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Fundamentals of Finance – The Type of Asset Essay

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Updated: May 4th, 2022

Purposes of Stock Exchange

Introducing stock exchange in the economic system opened up a series of possibilities, which are mirrored in the functions that stock exchange has in the world of finance. These functions are numerous but the most important ones are:

  1. The possibility for an established or developing business to accumulate large amounts of money in short time by selling shares to the public. This can be achieved by going public, establishing corporate partnership, venture capital, etc.
  2. A particularly important function of stock exchange is its ability to mobilize savings, and incite people to invest. It is well-known that having large sums of money extracted from the flows of capital in the form of savings is very bad for the economy; therefore, stock exchange opens up the possibility for people to invest their savings with the hope that their investment will pay off.
  3. Once a business raises enough money, it becomes much easier to develop its assets. So, another important function of the stock exchange is that it boosts the growth of companies.
  4. The fourth purpose of the stock exchange is profit sharing. This purpose is mirrored in the fact that people who are ready to invest can hope for big profits from their investments if the business starts to develop. On the other hand, they also take the risk of experiencing a loss in case the company bankrupts.
  5. The fact that the stock exchange enables many people to have their share in the company forces management to take their ideas into account. Therefore, management is constantly open to new ideas, which is very beneficial for the business.
  6. Finally, the prices of stocks are reliable signs of the state in which the economy of a country is.
  7. In addition, the government can issue bonds, which are a type of shares, in order to allocate funds for big projects of national importance – roads, sewage systems, etc. (Diamond, 1967)

Companies selling different types of securities

Firstly, an example of a company that offers ordinary shares is Bluglass, whose ASX code is BLG (BLUGLASS LIMITED). With its headquarters in Sydney, this company does research and development in the field of semiconducting materials. Semiconducting materials are used for the production of light-emitting diodes, also known as LEDs, and solar cells. These devices are essential parts of almost every modern digital gadget. Bluglass is a company famous for its devotion to the green industry and environmental protection. They take special care to produce less technological waste, and when compared to their competitors, they use much lower temperatures in their production process. In addition, they achieve all this, while at the same time succeeding to maintain low production costs.

Secondly, a company called Elders Limited (its ASX code is ELD) is an example of a company whose preferred stocks can be bought by potential investors (ELDERS LIMITED). This firm is very successful in the field called agribusiness. This means that their main customers are farmers who need some form of counseling in order to upgrade their business. This counseling may be related to what sorts of plants to grow or which animals to breed, but also Elders Limited can help the farmers establish connections with potential buyers and suppliers.

Thirdly, Advance Energy Limited, or as ASX codes it – ADV, is a company that offers its convertible notes to prospective investors (ADVANCE ENERGY LIMITED). This company is active in the field of fuel production, and in particular, it focuses on exploring, purchasing, and developing sites where oil and natural gas are extracted. They have been involved in a series of projects on a large scale all around the globe. Having finished a big project in Texas, they are now considering acquiring a new site in Ukraine.

Types of securities

The oldest type of security is ordinary shares or, as they are sometimes referred to, common shares. This type of security is obtained when a certain sum of money is invested in a company, and, in return, the investor receives a portion of the company’s ownership. The size of the portion is equal to the relation between the invested sum and the estimated worth of the entire company. Owners of ordinary shares are entitled to receive dividends, which are portions of the company’s profit. They also have the right to vote on important decisions that the company makes, and the strength of their vote is proportional to the size of their share in the company’s ownership. However, even though this type of security can bring great profit to the investor, owners of ordinary shares usually lose the entire investment in case of bankruptcy.

Preferred stocks are a type of hybrid security because they have some features of common stocks and also some features of convertible notes. Those who own a company’s preferred shares have, in principle, no voting rights, but they have many other advantages. In receiving dividends, they have priority over the owners of ordinary stocks, and also in the case of bankruptcy, they do not lose the entire investment. When buying preferred stocks, the investors usually negotiate the terms of the purchase with the issuers.

When companies want to raise money without acquiring debt through expensive bank loans, they usually issue convertible notes. This type of security comes with a price, and the investor is entitled to exchange the note for ordinary stocks or cash. If they decide to cash it, they receive a certain amount of interest that is lower than that of bank loans; however, if they decide to exchange it for ordinary shares, the company’s debt is annulled. This gives the owners some kind of protection because if they see that the price of shares is falling, then they can cash their convertible notes. On the other hand, if the company starts to grow, and the prices of shares begin to rise, owners of convertible notes can convert them into ordinary stocks and enjoy the benefits (Kieso et al, 2010, pp. 730-750).

Costs incurred in buying and selling shares

There is a possibility of buying shares directly from the company, in which case there are no additional costs apart from the price of the share itself. This can be done in case of an initial public offering, an event in which the stocks of a particular company are open for sale for the first time. Also, if a person already owns shares of the company, it is possible for them to buy new shares through a department called investors management.

The most common way of purchasing stocks is with the help of a broker, who charges the commission for his or her services. If a buyer is experienced and informed, they will probably hire a broker who charges less per trade and gives no advice on investment; however, there is the option of hiring a broker who will give detailed counseling in return for a higher price per trade. The fact that brokers charge their commission per trade means that every time one buys a certain number of shares, the commission is charged. This price is not very high since it ranges from 6 to 15 dollars; however, people who plan to earn money by trading stocks have to be ready to trade very often, sometimes on a daily basis or even several times a day. At that point, the price of commission becomes a significant factor.

Finally, there is a possibility of buying stocks on a margin. This method is carried out through a bank and is regarded as a type of loan similar to those which are used when buying a house or a car. The bank gives the money necessary for buying stocks, and the purchased shares become the guarantee that the buyer will repay the loan. In case the buyer loses the ability to pay installments, the bank confiscated the purchased shares. Also, if the value of a share drops below a defined margin, the broker will sell them in order to protect the bank.

Risks of losing the investment

In addition to the priorities that they have when dividends are distributed, preference shares also seem to have one more desirable feature, and that is when the company bankrupts the rights of the owners of preferred or preference shares have the priority over those of other shareholders. This right is exercised in such a way that in case of liquidation, the clause in the contract signed by both parties, which says that the shareholder has to be paid a fixed amount of money if the company bankrupts, protects the investor from losing the entire investment (Kieso et al., 2010, p. 710).

On the other hand, the fact that all the investors who possess preference shares have to have their investments returned first means that owners of common or ordinary shares in many cases lose the entire investment when the company bankrupts. If it happens that after the requirements specified in the contracts of all the owners of preference shares are met, some surplus assets remain, then those assets are distributed among the owners of common stocks. This practically means that those who own ordinary shares only have a residual claim, and they very often lose the entire investment (Kieso et al., 2010, p. 714).

Finally, the fact that convertible notes have a determined minimum price protects the owners because they cannot lose the entire investment. On the other hand, convertible notes are classified as subordinated debt. This means that preference shares still have priority over them in the case of bankruptcy (Convertible bonds explained). Taking all this into account, we can form a gradient of risk as follows: ordinary shares are the riskiest option of the three because it is possible to lose the entire investment; convertible notes involve less risk but there is still a greater possibility of a loss than in the case of preference shares because preference shares have the priority if the company faces liquidation. One must not forget, however, that the greatest risk carries also the greatest possible gain since all of the protective measures narrow down the possible range of price fluctuation in both ways.

Main factors to consider when choosing a type of asset

There are many factors to be considered when choosing which type of asset to invest in. First off, the fact that ordinary shares can give the greatest increase in the initial investment makes them the perfect solution for those investors who aim at very high profits. However, the possibility of losing the entire investment makes this type of asset appropriate only for the investors who are able to predict that the company will not enter a recession or even worse face liquidation.

Secondly, preference shares, because of their almost risk-free nature, are a very appealing option. However, one has to bear in mind that such an investment does not bring great profits especially in case of investments which are not very large. Therefore, people who plan to invest large sums of money can safely do so by choosing preference shares. This option is definitely not the best solution for those who are not able to invest larger sums.

Finally, convertible notes can be very appealing to investors, but they have to be careful when choosing this method. The most interesting property of convertible notes is that the company, based on its strength and reputation, determines the rate of interest it pays on convertible notes issued. If the interest rate is very high, then it is a sign that the company is not very strong and that the risk of potential loss is great. This means that the investors can very easily determine the balance between the potential gain and implied risks.

Our investment

The sum of money available for investment and the time period in which the investor hopes to make profit are the two most important variables that determine the appropriate choice of the type of asset. Given the facts that the hypothetical sum is relatively small – 5000 Australian dollars, and that we are aiming for a short-term profit, because the plan is to resell the assets after a month, it seems that the best solution would be to invest in ordinary shares. This type of asset carries a chance of highest gains and with the sum of 5000 dollars we have to hope for high gains to make the profit worth the risk. All of this is conditioned upon the fact that we have a reason to believe that the company will enter a period of growth.

Preference shares were not chosen here, despite their risk-free nature, because the possible profit relative to the invested sum would be insignificant. It seems that more profit could be made in a month by investing that sum of money in some other domain.

A similar reason holds for not choosing convertible notes. Investment in convertible notes makes sense in a situation in which the investor plans to follow the company during a longer period, particularly because of the possibility of converting them into ordinary shares at the point in which the price of ordinary shares is high. If the plan is to resell assets after a month, convertible notes do not carry the promise of significant gains.

References

ADVANCE ENERGY LIMITED (AVD) – ASX Listed Company Information Fact Sheet, n.d., Australian Securities Exchange – Stock Market Information, Stock Quotes – ASX. Web.

BLUGLASS LIMITED (BLG) – ASX Listed Company Information Fact Sheet, n.d., Australian Securities Exchange – Stock Market Information, Stock Quotes – ASX, Web.

Convertible Bonds Explained, n.d., Day Trading & Stock Market Strategies – mysmp.com., Web.

Diamond, P 1967, The Role of a Stock Market in a General Equilibrium Model with Technological Uncertainty, American Economic Review, vol. 54, pp. 759-776.

ELDERS LIMITED (ELD) – ASX Listed Company Information Fact Sheet, n.d., Australian Securities Exchange – Stock Market Information, Stock Quotes – ASX, Web.

Kieso, D W, Kieso, D E, Weygandt, J J & Warfield, T D 2010, Intermediate accounting (13th ed.), John Wiley & Sons, Inc., Hoboken, NJ.

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