Key Takeaways:
- Understand the major financial instruments used in business finance and their core features.
- Learn how financial instruments are classified, compared, and applied in practical contexts.
- Gain clarity about hybrid instruments and their growing significance in modern financial management.
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Every business, whether a local enterprise or a large corporation, needs funds to function, grow, and compete. How do organizations raise these funds? The answer lies in financial instruments—a set of contracts representing rights to receive or obligations to pay money. These tools are the backbone of business finance and understanding them is crucial for any commerce student or aspiring finance professional.
Introduction to Financial Instruments
Financial instruments are contracts representing monetary value. They enable firms to mobilize resources for operations, expansion, and investments. Let’s consider the core instruments businesses use:
a. Equity Shares
Equity shares signify ownership in a company. Shareholders receive dividends and have voting rights, but their returns are not fixed. Equity capital is considered risk capital, as dividends depend on profits. Importantly, equity holders are paid after all other claims in case of liquidation, reflecting the highest risk and potential for highest reward.
b. Preference Shares
Preference shares provide a fixed dividend and have priority over equity shares for dividend payments and repayment of capital. However, they usually don’t carry voting rights. They combine some features of both debt and equity, making them less risky than equity but more so than debt instruments.
c. Debentures
Debentures are long-term debt instruments. The company promises to pay a fixed interest rate and return the principal at maturity. Debenture holders are creditors, not owners. Debentures may be secured or unsecured, convertible or non-convertible, offering flexibility to both issuer and investor.
d. Commercial Paper (CP)
Commercial paper is a short-term, unsecured promissory note issued by companies with high credit ratings. Maturity ranges from a few days up to one year. Companies use CP to meet short-term liabilities, as it’s a cost-effective alternative to bank loans for blue-chip firms.
e. Treasury Bills (T-Bills)
Treasury bills are short-term government securities issued to meet temporary funding needs. They don’t offer interest payments, instead, they are sold at a discount and redeemed at face value. T-bills are considered risk-free as they’re backed by the government.
f. Bonds
Bonds are long-term debt instruments issued by companies or governments to raise capital. They pay periodic interest (coupon) and return the principal at maturity. Bonds can have various features like callable, convertible, or zero-coupon which tailoring them to investor needs.
Classification of Financial Instruments
a. Marketable vs. Non-Marketable Instruments
| Marketable Instruments | Non-Marketable Instruments |
|---|---|
| Can be easily bought or sold in the financial markets. Examples: Equity shares, debentures, bonds, commercial paper, treasury bills. | Cannot be easily transferred; often held until maturity. Examples: Bank deposits, loans, insurance policies, provident fund deposits. |
b. Short-Term vs. Long-Term Instruments
| Short-Term Instruments | Long-Term Instruments |
|---|---|
| Maturity less than or equal to one year. Examples: Commercial paper, treasury bills. | Maturity more than one year. Examples: Equity shares, preference shares, debentures, bonds. |
Significance of Hybrid Instruments
a. Convertible Debentures
Convertible debentures are debt instruments that can be converted into equity shares after a specified period. They offer fixed interest initially, then the potential for equity participation. This appeals to investors seeking both security and growth potential.
b. Warrants
Warrants give holders the Right but Not the obligation to buy company shares at a predetermined price within a set timeframe. They’re often issued alongside bonds or debentures as a sweetener, enhancing the attractiveness of the main instrument.
Hybrid instruments bridge the gap between pure debt and pure equity. They give investors a balance of safety and potential for higher returns, while granting companies more flexibility in structuring their capital.
Example
Suppose a company, XYZ Ltd., needs to raise funds for a new project. The management considers various financial instruments:
- Equity Shares: Issued to the public, raising permanent capital and sharing ownership.
- Debentures: Issued at 8% interest, with a 10-year maturity. Provides funds without diluting ownership.
- Commercial Paper: Raised for working capital, repayable in 180 days.
- Convertible Debentures: Issued to attract investors who want initial safety and the option to convert into shares if the company performs well.
Through these choices, the company balances its immediate funding needs, cost of capital, control considerations, and investor appeal. By evaluating and combining different instruments, businesses construct a capital structure aligned with their strategy and risk appetite.