FM11 Ch 21 Hybrid Financing_Preferred Stock,Warrants, and Convertibles

Dividend obligation not contractual Avoids dilution of common stock Avoids large repayment of principal Disadvantages Preferred dividends not tax deductible, so typically costs mor

Types of hybrid securities

Preferred stock

Warrants

Convertibles

Features and risk

Cost of capital to issuers

CHAPTER 21Hybrid Financing: Preferred Stock,

Warrants, and Convertibles

Preferred dividends are specified by contract, but they may be omitted

without placing the firm in default.

Most preferred stocks prohibit the

firm from paying common dividends when the preferred is in arrears

Usually cumulative up to a limit.

common stock and debt?

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Some preferred stock is perpetual , but

most new issues have sinking fund or

call provisions which limit maturities

Preferred stock has no voting rights, but may require companies to place preferred stockholders on the board (sometimes a majority) if the dividend is passed.

Is preferred stock closer to debt or

common stock? What is its risk to

investors? To issuers?

Dividend obligation not contractual

Avoids dilution of common stock

Avoids large repayment of principal

Disadvantages

Preferred dividends not tax deductible,

so typically costs more than debt

Increases financial leverage, and hence the firm’s cost of common equity

tages of preferred stock financing?

Dividends are indexed to the rate on treasury securities instead of being fixed.

Excellent S-T corporate investment:

Only 30% of dividends are taxable to

corporations.

The floating rate generally keeps issue

trading near par

However, if the issuer is risky, the floating rate preferred stock may have too much price instability for the liquid asset portfolios of many corporate investors.

A warrant is a long-term call option.

A convertible consists of a fixed

rate bond (or preferred stock)plus a long-term call option.

help one understand warrants and

convertibles?

P 0 = $20

r d of 20-year annual payment bond without warrants = 12%

50 warrants with an exercise price of $25

each are attached to bond.

Each warrant’s value is estimated to be $3

coupon rate must be set on a bond with warrants if the total package is to

sell for $1,000?

V Package = V Bond + V Warrants = $1,000.

V Warrants = 50($3) = $150.

V Bond + $150 = $1,000

V Bond = $850.

N I/YR PV PMT FV

20 12 -850 1000

Solve for payment = 100

Therefore, the required coupon rate

is $100/$1,000 = 10%

At issue, the package was actually

worth

V Package = $850 + 50($5) = $1,100 ,

which is $100 more than the selling

price.

sell for $5 each, what would this imply

about the value of the package?

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The firm could have set lower

interest payments whose PV would

be smaller by $100 per bond, or it could have offered fewer warrants and/or set a higher exercise price.

Under the original assumptions,

current stockholders would be

losing value to the bond/warrant

purchasers.

Generally, a warrant will sell in the

open market at a premium above its

value if exercised (it can’t sell for

less).

Therefore, warrants tend not to be

exercised until just before expiration.

years after issue When would you

expect them to be exercised?

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In a stepped-up exercise price, the

exercise price increases in steps over the warrant’s life Because the value of the warrant falls when the exercise price is

increased, step-up provisions encourage in-the-money warrant holders to exercise just prior to the step-up.

Since no dividends are earned on the

warrant , holders will tend to exercise

voluntarily if a stock’s payout ratio rises enough

When exercised, each warrant will bring in the exercise price, $25.

This is equity capital and holders will

receive one share of common stock per

warrant.

The exercise price is typically set some

20% to 30% above the current stock price when the warrants are issued.

capital when exercised?

No As we shall see, the warrants

have a cost which must be added to the coupon interest cost.

the accompanying debt issue, should all debt be issued with warrants?

The company will exchange stock worth

$36.75 for one warrant plus $25 The

opportunity cost to the company is

$36.75 - $25.00 = $11.75 per warrant

Bond has 50 warrants, so the opportunity cost per bond = 50($11.75) = $587.50

with-warrant holders (and cost to the

issuer) if the warrants are expected to be exercised in 5 years when P = $36.75?

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Here are the cash flows on a time line:

The cost of the bond with warrants

package is higher than the 12%

cost of straight debt because part

of the expected return is from

capital gains, which are riskier than interest income.

The cost is lower than the cost of

equity because part of the return is

fixed by contract.

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When the warrants are exercised, there is a wealth transfer from

existing stockholders to exercising warrant holders.

But, bondholders previously

transferred wealth to existing

stockholders, in the form of a low coupon rate, when the bond was

issued.

At the time of exercise, either more

or less wealth than expected may be transferred from the existing

shareholders to the warrant holders, depending upon the stock price.

At the time of issue, on a

risk-adjusted basis, the expected cost of

a bond-with-warrants issue is the

same as the cost of a straight-debt issue.

 20-year , 10.5% annual coupon, callable

convertible bond will sell at its $1,000 par value; straight debt issue would require a

12% coupon.

 Call protection = 5 years and call price =

$1,100 Call the bonds when conversion value > $1,200 , but the call must occur on the issue date anniversary.

 P 0 = $20 ; D 0 = $1.48 ; g = 8%

 Conversion ratio = CR = 40 shares

bond data:

c the bond?

Like with warrants, the conversion

price is typically set 20%-30% above the stock price on the issue date.

issued by Internet companies

Price at issue

$122 16 84 134 60 32 55 52

debt value and (2) the implied value of

the convertibility feature?

Because the convertibles will sell for

$1,000, the implied value of the

bond’s expected conversion value

in any year?

The floor value is the higher of the straight debt value and the

conversion value.

Straight debt value 0 = $887.96.

CV 0 = $800.

Floor value at Year 0 = $887.96.

convertible? What is the floor value

at t = 0? At t = 10?

Straight debt value 10 = $915.25.

on the first anniversary date after CV >

$1,200, when is the issue expected to

be called?

8 -800 0 1200 Solution: n = 5.27

N

Bond would be called at t = 6 since

call must occur on anniversary date.

cost of capital to the firm?

1,000 -105 -105 -105 -105 -105 -105

-1,269.50 -1,374.50

CV 6 = 40($20)(1.08) 6 = $1,269.50.

Input the cash flows in the calculator

and solve for IRR = 13.7%

For consistency, need r d < r c < r s

Why?

appear to be consistent with the costs

of debt and equity?

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Assume the firm’s tax rate is 40% and its

debt ratio is 50% Now suppose the firm is considering either:

(1) issuing convertibles, or (2) issuing bonds with warrants.

Its new target capital structure will have

40% straight debt, 40% common equity and

20% convertibles or bonds with warrants What effect will the two financing

alternatives have on the firm’s WACC?

cost of the convertibles.

0 1 2 3 4 5 6

1,000 -63 -63 -63 -63 -63 -63

-1,269.50 -1,332.50

INT(1 - T) = $105(0.6) = $63.

With a calculator, find:

r c (AT) = IRR = 9.81%

r d (AT) = 12%(0.06) = 7.2%

cost of straight debt.

WACC ( with = 0.4(7.2%) + 0.2(9.81%) convertibles) + 0.4(16%)

= 11.24%

WACC ( without = 0.5(7.2%) + 0.5(16%) convertibles)

= 11.60%

the WACC.

Some notes:

We have assumed that r s is not affected

by the addition of convertible debt.

In practice, most convertibles are

subordinated to the other debt, which

muddies our assumption of r d = 12%

when convertibles are used.

When the convertible is converted, the debt ratio would decrease and the firm’s financial risk would decline

cost of the bond with warrants.

0 1 4 5 6 19 20

+1,000 60 60 60 60 60 60

WACC ( with = 0.4(7.2%) + 0.2(10.32%) warrants) + 0.4(16%) = 11.34%

The firm’s future needs for equity

In either case, new lower debt ratio can

support more financial leverage.

should be considered?

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Does the firm want to commit to 20 years of debt?

Convertible conversion removes debt, while the exercise of warrants does not.

If stock price does not rise over time, then neither warrants nor convertibles would be exercised Debt would remain outstanding.

Warrants bring in new capital, while

convertibles do not.

Most convertibles are callable, while

warrants are not.

Warrants typically have shorter

maturities than convertibles, and

expire before the accompanying debt.

warrants and convertibles.

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Warrants usually provide for fewer common shares than do

convertibles.

Bonds with warrants typically have much higher flotation costs than do convertible issues.

Bonds with warrants are often used

by small start-up firms Why?

agency costs?

Agency costs due to conflicts between

shareholders and bondholders

Asset substitution (or bait-and-switch) Firm issues low cost straight debt, then invests in risky projects

Bondholders suspect this, so they charge

high interest rates

Convertible debt allows bondholders to share

in upside potential, so it has low rate.

Shareholders and New Shareholders

knows its future prospects better

than outside investors

Outside investors think company will issue new stock only if future prospects are not as good as market anticipates

Issuing new stock send negative signal

to market, causing stock price to fall

Company with good future prospects can issue stock “through the back

door” by issuing convertible bonds

Avoids negative signal of issuing stock directly

Since prospects are good, bonds will

likely be converted into equity, which is what the company wants to issue