Presentation on theme: "Hybrid Financing: Preferred Stock, Warrants, and Convertibles"— Presentation transcript:
1Hybrid Financing: Preferred Stock, Warrants, and Convertibles CHAPTER 21Hybrid Financing: Preferred Stock,Warrants, and ConvertiblesTypes of hybrid securitiesPreferred stockWarrantsConvertiblesFeatures and riskCost of capital to issuers
2How does preferred stock differ from common stock and debt?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.(More...)
3Some 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?
4What are the advantages and disadvan- tages of preferred stock financing?AdvantagesDividend obligation not contractualAvoids dilution of common stockAvoids large repayment of principalDisadvantagesPreferred dividends not tax deductible, so typically costs more than debtIncreases financial leverage, and hence the firm’s cost of common equity
5What is floating rate preferred? 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.
6However, 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.
7How can a knowledge of call options help one understand warrants and convertibles? 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.
8Given the following facts, what coupon rate must be set on a bond with warrants if the total package is to sell for $1,000?P0 = $20.rd 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.
10Step 2: Find Coupon Payment and Rate NI/YRPVPMTFVSolve for payment = 100Therefore, the required coupon rate is $100/$1,000 = 10%.
11At issue, the package was actually worth If after issue the warrants immediately sell for $5 each, what would this imply about the value of the package?At issue, the package was actually worthVPackage = $ ($5) = $1,100,which is $100 more than the selling price.(More...)
12The 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.
13Assume that the warrants expire 10 years after issue Assume that the warrants expire 10 years after issue. When would you expect them to be exercised?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.(More...)
14In 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.
15Will the warrants bring in additional capital when exercised? 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.
16Because warrants lower the cost of the accompanying debt issue, should all debt be issued with warrants?No. As we shall see, the warrants have a cost which must be added to the coupon interest cost.
17What 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?The company will exchange stock worth $36.75 for one warrant plus $25. The opportunity cost to the company is $ $25.00 = $11.75 per warrant.Bond has 50 warrants, so the opportunity cost per bond = 50($11.75) = $(More...)
18Here are the cash flows on a time line: +1,,000,100Input the cash flows into a calculator to find IRR = 14.7%. This is the pre-tax cost of the bond and warrant package.(More...)
19The 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...)
20When 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.
21At 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.
22Assume the following convertible bond data: 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.P0 = $20; D0 = $1.48; g = 8%.Conversion ratio = CR = 40 shares.
23What conversion price (Pc) is built into the bond? Par value# Shares receivedPc == = $25.$1,00040Like with warrants, the conversion price is typically set 20%-30% above the stock price on the issue date.
24Examples of real convertible bonds issued by Internet companies IssuerAmazon.comBeyond.comCNETDoubleClickMindspringNetBankPSINetSportsLine.comSize of issue$1,250 mil55 mil173 mil250 mil180 mil100 mil400 mil150 milCvt Price$156.0518.3474.8116562.535.6762.3665.12Price at issue$122168413460325552
25What is (1) the convertible’s straight debt value and (2) the implied value of the convertibility feature?Straight debt value:NI/YRPVPMTFVSolution:
26Implied Convertibility Value Because the convertibles will sell for $1,000, the implied value of the convertibility feature is $1,000 - $ = $The convertibility value corresponds to the warrant value in the previous example.
27What is the formula for the bond’s expected conversion value in any year?Conversion value = CVt = CR(P0)(1 + g)t.t = 0CV0 = 40($20)(1.08)0 = $800.t = 10CV10 = 40($20)(1.08)10= $1,
28What is meant by the floor value of a convertible What is meant by the floor value of a convertible? What is the floor valueat t = 0? At t = 10?The floor value is the higher of the straight debt value and the conversion value.Straight debt value0 = $CV0 = $800.Floor value at Year 0 = $
29Straight debt value10 = $CV10 = $1,Floor value10 = $1,A convertible will generally sell above its floor value prior to maturity because convertibility constitutes a call option that has value.
308 -800 0 1200 If the firm intends to force conversion on the first anniversary date after CV >$1,200, when is the issue expected to be called?NI/YRPVPMTFVSolution: n = 5.27Bond would be called at t = 6 sincecall must occur on anniversary date.
31What is the convertible’s expected cost of capital to the firm? 1,-1,269.50-1,374.50CV6 = 40($20)(1.08)6 = $1,Input the cash flows in the calculator and solve for IRR = 13.7%.
32For consistency, need rd < rc < rs. Why? Does the cost of the convertible appear to be consistent with the costs of debt and equity?For consistency, need rd < rc < rs.Why?(More...)
33Check the values:rd = 12% and rc = 13.7%.rs = g == 16.0%.Since rc is between rd and rs, the costs are consistent with the risks.D0(1 + g)P0$1.48(1.08)$20
34WACC EffectsAssume the firm’s tax rate is 40% and its debt ratio is 50%. Now suppose the firm is considering either:(1) issuing convertibles, or(2) issuing bonds with warrants.Its new target capital structure will have 40% straight debt, 40% common equity and 20% convertibles or bonds with warrants. What effect will the two financing alternatives have on the firm’s WACC?
35Convertibles Step 1: Find the after-tax cost of the convertibles. 1,-1,269.50-1,332.50INT(1 - T) = $105(0.6) = $63.With a calculator, find:rc (AT) = IRR = 9.81%.
36Convertibles Step 2: Find the after-tax cost of straight debt. rd (AT) = 12%(0.06) = 7.2%.
38Some notes:We have assumed that rs is not affected by the addition of convertible debt.In practice, most convertibles are subordinated to the other debt, which muddies our assumption of rd = 12% when convertibles are used.When the convertible is converted, the debt ratio would decrease and the firm’s financial risk would decline.
39Warrants Step 1: Find the after-tax cost of the bond with warrants. +1,,000,060INT(1 - T) = $100(0.60) = $60.# Warrants(Opportunity loss per warrant)= 50($11.75) = $Solve for: rw (AT) = 10.32%.
40Warrants Step 2: Calculate the WACC if the firm uses warrants. WACC (with = 0.4(7.2%) + 0.2(10.32%) warrants) (16%) = 11.34%.WACC (without = 0.5(7.2%) + 0.5(16%)warrants)= 11.60%.
41Besides cost, what other factors should be considered? The firm’s 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.(More...)
42Does the firm want to commit to 20 years 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 convertibles would be exercised. Debt would remain outstanding.
43Recap the differences between warrants and convertibles. Warrants bring in new capital, while convertibles do not.Most convertibles are callable, while warrants are not.Warrants typically have shorter maturities than convertibles, and expire before the accompanying debt.(More...)
44Warrants usually provide for fewer common shares than do convertibles. Bonds with warrants typically have much higher flotation costs than do convertible issues.Bonds with warrants are often used by small start-up firms. Why?
45How do convertibles help minimize agency costs? Agency costs due to conflicts between shareholders and bondholdersAsset substitution (or bait-and-switch). Firm issues low cost straight debt, then invests in risky projectsBondholders suspect this, so they charge high interest ratesConvertible debt allows bondholders to share in upside potential, so it has low rate.
46Agency Costs Between Current Shareholders and New Shareholders Information asymmetry: company knows its future prospects better than outside investorsOutside investors think company will issue new stock only if future prospects are not as good as market anticipatesIssuing new stock send negative signal to market, causing stock price to fall
47Company with good future prospects can issue stock “through the back door” by issuing convertible bondsAvoids negative signal of issuing stock directlySince prospects are good, bonds will likely be converted into equity, which is what the company wants to issue