CHAPTER 1
Overview of the Financial System
Real and Financial Assets
Most new businesses begin when an individual or a group of individuals come up with an idea: manufacturing a new type of cell phone, developing land for a future housing subdivision, launching a new Internet company, or exploring for crude oil. To make the idea a commercial reality, however, requires funds that the individual or group generally lacks or personally does not want to commit. Consequently, the fledgling business sells financial claims or instruments to raise the funds necessary to buy the capital goods (equipment, land, etc.), as well as human capital (architects, engineers, lawyers, etc.), needed to launch the project. Technically, such instruments are claims against the income of the business represented by a certificate, receipt, or other legal document. In this process of initiating and implementing the idea, both real and financial assets are therefore created. The real assets consist of both the tangible and intangible capital goods, as well as human capital, which are combined with labor to form the business. The business, in turn, transforms the idea into the production and sale of goods or services that will generate a future stream of earnings. The financial assets, however, consist of the financial claims on the earnings. Those individuals or institutions that provided the initial funds and resources hold these assets. Furthermore, if the idea is successful, then the new business may find it advantageous to initiate other new projects that it again may finance through the sale of financial claims. Thus, over time, more real and financial assets are created.
The creation of financial claims, of course, is not limited to the business sector. The federal government's expenditures on national defense, entitlements, and infrastructures and state governments' expenditures on the construction of highways, for example, represent the creation of real assets that these units of government often finance through the sale of financial claims on either the revenue generated from a particular public sector project or from future tax revenues. Similarly, the purchase of a house or a car by a household often is financed by a loan from a savings and loan or commercial bank. The loan represents a claim by the financial institution on a portion of the borrower's future income, as well as a claim on the ownership of the real asset (house or car) in the event the household defaults on its promise.
Modern economies expend enormous amounts of money on real assets to maintain their standards of living. Such expenditures usually require funds that are beyond the levels a business, household, or unit of government has or wants to commit at a given point in time. As a result, to raise the requisite amounts, economic entities sell financial claims. Those buying the financial claims therefore supply funds to the economic entity in return for promises that the entity will provide them with a future flow of income. As such, financial claims can be described as financial assets.
All financial assets provide a promise of a future return to the owners. Unlike real assets, however, financial assets do not depreciate (because they are in the form of certificates or information in a computer file), and they are fungible, meaning they can be converted into cash or other assets. There are many different types of financial assets. All of them, however, can be divided into two general categoriesâequity and debt. Common stock is the most popular form of equity claims. It entitles the holder to dividends or shares in the business's residual profit and participation in the management of the firm, usually indirectly through voting rights. The stock market where existing stock shares are traded is the most widely followed market in the world, and it receives considerable focus in many investment and security analysis texts. The other general type of financial asset is debt. Businesses finance more of their real assets and operations with debt than with equity, whereas governments and households finance their entire real assets and operations with debt. This chapter provides an overview of the types of equity and debt securities and their markets. The first book in the Bloomberg investment series, Debt Markets and Analysis, focused on debt securities. The focus of this book is on equity. This chapter provides an overview of both types of securities and markets.
Types of Equity Claims
Firms need capital to grow and acquire additional assets. When a corporation decides to finance its capital formation with equity, it will do so either internally by retaining earnings or externally by issuing common stock, preferred stock, or perhaps forming a limited partnership.
Common stock is an equity or ownership claim entitling the holder to dividends and ownership rights. Issued shares include outstanding shares held by investors that are used for per share calculations and treasury shares held by the firm, often through a repurchase of stock by the firm. As discussed in more detail in Chapter 4, the ownership rights of common stock can be classified into four categories: collective rights, specific rights, cumulative voting rights, and preemptive rights. Two important features of common stock are limited liability and double taxation. Limited liability means that the most one shareholder of a company can lose if the company goes bankrupt is his or her original investment. Thus, unlike proprietorships and partnerships in which the business ownership is defined in terms of the individuals and not a legal entity, the extent of the liability for an individual shareholder of a corporation is limited to his or her shares, with no risk of personal liability. Double taxation means that earnings of a company are taxed twice. First, before the payments to shareholders, the earnings of the company are subject to a corporate tax, and then the dividend payments to shareholders are subject to personal taxes.
Preferred stock can be thought of as a limited ownership share. It provides its owners with only limited income potential in the form of a stipulated dividend ( preferred dividend ), and it gives its holders fewer voting privileges and less control over the business than common stock does. To make preferred stock more attractive, companies frequently sell preferred stock with special rights. Among the most common of these special rights is the priority over common stockholders over earnings and assets upon liquidation and the right to cumulative dividendsâif preferred dividends are not paid, then all past dividends must be paid before any common dividends are paid. To the investor, preferred stock is similar to a bond in its priority of claims and its fixed income feature, and it is similar to common stock in that there is no maturity and there is no corporate default if preferred dividends are not paid by the company. Hence, preferred is commonly referred to as a hybrid security.
A limited partnership is a business structure consisting of a general partner who usually initiates, organizes, and manages a business venture, and limited partners who provide the investment funds by buying limited partnership shares. The limited partnership share, in turn, represents an equity position with limited participation in the management of the company. More importantly, in accordance with current tax and corporate laws, all tax obligations and deductions flow directly to the partners and not to the corporation. Thus, earnings go directly to the partners, with no corporate taxes applied. In addition, the usual corporate deductions for depreciation, interest paid on debt, and the like are also used by the individuals as part of their personal income tax deductions. Thus, a limited partnership share is similar to proprietorship or partnership in the way taxes are applied. However, limited partnerships do not subject their holders to personal liabilities in the case of a bankruptcy or an adverse legal judgment; that is, by law, limited partner shares have a limited liability feature like a common stock. Thus, limited partnership shares have the limited liability benefit of common stock without the disadvantage of double taxation.
Types of Debt Claims
Debt claims are loans whereby the borrower agrees to pay a fixed income per period, defined as a coupon or interest, and to repay the borrowed funds, defined as the principal (also called redemption value, maturity value, par value, and face value). Within this broad description, debt instruments can take on many different forms. For example, debt can take the form of a loan by a financial institution. In this case, the terms of the agreement and the contract instrument generally are prepared by the lender/creditor, and the instrument often is nonnegotiable, meaning it cannot be sold to another party. A debt instrument also can take the form of a bond or note, whereby the borrower obtains her loan by selling (also referred to as issuing) contracts or IOUs to pay interest and principal to investors/lenders. Many of these claims, in turn, are negotiable, often being sold to other investors before they mature.
Debt instruments also can differ in terms of the features of the contract: the number of future interest payments; when and how the principal is to be paid (e.g., at maturity, or the end of the contract) or spread out over the life of the contract (amortized); and the recourse the lender has should the bo...