1. 21 - 1
Types of hybrid securities
Preferred stock
Warrants
Convertibles
Features and risk
Cost of capital to issuers
CHAPTER 21
Hybrid Financing: Preferred Stock,
Warrants, and Convertibles

2. 21 - 2
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.
How does preferred stock differ from
common stock and debt?
(More...)

3. 21 - 3
Some 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?

4. 21 - 4
Advantages
Dividend obligation not contractual
Avoids dilution of common stock
Avoids large repayment of principal
Disadvantages
Preferred dividends not tax deductible,
so typically costs more than debt
Increases financial leverage, and hence
the firm’s cost of common equity
What are the advantages and disadvan-
tages of preferred stock financing?

5. 21 - 5
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.
What is floating rate preferred?

6. 21 - 6
However, 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.

7. 21 - 7
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 options
help one understand warrants and
convertibles?

8. 21 - 8
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.
Given the following facts, what
coupon rate must be set on a bond
with warrants if the total package is to
sell for $1,000?

9. 21 - 9
Step 1: Calculate VBond
VPackage = VBond + VWarrants = $1,000.
VWarrants = 50($3) = $150.
VBond + $150 = $1,000
VBond = $850.

10. 21 - 10
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 rate
is $100/$1,000 = 10%.

11. 21 - 11
At issue, the package was actually
worth
VPackage = $850 + 50($5) = $1,100,
which is $100 more than the selling
price.
If after issue the warrants immediately
sell for $5 each, what would this imply
about the value of the package?
(More...)

12. 21 - 12
The 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.

13. 21 - 13
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.
Assume that the warrants expire 10
years after issue. When would you
expect them to be exercised?
(More...)

14. 21 - 14
In 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.

15. 21 - 15
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.
Will the warrants bring in additional
capital when exercised?

16. 21 - 16
No. As we shall see, the warrants
have a cost which must be added to
the coupon interest cost.
Because warrants lower the cost of
the accompanying debt issue, should
all debt be issued with warrants?

17. 21 - 17
The company will exchange stock worth
$36.75 for one warrant plus $25. The
opportunity 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 the
issuer) if the warrants are expected to
be exercised in 5 years when P =
$36.75?
(More...)

18. 21 - 18
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 to
find IRR = 14.7%. This is the pre-tax
cost of the bond and warrant package.
(More...)

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The 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...)

20. 21 - 20
When 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.

21. 21 - 21
At 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.

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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.
Assume the following convertible
bond data:

23. 21 - 23
What conversion price (Pc) is built into
the bond?
Like with warrants, the conversion
price is typically set 20%-30% above
the stock price on the issue date.
$1,000
40
Pc =
= = $25.
Par value
# Shares received

24. 21 - 24
Examples of real convertible bonds
issued by Internet companies
Issuer
Amazon.com
Beyond.com
CNET
DoubleClick
Mindspring
NetBank
PSINet
SportsLine.com
Size of issue
$1,250 mil
55 mil
173 mil
250 mil
180 mil
100 mil
400 mil
150 mil
Cvt Price
$156.05
18.34
74.81
165
62.5
35.67
62.36
65.12
Price at issue
$122
16
84
134
60
32
55
52

25. 21 - 25
What is (1) the convertible’s straight
debt value and (2) the implied value of
the convertibility feature?
PV FV
20 12 105 1000
Solution: -887.96
I/YR PMTN
Straight debt value:

26. 21 - 26
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 corresponds
to the warrant value in the previous
example.
Implied Convertibility Value

27. 21 - 27
Conversion value = CVt = CR(P0)(1 + g)t
.
t = 0
CV0 = 40($20)(1.08)0
= $800.
t = 10
CV10 = 40($20)(1.08)10
= $1,727.14.
What is the formula for the
bond’s expected conversion value
in any year?

28. 21 - 28
The floor value is the higher of the
straight debt value and the
conversion 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 value
at 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 maturity
because convertibility constitutes a
call option that has value.

30. 21 - 30
If the firm intends to force conversion
on the first anniversary date after CV >
$1,200, when is the issue expected to
be called?
PV FV
8 -800 0 1200
Solution: n = 5.27
I/YR PMTN
Bond would be called at t = 6 since
call must occur on anniversary
date.

31. 21 - 31
What is the convertible’s 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 calculator
and solve for IRR = 13.7%.

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For consistency, need rd < rc < rs.
Why?
Does the cost of the convertible
appear to be consistent with the costs
of debt and equity?
(More...)

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rd = 12% and rc = 13.7%.
rs = + g = + 0.08
= 16.0%.
Since rc is between rd and rs, the costs
are consistent with the risks.
Check the values:
D0(1 + g)
P0
$1.48(1.08)
$20

34. 21 - 34
Assume 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?
WACC Effects

35. 21 - 35
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:
rc (AT) = IRR = 9.81%.

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rd (AT) = 12%(0.06) = 7.2%.
Convertibles Step 2: Find the after-tax
cost of straight debt.

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WACC (with = 0.4(7.2%) + 0.2(9.81%)
convertibles) + 0.4(16%)
= 11.24%.
WACC (without = 0.5(7.2%) + 0.5(16%)
convertibles)
= 11.60%.
Convertibles Step 3: Calculate
the WACC.

38. 21 - 38
Some 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.

39. 21 - 39
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: rw (AT) = 10.32%.

40. 21 - 40
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.

41. 21 - 41
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.
Besides cost, what other factors
should be considered?
(More...)

42. 21 - 42
Does 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.

43. 21 - 43
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.
Recap the differences between
warrants and convertibles.
(More...)

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Warrants 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?

45. 21 - 45
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, then
invests in risky projects
Bondholders suspect this, so they charge
high interest rates
Convertible debt allows bondholders to
share in upside potential, so it has low rate.

46. 21 - 46
Agency Costs Between Current
Shareholders and New Shareholders
Information asymmetry: company
knows its future prospects better
than outside investors
Outside investors think company will
issue new stock only if future prospects
are not as good as market anticipates
Issuing new stock send negative signal
to market, causing stock price to fall

47. 21 - 47
Company with good future prospects
can issue stock “through the back
door” by issuing convertible bonds
Avoids negative signal of issuing stock
directly
Since prospects are good, bonds will
likely be converted into equity, which is
what the company wants to issue