Financial Instruments-equity

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Financial Instruments-equity

Lecture number:
Lecture Note
University of Texas at Austin
Fin 320f - Foundations of Finance

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Lecture 3 Current Lecture  When companies need large sums of cash, they have two options: • Borrow the money • Sell something they own, above and beyond selling their regular product or service; that is, sell part of the company  The first option is called issuing debt; the second, issuing equity  Companies can issue equity in two ways: • Private placement of equity: A start-up might sell a portion of itself to a single investor (eg. an angel) or venture capital company • Public issue of equity: A bigger firm might sell many tiny pieces of itself (shares of stock) to each of many investors/stockholders/ shareholders  When investors buy common stock, they become part owners of the company  Common stock: the most common type • Represents ownership of the company • Has no maturity date • May or may not pay dividends • Usually has voting rights • Is last in line in the event of liquidation  Preferred stock: a hybrid security • Like bonds, provide regular income to owners • Like common stock, cannot cause bankruptcy • Priority is between bonds and common stock Advantages of Equity  Common stock doesn’t require the firm to make fixed payments  Common stock never matures, thus never has to be repaid  Using common stock will improve the firm’s debt ratio, thereby reducing risk of bankruptcy & providing financial flexibility Disadvantages of Equity  Giving up ownership means giving up some control  Paying dividends means handing over cash to owners  Issuing equity costs more than issuing debt (because of the risk-return trade-off)  Paying dividends is not a tax-deductible expense for the firm Type of Investment Positions  Long: • Buy a security, hold it, and hope the price will rise • When the price rises, sell it • The spread between the price paid when purchased & the price earned when sold is profit (capital gain)  Short: • Borrow a security, sell it, and hope the price will fall • When the price falls, repurchase it and return it FIN 320F 1st Edition

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