Hybrid Financing

Advanced Corporate Finance

FINC 5880- week 6

Hybrid Financing

Financial instruments that carry both characteristics of common stock and LT debt:

Preferred stock LT debt with warrants Convertible bonds

The coupon rate is lower then plain bonds There is a future common stock conversion

Amazon Inc. convertible

January 1999 $ 1,25 bln. Stock +70% between jan-may 1999 Convertibles up from $ 1000 to $ 1500 Stock lost 60% between may-sept 1999 Convertibles dropped to $ 750 Between sep-nov 1999 stock rebounded Convertibles back to $ 1500 level Last month 1999 dropped again to $ 1000

Amazon Inc,

Hybrids we look at

Preferred stock: hybrid between debt and common equity

Warrants: derivatives used to facilitate the issuance of other securities thus making the total a hybrid financing form

Convertibles: hybrid of debt and warrants

Preferred Stock (characteristics) Accountants classify preferred stock as equity In fact it’s a financing form in between debt and

common equity Imposes a “fixed” charge (dividend) Omitting this dividend does not bring the firm into

bankruptcy Interest is tax deductible but preferred dividend is not Preferred stock therefore has a higher cost of capital

then LT debt Unpaid dividend can cumulate to say 3 years If the company is behind in paying this dividend these

sums are called arrearages… (arrear means behind) Preferred stock normally has no voting rights Preferred stock carries more risk for investors and

less for the firm (then debt) Most preferred stock can be transferred into common

stock

Class Assignment 1: Taxes and preferred stock

A company has the choice to issue debt or pref stock If debt is issued interest would be 10% If pref stock is issued dividend is 8% A corporation (investor) considers to buy the stock

however it’s tax rate is 40% and dividend on pref stock is 70% tax exempt

Required: What would be the return on buying the debt or pref stock

in this case? At which tax rate is the investor indifferent?

Answer:

Return investing pref stock: 8%*(1-30%*40%)= 7.04% after tax

Return investing debt= 10%*(1-40%)=6%

8%(1-30%*t)=10%(1-t) if t=31.25%

Preferred stock

Advantages: The obligation to pay dividend is not as firm as interest

payment on debt The issuance of preferred stock does not dilute common

equity Reduced cash flow drain since the principal is normally not

paid back as on debt Disadvantages:

The after tax cost of preferred stock is higher then debt since debt is tax deductible

If dividends are not paid common investors normally can not get dividend either…

Warrants (sweeteners) Generally issued along with debt Induce investors to by the debt at a lower coupon rate then normal

but with the upside of the warrant The warrant is a LT call option… If the share of the company is doing well in the longer term the lower

coupon rate will be (over) compensated with profit on the warrants Warrants are often detachable and can be traded separately they do

not have dividend rights The exercise price at issuance is normally set 20-30% above the

days stock price level Sometimes the exercise price follow a step-up system… Warrants dilute wealth of common shareholders With warrants additional equity is issued

Warrant= call option….

Warrants definition…

WARRANTS

A warrant is a certificate issued by a company which gives the warrant holder the right to buy a stated number of 'shares of the company's stock at a specified price for some specified length of time. Such warrants are called long-term call options, because they offer investors the opportunity to buy the firm's common stock at a fixed price, regardless of how high the stock may climb. This option offsets a low interest rate on a bond and can make a low-yield bond/warrant package more appealing to investors. An important difference with a normal call option is that a warrant requires a company to issue more shares to satisfy it’s obligations thus the number of shares outstanding will increase!

Class assignment 2: Warrants…

Problem

A corporation decides to issue 20 year bonds (2010) to fund a $50 million expansion. If they were to issue a straight bond 'package, the bonds would carry a 10% coupon rate, however the current bond proposal calls for an 8% coupon and 'stock warrants. Thus, investors will be paying $1,000 in return for the 8% coupon, 20-year bond and 20 warrants '(the exercise price of the warrants is $22). The warrants would expire in 2020 (10 years later) if they were not exercised before that date. What is the implied value of each warrant at the time of issue?

NOTE: To find the implied value of each warrant, we must first determine the total value of this call option. The value of the option can be determined as the difference in price between the 8% coupon bond being issued, discounted by 10%. We use a 10% discount rate, because it is the true measure of the firm's cost of debt, and it accurately reflects the riskiness of these bonds.

Compare with straight debt…

However, investors actually paid $1,000 for these bonds. The total value of the warrants would be the difference 'between the two prices.

Value of the warrants = Price paid - Value of bonds

Value of the warrants = $1,000 - $829.73

Value of the warrants = $170.27

Since there are 20 warrants being issued to every investor, the value of each warrant is simply the total value of the warrants divided by the number of warrants.

Value of each warrant = $8.51 ÷ 20

Class Assignment 3: How warrants dilute share prices…The value of above Corporation is $ 250 M and there are 10M stock outstanding before the issue of the warrants.There are 1 M warrants issued (20 warrants* 50,000 for a $50M expansion)The company value is growing 9% per year so after 10 years when the warrants expire the value has been growing to: $250M*(1+9%)^10=$591.841M

How is this value allocated between original stock holders, bond holders and warrant holders ?

Hint:

Calculate the PV of the bond with coupon 8% discounted at 10%There are $ 50M/$1000 bonds outstanding…Subtract this value from the company value after 10 years…

Without warrants the original stockholders were entitled to all of this value! (calculate the share price)

If the warrants are exercised at $22 (this is an addition to the company’s capital) How much do original shareholders get now of total value and what is their share price after this? (note after exercising there are 11 mln shares outstanding)

AnswerTotal company value after 10 years: $ 591.841MValue of Bond with coupon $80 n=10 dcf=10%: $877.11 *50,000=$43.856MWithout warrant shareholders get: $591.841M-$43.856M=$547.985M

Share price: $547.985M/10M shares=$54.80/share (rounded)

With warrants: Company value: $591.841M+$22M=$613.841MOf which bondholders get same as above…So shareholders get: $ 613.841M - $ 43.856M=$ 569.985MBut this equity value is now divided over 11 M shares (1 warrant exercised=1 share) so this is $ 569.985M/ 11M shares= $ 51.82/share Dilution: $54.80 - $ 51.82=$ 2.98/share or 5.4%!

Class Assignment: Warrant returns…

What is the investment return of an investor who would have bought this 20 year bondIn this company with 8% coupon annually who converts 20 warrants after 10 years In the year 2020 into stock at maturity of the bond?

Hint: PV of cash flows (dcf=10%)At conversion every warrant triggers a $51.82 - $22=$29.82 cash profit!

Answer:Cash flows of regular bond: $80 coupon 20 yearsCash flow in 2020: $80+ 20 warrants* $29.82=$676.40

IRR% (20 years) with initial investment $1000 and principal return in 2030 $1000 is: 10.7% > 10% coupon on regular bond!

Convertibles Both preferred stock and bonds that under

certain conditions can be exchanged in common stock

CR=conversion ratio; number of common shares received for a bond/preferred stock

Pc=effective price that investors pay for a common stock based on the CR

The conversion price is typically 20-30% above the market price at issue (as the warrant)

If the common stock will be traded below conversion level the conversion level will be adjusted (legal)

If the stock follow a stock split all calculations will be adjusted accordingly…

With convertibles equity is replaced for LT debt no additional capital is issued in total!

What it is…

A convertible bond is a bond that can be converted into a pre- determined number of shares, at the option of the bond holder.

While it generally does not pay to convert at the time of the bond issue, conversion becomes a more attractive option as stock prices increase.

A convertible bond can be considered to be made up of two securities - a straight bond and a conversion option.

Firms generally add conversions options to bonds to lower the interest rate paid on the bonds.

CV=straight bond + conversion option

Embedded in every convertible bond is a straight bond component.

The easiest way to value the straight bond component is to act as if the conversion option does not exist and value the bond. This can be accomplished as follows:

• Step 1: Obtain the coupon rate on the convertible bond (which will generally be low because of the conversion option)

• Step 2: Estimate the interest rate that the company would have had to pay if it had issued a straight bond. This can be obtained either from other bonds that the company has outstanding or from its bond rating.

• Step 3: Using the maturity of the convertible bond, the coupon rate and the market interest rate, estimate the value of the bond as: Value of Bond = PV of coupons at market interest rate + PV of face value of bond at market interest rate

The straight bond component is clearly debt.

How to get to value per share?

Step 1: Value the firm, using discounted cash flow or other valuation models.

Step 2:Subtract out the value of the outstanding debt to arrive at the value of equity.

Step 3:Subtract out the market value (or estimated market value) of other equity claims: • Value of Warrants = Market Price per Warrant * Number of Warrants : Alternatively estimate the value using option pricing model • Value of Conversion Option = Market Value of Convertible Bonds - Value of Straight Debt Portion of Convertible Bonds

Step 4:Divide the remaining value of equity by the number of shares outstanding to get value per share.

Class Assignment 4 : Hybrid FINC An Example: “Valuing Sterling Software” The equity in Sterling Software was valued at $2,036 million, based

upon projected cash flows

The firm has two equity options outstanding:

1) The firm has 115,000 bonds outstanding, each of which can be converted into 20 shares of stock. The market price of each convertible bond is $1,522 and the face value is $ 1000; coupon rate of 5.75%; expires in 8 years; Bond Rating is A-; Interest rate on comparable debt = 7.50%;

2) The firm has 1.8 million warrants outstanding, with a strike price of $ 55 per share; these are trading at $ 30 per share

Required: Determine the value per share; there are 25.5 million shares outstanding.

Determine the value of the options… Convertible Debt has market value of $ 175 million; face value of $

115 million; coupon rate of 5.75%; expires in 8 years;

Bond Rating is A-; Interest rate on comparable debt = 7.50%;

• Coupon on Convertible Debt = .0575 * 115 million = $ 6.6125 million

• Value of Straight Debt Portion of Convertible Debt = $ 6.6125 (PV of Annuity,7.5%,8 years) + $ 115 million/1.0758 = $ 103.21 million

• Value of Conversion Option in Debt = Market Value of Convertible Debt - Straight Debt Portion = $ 175m - $ 103m = $ 72 million Equity

Value of Warrants = Number of warrants * Warrant Price = 1.8 million warrants * $ 30 = $ 54 million

Now calculate value per share Value of Equity = $ 2,036 million

If this includes Equity value of Convertibles and warrants:

Value of Equity in Convertible Debt = $ 72 million

Value of Equity in Warrants = $ 54 million

Value of Equity in Common Stock = $ 1,910 million / Number of Shares outstanding = 25.50 million

Value per Share = $ 1,910m/25.5m= $ 74.90

Value per Share Fully Diluted: $ 2,036m/(25.5m+1.8m+2.3m)=$ 68.78

If the Equity value excludes CV and warrants:

$2,036M+$72M+$54M=$ 2,062M/29.6M=$73.03

Example Convertibles 20 yr convertible bond Price $1000 (selling price, par price, maturity value) 10% coupon (13% without conversion) Each bond would be converted into 20 common shares Pc=conversion price= $1000/20=$50 per share D1= dividend next time is $2,80 Share price is P=$35; g=8% constant per annum Ks= D1/P+g= $ 2,80/$35+8%=16% Without conversion we assume that the bond yield was 13% The convertibles will be called after year 10 at price $ 1050 declining $5 per annum after

year 10 If treated as straight bond we can calculate the NPV at 13% Conversion today if possible would have value 20*$35=$700 this value will rise with the

assumed g=8% per annum to $1029in yr 20 The floor value is the straight bond value the value can not be lower then that level The other floor is the conversion value level if the market price would drop under this level

investors would by the convertibles The market value will at a point converge with the conversion value line The cost of the convertible Kc lies in between Ks (cost of equity) and Kd (cost of debt)

Calculations…

  Pure-bond Conversion Maturity Call Floor Market  

Year Value, Bt Value, Ct Value Value Value Value Premium

0 $789.26 $700.00 $1,000.00 N/A $789.26 $1,000.00 $210.74

1 $791.86 $756.00 $1,000.00 N/A $791.86 $1,023.00 $231.14

2 $794.80 $816.48 $1,000.00 N/A $816.48 $1,071.00 $254.52

3 $798.13 $881.80 $1,000.00 N/A $881.80 $1,147.00 $265.20

4 $801.88 $952.34 $1,000.00 N/A $952.34 $1,192.00 $239.66

5 $806.13 $1,028.53 $1,000.00 N/A $1,028.53 $1,241.00 $212.47

6 $810.93 $1,110.81 $1,000.00 N/A $1,110.81 $1,293.00 $182.19

7 $816.35 $1,199.68 $1,000.00 N/A $1,199.68 $1,344.00 $144.32

8 $822.47 $1,295.65 $1,000.00 N/A $1,295.65 $1,398.00 $102.35

9 $829.39 $1,399.30 $1,000.00 N/A $1,399.30 $1,453.00 $53.70

10 $837.21 $1,511.25 $1,000.00 $1,050.00 $1,511.25 $1,511.25 $0.00

11 $846.05 $1,632.15 $1,000.00 $1,045.00 $1,632.15 $1,632.15 $0.00

12 $856.04 $1,762.72 $1,000.00 $1,040.00 $1,762.72 $1,762.72 $0.00

13 $867.32 $1,903.74 $1,000.00 $1,035.00 $1,903.74 $1,903.74 $0.00

14 $880.07 $2,056.04 $1,000.00 $1,030.00 $2,056.04 $2,056.04 $0.00

15 $894.48 $2,220.52 $1,000.00 $1,025.00 $2,220.52 $2,220.52 $0.00

16 $910.77 $2,398.16 $1,000.00 $1,020.00 $2,398.16 $2,398.16 $0.00

17 $929.17 $2,590.01 $1,000.00 $1,015.00 $2,590.01 $2,590.01 $0.00

18 $949.96 $2,797.21 $1,000.00 $1,010.00 $2,797.21 $2,797.21 $0.00

19 $973.45 $3,020.99 $1,000.00 $1,005.00 $3,020.99 $3,020.99 $0.00

20 $1,000.00 $3,262.67 $1,000.00 $1,000.00 $3,262.67 $3,262.67 $0.00

Floor value guarantees…

convertibles

0500

100015002000250030003500

year

US

D

Pure Bond

Conversion Value

Maturity Value

Market Value

Floor Value

If exercised at year 10 The value of this security is defined by its cash flows: Cash out for the bond at t0= -1000 Cash ins for 10 yrs. Coupon bond= +100 Value of the (20) warrants being the current share price $ 35

expected to grow 8% per yr. for 10 yrs. $ 1.511,- The Kc (IRR of the convertible bond found is 12.8%....(10%

straight bond income and 2.8% capital gains) Straight equity was 16% and straight bond 13% this issue

has a Kc that is probably too low; Kc should be in between Kd and Ks thus Ks>Kc>Kd since a convertible is more risky then a straight bond…..

Typical value structure…

Earnings reporting with hybrids

Basic EPS; earning available for common stockholders divided by the average number of common shares outstanding

Primary EPS; both earnings are estimated and nr. Of shares based on assumed conversion into shares

Diluted EPS; both earnings and nr. of shares corrected with total amount of outstanding convertibles and warrants

Assignment : Convertibles

Consider your team’s company Review the LT debt components Does your company have convertible bonds? If so you need to revalue these convertibles for

valuation purposes… Calculate the equity value under the assumption

that all bonds will be converted at maturity of the bonds

Set the D/E ratio accordingly… Recalculate the value of your company…

Assignment : Convertibles

If your company does not have any convertible bonds

Pick an S&P500 that has and do the exercise…

Calculate the impact of the revaluation on the value of the company…

Homework Assignment : Earnings reporting

How does your company report their quarterly earnings: Basic EPS ? Primary EPS ? Diluted EPS ?

Is this according to regulations, procedures and law? What rules, regulations and laws are applicable here?