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

2. 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

3. 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

4. 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

5. 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

6. 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

7. 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

8. 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

9. 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

10. 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

11. 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

12. 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

13. 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

14. 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

15. 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

16. 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

17. 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

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

19. 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

20. 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