Lecture 10 And 11 - Financial Instruments

Question 1

What is the definition of a financial instrument?

Answer 1

IAS 32 defines a financial instrument as any contract that gives rise to a financial asset of one entity and a financial liability or equity instrument of another entity.

Question 2

A share always results in what sort of position for the issuing firm and the investor?

Answer 2

An equity position for the issuing firm.

An asset position for the investor.

Question 3

A loan always results in what position for the borrower and the lender?

Answer 3

Results in a liability for the borrower.

Results in an asset for the lender.

Question 4

The presentation of a financial instrument as either liability or equity impacts two main things:

Answer 4

1. Gearing/solvency ratios. (Leverage ratios)

2. Debt covenants with finial institutions.

Question 5

What is meant by the term ‘redeemable shares’?

Answer 5

Redeemable shares are those shares where the issuer of the share has the right to redeem the shares within 20 years of the issuance at a pre-determined price.

Question 6

What is meant by a ‘compound interest instrument’?

Answer 6

A compound financial instrument is a financial instrument that contains both a liability and an equity element.

Question 7

Give an example of a compound financial instrument and explain what is it.

Answer 7

A convertible loan.

This is where a bond issue can be converted into shares. At maturity, the bond can be either paid in cash or shares.

Question 8

What is the accounting treatment for compound financial instruments?

Answer 8

Compound financial instruments are to be separated into their components that are to be recognised separately.

That is:
Determine the debt portion
Determine the equity portion

Question 9

How are the 4 steps for calculating the debt and equity portions of a compound financial instrument?

Answer 9

1. Calculate the discount factor for the redemption payment.
2. Calculate the present value for the redemption payment.
3. Calculate the discount factor for the interest payments.
4. Calculate the present value for the interest payments
5. Calculate the equity portion (par value less debt portion).

Question 10

What is the formula for calculating the present value of the redemption payment?

Answer 10

Value/(1.discount rate)^t

Question 11

What is the formula for calculating the present value of interest payments?

Answer 11

(1/1.discount rate) + (1/1.discount rate ^2) + (1/1.discount rate ^3)