FM11 Ch 21 Hybrid Financing_Preferred Stock,Warrants, and Convertibles

21 - 1

Types of hybrid securities

Preferred stock

Warrants

Convertibles

Features and risk

Cost of capital to issuers
CHAPTER 21
Hybrid Financing: Preferred Stock,
Warrants, and Convertibles
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
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.
How does preferred stock differ from
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?
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
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 firm’s cost of common equity
What are the advantages and disadvan-
tages of preferred stock financing?
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
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.
What is floating rate preferred?
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
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.
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
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.
How can a knowledge of call options
help one understand warrants and
convertibles?
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
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.
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?
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Step 1: Calculate V
Bond
V
Package
= V

Bond
+ V
Warrants
= $1,000.
V
Warrants
= 50($3) = $150.
V
Bond
+ $150 = $1,000
V
Bond
= $850.
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Step 2: Find Coupon Payment and Rate
N I/YR PV
PMT
FV
20 12 -850 1000
Solve for payment = 100
Therefore, the required coupon rate
is $100/$1,000 = 10%.
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
At issue, the package was actually
worth
V
Package
= $850 + 50($5) = $1,100,
which is $100 more than the selling

price.
If after issue the warrants immediately
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.
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
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.
Assume that the warrants expire 10
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.
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
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.
Will the warrants bring in additional
capital when exercised?
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No. As we shall see, the warrants

have a cost which must be added to
the coupon interest cost.
Because warrants lower the cost of
the accompanying debt issue, should
all debt be issued with warrants?
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
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.
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?
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
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 )
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
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.
(More )
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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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
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.
Assume the following convertible
bond data:

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What conversion price (P
c
) is built into
the bond?
Like with warrants, the conversion
price is typically set 20%-30% above
the stock price on the issue date.
$1,000
40
P
c
=
= = $25.
Par value
# Shares received
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Examples of real convertible bonds
issued by Internet companies
Issuer
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
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
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What is (1) the convertible’s straight
debt value and (2) the implied value of
the convertibility feature?
PV FV

20 12 105 1000
Solution: -887.96
I/YR
PMT
N
Straight debt value: