1 CHAPTER 15 Hybrid Financing Preferred Stock Warrants and Convertibles
Types of Hybrid Securities
Features and Risk
Cost of Capital to Issuers
2 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.
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
4 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...)
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.
6 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
7 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).
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.
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.
10 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.
11 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
12 Disadvantages of Warrants
Taxable if not exercised
Can not be forced
Exercise of warrants lowers the Earnings Per Share
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
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. 14 Step 1 Calculate VBond.
VPackage VBond VWarrants 1000
VWarrants 50(3) 150
VBond 150 1000
From Mini Case 15 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.. .)
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.
18 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.
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.
20 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.
21 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 23 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) 24
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.
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.
27 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
28 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.
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. 30 What conversion price (Pc) is built into the bond
Conversion Par value
price Shares received
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.
25 31 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 32 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
34 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
Floor value at Year 0 887.96
35 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.
36 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. 37 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. 38 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
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.
39 kC (Cont.)
kd 12 and kC 13.66
ks D0(1g) g 1.48(1.08) .08
Since kC is between kd and kS the costs are consistent with the risks.
40 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.
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.
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.
43 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 44 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 45 Convertibles Step 2 Find the after-tax cost of straight debt. kd(AT) 12(0.06) 7.2 46 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 47
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 49 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 50 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
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.
52 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.
Liquid Yield Option Note - convertible zero coupon
54 How can earnings be reported when warrants and convertibles are used
Based on the number of common shares actually outstanding
Includes shares that would result from conversions and exercises likely to occur in the near future.
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
Corporate Financing Innovations
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