Hybrid Securities

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Hybrid Securities
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1. Preferred stock

• Preferred stock normally, stock without voting
  rights but with a fixed dividend payment (fixed
  charge).
• Typical face value of 25 or 100.
• The fixed dividend payment is stated as a
  percentage of face value of as dollar amounts per
  share. The most preferred stock has a cumulative
  dividend. That is, if a firm does not pay
  dividends, the cumulative total of unpaid
  dividends must be paid before dividends can be
  paid on the common stock. Unpaid preferred
  dividend is call arrearages.
• The fixed charge increases the firms financial
  leverage.
• Omitting the preferred dividend payment does not
  force a company into bankruptcy.
• Preferred dividend is not tax-deductible.
• Higher cost capital than does debt.

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• Normally no voting rights. However most
  preferred issues stipulate that the preferred
  stockholders can elect a minority of directors.
• Some preferred stocks are similar to perpetual
  bonds. But most new issues now have specific
  maturities and sinking fund provision that calls
  for the retirement of 2 of the issue each year.
• Many preferred issues are callable.
• Preferred stock often has a feature of
  convertibility to common stocks.

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• To issuers viewpoints, preferred stocks are less
  risky than bonds. To investors view, however,
  preferred stock could be riskier because of a
  lower priority of claims in bankruptcy and a
  possibility of omitting dividend payments.
  Despite of this risk, there is a tax benefit to
  corporation. 70 of preferred dividend received
  is tax exempt. Thus major investors in preferred
  stocks are corporations. Especially corporation
  buyers in a high tax bracket will have great tax
  benefits.

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1-1. Other types of preferred stocks

• Adjustable rate of preferred stock (ARP)
  dividend amounts are tied to the rate on Treasury
  securities. It is typically issued by utilities
  and large commercial banks and popular as a short
  term investment for firms (e.g. mutual funds)
  with idle cash. However price is too volatile to
  be held in the liquid asset portfolio.

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• Market auction preferred stock (Money market
  preferred stock) Corporations need to hold at
  least 46 days (approximately 7 weeks) in order to
  get the 70 exclusion from taxable income. Basing
  on this information, the underwriter conducts an
  auction on the issue every 7 weeks. Holders who
  want to sell can put their market auction
  preferred stock for auction at par value. Buyers
  submit bids in the form of the yield they are
  willing to accept over the next 7 week period.
  The yield accepted generally is the lowest yield
  sufficient to sell all the preferred stocks being
  offered at that auction. To the holders view
  points, it is a low risk, large tax-exempt 7 week
  maturity security that can be sold between
  auction dates at close to par.

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1-2. Advantages and disadvantages of preferred
stock

• Advantages (1) dividend payment is not obligated
  and not associated with being default. (2)
  issuing preferred stocks avoid the dilution of
  common stocks. (3) because preferred stock
  sometimes has no maturity and because sinking
  fund payment (if present) are typically spread
  over a long period, preferred issues reduce the
  cash flow drain from repayment of principal.

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• Disadvantages (1) dividend payment is not
  tax-deductible. After tax cost of preferred is
  typically higher than after tax cost of debt.
  (2) preferred dividends are considered to be a
  fixed cost and to increase a financial cost to an
  issuer.

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2. Options and corporate finance

• 2.1. Employ stock options (ESOs) a call option
  granted to employee by a company. Under this
  option, employee can buy shares at a fixed price
  for a fixed period.
• (1) ESO features
• Difference between regular stock option and ESO
• ESO can not be sold.
• vesting period for up to three years or so, an
  ESO can not be exercised and also must be
  fortified if an employee leaves the company.
  After vesting period, ESO vests and employee
  exercise ESO.

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• ESO is used to align an interest of management
  and that of shareholders. ESO is used as a
  recruitment tool in a small size firm or firms
  with a lack of liquidity.
• (2) ESO repricing
• In general, a strike price of ESO is same as the
  market price or at the money on the grant date.
  Sometimes, however, a market price is lower than
  a strike price. ESO is called underwater. On
  occasion, a company decides to lower the strike
  price on underwater options. Such options are
  said to be restricted or repriced.
• Critics on repricing a reward for failure and
  possible manipulation to provide money to current
  management.
• Typically underwater ESO is exchanged for a
  smaller number of new ESOs with a lower exercise
  price.

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• (3) ESO backdating.
• Financial researchers find that many companies
  have a practice of looking backward in time to
  select the grant date. Main purpose is to pick a
  date in which stock price was low. But it is not
  illegal as long as there is full disclosure and
  various tax and accounting issues are handled
  properly. Before Sarbanes-Oxley, companies had
  up to 45 days after the end of their fiscal years
  to report options grants. After Sarbanes-Oxley,
  in two days the company is required to report
  options grants.

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• 2.2. Equity as a call option on the firms assets
• Common stock in a leveraged firm is a call option
  on the assets of the firm.
• E.g) suppose a firm has a single debt issue
  outstanding. The face value is 1000 and the
  debt is coming due in a year. There are no
  coupon payments between now and then. The debt
  is effectively a pure discount bond. In
  addition, the current market value is 980 and
  risk free rate is 12.5.

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• In a year, a stockholder will have two choices
  pay off 1000 and get the assets or let it
  default and bondholders will have the assets. In
  this situation, shareholders essentially look
  like having a call option on the assets of the
  firm with an exercise price of 1000. If they
  exercise this call option by paying 1000, they
  will obtain the assets. Otherwise let it default.
  Here the equity value is a value of the call
  option. Using option valuation, we can estimate
  the value of equity and debt ( market price
  value of equity).

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• Case 1 The debt is risk-free. Option is in the
  money.
• Suppose that in one year the firms assets will
  be either 1100 or 1200. The option is in the
  money.
• Equity value option value value of underlying
  asset PV of exercise price 980
  1000/(10.125)91.11.
• Debt value 980-91.11 888.89.

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• Case 2 The debt is risky. Option is not in the
  money.
• Suppose that in one year the firms assets will
  be either 800 or 1200. In this case, when the
  price is 800, the option value is 0. When it is
  1200, the option value is 200.
• PV of 800 and (1200-800)/(200-0) call options
  replicate the value of the assets of the firm.
• 980 800/(10.125) 2C. C 134.44 option
  value equity value.
• Debt value 980 -134.44 845.56.

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2.3. Options and capital budgeting

• Real option an option that involves real assets
  (buying car or land, investing in, etc) as
  opposed to financial assets such as shares of
  stocks.
• (1) The investment timing decision evaluation of
  the optimal time to begin a project.
• A project costs 100 and has a single future cash
  flow. If we take it today, the cash flow will be
  120 in one year. If we wait for one year, the
  project will still cost 100, but the cash flow
  following year will be 130. If the discount rate
  is 10,
• NPV of taking today -100120/1.1 9.09
• NPV of taking next year -100130/1.1 18.18.
  Then 18.18/(1.1) 16.53.
• The value of waiting option is 16.53-9.09 7.44.

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• (2) Managerial options opportunities that
  managers can exploit or modify if certain things
  happen in the future.
• E.g) US Airways reduce lines and eliminate 1,700
  jobs through attrition, voluntary leaves of
  absence, and furloughs. Also US Airways
  announced the increase in fees.

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• a) Contingency planning taking into account the
  managerial options implicit in a project if the
  project may or may not work as planned. In this
  situation, break-even tends to be used as
  decision criteria. Three broad categories
• - Option to expand If the positive NPV project
  works as planned or expected, the next question
  will be whether we want to repeat or expand the
  project. If we ignore this option, we
  underestimate NPV.
• - Option to abandon would be better off by
  abandoning cash or profit losing business units.
  If we ignore this option, we underestimate NPV.
• - Option to suspend or contract operations
  decision to temporarily shut down or suspend
  operations. E.g) natural resource gold. When
  price goes up, just resume operations.

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• b) Strategic options options for future, related
  business products or strategies. It is like
  testing the possibilities or potential future
  business strategies. It is very costly and
  difficult to measure its impact in the future.
  But experience of pilot testing will definitely
  help firm to revise product mix or pricing, etc.
  

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2.4. Options and corporate securities

• A. Warrants (sweeteners or equity kickers) a
  security that gives the holder the right to
  purchase shares of stock directly from a company
  at a fixed price over a given period of time.
  Each warrant specifies the number of shares of
  stock the holder can buy, the strike (or
  exercise) price, and the expiration date.
  Warrants tend to have a longer maturity than
  options. Warrants are often issued in
  combination with privately placed loans or bonds
  in order to promote the sales of loans or bonds
  with low coupon rates. Loan or Bond holders
  usually detach warrants and sell them at the
  market. Warrants are listed and traded on the
  NYSE.

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• (1) Difference between warrants and call options
• A call option is issued by an individual whereas
  warrants are issued by firms.
• When a call option is exercised, it does not
  relate to a firm. However when warrants are
  exercised, a firm need to issue new shares or to
  use treasury stocks. The firm will receive money.
  The number of shares outstanding in the market
  increases, meaning the value dilution of original
  securities.
• Options tend to have a life of just a few weeks
  or months whereas warrants often lives of 5 or 10
  years.

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• (2) Earnings Dilution
• When warrants and convertible bonds are
  exercised, the number of shares outstanding
  increases and EPS is diluted.
• Diluted EPS net income / all possible number of
  shares considering exercising warrants and
  convertible bonds.
• Basic EPS net income / number of shares
  outstanding.
•  
• (3) Strike or exercise price
• The bankers hold a presale auction and determine
  the set of terms that will just clear the market.
• The strike price on warrant is generally set some
  20 to 30 above the market price of the stock on
  the date the bond is issued.
• stepped up exercise price sometimes, issuers
  increase the strike price before maturity.

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• (4) Component cost of bonds with warrants
• e.g) Fin Corp issues 5000 bonds with 20 warrants
  per bond. Market price is 1000. Strike price
  is 22. Coupon rate is 8. Bond maturity is 20
  years. Warrant maturity is 10 years. The pre-tax
  cost of debt is 10 if no warrant is attached.
  Fin Corps operation and investments is 250
  million right after issuing the bonds with
  warrants. Total value is expected to grow at 9
  per year. Currently Fin Corp has 10 million
  shares outstanding.

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• Price of bond value of straight bond value of
  warrants.
• 1000 80(1-1/(1.120))/0.1 1000/(1.120)
  value of warrants.
• Value of warrants 1000 830 170.
• At the expiration date of warrants, Fin Corp
  value 250 (1.0910) 591.841 million.
• If 1 million warrants ( 500020) are exercised,
  Fin Corp will receive 22 million (22 1
  million warrants). Total value of Fin Corp
  591.841 22 613.84 million.

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• At the expiration date of warrants, bonds still
  have 10 year maturity remaining. PV of a bond
  80(1-1/(1.110))/0.1 1000/(1.110) 877.11.
  Total bond value is 5000877.11 43.856 million.
  Intrinsic value of equity 613.84 43.856
  569.985.
• After warrants are exercised, the number of
  shares outstanding will be 11 million (10
  million 1 million). Intrinsic value per share
  51.82 ( 569.985/11).
• Thus cost of each warrant to Fin Corp the value
  of warrant to holders at the end of 10th year
  (maturity of warrant) 51.82 -22 29.82. Per
  bond, 20 warrants costs 596.40 (2029.82) to
  Fin Corp or valuable as much as 596.40 to a
  holder.

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• The initial value of warrant is 170 and at the
  end of 10th year, will be 596.40.
• Thus 569.40 170 (1IRR)10. You can have
  13.35. That is, an annual cost to Fin Corp or
  annual return to a holder is 13.35.
• Pretax cost of bonds with warrants rd
  (830/1000)rw(170/1000) 10(830/1000)
  13.35(170/1000) 10.57.
• Cost of a bond with warrants tend to be higher
  than a cost of straight bond and will be much
  higher than the coupon rate on the bonds- with
  warrants package.
• Cost of a warrant tends to be higher than cost of
  equity. But it may depend on dilution of equity
  and strike (or exercise) price.

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• B. Convertible bonds A bond that can be
  exchanged for a fixed number of shares of stock
  for a specified amount of time (anytime up to and
  including the maturity of the bond). It is
  similar to bonds with warrants. But unlike
  warrants, conversion option is not detachable.
• Preferred stock can frequently be converted into
  common stock. A convertible preferred stock is
  the same as a convertible bond except that it has
  an infinite maturity date.

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• (1) Features of a convertible bond
• Conversion price the dollar amount of a bonds
  par value that is exchangeable for one share of
  stock. That is, it is a price per share of stock.
• Conversion ratio the number of shares per bond
  ( 1000/conversion price).
• Conversion premium (conversion price market
  price)/ market price.
• Positive conversion premium reflects conversion
  option was out of the money at the time of
  issuance.
• In general, convertibles have a 10 year call
  protection. During this period, an issuer can not
  call back his or her convertibles.

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• (2) Value of a convertible bond
• e.g) MO company has an outstanding B- rated
  convertible bond issue. The coupon rate is 7
  and the conversion ratio is 15. There are 12
  remaining coupons and the stock is trading for
  68.
• - Straight bond value the value a convertible
  bond would have if it would have if it could not
  be converted into common stocks. Assume that B
  rated bond is priced at 8 yield to maturity.
• PV 35(1-1/(10.04)12)/0.04 1000/(10.04)12
  953.08
• Conversion value the value a convertible bond
  would have if it were to be immediately converted
  into common stocks.
• current stock price conversion ratio
• 6815 1020

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• In general, a convertible can not sell for less
  than its conversion value.
• Floor value minimum value of a convertible. It
  is Max straight bond value, conversion value. A
  logic is that a convertible is composed of
  straight bond and conversion value. The market
  price of a convertible can not be lower than
  straight bond value and doe not exceed conversion
  value. But due to option value, the market price
  sometimes exceeds conversion value.
•  
• Figure 24.4

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• Option value the value of an option to wait.
  The convertible holders do not need to convert
  immediately. Instead, by waiting, they can take
  advantage of whichever is greater in the future -
  straight bond value or conversion value.
• Value of a convertible floor value option
  value

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(3)Component cost of convertible securities

• e.g) In 2013, Silicon Valley Software (SVS) was
  considering issuing convertible bonds that would
  sell at a price of 1000 per bond. Figure 20-1.
• - Maturity 20 years
• - 8 annual coupon rate
• - Each bond is converted into 18 shares.
  Conversion price 1000/18 55.56.
• - Current stock price is 35.
• - If the bond does not have convertibility, its
  YTM is expected to be 10.
• - This convertible bond is not callable for 10
  years. But if it is called, call price is 1050
  with this price declining by 5 per year
  thereafter.
• - If after 10 years, the conversion value
  exceeded the call price by at least 20,
  management would probably call the bonds.
• - SVSs cost of equity is 13 with a 4 dividend
  yield and expected capital gain of 9 per year.

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• Straight bond value 80(1-1/(10.1)20)/0.1
  1000/(1.120) 830. This value will converge to
  1000 when maturity approaches to an expiration
  date.
•  
• Initial conversion value 3518 630. Here
  35 will increase by 9 every year. If a market
  value of convertible is less than straight bond
  value or conversion value, investors will see
  bargain and buy convertible bond.
•  

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• Also there is another one to be considered. It
  has a callable option by an issuer at 1050. If
  conversion value is more than a call price
  (1050), the issuer definitely calls back their
  convertible bonds before investors exercise
  conversion option.
•  
• At the end of 10th year, conversion value will be
  35(10.09)10 18 1491. It is greater than
  the call price. Thus an investor will exercise
  his or her option before the issuer calls back
  convertible bonds. An expected rate of return
  (cost of convertible bond) is an IRR,
  considering following cash flow patterns initial
  investment is 1000. Two incoming cash inflows
  are annual coupon payment and conversion value.
•  
• N10, PV -1000, PMT 80, FV1491. Then IRR
  10.94.

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• In general, convertible bond is riskier than
  straight debt but less risky than stock. Its
  cost of capital is between the cost of straight
  debt and the cost of equity.

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• (4) Use of convertibles in financing
• Two important advantages to issuers (1) like
  warrants, convertibles offer a company the chance
  to sell debt with a low coupon rate. (2) a chance
  to sell equity at a higher price than a current
  price that is believed to be depressed.
• Three disadvantages to issuers (1) if stock
  price increases a lot, the issuer loses an
  opportunity to sell equity and refinance old
  debt, (2) convertibles have a low coupon interest
  rate. But conversion will reduce the benefit of
  paying low interest, (3) if stock price does not
  increase as expected, the issuer will be stuck
  with debt.

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• (5) Agency problem and convertibles
• If a company would like to finance with straight
  debt but lenders are afraid the fund will be
  invested in a manner that increase the firms
  risk profile, lowering debt value and increasing
  equity value (it is called bait and switch),
  convertibles will be one option to release this
  kind of potential agency. Convertibles give
  options of converting to equities to debt
  holders.

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• If a company would like to finance with equity,
  it would adversely signal to the market
  overvaluation of his or her equity and then
  decrease equity price. It could happen even
  though the firm actually has a better prospect.
  In this case, convertibles could be used to avoid
  price depression caused by equity issuing,
  allowing convertibles to convert to equity (like
  issuing through back door).

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• C. Comparison of Warrants and Convertibles
• The exercise of warrants brings in new equity
  capital, whereas the conversion of convertibles
  results only in an accounting transfer.
• Most convertibles have a call provision that
  allows the issuer either to refund the debt or to
  force conversion. But warrants are not callable.
• Warrants typically have much shorter maturities
  than convertibles. Warrant typically expires
  before their accompanying debt maturity.
• Warrants typically provide fewer future common
  shares than do convertibles. In convertibles, the
  total value of a bond will convert the number of
  shares. But not in warrants.
• Warrant issuers tend to be smaller and riskier
  than convertible issuers.
• Bond with warrants financing have underwriting
  fees that approximate the weighted average of the
  fee associated with debt and equity issues,
  whereas underwriting costs for convertibles are
  more like those of straight debt.

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• D. Other options
• Call provision on a bond. A convertible is
  typically callable. Thus a convertible a
  straight bond conversion feature call
  provision.
• Put bonds a bond giving the owner the right to
  force the issuer to buy the bond back at a fixed
  price for a fixed time. This kind of bond is a
  combination of a straight bond and a put option.
• Insurance and loan guarantee a kind of put
  option asking insurers to pay for you. It is like
  you sell something to insurers and guarantors.
•