Hybrid Financing: Preferred Stock, Warrants, and Convertibles

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CHAPTER 20

• Hybrid Financing Preferred Stock, Warrants, and
  Convertibles

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Topics in Chapter

• Types of hybrid securities
• Preferred stock
• Warrants
• Convertibles
• Features and risk
• Cost of capital to issuers

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How 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.

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• 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?

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Advantages and Disadvantages of Preferred Stock

• 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
  firms cost of common equity

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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.

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• 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.

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How 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.

9
What coupon rate must be set on the following
bond with warrants if the total package is to
sell for 1,000?

• P0 20.
• rd of 20-year annual payment bond without
  warrants 10.
• 45 warrants with a strike price (also called an
  exercise price) of 25 each are attached to bond.
• Each warrants value is estimated to be 3.

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Step 1 Calculate VBond

• VPackage VBond VWarrants 1,000.
• VWarrants 45(3) 135.
• VBond 135 1,000
• VBond 865.

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Step 2 Find Coupon Payment and Rate
Therefore, the required coupon rate is 84/1,000
8.4.
12
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 865 45(5) 1,090.
• This is 90 more than the selling price.

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• The firm could have set lower interest payments
  whose PV would be smaller by 90 per bond, or it
  could have offered fewer warrants and/or set a
  higher strike price.
• Under the original assumptions, current
  stockholders would be losing value to the
  bond/warrant purchasers.

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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
  cant sell for less).
• Therefore, warrants tend not to be exercised
  until just before expiration.

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• In a stepped-up strike price (also called a
  stepped-up exercise price), the strike price
  increases in steps over the warrants life.
  Because the value of the warrant falls when the
  strike 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
  stocks payout ratio rises enough.

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Will the warrants bring in additional capital
when exercised?

• When exercised, each warrant will bring in an
  amount equal to the strike price, 25.
• This is equity capital and holders will receive
  one share of common stock per warrant.
• The strike price is typically set some 20 to 30
  above the current stock price when the warrants
  are issued.

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Because 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.

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What is the expected return to the bond-
with-warrant holders (and cost to the issuer)?

• You need to estimate when the warrants are likely
  to be exercised and the expected stock price on
  that exercise date.

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The stock (currently 20) is expected to grow at
a rate of 8 per year

• The company will exchange stock worth 43.18 for
  one warrant plus 25. The opportunity cost to
  the company is 43.18 - 25.00 18.18 per
  warrant.
• Bond has 45 warrants, so the opportunity cost per
  bond 45(18.18) 818.10.

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Here are the cash flows on a time line
Input the cash flows into a calculator to find
IRR 11.93. This is the pre-tax cost of the
bond and warrant package.
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• The cost of the bond with warrants package is
  higher than the 10 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.

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• 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.

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• 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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Assume the following convertible bond data

• 20-year, 8.5 annual coupon, callable convertible
  bond will sell at its 1,000 par value straight
  debt issue would require a 10 coupon.
• Call protection 5 years and call price
  1,100. Call the bonds when conversion value gt
  1,200, but the call must occur on the issue date
  anniversary.
• P0 20 D0 1.00 g 8.
• Conversion ratio CR 40 shares.

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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.
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What is (1) the convertibles straight debt value
and (2) the implied value of the convertibility
feature?
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Implied Convertibility Value

• Because the convertibles will sell for 1,000,
  the implied value of the convertibility feature
  is 1,000 - 872.20 127.70.
• The convertibility value corresponds to the
  warrant value in the previous example.

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What is the formula for the bonds expected
conversion value in any year?

• Conversion value CVt CR(P0)(1 g)t.
• For t 0
• CV0 40(20)(1.08)0 800.
• For t 10
• CV10 40(20)(1.08)10
• 1,727.14.

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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 872.30.
• CV0 800.
• Floor value at Year 0 872.30.

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• Straight debt value10 907.83.
• 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.

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If the firm intends to force conversion on the
first anniversary date after CV gt1,200, when is
the issue expected to be called?
Bond would be called at t 6 since call must
occur on anniversary date.
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What is the convertibles expected cost of
capital to the firm?
Input the cash flows in the calculator and solve
for IRR 11.8.
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Does the cost of the convertible appear to be
consistent with the costs of debt and equity?

• For consistency, need rd lt rc lt rs.
• Why?

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Check the values

• Since rc is between rd and rs, the costs are
  consistent with the risks.

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WACC Effects

• Assume the firms tax rate is 40 and its capital
  structure consists of 50 straight debt and 50
  equity. 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
  firms WACC?

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Convertibles Step 1 Find the after-tax cost of
the convertibles.
INT(1 - T) 85(0.6) 51. With a calculator,
find rc (AT) IRR 8.71.
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Convertibles Step 2 Find the after-tax cost of
straight debt.
rd (AT) 10(0.06) 6.0.
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Convertibles Step 3 Calculatethe WACC.
WACC (with 0.4(6.0) 0.2(8.71) convertibles)
0.4(13.4) 9.5. WACC (without
0.5(6.0) 0.5(13.4) convertibles) 9.7.
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• 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 10 when convertibles are used.
• When the convertible is converted, the debt ratio
  would decrease and the firms financial risk
  would decline.

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Warrants Step 1 Find the after-tax cost of the
bond with warrants.
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Warrants Step 2 Calculate the WACC if the firm
uses warrants.
WACC (with 0.4(6.0) 0.2(8.84) warrants)
0.4(13.4) 9.53. WACC (without
0.5(6.0) 0.5(13.4) warrants) 9.7.
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Besides cost, what other factors should be
considered?

• The firms 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.

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• 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.

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Recap 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.

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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?

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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.

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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

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• 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