Cost and Financial Management 1B (CFM11B1)

Unit 2 – Basic financial instruments and financial markets

Part 1 - Chapter 2
 Learning Outcome

• Differentiate and discuss the characteristics

and workings of
1. basic financial instruments, and
2. financial markets

2
 Assessment Criteria
• The reasons for the development of a market as well as the role of a
market are correctly explained;
• The money market and the capital market are correctly differentiated;
• The characteristics and the working of the basic money market
instruments are accurately defined and explained;
• The characteristics and the working of the basic capital market
instruments are correctly defined and explained;
• Capital market instruments should be correctly ranked in terms of their
risk profiles.

3
 Introduction to financial instruments

• Different financial instruments available as possible

sources of finance or investments.
• Chapter 2 deals with most important financial instruments
on the money market and the capital market.
• Role of FM to make investment decisions and financing
decisions.
• Selecting the most appropriate source of finance and the
best investment opportunity will maximise shareholders’
wealth.

4
 Introduction to financial instruments

• Financial instruments are traded (i.e. bought and sold)

on financial markets, consisting of:
 Money market – instruments with a maturity less
than 1 year
 Capital market – instruments with a maturity
longer than 1 year
• Classification is based on period from original issue
date until date when instrument is paid back or
cancelled
• Note: many other financial instruments available
5
 Selected money market instruments
• Short-term debt securities are issued and traded on money
market
• Two parties involved: participants have either short-term
surplus or shortage of cash at different points in time
• Participants: governments, banks, corporates, other financial
institutions and even individuals
• Period of transaction is always less than 12 months
• Purpose of money market is to finance the short-term working
capital needs of companies or governments
• Money market consists of primary and secondary market

6
 Selected money market instruments (cont.)
• Examples of money market instruments:
 Commercial paper – P18 = NB
 Treasury bills – P18 = NB
 Negotiable certificates of Deposit – P18 to 19 = NB
 Repurchase agreements
 Trade bills
 Promissory notes
 Land Bank bills
 Reserve bank debentures

7
8
 Selected capital market instruments

• Market for securities to raise long-term funds and

includes equity market and bond market
• Consist of primary and secondary market

9
 Selected capital market instruments (cont.)

• Bond is agreement, contract or guarantee

• An investor/bond holder (lender) who purchases a bond
is lending money to the bond issuer (borrower).
• The bond represents the issuer’s contractual promise to
pay interest and repay the capital (principal) according
to the specified terms.

10
 Selected capital market instruments (cont.)

• Bond expensive to issue – only available to

governments and large companies
• Government bonds = traditionally low risk
• Think about….. especially considering SA’s
current situation…. Moody’s, Fitch, Standard &
Poor…

11
12
13
 Selected capital market instruments (cont.)

• Characteristics of bonds – P20

• Principal amount (nominal/face/par value) – Amount issuer must repay at maturity
• Coupon or coupon rate – fixed rate of interest that the issuer agrees to pay the
bondholder
• Term of maturity – number of years the issuer agreed to conditions of issue
• The yield to maturity – rate of interest that will make the PV of bond cash-flows,
coupon or principal equal to the bond
• The required yield – yield needed to persuade investors to invest in the bond
• Price quotes – bonds quoted in market as a percentage of par value

14
 Selected capital market instruments (cont.)

• Debenture is fixed interest-bearing security issued by companies.

• Capital amount is repayable at set future date.
• Preference claim against assets of company (should the company be at
default and fail to pay interest or capital) as debenture-holders have a claim
against the revenues of the company.
• Risk of debenture higher than risk-free government bonds,
but lower than preference shares or ordinary shares.

15
 Selected capital market instruments (cont.)

• Preference shares are normally issued at fixed annual rate of dividend.

• The investor will therefore receive preference dividends as reward for

investing in preference shares.
• Prior right over ordinary shareholders by way of dividends and a prior
claim to repayment of capital on liquidation of company.
• Risk of preference shares higher than government bonds and
debentures, but lower than ordinary shares.

16
 Selected capital market instruments (cont.)

• Different types of preference shares

 Participating preference shares
• Fixed dividend and profit-share
 Redeemable preference shares
• Therefore similar to characteristics of debt
 Convertible preference shares
• To other forms of equity or debt

17
 Selected capital market instruments (cont.)
• Ordinary (equity) shares represent part ownership in company

• Receive ordinary dividends (not guaranteed) – dependent on

dividend payout decision
• Therefore more risk than
Bonds,
Debentures; or
preference shares

18
 Selected capital market instruments (cont.)

•Important to distinguish the following for each capital market

instrument:
 Risk
 Liquidation claims
 Rewards
 Classification as debt/equity
 Ownership

19
 Selected capital market instruments (cont.)
• Differences between bonds and equities – P21
Bonds
agreement, contract or guarantee
between holder & issuer
certain, guaranteed income stream
no or limited capital growth
fixed term and set maturity date
expensive to issue as they guarantee a fixed
income and must be repaid
less risk
Equity (Ordinary shares):
part ownership
uncertain income stream
potential for capital growth
no term or maturity date
no income guarantee and are not redeemable but
dilute future earnings
much more risk
20
 Selected capital market instruments (5)

Sales

- Cost of Sales
Profit distribution
= Gross Profit and claim to
repayment on
+ Income liquidation

- Expenses

= Profit before Interest and Tax

- Interest (Bond, Debenture,
DEBT

Paid first = Low risk of not receiving

Loan) income (Bond = risk-free)

- Tax

= Net Profit
Paid next – Higher risk of not receiving income
Preference Dividends
EQUITY

Paid last – Highest risk of not receiving income

Ordinary Dividends 21

Slide Prepared by L Joubert

Selecting most appropriate financial instrument

22
 Selecting most appropriate financial instrument

• Two broad categories:

 Financing decision
(funds for projects, which instrument should be issued?)

 Investment decision
(surplus funds available, in which instrument should the company
invest?)

23
 Selecting most appropriate financial instrument

• Financing decision:
 What is the current make-up of the balance sheet in terms of
sources of finance used?
 For how long are the funds needed?
 What is the cost of each instrument?
 What is the cash flow position of the company?
 What is the availability of different sources?

24
 Selecting most appropriate financial instrument

• Investment decision:
 What are the needs in terms of cash-flow from the instrument?
 What is the risk related to the instrument?
 How much risk do we want to take?
 For how long do we want to invest?
 What are the alternatives?
 What are the possible/expected returns from each alternative?

25
Selecting most appropriate financial instrument (2)

 Remember to differentiate between the point of

view of a borrower and the point of view of an
investor!

26
Questions?
Thank you