Ch 21 Show
Transcript of Ch 21 Show
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Types of hybrid securitiesPreferred stock
Warrants
ConvertiblesFeatures and risk
Cost of capital to issuers
CHAPTER 21Hybrid Financing: Preferred Stock,
Warrants, and Convertibles
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Preferred dividends are specified by
contract, but they may be omittedwithout placing the firm in default.
Most preferred stocks prohibit the
firm from paying common dividendswhen 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, butmost new issues have sinking fund orcall provisions which limit maturities.
Preferred stock has no voting rights,
but may require companies to placepreferred 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 toinvestors? To issuers?
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AdvantagesDividend obligation not contractual
Avoids dilution of common stockAvoids large repayment of principal
Disadvantages
Preferred dividends not tax deductible,so typically costs more than debt
Increases financial leverage, and hencethe firms 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 beingfixed.
Excellent S-T corporate investment:
Only 30% of dividends are taxable tocorporations.
The floating rate generally keeps issuetrading near par.
What is floating rate preferred?
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However, if the issuer is risky, thefloating rate preferred stock mayhave too much price instability forthe liquid asset portfolios of manycorporate 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 optionshelp one understand warrants and
convertibles?
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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 is estimated to
be $3.
Given the following facts, what
coupon rate must be set on a bondwith warrants if the total package is tosell for $1,000?
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Step 1: Calculate VBond
VPackage = VBond + VWarrants = $1,000.
VWarrants = 50($3) = $150.
VBond + $150 = $1,000
VBond = $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 rateis $100/$1,000 = 10%.
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At issue, the package was actuallyworth
VPackage = $850 + 50($5) = $1,100,
which is $100 more than the sellingprice.
If after issue the warrants immediately
sell for $5 each, what would this implyabout the value of the package?
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The firm could have set lowerinterest payments whose PV wouldbe smaller by $100 per bond, or it
could have offered fewerwarrantsand/or set a higherexercise price.
Under the original assumptions,
current stockholders would belosing value to the bond/warrantpurchasers.
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Generally, a warrant will sell in theopen market at a premium above itsvalue if exercised (it cant sell forless).
Therefore, warrants tend not to beexercised untiljust before expiration.
Assume that the warrants expire 10
years after issue. When would youexpect them to be exercised?
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In a stepped-up exercise price, theexercise price increases in steps overthe warrants life. Because the value ofthe warrant falls when the exercise price
is increased, step-up provisionsencourage in-the-money warrant holdersto exercise just prior to the step-up.
Since no dividends are earned on thewarrant , holders will tend to exercisevoluntarily if a stocks payout ratio risesenough.
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When exercised, each warrant willbring in the exercise price, $25.
This is equity capital and holders willreceive one share of common stockper warrant.
The exercise price is typically set some20% to 30% above the current stockprice when the warrants are issued.
Will the warrants bring in additional
capital when exercised?
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No. As we shall see, the warrantshave a cost which must be added tothe coupon interest cost.
Because warrants lower the cost of
the accompanying debt issue, shouldall debt be issued with warrants?
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The company will exchange stock worth$36.75 for one warrant plus $25. Theopportunity 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 theissuer) if the warrants are expected tobe 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 tofind IRR = 14.7%. This is the pre-taxcost of the bond and warrant package.
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The cost of the bond with warrantspackage is higherthan the 12%cost of straight debt because part
of the expected return is fromcapital gains, which are riskier thaninterest income.
The cost is lowerthan the cost ofequity because part of the return isfixed by contract.
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When the warrants are exercised,there is a wealth transfer fromexisting stockholders toexercising warrant holders.
But, bondholders previouslytransferred wealth to existingstockholders, in the form of a low
coupon rate, when the bond wasissued.
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At the time of exercise, either moreor less wealth than expected may betransferred 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 ofa bond-with-warrants issue isthesame as the cost of a straight-debtissue.
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20-year, 10.5% annual coupon, callableconvertible bond will sell at its $1,000 par
value; straight debt issue would require a12% coupon.Call protection = 5 years and call price =
$1,100. Call the bonds when conversion
value > $1,200, but the call must occur onthe issue date anniversary.P0 = $20; D0 = $1.48; g = 8%.
Conversion ratio = CR = 40 shares.
Assume the following convertible
bond data:
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What conversion price (Pc) is built into
the bond?
Like with warrants, the conversionprice is typically set 20%-30% abovethe stock price on the issue date.
$1,00040
Pc =
= = $25.
Par value# Shares received
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Examples of real convertible bonds
issued by Internet companiesIssuer
Amazon.com
Beyond.comCNET
DoubleClick
Mindspring
NetBank
PSINet
SportsLine.com
Size of issue
$1,250 mil
55 mil173 mil
250 mil
180 mil
100 mil
400 mil
150 mil
Cvt Price
$156.05
18.3474.81
165
62.5
35.67
62.36
65.12
Price at issue
$122
1684
134
60
32
55
52
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What is (1) the convertibles straight
debt value and (2) the implied value ofthe convertibility feature?
PV FV
20 12 105 1000
Solution: -887.96
I/YR PMTN
Straight debt value:
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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 correspondsto the warrant value in the previousexample.
Implied Convertibility Value
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Conversion value = CVt
= CR(P0
)(1 + g)t.
t = 0
CV0 = 40($20)(1.08)0 = $800.
t = 10CV10 = 40($20)(1.08)
10
= $1,727.14.
What is the formula for the
bonds expected conversion valuein any year?
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The floor value is the higher of the
straight debt value and theconversion value.
Straight debt value0 = $887.96.
CV0 = $800.
Floor value at Year 0 = $887.96.
What is meant by the floor value of a
convertible? What is the floor valueat t = 0? At t = 10?
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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 maturitybecause convertibility constitutes acall option that has value.
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If the firm intends to force conversion
on the first anniversary date after CV >$1,200, when is the issue expected tobe called?
PV FV
8 -800 0 1200
Solution: n = 5.27
I/YR PMTN
Bond would be called at t =6sincecall must occur on anniversary
date.
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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 calculatorand solve forIRR = 13.7%.
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For consistency, need kd < kc < ks.
Why?
Does the cost of the convertible
appear to be consistent with the costsof debt and equity?
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kd = 12% and kc = 13.7%.
ks = + g = + 0.08
= 16.0%.
Since kc is between kd and ks, the
costs are consistent with the risks.
Check the values:
D0(1 + g)P0
$1.48(1.08)$20
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Assume the firms tax rate is 40% and itsdebt ratio is 50%. Now suppose the firm isconsidering either:
(1) issuing convertibles, or(2) issuing bonds with warrants.
Its new target capital structure will have
40% straight debt, 40% common equity and20% convertibles or bonds with warrants.What effect will the two financingalternatives have on the firms WACC?
WACC Effects
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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:
kc (AT) = IRR = 9.81%.
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kd (AT) = 12%(0.06) = 7.2%.
Convertibles Step 2: Find the after-tax
cost of straight debt.
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Some notes:
We have assumed that ks is not affected
by the addition of convertible debt.
In practice, most convertibles are
subordinated to the other debt, whichmuddies our assumption of kd = 12%
when convertibles are used.
When the convertible is converted, thedebt ratio would decrease and the firmsfinancial risk would decline.
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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: kw (AT) = 10.32%.
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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%.
Warrants Step 2: Calculate the WACC
if the firm uses warrants.
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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.
Besides cost, what other factors
should be considered?
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Does the firm want to commit to 20years 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 convertibleswould be exercised. Debt would remain
outstanding.
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Warrants bring in new capital, while
convertibles do not.Most convertibles are callable, while
warrants are not.
Warrants typically have shortermaturities than convertibles, andexpire before the accompanying debt.
Recap the differences between
warrants and convertibles.
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Warrants usually provide for fewercommon shares than doconvertibles.
Bonds with warrants typically havemuch higher flotation costs than doconvertible issues.
Bonds with warrants are often usedby small start-up firms. Why?
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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, theninvests in risky projectsBondholders suspect this, so they charge
high interest ratesConvertible debt allows bondholders to
share in upside potential, so it has low rate.
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Agency Costs Between Current
Shareholders and New ShareholdersInformation asymmetry: company
knows its future prospects better
than outside investorsOtside investors think company will
issue new stock only if future prospectsare not as good as market anticipates
Issuing new stock send negative signalto market, causing stock price to fall
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Company with good future prospects
can issue stock through the backdoor by issuing convertible bondsAvoids negative signal of issuing stock
directlySince prospects are good, bonds will
likely be converted into equity, which iswhat the company wants to issue