IAI Actuarial Core Principles · Business Finance

Financial Instruments Issued or Used by Companies

This chapter covers how companies raise money and manage risk: ordinary shares, preference shares, bonds, convertibles, warrants, bank loans, leases and derivatives. To solve questions, identify who bears risk, who ranks first on a winding-up, what cash flows occur, and why the company would choose that instrument.

What this chapter covers

This chapter is about the tools a company uses to raise funds and to manage risk. You start with the most basic claim on a company, ordinary shares, and move through preference shares, debt, hybrids, short-term finance and finally derivatives. Each instrument sits at a different point on the risk and return scale.

The key idea is the trade-off. Debt is usually cheaper for the company and ranks ahead of equity, but it brings fixed payments and a risk of default. Equity is costlier but flexible and carries no fixed repayment. Hybrids mix features of both. If you can place every instrument on this scale, most questions become easier.

The chapter links directly to the rest of CB1. It feeds into the chapter on how corporates are financed (capital structure, cost of capital and gearing), into project evaluation (the discount rate depends on the financing mix) and into company accounts (how each instrument appears on the balance sheet and income statement). It also connects to CM2, where bonds, equity and options are valued mathematically.

How corporates are financed carries a large share of the CB1 syllabus, and almost every question in that area assumes you know the instruments in this chapter. Multiple-choice questions often test definitions and ranking, such as who is paid first or what a feature does. Written questions ask you to compare instruments, recommend one for a given company, or explain the risk to each party. The material is mostly descriptive, so careful, structured answers earn reliable marks without heavy calculation.

Financial instruments issued or used by companies: topics in the order to study them

1Ordinary Shares and Equity FinancingEquity is the residual claim. Every other instrument is easier to understand once you know what sits below it.
2Preference SharesThey are the next step up in ranking and show how fixed dividends and cumulative or participating features change the risk.
3Corporate Bonds, Debentures and Loan StockDebt introduces fixed interest, security, ranking on winding-up and default risk, which you need before hybrids.
4Convertible Bonds, Warrants and Hybrid InstrumentsHybrids combine debt and equity features, so you can only judge them after the pure forms are clear.
5Bank Borrowing, Leasing and Other Short-Term FinanceThis shifts from long-term capital to working capital and asset finance, and it adds practical comparison points such as flexibility and cost.
6Derivatives Used by CompaniesDerivatives are used to manage risk rather than raise funds, and they make most sense once you know what exposures the other instruments create.

How to prepare Financial instruments issued or used by companies

This chapter rewards structure more than memorisation. Build one comparison framework and apply it to every instrument.

Make a one-page table with instruments down the side and these columns: who issues it, return to holder, ranking on winding-up, voting rights, tax treatment of payments, and main risk.
Study the topics in the order given. After each, add a row to your table from memory before checking your notes.
For every instrument, write two reasons a company would issue it and two reasons it might not. Exams often ask for advantages and disadvantages from the company's side and the investor's side.
Practise explaining features in your own words, such as cumulative, redeemable, convertible, secured and floating rate. Check you state the effect on risk, not only the definition.
Link each instrument to capital structure. Ask how it changes gearing, cost of capital and control of the company.
For derivatives, learn the purpose first (hedging interest rate, currency or commodity risk), then the basic payoff of forwards, futures, swaps and options.
Finish with past-paper style questions. Write short structured answers with a point, an explanation and a link to the company's situation.

Common mistakes in Financial instruments issued or used by companies

Treating preference shares as debt or as ordinary equity.
Fix: State that they are a hybrid in practice: fixed-type dividend like debt, but dividends are paid from profits, and they rank below debt on winding-up.
Mixing up the ranking order on winding-up.
Fix: Learn the order: secured creditors, unsecured creditors, preference shareholders, ordinary shareholders. Apply it to every risk comparison.
Giving advantages and disadvantages from only one side.
Fix: Always cover issuer and investor views separately, then link to the situation given in the question.
Assuming convertibles are always cheaper for the company.
Fix: Note the lower coupon, then add the dilution if conversion happens and the uncertainty over whether it will.
Describing derivatives only as speculation.
Fix: In company questions, frame derivatives as hedging tools. Name the exposure first, then the instrument that offsets it.
Writing generic lists without applying them to the company in the question.
Fix: Use the facts given, such as company size, asset base or cash flow stability, to justify which instrument suits.

Last-day revision: Financial instruments issued or used by companies

Ordinary shareholders are the residual claimants: paid last, with unlimited upside and limited liability.
Dividends on ordinary shares are discretionary; interest on debt is a legal obligation.
Preference shares usually carry a fixed dividend and rank ahead of ordinary shares but behind debt.
Cumulative preference shares carry unpaid dividends forward; participating ones share in extra profits.
Debt ranks ahead of equity on winding-up, and secured debt ranks ahead of unsecured.
A fixed charge is on specific assets; a floating charge is on a class of changing assets.
Convertible bonds give the holder the option to swap into shares, so they usually pay a lower coupon.
Warrants give the right to buy shares at a set price and can be detached and traded separately.
Conversion can dilute existing shareholders' ownership and earnings per share.
Leasing finances use of an asset without buying it; compare finance leases and operating leases by who bears ownership risks.
Companies use derivatives mainly to hedge interest rate, currency and commodity risks.
Higher gearing raises financial risk because fixed payments must be met whatever the profit.

Financial instruments issued or used by companies practice questions

Financial instruments issued or used by companies in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Financial instruments issued or used by companies: frequently asked questions

Is this chapter mostly theory or calculation?

It is mostly descriptive. You need to explain features, ranking, risk and suitability. Some questions use simple numbers, such as dividend or interest effects, but the marks come mainly from clear reasoning.

How do I remember the differences between so many instruments?

Use one comparison table with the same columns for every instrument. Rebuild it from memory each week. It is faster and more reliable than rereading notes.

Do I need to know derivative pricing for this chapter?

For CB1 you mainly need to know what companies use derivatives for and the basic payoff of each type. Detailed pricing belongs to CM2, though knowing the basics helps.

How is this chapter linked to capital structure questions?

Capital structure questions ask about the mix of debt, equity and hybrids. You can only discuss gearing, risk and cost properly if you understand the features of each instrument in this chapter.