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Copyright 2002 Harcourt, Inc. All rights reserved.

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

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