14.1 Complex Financial Instruments: Overview
As stated in the previous chapter regarding long-term debt, most businesses will require financing at various points throughout their lives. For example, new businesses may require start-up cash to purchase revenue-generating assets, as they have yet to accumulate cash holdings. Existing companies may want to expand their operations or replenish depleted cash holdings due to a temporary downturn in sales. There are also companies that possess large infrastructures, such as airlines or railways, and require more cash for their capital projects than can be generated from normal operations. These businesses obtain the necessary additional cash through various financing activities such as internally generated free cash flow, borrowing from creditors (debt), and issuing capital shares (equity).
The material presented in the previous chapters looked at debt and equity as separate instruments. However, in recent decades financing activities have created hybrid sources of financing where a single instrument can possess characteristics of both debt and equity. Examples of these more complex instruments are convertible debt, convertible preferred shares, and various derivatives such as options and warrants that can be converted into common shares.
Why do companies seek out these alternative financing sources? As the opening story explains, instruments such as convertible debt can often be simpler, cheaper, and faster to obtain – all while maintaining existing control, or at least knowing exactly when the control will change due to the triggering event. Also, these hybrid securities usually include sweeteners, such as conversion to shares at a lower than market price, thereby increasing their attractiveness to investors. Moreover, investors will be more willing to purchase the bonds because they not only provide greater security if secured by company assets, but they also allow investors to participate in the company profits and growth through the option to convert to common shares. Since the conversion feature adds flexibility, and hence increased value, companies can usually obtain convertible debt at cheaper interest rates. However, there is more to the story. Convertible instruments have a significantly different effect on perceptions held by shareholders and the marketplace. For example, if a company issues additional common shares to raise capital, instead of using its own internally generated funds from profits or by borrowing funds (to be repaid by internally generated funds), the market can interpret this negatively, as a sign that the company is unable to obtain debt financing, perhaps due to a poor credit rating. In other words, it sends a signal that the company might not be performing as well as it should. This can lower the market value of the shares, thereby creating a negative climate and causing concern for the shareholders.
If convertible bonds (debt) or convertible preferred shares or warrants (equity) are issued instead, the investment holders will only convert to common shares if conditions are favourable. This sends a positive signal to the market that the company is continuing to do well. As a result, these hybrid instruments become a way to access funding while maintaining a more positive climate, without unduly alarming shareholders and creditors. As such, these hybrid instruments have become widely accepted and commonplace in today’s market.
From an accounting standards point of view, the issue becomes: how do you separate, measure, and report the debt and equity attributes of these complex financial instruments throughout their life-cycle of issuance, subsequent measurement, and conversion or retirement?
