Chapter 20 Hybrid financing: preferred stock, warrants, & convertibles Finance Chapter 20 Hybrid financing: preferred stock, warrants, & convertibles

Additional long term capital types Preferred stock – a hybrid security that is a cross between debt and common equity Leasing – an alternative to borrowing to finance fixed assets Warrants – derivative securities issued by firms to facilitate issuing some other type of security Convertibles – combine features of debt (or preferred stock) and warrents

Preferred stock Accountants show preferred stock as equities on the balance sheet From a financial perspective they’re somewhere in between debt and common equity It imposes a fixed charge thus increasing a firm’s financial leverage but omitting the preferred dividend does not force a company into bankruptcy

Preferred stock basic features Preferred stock has a par (or liquidating) value often $25 or $100 Dividend is stated as a percentage of par or as so many dollars per share, e.g.: par value of preferred stock $100 at time of issue is $12 annual dividend Or 12% annual yield

Preferred stock basic features Cumulative – a protective feature that requires preferred dividends previously not paid to be paid before any common dividends can be paid Arrearages – unpaid preferred dividends Arrearages do not earn interest Arrearages accumulate for a limited time only (e.g., 3 years) but continue in force until they are paid

Preferred stock basic features Normally no voting rights unless the dividend is not paid (passes) – PS holders can then elect a minority of directors Recent trends in issuing PS: About ½ PS are convertible Some PS are similar to perpetual = no maturity date Some PS issued with a sinking rate (e.g., 2% must be retired each year) Some have limited life (e.g., 50 years) Some are callable

ARPs Adjustable Rate Preferred Stocks (ARPs) Rates tied to Treasuries Favorable tax rates to corporations Floating rate designed to keep the issue trading near par Riskiness became an issue resulting in price instability. This made ARPs unattractive for liquid asset portfolios

Market Auction Preferred Market Auction (Money Market) Preferred – low-risk, largely tax-exempt, 7-week maturity security that can be sold between auction dates at close to par. Holders who want to sell their shares auction them at par value. Buyers submit bids in the form of yields. The yield set on the issue for the coming period is the lowest yield sufficient to to sell all the shares being offered Buyers pay the sellers par value Issuer pays a dividend rate over the next 7-week period as determined by the auction

Advantages of PS Unlike bonds, the obligation to preferred dividends is not contractual and passing a preferred dividend does not force bankruptcy Preferred stock avoids diluting common equity If no maturity date - reduces cash flow drain from repayment of principal that occurs with bonds

Disadvantages of PS PS dividends are not deductible to the issuer Since the intent is to pay dividends, dividends are a fixed cost. Therefore, their use, like that of debt, increases financial risk and thus the cost of common equity Industry practice, pg. 762

Leasing An alternative to owning assets since it’s the use of the asset that’s important, not the ownership of it Traditionally associated with real estate (land & buildings) Since 2002, about 30% of all capital equipment is leased Types of leases Sale-and-leaseback Operating leases Straight financial, or capital, leases

Sales & leaseback An arrangement whereby a form sells land, buildings, or equipment and simultaneously leases the property back for a specified period under specific terms Lessee – the firm selling the property; the party that uses rather than owns the leased property Lessor – the owner of the leased property Payments are set-up similar to a mortgage

Operating leases A lease under which the lessor maintains and finances the property; also called a service lease Lease payments include cost of providing maintenance Property is not fully amortized; the full cost of the equipment is not recovered. Recovery can be of 3 types: Renewals Subsequent leases Selling the leased equipment

Operating leases Cancellation clause – allows the lessee the right to cancel the lease before the term of the lease expires. Useful when: Technology makes the equipment leased obsolete (computers) Lessee’s business declines

Financial, or Capital, leases A financial lease does not provide for maintenance services, is not cancelable, and is fully amortized over its life Similar to sale-and-leaseback lease but Equipment is new Lessor buys from a manufacturer/distributer not the lessee

Financial statement effects Deciding to buy or sell Comparing alternatives and choosing the method with lower PV cost All cash flows should be discounted at the after- tax cost of debt because the relevant cash flows are relatively certain and are on an after-tax basis

Warrants A long-term option to buy a stated number of shares of common stock at a specified price A long term call option issued along with the bond Warrants are generally detachable from the bond Warrants are traded separately in the market When warrants are exercised, the firm receives additional equity capital, and the original bonds remain outstanding Induces investors to buy long term debt with lower coupon rates Option offsets the bond’s lower interest rate

Warrants Warrants are used by small, rapidly growing (higher risk) firms as “sweeteners” Sony-Columbia Pictures case, pg. 776

convertibles Convertible security – usually a bond or preferred stock that is exchangeable at the option of the holder for the common stock of the issuing firm Conversion ration (CR) – the number of shares of common stock that are obtained by converting a convertible bond or share of convertible preferred stock Conversion price, Pc – the effective price paid for common stock obtained by converting a convertible security Conversion price usually set-up from 20-30% above prevailing market value of the common stock (similar to warrant pricing) Industry Practice, pg. 778

Warrants cf. convertibles Both are “sweeteners” but differences include: Separability – warrants are separated from bonds Impact when exercised – exercising warrants brings in new equity capital, while conversion of convertibles is only an accounting transfer Callability – most convertible issues are callable, warrants are not callable Maturity – warrants have a much shorter maturity Flotation costs – costs for warrants substantially higher than costs for convertibles