Hybrid Securities

1. Preferred stock• Preferred stock: normally, stock without voting rights but with a

fixed dividend payment (fixed charge).• Typical face value of $25 or $100. • The fixed dividend payment is stated as a percentage of face value

of as dollar amounts per share. The most preferred stock has a cumulative dividend. That is, if a firm does not pay dividends, the cumulative total of unpaid dividends must be paid before dividends can be paid on the common stock. Unpaid preferred dividend is call “arrearages.”

• The fixed charge increases the firm’s financial leverage.• Omitting the preferred dividend payment does not force a company

into bankruptcy.• Preferred dividend is not tax-deductible.• Higher cost capital than does debt.

• Normally no voting rights. However most preferred issues stipulate that the preferred stockholders can elect a minority of directors.

• Some preferred stocks are similar to perpetual bonds. But most new issues now have specific maturities and sinking fund provision that calls for the retirement of 2% of the issue each year.

• Many preferred issues are callable.• Preferred stock often has a feature of

convertibility to common stocks.

• To issuers’ viewpoints, preferred stocks are less risky than bonds. To investors’ view, however, preferred stock could be riskier because of a lower priority of claims in bankruptcy and a possibility of omitting dividend payments. Despite of this risk, there is a tax benefit to corporation. 70% of preferred dividend received is tax exempt. Thus major investors in preferred stocks are corporations. Especially corporation buyers in a high tax bracket will have great tax benefits.

1-1. Other types of preferred stocks

• Adjustable rate of preferred stock (ARP): dividend amounts are tied to the rate on Treasury securities. It is typically issued by utilities and large commercial banks and popular as a short term investment for firms (e.g. mutual funds) with idle cash. However price is too volatile to be held in the liquid asset portfolio.

• Market auction preferred stock (Money market preferred stock): Corporations need to hold at least 46 days (approximately 7 weeks) in order to get the 70% exclusion from taxable income. Basing on this information, the underwriter conducts an auction on the issue every 7 weeks. Holders who want to sell can put their market auction preferred stock for auction at par value. Buyers submit bids in the form of the yield they are willing to accept over the next 7 week period. The yield accepted generally is the lowest yield sufficient to sell all the preferred stocks being offered at that auction. To the holders’ view points, it is a low risk, large tax-exempt 7 week maturity security that can be sold between auction dates at close to par.

1-2. Advantages and disadvantages of preferred stock

• Advantages: (1) dividend payment is not obligated and not associated with being default. (2) issuing preferred stocks avoid the dilution of common stocks. (3) because preferred stock sometimes has no maturity and because sinking fund payment (if present) are typically spread over a long period, preferred issues reduce the cash flow drain from repayment of principal.

• Disadvantages: (1) dividend payment is not tax-deductible. After tax cost of preferred is typically higher than after tax cost of debt. (2) preferred dividends are considered to be a fixed cost and to increase a financial cost to an issuer.

2. Options and corporate finance2.1. Employ stock options (ESOs): a call option granted to employee by a company. Under this option, employee can buy shares at a fixed price for a fixed period. (1) ESO featuresDifference between regular stock option and ESO:•ESO can not be sold.•“vesting” period: for up to three years or so, an ESO can not be exercised and also must be fortified if an employee leaves the company. After vesting period, ESO vests and employee exercise ESO.

• ESO is used to align an interest of management and that of shareholders. ESO is used as a recruitment tool in a small size firm or firms with a lack of liquidity.

(2) ESO repricing• In general, a strike price of ESO is same as the market price

or at the money on the grant date. Sometimes, however, a market price is lower than a strike price. ESO is called “underwater.” On occasion, a company decides to lower the strike price on underwater options. Such options are said to be restricted or repriced.

• Critics on repricing: a reward for failure and possible manipulation to provide money to current management.

• Typically underwater ESO is exchanged for a smaller number of new ESOs with a lower exercise price.

(3) ESO backdating.•Financial researchers find that many companies have a practice of looking backward in time to select the grant date. Main purpose is to pick a date in which stock price was low. But it is not illegal as long as there is full disclosure and various tax and accounting issues are handled properly. Before Sarbanes-Oxley, companies had up to 45 days after the end of their fiscal years to report options grants. After Sarbanes-Oxley, in two days the company is required to report options grants.

2.2. Equity as a call option on the firm’s assets•Common stock in a leveraged firm is a call option on the assets of the firm.

•E.g) suppose a firm has a single debt issue outstanding. The face value is $1000 and the debt is coming due in a year. There are no coupon payments between now and then. The debt is effectively a pure discount bond. In addition, the current market value is $980 and risk free rate is 12.5%.

• In a year, a stockholder will have two choices: pay off $1000 and get the assets or let it default and bondholders will have the assets. In this situation, shareholders essentially look like having a call option on the assets of the firm with an exercise price of $1000. If they exercise this call option by paying $1000, they will obtain the assets. Otherwise let it default. Here the equity value is a value of the call option. Using option valuation, we can estimate the value of equity and debt (= market price – value of equity).

Case 1: The debt is risk-free. Option is in the money.•Suppose that in one year the firm’s assets will be either $1100 or 1200. The option is in the money. •Equity value = option value = value of underlying asset – PV of exercise price = 980 – 1000/(1+0.125)=91.11.•Debt value = 980-91.11 = 888.89.

Case 2: The debt is risky. Option is not in the money.•Suppose that in one year the firm’s assets will be either 800 or 1200. In this case, when the price is $800, the option value is 0. When it is $1200, the option value is $200.•PV of $800 and (1200-800)/(200-0) call options replicate the value of the assets of the firm.•980 = 800/(1+0.125)+ 2C. C= 134.44 = option value = equity value.•Debt value = 980 -134.44 = 845.56.

2.3. Options and capital budgeting• Real option: an option that involves real assets (buying

car or land, investing in, etc) as opposed to financial assets such as shares of stocks.

(1) The investment timing decision: evaluation of the optimal time to begin a project.

• A project costs $100 and has a single future cash flow. If we take it today, the cash flow will be $120 in one year. If we wait for one year, the project will still cost $100, but the cash flow following year will be $130. If the discount rate is 10%,

• NPV of taking today= -100+120/1.1 =9.09• NPV of taking next year = -100+130/1.1 = 18.18. Then

18.18/(1.1) = 16.53.• The value of waiting option is 16.53-9.09 =7.44.

(2) Managerial options: opportunities that managers can exploit or modify if certain things happen in the future. •E.g) US Airways reduce lines and eliminate 1,700 jobs through attrition, voluntary leaves of absence, and furloughs. Also US Airways announced the increase in fees.

• a) Contingency planning: taking into account the managerial options implicit in a project if the project may or may not work as planned. In this situation, break-even tends to be used as decision criteria. Three broad categories:

• - Option to expand: If the positive NPV project works as planned or expected, the next question will be whether we want to repeat or expand the project. If we ignore this option, we underestimate NPV.

• - Option to abandon: would be better off by abandoning cash or profit losing business units. If we ignore this option, we underestimate NPV.

• - Option to suspend or contract operations: decision to temporarily shut down or suspend operations. E.g) natural resource – gold. When price goes up, just resume operations.

• b) Strategic options: options for future, related business products or strategies. It is like testing the possibilities or potential future business strategies. It is very costly and difficult to measure its impact in the future. But experience of pilot testing will definitely help firm to revise product mix or pricing, etc.

2.4. Options and corporate securities

• A. Warrants (sweeteners or equity kickers): a security that gives the holder the right to purchase shares of stock directly from a company at a fixed price over a given period of time. Each warrant specifies the number of shares of stock the holder can buy, the strike (or exercise) price, and the expiration date. Warrants tend to have a longer maturity than options. Warrants are often issued in combination with privately placed loans or bonds in order to promote the sales of loans or bonds with low coupon rates. Loan or Bond holders usually detach warrants and sell them at the market. Warrants are listed and traded on the NYSE.

(1) Difference between warrants and call options•A call option is issued by an individual whereas warrants are issued by firms. •When a call option is exercised, it does not relate to a firm. However when warrants are exercised, a firm need to issue new shares or to use treasury stocks. The firm will receive money. The number of shares outstanding in the market increases, meaning the value dilution of original securities.•Options tend to have a life of just a few weeks or months whereas warrants often lives of 5 or 10 years.

(2) Earnings Dilution•When warrants and convertible bonds are exercised, the number of shares outstanding increases and EPS is diluted.•Diluted EPS= net income / all possible number of shares considering exercising warrants and convertible bonds.•Basic EPS = net income / number of shares outstanding. (3) Strike or exercise price•The bankers hold a presale auction and determine the set of terms that will just clear the market.•The strike price on warrant is generally set some 20% to 30% above the market price of the stock on the date the bond is issued.•“stepped up exercise price”: sometimes, issuers increase the strike price before maturity.

(4) Component cost of bonds with warrants•e.g) Fin Corp issues 5000 bonds with 20 warrants per bond. Market price is $1000. Strike price is $22. Coupon rate is 8%. Bond maturity is 20 years. Warrant maturity is 10 years. The pre-tax cost of debt is 10% if no warrant is attached. Fin Corp’s operation and investments is $250 million right after issuing the bonds with warrants. Total value is expected to grow at 9% per year. Currently Fin Corp has 10 million shares outstanding.

• Price of bond = value of straight bond + value of warrants.

• 1000 = [80*(1-1/(1.1^20))/0.1 + 1000/(1.1^20)] + value of warrants.

• Value of warrants = 1000 – 830 = 170.• At the expiration date of warrants, Fin Corp

value = 250 * (1.09^10) =591.841 million. • If 1 million warrants ( =5000*20) are exercised,

Fin Corp will receive $22 million (=$22 * 1 million warrants). Total value of Fin Corp = 591.841 + 22 = $613.84 million.

• At the expiration date of warrants, bonds still have 10 year maturity remaining. PV of a bond = 80*(1-1/(1.1^10))/0.1 + 1000/(1.1^10) = 877.11. Total bond value is 5000*877.11 = 43.856 million. Intrinsic value of equity = 613.84 – 43.856 = 569.985.

• After warrants are exercised, the number of shares outstanding will be 11 million (=10 million + 1 million). Intrinsic value per share = $51.82 (= 569.985/11).

• Thus cost of each warrant to Fin Corp = the value of warrant to holders at the end of 10th year (maturity of warrant) = 51.82 -22 = 29.82. Per bond, 20 warrants costs 596.40 (=20*$29.82) to Fin Corp or valuable as much as 596.40 to a holder.

• The initial value of warrant is $170 and at the end of 10th year, will be $596.40.

• Thus 569.40 = 170 *(1+IRR)^10. You can have 13.35%. That is, an annual cost to Fin Corp or annual return to a holder is 13.35%.

• Pretax cost of bonds with warrants = rd *(830/1000)+rw(170/1000) = 10%*(830/1000) + 13.35%*(170/1000) = 10.57%.

• Cost of a bond with warrants tend to be higher than a cost of straight bond and will be much higher than the coupon rate on the bonds- with warrants package.

• Cost of a warrant tends to be higher than cost of equity. But it may depend on dilution of equity and strike (or exercise) price.

B. Convertible bonds: A bond that can be exchanged for a fixed number of shares of stock for a specified amount of time (anytime up to and including the maturity of the bond). It is similar to bonds with warrants. But unlike warrants, conversion option is not detachable.

•Preferred stock can frequently be converted into common stock. A convertible preferred stock is the same as a convertible bond except that it has an infinite maturity date.

(1) Features of a convertible bond•Conversion price: the dollar amount of a bond’s par value that is exchangeable for one share of stock. That is, it is a price per share of stock.•Conversion ratio: the number of shares per bond (= $1000/conversion price).•Conversion premium = (conversion price – market price)/ market price. •Positive conversion premium reflects conversion option was out of the money at the time of issuance.•In general, convertibles have a 10 year call protection. During this period, an issuer can not call back his or her convertibles.

(2) Value of a convertible bond•e.g) MO company has an outstanding B- rated convertible bond issue. The coupon rate is 7% and the conversion ratio is 15. There are 12 remaining coupons and the stock is trading for $68.•- Straight bond value: the value a convertible bond would have if it would have if it could not be converted into common stocks. Assume that B – rated bond is priced at 8% yield to maturity.•PV = 35*(1-1/(1+0.04)^12)/0.04 + 1000/(1+0.04)^12 = 953.08•Conversion value: the value a convertible bond would have if it were to be immediately converted into common stocks.•= current stock price * conversion ratio•= 68*15 = 1020

• In general, a convertible can not sell for less than its conversion value.

• Floor value: minimum value of a convertible. It is Max [straight bond value, conversion value]. A logic is that a convertible is composed of straight bond and conversion value. The market price of a convertible can not be lower than straight bond value and doe not exceed conversion value. But due to option value, the market price sometimes exceeds conversion value.

• • Figure 24.4

• Option value: the value of an option to wait. The convertible holders do not need to convert immediately. Instead, by waiting, they can take advantage of whichever is greater in the future - straight bond value or conversion value.

• Value of a convertible = floor value + option value

(3)Component cost of convertible securities

e.g) In 2013, Silicon Valley Software (SVS) was considering issuing convertible bonds that would sell at a price of $1000 per bond. Figure 20-1.•- Maturity: 20 years•- 8% annual coupon rate•- Each bond is converted into 18 shares. Conversion price =1000/18 = 55.56.•- Current stock price is $35. •- If the bond does not have convertibility, its YTM is expected to be 10%. •- This convertible bond is not callable for 10 years. But if it is called, call price is $1050 with this price declining by $5 per year thereafter.•- If after 10 years, the conversion value exceeded the call price by at least 20%, management would probably call the bonds. •- SVS’s cost of equity is 13% with a 4% dividend yield and expected capital gain of 9% per year.

• Straight bond value = 80*(1-1/(1+0.1)^20)/0.1 + 1000/(1.1^20) = 830. This value will converge to $1000 when maturity approaches to an expiration date.

• • Initial conversion value = $35*18 = 630. Here

$35 will increase by 9% every year. If a market value of convertible is less than straight bond value or conversion value, investors will see bargain and buy convertible bond.

•

• Also there is another one to be considered. It has a callable option by an issuer at $1050. If conversion value is more than a call price ($1050), the issuer definitely calls back their convertible bonds before investors exercise conversion option.

• At the end of 10th year, conversion value will be

$35*(1+0.09)10 * 18 =1491. It is greater than the call price. Thus an investor will exercise his or her option before the issuer calls back convertible bonds. An expected rate of return (=cost of convertible bond) is an IRR, considering following cash flow patterns: initial investment is $1000. Two incoming cash inflows are annual coupon payment and conversion value.

• • N=10, PV =-1000, PMT = 80, FV=1491. Then IRR =10.94%.

• In general, convertible bond is riskier than straight debt but less risky than stock. Its cost of capital is between the cost of straight debt and the cost of equity.

(4) Use of convertibles in financing•Two important advantages to issuers: (1) like warrants, convertibles offer a company the chance to sell debt with a low coupon rate. (2) a chance to sell equity at a higher price than a current price that is believed to be depressed. •Three disadvantages to issuers: (1) if stock price increases a lot, the issuer loses an opportunity to sell equity and refinance old debt, (2) convertibles have a low coupon interest rate. But conversion will reduce the benefit of paying low interest, (3) if stock price does not increase as expected, the issuer will be stuck with debt.

(5) Agency problem and convertibles•If a company would like to finance with straight debt but lenders are afraid the fund will be invested in a manner that increase the firm’s risk profile, lowering debt value and increasing equity value (it is called “bait and switch”), convertibles will be one option to release this kind of potential agency. Convertibles give options of converting to equities to debt holders.

• If a company would like to finance with equity, it would adversely signal to the market overvaluation of his or her equity and then decrease equity price. It could happen even though the firm actually has a better prospect. In this case, convertibles could be used to avoid price depression caused by equity issuing, allowing convertibles to convert to equity (like issuing through back door).

C. Comparison of Warrants and Convertibles•The exercise of warrants brings in new equity capital, whereas the conversion of convertibles results only in an accounting transfer.•Most convertibles have a call provision that allows the issuer either to refund the debt or to force conversion. But warrants are not callable.•Warrants typically have much shorter maturities than convertibles. Warrant typically expires before their accompanying debt maturity. •Warrants typically provide fewer future common shares than do convertibles. In convertibles, the total value of a bond will convert the number of shares. But not in warrants.•Warrant issuers tend to be smaller and riskier than convertible issuers. •Bond with warrants financing have underwriting fees that approximate the weighted average of the fee associated with debt and equity issues, whereas underwriting costs for convertibles are more like those of straight debt.

D. Other options•Call provision on a bond. A convertible is typically callable. Thus a convertible = a straight bond + conversion feature + call provision.•Put bonds: a bond giving the owner the right to force the issuer to buy the bond back at a fixed price for a fixed time. This kind of bond is a combination of a straight bond and a put option. •Insurance and loan guarantee: a kind of put option asking insurers to pay for you. It is like you sell something to insurers and guarantors. •