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Types of hybrid securities

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Amazon.com. Beyond.com. CNET. DoubleClick. Mindspring. NetBank. PSINet. SportsLine.com. Size of issue $1,250 mil. 55 mil. 173 mil. 250 mil. 180 mil. 100 mil. 400 mil ... – PowerPoint PPT presentation

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Title: Types of hybrid securities


1
CHAPTER 19 Hybrid Financing Preferred
Stock, Warrants, and Convertibles
  • Types of hybrid securities
  • Preferred stock
  • Warrants
  • Convertibles
  • Features and risk
  • Cost of capital to issuers

2
How does preferred stock differ from common stock
and debt?
  • 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.

(More...)
3
  • 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?

4
What are the advantages and disadvan- tages of
preferred stock financing?
  • Advantages
  • 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
    firms cost of common equity

5
What is floating rate preferred?
  • 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.

6
  • 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.

7
How can a knowledge of call options help one
understand warrants and convertibles?
  • 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.

8
Given the following facts, what coupon rate must
be set on a bond with warrants if the total
package is to sell for 1,000?
  • P0 20.
  • rd 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 is estimated to be 3.

9
Step 1 Calculate VBond
  • VPackage VBond VWarrants 1,000.
  • VWarrants 50(3) 150.
  • VBond 150 1,000
  • VBond 850.

10
Step 2 Find Coupon Payment and Rate
20 12 -850
1000
N
I/YR
PV
FV
PMT
Solve for payment 100
Therefore, the required coupon rate is
100/1,000 10.
11
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 worth
  • VPackage 850 50(5) 1,100,
  • which is 100 more than the selling price.

(More...)
12
  • 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.

13
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 value if exercised (it
    cant sell for less).
  • Therefore, warrants tend not to be exercised
    until just before expiration.

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14
  • 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 payout ratio rises enough.

15
Will the warrants 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 some 20 to
    30 above the current stock price when the
    warrants are issued.

16
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.

17
What is the expected return to the bond-
with-warrant holders (and cost to the issuer) 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.
  • Bond has 50 warrants, so the opportunity cost per
    bond 50(11.75) 587.50.

(More...)
18
  • Here are the cash flows on a time line

0 1 4 5 6 19 20 1,000
-100 -100 -100 -100 -100 -100 -587
.50 -1,000 -687.50 -1,100
Input the cash flows into a calculator to find
IRR 14.7. This is the pre-tax cost of the
bond and warrant package.
(More...)
19
  • 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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20
  • 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.

21
  • 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.

22
Assume the following convertible bond data
  • 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 gt
    1,200, but the call must occur on the issue date
    anniversary.
  • P0 20 D0 1.48 g 8.
  • Conversion ratio CR 40 shares.

23
What conversion price (Pc) is built into the bond?
Par value Shares received
Pc 25.
  • 1,000
  • 40

Like with warrants, the conversion price is
typically set 20-30 above the stock price on
the issue date.
24
Examples of real convertible bonds issued by
Internet companies
Issuer Amazon.com Beyond.com CNET DoubleClick Mind
spring NetBank PSINet SportsLine.com
Size of issue 1,250 mil 55 mil 173 mil 250
mil 180 mil 100 mil 400 mil 150 mil
Cvt Price 156.05 18.34 74.81 165 62.5 35.67 62.36
65.12
Price at issue 122 16 84 134 60 32 55 52
25
What is (1) the convertibles straight debt value
and (2) the implied value of the convertibility
feature?
Straight debt value
20 12 105 1000
PV
FV
I/YR
PMT
N
Solution -887.96
26
Implied Convertibility Value
  • Because the convertibles will sell for 1,000,
    the implied value of the convertibility feature
    is 1,000 - 887.96 112.04.
  • The convertibility value corresponds to the
    warrant value in the previous example.

27
What is the formula for the bonds expected
conversion value in any year?
  • Conversion value CVt CR(P0)(1 g)t.
  • t 0
  • CV0 40(20)(1.08)0 800.
  • t 10
  • CV10 40(20)(1.08)10
  • 1,727.14.

28
What is meant by the floor value of a
convertible? What is the floor value at t 0?
At t 10?
  • The floor value is the higher of the straight
    debt value and the conversion value.
  • Straight debt value0 887.96.
  • CV0 800.
  • Floor value at Year 0 887.96.

29
  • Straight debt value10 915.25.
  • CV10 1,727.14.
  • Floor value10 1,727.14.
  • A convertible will generally sell above its floor
    value prior to maturity because convertibility
    constitutes a call option that has value.

30
If the firm intends to force conversion on the
first anniversary date after CV gt 1,200, when is
the issue expected to be called?
8 -800 0 1200
PV
FV
PMT
I/YR
N
Solution n 5.27
Bond would be called at t 6 since call must
occur on anniversary date.
31
What is the convertibles expected cost of
capital to the firm?
0 1 2 3 4 5 6
1,000 -105 -105 -105 -105 -105
-105 -1,269.50
-1,374.50
CV6 40(20)(1.08)6 1,269.50.
Input the cash flows in the calculator and solve
for IRR 13.7.
32
Does the cost of the convertible appear to be
consistent with the costs of debt and equity?
  • For consistency, need rd lt rc lt rs.
  • Why?

(More...)
33
  • Check the values
  • rd 12 and rc 13.7.
  • rs g
    0.08
  • 16.0.
  • Since rc is between rd and rs, the costs are
    consistent with the risks.

D0(1 g) P0
1.48(1.08) 20
34
WACC Effects
Assume the firms 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 firms WACC?
35
Convertibles Step 1 Find the after-tax 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 rc (AT) IRR 9.81.
36
Convertibles Step 2 Find the after-tax cost of
straight debt.
rd (AT) 12(0.06) 7.2.
37
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.
38
  • Some notes
  • We have assumed that rs is not affected by the
    addition of convertible debt.
  • In practice, most convertibles are subordinated
    to the other debt, which muddies our assumption
    of rd 12 when convertibles are used.
  • When the convertible is converted, the debt ratio
    would decrease and the firms financial risk
    would decline.

39
Warrants Step 1 Find the after-tax cost of the
bond with warrants.
0 1 ... 4 5 6 ... 19
20
1,000 -60 -60 -60
-60 -60 -60 -587.50
-1,000 -647.50 -1,060 INT(1 - T)
100(0.60) 60. Warrants(Opportunity loss per
warrant) 50(11.75) 587.50. Solve for rw
(AT) 10.32.
40
Warrants Step 2 Calculate the WACC if the firm
uses warrants.
WACC (with 0.4(7.2) 0.2(10.32) warrants)
0.4(16) 11.34. WACC (without
0.5(7.2) 0.5(16) warrants) 11.60.
41
Besides cost, what other factors should be
considered?
  • The firms future needs for equity capital
  • Exercise of warrants brings in new equity
    capital.
  • Convertible conversion brings in no new funds.
  • In either case, new lower debt ratio can support
    more financial leverage.

(More...)
42
  • 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.

43
Recap the differences between warrants and
convertibles.
  • 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.

(More...)
44
  • 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?

45
How do convertibles help minimize 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.

46
Agency Costs Between Current Shareholders and New
Shareholders
  • Information asymmetry company knows its future
    prospects better than outside investors
  • Otside 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

47
  • 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
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