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 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 ) 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? 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? 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? 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. 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? 21 - 8  P 0 = $20.  r d 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? 21 - 9 Step 1: Calculate V Bond V Package = V Bond + V Warrants = $1,000. V Warrants = 50($3) = $150. V Bond + $150 = $1,000 V Bond = $850. 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%. [...]... flows in the calculator and solve for IRR = 13.7% 21 - 32 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 ) 21 - 33 Check the values: rd = 12% and rc = 13.7% D0(1 + g) $1.48(1.08) rs = +g = + 0.08 P0 $20 = 16.0% Since rc is between rd and rs, the costs are consistent with the risks 21 - 34 WACC Effects Assume... 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? 21 - 35 Convertibles Step 1: Find the after-tax cost of the convertibles. . .21 - 11 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 worth VPackage = $850 + 50($5) = $1,100, which is $100 more than the selling price (More ) 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... stock’s payout ratio rises enough 21 - 15 Will 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 21 - 16 Because warrants lower... 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 21 - 17 What is the expected return to the bondwith-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... 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 ) 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. .. date 21 - 24 Examples of real convertible bonds issued by Internet companies Issuer Size of issue Cvt Price Price at issue Amazon.com $1,250 mil $156.05 $122 Beyond.com 55 mil 18.34 16 CNET 173 mil 74.81 84 DoubleClick 250 mil 165 134 Mindspring 180 mil 62.5 60 NetBank 100 mil 35.67 32 PSINet 400 mil 62.36 55 SportsLine.com 150 mil 65.12 52 21 - 25 What is (1) the convertible’s straight debt value and. .. feature? Straight debt value: 20 N 12 I/YR PV Solution: -887.96 105 PMT 1000 FV 21 - 26 Implied Convertibility Value  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 21 - 27 What is the formula for the bond’s expected conversion value in any... = 40($20)(1.08)0 = $800 t = 10 CV10 = 40($20)(1.08)10 = $1,727.14 21 - 28 What is meant by the floor value of a convertible? What is the floor value at t = 0? At t = 10?  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 21 - 29  Straight debt value10 = $915.25  CV10 = $1,727.14 Floor... would be losing value to the bond/warrant purchasers 21 - 13 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 ) 21 - 14  In a stepped-up exercise price, . 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 21. 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 ) 21 - 3  Some preferred stock is perpetual,. rate preferred? 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. 21