SECURITY ANALYSIS & PORTFOLIO MANAGEMENT

LECTURE 05
Financial Risk

J P Singh
Department of Management Studies

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RECAP & KEY TAKEAWAYS OF
PREVIOUS LECTURE

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• Need for a debt-equity mix for optimality.
• Miller-Modigliani Capital Structure Irrelevance
Theorem
• Derivatives are securities whose value is based
on the price or value of an underlying asset.
• Price of a derivative
EQ f  S T  
-r  T-t 
Pt = e

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• Forwards are customized contracts, the terms
whereof are negotiated today (t=0), but the
actual settlement by delivery of the underlying
& payment of price takes place at a future date
(maturity).
• Cash flow occurs in the future. No cash flow now
except margin.
• Since forwards are private contracts, they are
susceptible to default risk.
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• Futures are similar to forwards but traded at futures
exchanges
• Futures are standardized and default free.
• Marking to market & margining in futures.
• Option contracts entail creation of a right & an
obligation
• The buyer of option has a right to buy/sell the
underlying asset at predetermined conditions of
price, timing etc..
• Swaps are exchanges of a series of cash flows.
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HYBRID INSTRUMENTS

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 PREFERENCE SHARES
• Preference share capital means, in the case of a
company limited by shares, that part of the
capital of the company which:
• (1) carries a preferential right to payment of
dividend during the lifetime of the company;
• (2) carries, on a winding up, a preferential right
to be repaid the amount of capital paid-up.
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 DEBT RELATED FEATURES
• Fixed returns as dividend
• Pre-emptive right to
• (i) dividend
• (ii) return of capital
• No voting rights
• Voting rights only if the company is in default of
preference dividend for 2 years or more (sec 47 of
2013 Act).
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 EQUITY RELATED FEATURES
• Dividend is discretionary
• Dividend is appropriation of profits
• Dividend is not a charge against profits
• No tax shield on dividend
• Voting rights in case of default of dividend

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• We can have situations where:
• both preference and equity dividends are paid,
• both preference and equity dividends are NOT paid,
• preference dividends are paid but equity dividends
are not paid,
• BUT WE CANNOT HAVE A SITUATION WHERE
PREFERENCE DIVIDEND IS NOT PAID BUT EQUITY
DIVIDEND IS PAID.
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 WHY PREFERENCE SHARES ARE NOT POPULAR
• There are no voting rights for preference investors
• From an investor perspective, the business is not liable to
preference shareholders as opposed to equity shareholders.
• If the business really turns a profit, it would benefit equity.
• If the interest rate increases, it would benefit debt.
• The preferred shareholders will be stuck on the fixed
dividend.
• Limited capital appreciation.

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• Higher cost than debt for issuing company
• No interest tax shield.
• Demand for higher returns than debt by
investors without tax shield thereon.

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 TYPES OF PREFERENCE SHARES
• Cumulative & Non-cumulative Preference Shares.
• Convertible & Non-convertible Preference Shares.
• Redeemable & Irredeemable Preference Shares.
• Participating & Non-participating Preference Shares
• Callable & Non-callable Preference Shares

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 WHY IRREDEEMABLE PREF SHARES ARE
PROHIBITED
• Refer Sachar Committee Report pg. 189, 1978,
Companies Amendment Act 1988:
• Irredeemable preference shares do not provide
investors any exit route from company in case of
adverse market conditions where company is
incurring losses and unable to fulfill its
commitment of assured dividend.
• In contrast to equity shares, preference shares
are
• not entitled to voting rights and
• hence do not have a say in business decisions.

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• Some suggestions are made that preference
shares should be abolished.
• The view of the financial institutions is that
preference shares, though not a good
investment, are still helpful to them because
they ensure a steady income at the initial stages.
• Existence of irredeemable preference shares,
was an anomaly as the shareholders are
compelled to be satisfied with the amount of
return which is totally unrealistic and unrelated
to the prevailing circumstances. Thus, there is
sufficient justification for such a complaint.
 TREATMENT OF PREFERENCE SHARES
• If an entity issues preference (preferred) shares
that:
• pay a fixed rate of dividend and
• have a mandatory redemption feature at a future
date,
• the substance is that they are a contractual
obligation to deliver cash and, therefore, should be
recognized as a liability. [IAS 32.18(a)]
• In contrast, preference shares that do not have a
fixed maturity, and where the issuer does not
have a contractual obligation to make any
payment are equity.
 CONVERTIBLE SECURITIES
& WARRANTS
• Convertible securities
• may be convertible bonds or preferred stocks
• that pay regular interest/dividend for a pre-
specified period
• and then can be converted into shares of
common stock.
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 WARRANTS
• In finance, a warrant is a security that
• entitles the holder to buy the underlying stock
of the issuing company
• at a fixed price called exercise price
• on or until the expiry date.

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 WARRANTS VS OPTIONS
• Warrants and options are similar in that the two
contractual financial instruments allow the holder special
rights to buy securities.
• However, warrants are usually issued as sweeteners to
assist marketability of a bond issue. They are issued by
the bond issuer.
• Option contracts are released for trading by the
exchange. They have nothing to do with the issuer of the
underlying.
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