof, of the common stock.
The primary difference between preferred stock and common stock relates to the order in which shareholders are paid in the event of bankruptcy or other corporate restructuring. If the issuing company seeks bankruptcy protection, then the owners of preferred shares take priority over common shareholders when it comes time to pay dividends and liquidate the company’s assets. These securities are a way to increase yields and lower risk. Ultimately, investors must consider whether the higher yield of convertible preferred compensates them for the higher risk of an equity security.
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. The cost of having a lower interest expense is the potential dilution of shareholder’s equity caused by exercising the conversion feature. 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. The cost of having a lower interest expense is the potential dilution of shareholder’s equity caused by exercising the conversion feature.
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 — 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 or other assets and thereby render both cash and derivatives. Derivative products provide certain important economic benefits such as risk management or redistribution of risk away from risk-averse investors towards those more willing and able to bear the risk.
Hence, one should choose wisely among different instruments that it can offer to its investors because 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.