Types of Hybrid Securities

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CHAPTER 15 Hybrid Financing Preferred
Stock Warrants and Convertibles

• Types of Hybrid Securities
• Preferred Stock
• Warrants
• Convertibles
• Features and Risk
• Cost of Capital to Issuers
• Recent Innovations

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How does preferred stock differ from both common
equity and debt

• Preferred is a hybrid.
• Preferred dividends are specified by contract
  but they may be omitted without placing the firm
  in default.
• For corporations the 70 Dividends Received
  Deduction applies.
• Most preferred stocks prohibit the firm from
  paying common dividends when the preferred is in
  arrears.

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• Preferred dividends are usually cumulative up to
  a limit.
• Some preferred stock is perpetual but most new
  issues have sinking funds or call provisions
  which limit maturities.
• National Association of Insurance Commissioners
• Corporations typically own regular preferred
  stock.
• No voting rights but may require companies to
  place preferred stockholders on Board if the
  dividend is passed.
• Is preferred stock closer to debt or common stock

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What is floating rate preferred

• Dividends are indexed to the rate on treasury
  securities instead of being fixed. Adjusted every
  90 days.
• Proposed S-T corporate investment
• Only 30 of dividends are taxable to
  corporations.
• The floating rate theoretically would keep the
  issue trading near par. (More...)

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• However if the issuer is in poor financial
  condition it may have too much credit risk to be
  held as a marketable security.
• Rates tied to U.S. Treasury securities are not
  viable as a measure of risk (different markets).
• Adjustable Rate Preferred were a failure. Issue
  did not stay at par. I do not know of any new
  issues in recent years.

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Market Auction Preferred

• With market auction preferred stock (Money Market
  Preferred) a Dutch Auction is held every seven
  weeks where buyers submit dividend rate bids.
  Thus credit risk changes can be built into the
  yield and the stock price remains very close to
  par.
• Life of 49 days

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What new hybrid securities have recently been
developed

• A new breed of preferred stock has been created
  that has appeal to both issuers and individual
  (non-corporate) investors.
• These issues have unusual names such as
  trust-oriented preferred securities TOPrS
  monthly income preferred securities (MIPS) and
  quarterly income preferred securities (QUIPS).

More
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• The new securities are tax deductible to the
  issuer.
• They are issued by a trust or a partnership which
  then loans the proceeds to the company.
• Thus the company technically makes interest
  rather than dividend payments.
• The tax deductibility allows yields to be set
  higher than on conventional preferred.
• Corporate investors are not permitted because of
  the Dividends Received Deduction.

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• A call option is an investor-written contract
  that gives the holder the right but not the
  obligation to buy some defined asset at a
  specified price within some specified period of
  time.

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What is the relationship between call options
warrants and convertibles

• A warrant is a long-term call option. It is
  issued (written) by the company.
• A convertible has built into it an implied call
  option.
• A convertible consists of a fixed rate bond plus
  a long-term call option.

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Advantages of Warrants

• Can sell stock at a price higher than the current
  price
• No floatation costs when selling the stock
• Lowers the interest rate required
• Reduces Agency Costs
• Can be used as compensation to investment bankers

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Disadvantages of Warrants

• Taxable if not exercised
• Can not be forced
• Exercise of warrants lowers the Earnings Per
  Share
• Dilutes ownership

13
Given the following facts what coupon rate must
be set on a bond with warrants if the
total package is to sell for 1000

• P0 20
• kd of 20-year annual payment bond without
  warrants 12
• 50 warrants with an exercise price of 25 each
  are attached to bond.
• Each warrants value will be 3.

Data are from the Mini Case.
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Step 1 Calculate VBond.

• VPackage VBond VWarrants 1000
• VWarrants 50(3) 150
• VBond 150 1000
• VBond 850

From Mini Case
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Step 2 Find PMT
Inputs Output
20 12 -850
1000
N
I/YR
PV
PMT
FV
Solve for Coupon payment 100
Therefore the required coupon rate
is 100/1000 10
16
If after issue the warrants immediately sell for
5 each what would this imply about the value of
the package

• At issue the package was actually
  worthVpackage 850 50(5) 1100which
  is 100 more than the selling price. (More..
  .)

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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 with a higher
  exercise price.
• Under the current assumptions current
  stockholders would be losing value to the
  bond/warrant purchasers.

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Assume that the warrants expire 10 years after
issue. When would you expect them to be
exercised

• Generally a warrant will sell in the open market
  at a premium above its formula value (it cant
  sell for less).
• Therefore warrants tend not to be exercised
  until just before they expire.

More
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• In a stepped-up exercise price the exercise
  price increases in steps over the warrants 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
  stocks dividend rises enough.

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Will the warrant bring in additional capital when
exercised

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

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Because warrants lower the cost of the
accompanying debt issue should all debt
be issued with warrants

• No. As we shall see the warrants have a cost
  which must be added to the coupon interest cost.

22
What is the expected return to the holders of
the bond with warrants (or the expected cost to
the company) if the warrants are expected to be
exercised in 5 years when P 36.75

• 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.
• Each bond has 50 warrants so the opportunity
  cost per bond 50(11.75) 587.50.

More
See Mini Case
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Here is the cash flow time line
0 1 4 5 6 19 20 1000
-100 -100 -100 -100 -100 -100 -587.50 -100
0 -687.50 -1100 Input the cash flows in
the calculator to find IRR 14.65. This is
the pretax cost of the bond and warrant package.
(From the mini case)
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• The cost of the bond-warrant 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.

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• 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.

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Advantages of Convertible Bonds

• Delayed Equity Financing - Sell stock at a higher
  than prevailing price
• Issue bonds at a lower interest rate
• Agency Costs can be reduced
• Sale of securities to institutional investors
• Can force conversion
• Avoids dilution of primary EPS
• Avoids floatation costs in the future

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Disadvantages of Convertibles

• It might have been better to wait and issue
  common at a higher price
• Overhanging convertible issue may depress stock
  prices
• If the stock does not rise the firm may be stuck
  with debt
• When conversion occurs the advantage of
  low-cost debt will be lost.

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• Assume the following
• 20-year 10.5 annual coupon callable
  convertible bond will sell at its 1000 par
  value straight debt issue would require a 12
  coupon.
• Call protection 5 years and call price
  1100. Call the bonds when conversion value gt
  1200 but the call must occur on the issue date
  anniversary. (Arbitrary decision)
• P0 20 D0 1.48 g 8 (both dividends and
  share price)
• Conversion ratio CR 40 shares.

Data are from Mini Case.
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What conversion price (Pc) is built into the
bond

• Conversion Par value
• price Shares received
• 1000
• 40
• The conversion price is typically set 20 to 30
  above the stock price on the issue date.
  Typically the conversion price is not an even
  number.

PC

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What is (1) the convertibles straight debt
value and (2) the implied value of the
convertibility feature
Straight debt value
20 12 105 1000
Inputs Solution
I/YR
PMT
PV
FV
N
-887.96
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Implied convertibility value

• Because the convertibles will sell for 1000
  the implied convertibility value of the
  convertibility feature is1000 - 887.96
  112.04
• The convertibility value corresponds to the
  warrant value in the previous example.

33
What is the formula for the bonds expected
conversion value in a given year

• Conversion value CVt CR(P0)(1g)t.
• t 0 CV0 40(20)(1.08)0 800
• t 10 CV10 40(20)(1.08)10
• 1727.14

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What is meant by the floor value of a
convertible

• The floor value is the higher of the straight
  debt value and the conversion value.
• Straight debt0 887.96
• CV0 800
• Floor value at Year 0 887.96

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Floor value at t 10

• Straight debt 10 915.25
• CV10 1727.14 Floor value10 1727.14
• Convertibles will generally sell above their
  floor value prior to maturity because
  convertibility constitutes a call option that has
  value.

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If the firm intends to force conversion on the
first anniversary date after CVt exceeds 1200
when is the issue expected to be called
8 -800 0 1200
Inputs Output
I/YR
PMT
PV
FV
N
5.27 Time when CV 1200
Bond would be called after 6 years since call
arbitrarily must occur on anniversary.
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What is the convertibles expected pre-tax return
to an investor and cost of capital to the firm
Cash flow time line
0 1 2 3 4 5 6
1000 -105 -105 -105 -105 -105
-105.00 -1269.50
-1374.50
CV6 40(20)(1.08)6 1269.50
Input the cash flows in the calculator and
solve for IRR 13.68
From the mini case.
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Does the cost of the convertible appear to be
consistent with the costs of debt and equity

• For consistency need kd lt kc lt ke
• Why
• The convertible bonds risk is a blend of the
  risk of debt and equity so k should be in
  between the cost of debt and equity.

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kC (Cont.)

• kd 12 and kC 13.66
• ks D0(1g) g 1.48(1.08) .08
• P0 20
• 16.0
• Since kC is between kd and kS the costs are
  consistent with the risks.

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When should convertible issues be called

• Three possible situations
• If the conversion value is less than the call
  price call only if interest rates have fallen
  and new securities are less expensive
• If conversion value is substantially greater than
  call price call at the first opportunity.
• If the conversion value is close to the call
  price call so that new equity is not added.

More
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• The difference between the current stock price
  and conversion price constitutes an opportunity
  cost to existing stockholders.
• By calling at the first opportunity this cost is
  minimized.

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• Some studies have shown that calls do not
  minimize wealth transfers but rather are made
  later than indicated by theory.
• Perhaps to save near-term cash flow.
• After-tax interest payment on convertible is less
  than the dividend payment on common stock.
• Perhaps signaling value of future issues.
• Investors may be less interested in future
  issues of convertibles if called prematurely.

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WACC Effects
Assume the firms tax rate is 40 and its debt
ratio is 50. Now suppose the firm decides
to (1) issue convertibles or (2) issue 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 this have on the WACC
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Convertibles Step 1 Find the after-tax cost of
the convertibles.
0 1 2 3 4 5 6
1000 -63 -63 -63 -63
-63 -63 -1269.50
-1332.50 INT(1-T) 105(0.6) 63 With a
calculator find kC(AT) IRR 9.81
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Convertibles Step 2 Find the after-tax cost of
straight debt.
kd(AT) 12(0.06) 7.2
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Convertibles Step 3 Calculate the WACC
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
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• We have assumed that kS is not affected by the
  addition of convertible debt.
• In practice most convertibles are subordinated
  to the other debt which muddies our assumption
  of kd 12 for the convertibles.
• When the convertible debt is converted the debt
  ratio would decrease the equity ratio would
  increase and the firms financial risk would
  decline.

48
Warrants Step 1 Find the after-tax cost of the
bonds-with-warrants assuming exercise in year 5.
0 1 ... 4 5 6 ... 19
20
1000 -60 -60 -60
-60 -60 -60 -587.50
-1000 -647.50 -1060 INT(1-T)
100(0.60) 60 Warrants(Opportunity
loss/Warrant) 50(11.75) 587.50 Solve
for kW (AT) 10.32
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Warrants Step 2 Calculate the WACC if the firm
uses warrants.
WACC (with warrants) 0.4(7.2)
0.2(10.32) 0.4(16) 11.34
WACC (without warrants) 0.5(7.2)
0.5(16) 11.60
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Besides cost what other factors would be
considered

• The firms future needs for equity capital
• Exercise of warrants brings in new equity
  capital.
• Additional equity capital through warrants
  without the need to retire low-coupon debt.
• Convertible conversion brings in no new funds.
• In either case new lower debt ratio can support
  more leverage

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• Does the firm want to commit to 20 years of debt
• 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.

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Differences Between Convertibles and Warrants

• Warrants bring in additional capital
• Warrants leave the debt on the books
• Warrants can not be called
• Start-up firms typically issue warrants
• Warrants typically have a shorter maturity
• Warrants typically provide for fewer common
  shares than convertibles
• Bonds with warrants usually have higher flotation
  costs
• Warrants can usually be detached.

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LYON

• Liquid Yield Option Note - convertible zero
  coupon

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How can earnings be reported when warrants and
convertibles are used

• Basic EPS
• Based on the number of common shares actually
  outstanding
• Primary EPS
• Includes shares that would result from
  conversions and exercises likely to occur in the
  near future.

More
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• Diluted EPS
• Includes shares that would result from exercise
  of all outstanding warrants and conversion of all
  convertibles.
• SEC requires firms to report both basic and
  diluted EPS
• FASB requires firms to report basic EPS
• Why should investors be concerned about how EPS
  is reported

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Conclusion

• Preferred Stock
• Warrants
• Convertibles
• Corporate Financing Innovations