Thursday, July 10, 2014

Basic Financial Securities - a very basic quick lesson in Finance

Let us say Alice and Bob want to start a business. Alice contributes $3,000 and Bob $5,000. Let's say for sake of argument they work equally hard at the business and make $800 in profits at the end of the month after taxes. So what is each person's share? Fairness dictates that the profits be split among the parties in the ratio of their contributed capital (or risk they took going in). Thus, Alice makes $300 and Bob gets $500. This is the basic idea of a Partnership.

Now let's say Alice and Bob's business, ACME, needs more capital to expand. They need to raise it from other sources. They could ask friends and relatives. They could go to a bank. Let's say for argument that they issue shares or equity in the business. These shares would normally be placed by a bank or a group of banks that a. advice ACME on what a suitable price should be for the shares, and b. do a roadshow to market ACME to potential clients to informally see what price ACME shares can command given its growth prospects. This process of investment banks marketing a new company that is coming to market to issue shares is called a roadshow.

After the roadshow, the investment banks advice ACME what a suitable share price might be, how many shares they can issue, and how to go about selling them. Typically, selling shares involves listing the company on a stock exchange and then letting shares start trading (ACME may keep some shares for themselves, and the banks may do the same, per their agreement with ACME). The rest of the shares are sold on the agreed upon day on the stock market in an exchange in a process called the Initial Public Offering or IPO. ACME shares start trading on that day. This is also called the primary market.

After the IPO, ACME shares may be bought or sold on the exchange. This is the secondary market. And prices of these shares may go up or down based on ACME's revenues, sales, margins, future prospects and a whole host of other factors.

So why do people buy ACME shares? They buy these shares because owning a share means owning a part of ACME's business. Let's say ACME was worth $8M when they floated shares, and they have a total of $2M in shares outstanding, havng sold 500,000 shares at $4 each. Then each share owns $4 of ACME's business. If ACME is later worth $8M due to increased sales etc, then the share prices rise proportionately, and the owners of these shares profit.

People may buy shares for another reason as well. ACME may periodically distribute extra income from sales, after all investments in its business and expansion plans are met, as dividends to shareholders. So not only do shareholders accrue capital gains from holding stock, they get a periodic dividend as well, if the company gives one.

But what if ACME didn't want to issue common stock? ACME could have financed their business growth by issuing debt, called bonds instead. The way this works, ACME (again through banks) approaches the market and says "give us $2M now, and we will pay you back $2M after 10 years, and interest at 5% semi-annually in the mean-time on the principle".

Here, the $2M is split into 2000 bonds each worth $1,000 say, and sold in the debt capital market. The 5% coupon is something the banks consult with rating agencies (who determine the credit-worthiness of ACME and its ability to pay back the loan), that they think the market will bear at the level of risk. Then the bonds are sold in the debt markets, to bond owners called bond-holders.

Let us say for sake of argument the prevailing interest rate is also 5%. These bond holders are each paid $1,000 for a bond, and receive $25 two times a year (semi-annually), and receive at the end of the 10th year, a final payment of $25 and their original principal of $1000.  Of course, if ACME goes bankrupt sometime in these 10 years, then both the coupons (interest payments) and the principal are forfeit by the bond-holders. This is called credit risk. So bond-holders are careful to only buy bonds for good companies, and demand a hefty premium over the prevailing interest rate as at least some compensation for this risk.

... more to come. will keep it very basic for the complete novice.

Interest rate, tax rate

Syndicated Loans

Bonds - maturity, coupon, duration


Quasi Sovereigns

Corporate Credits







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