Financial instruments refer to commercial contracts that can be created, traded, modified and settled between parties and can be categorized in three primary dimensions - currency, shares or bonds (Laux, 2012). Over the past five decades, financial instruments have gone through tremendous changes with more recent ones being the extension of the classification of exchange-traded derivatives and the introduction of over-the-counter derivatives contracts such as spot, swaps, forwards and complicated options. This change was triggered by the regulatory mandate aiding the clearing of some OTC contracts through clearing houses and regulatory reporting on their formation and evolving status as they age (Laux, 2012).
Previously, financial instruments were arranged and classified into broad category heading of equity, debt instruments, and other instruments. However, over the period close to 1993, observable developments on the tools were noted as highlighted. Based on the analytical importance of the international accounts, monetary gold and SDRs are shown through classification separately. Additionally, debt securities' replaced securities and other shares' since the term is considered clearer. The generic term equity finance' also was used as opposed to shares and other equity' since the term is clearer and shorter (Attaoui & Poncet, 2013). To further avoid confusion with the term capital in the capital account, equity finance would be used instead.
The agreement by the Advisory Expert Group on National Accounts in the February 2004 meeting paved the way to an instrument category financial derivatives and employees stock option' with the subcategories financial derivatives and employees stock options. This change was based on the argument that employees stock options do not fully meet the definition of financial derivatives although they share some characteristics. A further realization to classify financial derivatives by risk categories resulted in foreign exchange, interest rate, equities, commodities, and others which hugely relied on the supplementary basis.
In addition to the changes, financial gold was to be reclassified as a financial asset rather than a good. This was due to its role in financial markets thereby making international transactions to be recorded in the financial account instead of goods, and would be net instead of gross. Nonetheless, the positions would not be included in the international investment position because they lack the global element that arises for monetary gold included in reserve assets (Laux, 2012).
In concluding the changes, another aspect of financial instrument that underwent a considerable change was the trade-related credit. Trade credit is limited to credit extended by suppliers. Therefore, it resulted in the introduction of a broader concept of trade-related lending including trade credit, trade-related bills, and credit by third parties to finance trade which are identified as a separate component of loans as supplementary information where they are considered statistically and analytically useful (Laux, 2012).
$200 million financing is a considerable amount of money that requires a firm to make an optimal decision on its source to reap maximum benefits and minimum costs that are associated with it. As a result, issue of new debt would be a better source of financing compared to new equity issue. This is because the firm will have to repay the loan over an extended period, usually longer than one year, thus minimizing the firm's monthly payment obligation (Goldstein & Hackbarth, 2014). Additionally, the business mostly uses such long-term loans to purchase buildings, equipment, and significant assets which attract benefits in the form of interest on property that is often tax-deductible. Lastly, financing through a new issue of debt does not compromise with the management or ownership of the firm.
Going by the directives of the Chief Financial Officers (CFOs), a firm's capital structure should be composed of equity and debt with the later constituting, the higher percentage of about 70% of the total capital. Therefore with a total capital requirement of $200 million, $140 million should be obtained through the issue of new debt.
A further analysis bends towards the discussion of the effects of firm's financing on future financial position, and the findings show that equity and debt are the sources of funding. The total cost of capital to a company is measured using the weighted average cost of capital (WACC). Equity financing typically has no impact on the profitability, but it can dilute existing shareholders since net income is divided among the large number of shares (Goldstein & Hackbarth, 2014). By raising the firm's funds through equity financing, two results are noted in the cash flow and balance sheet; an increase in the item in financing activities section and par value increase for common stock respectively.
On the other hand, debt financing results in a rise in the number of items in the financing section of the cash flow statement as well as an increase in liabilities on the statement of financial position. Interest payment on debt reduces net income and cash flow which in turn represents a tax benefit through the lower taxable income. As a result, leverage ratios such as debt to equity and debt to total capital rises. Finally, in the event of liquidation, debt holders are senior to equity holders (Goldstein & Hackbarth, 2014).
Attaoui, S., & Poncet, P. (2013). Capital Structure and Debt Priority. Financial Management, 42(4), 737-775. http://dx.doi.org/10.1111/fima.12011
Goldstein, I., & Hackbarth, D. (2014). Corporate finance theory: Introduction to special issue. Journal Of Corporate Finance, 29, 535-541. http://dx.doi.org/10.1016/j.jcorpfin.2014.10.018
Laux, C. (2012). Financial Instruments, Financial Reporting, and Financial Stability. SSRN Electronic Journal. http://dx.doi.org/10.2139/ssrn.1991825
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