Posts Tagged ‘Definition’

Anti-Dilution Provision: Definition, How It Works, Types, Formula

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Anti-Dilution Provision: Definition, How It Works, Types, Formula

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What Is an Anti-Dilution Provision?

Anti-dilution provisions are clauses built into convertible preferred stocks and some options to help shield investors from their investment potentially losing value. When new issues of a stock hit the market at a cheaper price than that paid by earlier investors in the same stock, then equity dilution can occur. Anti-dilution provisions are also referred to as anti-dilution clauses, subscription rights, subscription privileges, or preemptive rights.

Understanding Anti-Dilution Provisions

Anti-dilution provisions act as a buffer to protect investors against their equity ownership positions becoming diluted or less valuable. This can happen when the percentage of an owner’s stake in a company decreases because of an increase in the total number of shares outstanding. Total shares outstanding may increase because of new share issuance based on a round of equity financing. Dilution can also occur when holders of stock options, such as company employees, or holders of other optionable securities exercise their options.

When the number of shares outstanding increases, each existing stockholder owns a smaller, or diluted, percentage of the company, making each share less valuable.

Sometimes the company receives enough cash in exchange for the shares that the increase in the value of the shares offsets the effects of dilution; but often this is not the case.

Anti-Dilution Provisions at Work

Dilution can be particularly vexing to preferred shareholders of venture capital deals, whose stock ownership may become diluted when later issues of the same stock hit the market at a cheaper price. Anti-dilution provisions can discourage this from happening by tweaking the conversion price between convertible securities, such as corporate bonds or preferred shares, and common stocks. In this way, anti-dilution clauses can keep an investor’s original ownership percentage intact.

Dilution in Action

  • As a simple example of dilution, assume that an investor owns 200,000 shares of a company that has 1,000,000 shares outstanding. The price per share is $5, meaning that the investor has a $1,000,000 stake in a company valued at $5,000,000. The investor owns 20% of the company.
  • Next, assume that the company enters a new round of financing and issues 1,000,000 more shares, bringing the total shares outstanding to 2,000,000. Now, at that same $5 per share price, the investor owns a $1,000,000 stake in a $10,000,000 company. Instantly, the investors’ ownership has been diluted to 10%.

Types of Anti-Dilution Provisions

The two common types of anti-dilution clauses are known as “full ratchet” and “weighted average.”

With a full ratchet provision, the conversion price of the existing preferred shares is adjusted downward to the price at which new shares are issued in later rounds. Very simply, if the original conversion price was $5 and in a later round the conversion price is $2.50, the investor’s original conversion price would adjust to $2.50.

The weighted average provision uses the following formula to determine new conversion prices:

  • C2 = C1 x (A + B) / (A + C)

Where:

  • C2 = new conversion price
  • C1 = old conversion price
  • A = number of outstanding shares before a new issue
  • B = total consideration received by the company for the new issue
  • C = number of new shares issued

Key Takeaways

  • Anti-dilution provisions are clauses built into convertible preferred stocks to help shield investors from their investment potentially losing value.
  • Dilution can occur when the percentage of an owner’s stake in a company decreases because of an increase in the total number of shares outstanding. 
  • Anti-dilution provisions are also referred to as anti-dilution clauses, subscription rights, subscription privileges, or preemptive rights.

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What Is an Asset? Definition, Types, and Examples

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What Is an Asset? Definition, Types, and Examples

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What Is an Asset?

An asset is a resource with economic value that an individual, corporation, or country owns or controls with the expectation that it will provide a future benefit.

Assets are reported on a company’s balance sheet. They’re classified as current, fixed, financial, and intangible. They are bought or created to increase a firm’s value or benefit the firm’s operations.

An asset can be thought of as something that, in the future, can generate cash flow, reduce expenses, or improve sales, regardless of whether it’s manufacturing equipment or a patent. 

Key Takeaways

  • An asset is a resource with economic value that an individual, corporation, or country owns or controls with the expectation that it will provide a future benefit.
  • Assets are reported on a company’s balance sheet.
  • They are bought or created to increase a firm’s value or benefit the firm’s operations.
  • An asset is something that may generate cash flow, reduce expenses or improve sales, regardless of whether it’s manufacturing equipment or a patent.
  • Assets can be classified as current, fixed, financial, or intangible.

Understanding Assets

An asset represents an economic resource owned or controlled by, for example, a company. An economic resource is something that may be scarce and has the ability to produce economic benefit by generating cash inflows or decreasing cash outflows.

An asset can also represent access that other individuals or firms do not have. Furthermore, a right or other type of access can be legally enforceable, which means economic resources can be used at a company’s discretion. Their use can be precluded or limited by an owner.

For something to be considered an asset, a company must possess a right to it as of the date of the company’s financial statements.

Assets can be broadly categorized into current (or short-term) assets, fixed assets, financial investments, and intangible assets.

Types of Assets

Current Assets

In accounting, some assets are referred to as current. Current assets are short-term economic resources that are expected to be converted into cash or consumed within one year. Current assets include cash and cash equivalents, accounts receivable, inventory, and various prepaid expenses.

While cash is easy to value, accountants periodically reassess the recoverability of inventory and accounts receivable. If there is evidence that a receivable might be uncollectible, it’ll be classified as impaired. Or if inventory becomes obsolete, companies may write off these assets.

Some assets are recorded on companies’ balance sheets using the concept of historical cost. Historical cost represents the original cost of the asset when purchased by a company. Historical cost can also include costs (such as delivery and set up) incurred to incorporate an asset into the company’s operations.

Fixed Assets

Fixed assets are resources with an expected life of greater than a year, such as plants, equipment, and buildings. An accounting adjustment called depreciation is made for fixed assets as they age. It allocates the cost of the asset over time. Depreciation may or may not reflect the fixed asset’s loss of earning power.

Generally accepted accounting principles (GAAP) allow depreciation under several methods. The straight-line method assumes that a fixed asset loses its value in proportion to its useful life, while the accelerated method assumes that the asset loses its value faster in its first years of use.

Financial Assets

Financial assets represent investments in the assets and securities of other institutions. Financial assets include stocks, sovereign and corporate bonds, preferred equity, and other, hybrid securities. Financial assets are valued according to the underlying security and market supply and demand.

Intangible Assets

Intangible assets are economic resources that have no physical presence. They include patents, trademarks, copyrights, and goodwill. Accounting for intangible assets differs depending on the type of asset. They can be either amortized or tested for impairment each year.

While an asset is something with economic value that’s owned or controlled by a person or company, a liability is something that is owed by a person or company. A liability could be a loan, taxes payable, or accounts payable.

What Is Considered an Asset?

When looking at an asset definition, you’ll typically find that it is something that provides a current, future, or potential economic benefit for an individual or company. An asset is, therefore, something that is owned by you or something that is owed to you. A $10 bill, a desktop computer, a chair, and a car are all assets. If you loaned money to someone, that loan is also an asset because you are owed that amount. For the person who owes it, the loan is a liability.

What Are Examples of Assets?

Personal assets can include a home, land, financial securities, jewelry, artwork, gold and silver, or your checking account. Business assets can include such things as motor vehicles, buildings, machinery, equipment, cash, and accounts receivable.

What Are Non-Physical Assets?

Non-physical or intangible assets provide an economic benefit even though you cannot physically touch them. They are an important class of assets that include things like intellectual property (e.g., patents or trademarks), contractual obligations, royalties, and goodwill. Brand equity and reputation are also examples of non-physical or intangible assets that can be quite valuable.

Is Labor an Asset?

No. Labor is the work carried out by human beings, for which they are paid in wages or a salary. Labor is distinct from assets, which are considered to be capital.

How Are Current Assets Different From Fixed (Noncurrent) Assets?

In accounting, assets are categorized by their time horizon of use. Current assets are expected to be sold or used within one year. Fixed assets, also known as noncurrent assets, are expected to be in use for longer than one year. Fixed assets are not easily liquidated. As a result, unlike current assets, fixed assets undergo depreciation.

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Auction Market: Definition, How It Works in Trading, and Examples

Written by admin. Posted in A, Financial Terms Dictionary

Auction Market: Definition, How It Works in Trading, and Examples

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What Is an Auction Market?

In an auction market, buyers enter competitive bids and sellers submit competitive offers at the same time. The price at which a stock trades represents the highest price that a buyer is willing to pay and the lowest price that a seller is willing to accept. Matching bids and offers are then paired together, and the orders are executed. The New York Stock Exchange (NYSE) is an example of an auction market.

Auction Market Process

The process involved in an auction market differs from the process in an over-the-counter (OTC) market. On the NYSE, for example, there are no direct negotiations between individual buyers and sellers, while negotiations occur in OTC trades. Most traditional auctions involve multiple potential buyers or bidders, but only a single seller, whereas auction markets for securities have multiple buyers and multiple sellers, all looking to make deals simultaneously.

Key Takeaways

  • An auction market is one where buyers and sellers enter competitive bids simultaneously.
  • The price at which a stock trades represents the highest price that a buyer is willing to pay and the lowest price that a seller is willing to accept.
  • A double auction market is when a buyer’s price and a seller’s asking price match, and the trade proceeds at that price.
  • Auction markets do not involve direct negotiations between individual buyers and sellers, while negotiations occur for OTC trades.
  • The U.S. Treasury holds auctions, which are open to the public and large investment entities, to finance certain government financial activities.

Double Auction Markets

An auction market also known as a double auction market, allows buyers and sellers to submit prices they deem acceptable to a list. When a match between a buyer’s price and a seller’s asking price is found, the trade proceeds at that price. Trades without matches will not be executed.

Examples of the Auction Market Process

Imagine that four buyers want to buy a share of company XYZ and make the following bids: $10.00, $10.02, $10.03 and $10.06, respectively. Conversely, four sellers wish to sell shares of company XYZ, and these sellers submitted offers to sell their shares at the following prices: $10.06, $10.09, $10.12 and $10.13, respectively.

In this scenario, the individuals that made bids/offers for company XYZ at $10.06 will have their orders executed. All remaining orders will not immediately be executed, and the current price of company XYZ will be $10.06.

Treasury Auctions

The U.S. Treasury holds auctions to finance certain government financial activities. The Treasury auction is open to the public and various larger investment entities. These bids are submitted electronically and are divided into competing and noncompeting bids depending on the person or entity who places the recorded bid.

Noncompeting bids are addressed first because noncompetitive bidders are guaranteed to receive a predetermined amount of securities as a minimum and up to a maximum of $5 million. These are most commonly entered by individual investors or those representing small entities.

In competitive bidding, once the auction period closes, all of the incoming bids are reviewed to determine the winning price. Securities are sold to the competing bidders based on the amount listed within the bid. Once all of the securities have been sold, the remaining competing bidders will not receive any securities.

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Average Life: Definition, Calculation Formula, Vs. Maturity

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Average Life: Definition, Calculation Formula, Vs. Maturity

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What Is Average Life?

The average life is the length of time the principal of a debt issue is expected to be outstanding. Average life does not take into account interest payments, but only principal payments made on the loan or security. In loans, mortgages, and bonds, the average life is the average period of time before the debt is repaid through amortization or sinking fund payments.

Investors and analysts use the average life calculation to measure the risk associated with amortizing bonds, loans, and mortgage-backed securities. The calculation gives investors an idea of how quickly they can expect returns and provides a useful metric for comparing investment options. In general, most investors will choose to receive their financial returns earlier and will, therefore, choose the investment with the shorter average life.

Key Takeaways

  • The average life is the average length of time it will take to repay the outstanding principal on a debt issue, such as a Treasury bill, bond, loan, or mortgage-backed security. 
  • The average life calculation is useful for investors who want to compare the risk associated with various investments before making an investment decision.
  • Most investors will choose an investment with a shorter average life as this means they will receive their investment returns sooner.
  • Prepayment risk occurs when the loan borrower or bond issuer repays the principal earlier than scheduled, thereby shortening the investment’s average life and reducing the amount of interest the investor will receive.

Understanding Average Life

Also called the weighted average maturity and weighted average life, the average life is calculated to determine how long it will take to pay the outstanding principal of a debt issue, such as a Treasury Bill (T-Bill) or bond. While some bonds repay the principal in a lump sum at maturity, others repay the principal in installments over the term of the bond. In cases where the bond’s principal is amortized, the average life allows investors to determine how quickly the principal will be repaid.

The payments received are based on the repayment schedule of the loans backing the particular security, such as with mortgage-backed securities (MBS) and asset-backed securities (ABS). As borrowers make payments on the associated debt obligations, investors are issued payments reflecting a portion of these cumulative interest and principal payments.

Calculating the Average Life on a Bond

To calculate the average life, multiply the date of each payment (expressed as a fraction of years or months) by the percentage of total principal that has been paid by that date, add the results, and divide by the total issue size.

For example, assume an annual-paying four-year bond has a face value of $200 and principal payments of $80 during the first year, $60 for the second year, $40 during the third year, and $20 for the fourth (and final) year. The average life for this bond would be calculated with the following formula:

($80 x 1) + ($60 x 2) + ($40 x 3) + ($20 x 4) = 400

Then divide the weighted total by the bond face value to get the average life. In this example, the average life equals 2 years (400 divided by 200 = 2).

This bond would have an average life of two years against its maturity of four years.

Mortgage-Backed and Asset-Backed Securities

In the case of an MBS or ABS, the average life represents the average length of time required for the associated borrowers to repay the loan debt. An investment in an MBS or ABS involves purchasing a small portion of the associated debt that is packaged within the security.

The risk associated with an MBS or ABS centers on whether the borrower associated with the loan will default. If the borrower fails to make a payment, the investors associated with the security will experience losses. In the financial crisis of 2008, a large number of defaults on home loans, particularly in the subprime market, led to significant losses in the MBS arena.

Special Considerations

While certainly not as dire as default risk, another risk bond investors face is prepayment risk. This occurs when the bond issuer (or the borrower in the case of mortgage-backed securities) pays back the principal earlier than scheduled. These prepayments will reduce the average life of the investment. Because the principal is paid back early, the investor will not receive future interest payments on that part of the principal.

This interest reduction can represent an unexpected challenge for investors of fixed-income securities dependent on a reliable stream of income. For this reason, some bonds with payment risk include prepayment penalties.

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