IFM10 Ch20 Lecture

8/10/2019 IFM10 Ch20 Lecture

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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 firmfrom paying common dividends when

the preferred is in arrears. Usually cumulative up to a limit.

(More...)


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Some preferred stock is perpetual, but mostnew issues have sinking fund or call

provisions which limit maturities. Preferred stock has no voting rights, but may

require companies to place preferredstockholders 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? Toissuers?


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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 typicallycosts more than debt

Increases financial leverage, and hence the firmscost 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, thefloating rate preferred stock may have

too much price instability for the liquidasset portfolios of many corporateinvestors.


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How can a knowledge of call options helpone understand warrants and

convertibles?

A warrant is a long-term call option.

A convertible consists of a fixed ratebond (or preferred stock)plus a long-term call option.


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What coupon rate must be set on thefollowing bond with warrants if the total

package is to sell for $1,000? P0= $20.

rdof 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

N I/YR PV PMT FV

20 12 -865 1000

Solve for payment = 84

Therefore, the required coupon rateis $84/$1,000 = 8.4%.


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If after issue the warrants immediatelysell 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.

(More...)


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The firm could have set lower interestpayments whose PV would be smaller

by $90 per bond, or it could haveoffered fewer warrants and/or set ahigher strike price.

Under the original assumptions, currentstockholders would be losing value tothe bond/warrant purchasers.


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Assume that the warrants expire 10 yearsafter issue. When would you expect them

to be exercised?

Generally, a warrant will sell in the openmarket at a premium above its value if

exercised (it cant sell for less). Therefore, warrants tend not to be

exercised until just before expiration.

(More...)


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In a stepped-up strike price (also called astepped-up exercise price), the strike priceincreases in steps over the warrants life.

Because the value of the warrant falls whenthe strike price is increased, step-upprovisions encourage in-the-money warrantholders to exercise just prior to the step-up.

Since no dividends are earned on thewarrant, holders will tend to exercisevoluntarily if a stocks payout ratio risesenough.


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Will the warrants bring in additionalcapital when exercised?

When exercised, each warrant will bring in anamount equal to the strike price, $25.

This is equity capital and holders will receiveone share of common stock per warrant.

The strike price is typically set some 20% to30% above the current stock price when thewarrants are issued.


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Because warrants lower the cost of theaccompanying debt issue, should all debtbe issued with warrants?

No. As we shall see, the warrants havea 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 theissuer)?

You need to estimate when thewarrants are likely to be exercised and

the expected stock price on thatexercise date.

(More...)


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The stock (currently $20) is expectedto 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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Input the cash flows into a calculator tofind IRR = 11.93%. This is the pre-taxcost of the bond and warrant package.

0 1 9 10 11 19 20

+1,000 -84 -84 -84 -84 -84 -84-818.10 -

1,000-902.10 -

1,084

(More...)

Here are the cash flows on atime line:


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The cost of the bond with warrantspackage is higher than the 10% cost of

straight debt because part of theexpected return is from capital gains,which are riskier than interest income.

The cost is lower than the cost of equitybecause part of the return is fixed bycontract.

(More...)


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When the warrants are exercised, thereis a wealth transfer from existing

stockholders to exercising warrantholders.

But, bondholders previously transferred

wealth to existing stockholders, in theform of a low coupon rate, when thebond was issued.


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At the time of exercise, either more orless wealth than expected may be

transferred from the existingshareholders to the warrant holders,depending upon the stock price.

At the time of issue, on a risk-adjustedbasis, 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 followingconvertible bond data:

20-year, 8.5% annual coupon, callableconvertible bond will sell at its $1,000 parvalue; straight debt issue would require a

10% coupon. Call protection = 5 years and call price =

$1,100. Call the bonds when conversionvalue > $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) isbuilt into the bond?

Like with warrants, the conversionprice is typically set 20%-30% abovethe stock price on the issue date.

Pc=Par value

# Shares received

= $1,00040

= $25 .


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PV FV

20 10 85 1000

Solution: -872.30

I/YR PMTN

Straight debt value:

What is (1) the convertibles straight debtvalue and (2) the implied value of theconvertibility 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 thewarrant value in the previous example.


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What is the formula for the bondsexpected 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 aconvertible? What is the floor valueat t = 0? At t = 10?

The floor value is the higher of thestraight 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 aboveits floor value prior to maturity becauseconvertibility constitutes a call optionthat has value.


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PV FV

8 -800 0 1200

Solution: n = 5.27

I/YR PMTN

Bond would be called at t = 6 sincecall must occur on anniversary date.

If the firm intends to force conversion on thefirst anniversary date after CV >$1,200, when isthe issue expected to be called?


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Input the cash flows in the calculatorand solve for IRR = 11.8%.

0 1 2 3 4 5 6

1,000 -85 -85 -85 -85 -85 -85-1,269.50-1,354.50

CV6= 40($20)(1.08)6= $1,269.50.

What is the convertibles expectedcost of capital to the firm?

h f h bl


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Does the cost of the convertible appear tobe consistent with the costs of debt andequity?

For consistency, need rd< rc< rs.

Why?

(More...)


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Check the values:

Since rcis between rd and rs, the costs

are consistent with the risks.

rd= 10% and rc= 11.8%

rs=D0(1 + g)

P0

+ g =$1.00(1.08)

$20+ 0.08

= 13.4%


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WACC Effects

Assume the firms tax rate is 40% and itscapital structure consists of 50% straightdebt 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. Whateffect will the two financing alternatives haveon the firms WACC?


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0 1 2 3 4 5 6

1,000 -51 -51 -51 -51 -51 -51-1,269.50-1,320.50

INT(1 - T) = $85(0.6) = $51.With a calculator, find:

rc (AT) = IRR = 8.71%.

Convertibles Step 1: Find theafter-tax cost of the convertibles.


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rd (AT) = 10%(0.06) = 6.0%.

Convertibles Step 2: Find theafter-tax cost of straight debt.


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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%.

Convertibles Step 3: Calculatethe WACC.


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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, whichmuddies our assumption of r

d

= 10% whenconvertibles are used.

When the convertible is converted, thedebt ratio would decrease and the firms

financial risk would decline.


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0 1 ... 9 10 11 ... 19 20

+1,000 -50.4 -50.4 -50.4 -50.4 -50.4 -50.4-818.10 -1,000.0-868.50 -1,060.0

INT(1 - T) = $84(0.60) = $50.4.# Warrants(Opportunity loss per warrant)= 45($18.18) = $818.10.

Solve for: rw(AT) = 8.84%.

Warrants Step 1: Find the after-taxcost of the bond with warrants.


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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%.

Warrants Step 2: Calculate theWACC if the firm uses warrants.


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Besides cost, what otherfactors should be considered?

The firms future needs for equitycapital:

Exercise of warrants brings in new equitycapital.

Convertible conversion brings in no new

funds. In either case, new lower debt ratio can

support more financial leverage.(More...)


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Does the firm want to commit to 20years of debt?

Convertible conversion removes debt, whilethe exercise of warrants does not.

If stock price does not rise over time, then

neither warrants nor convertibles would beexercised. Debt would remain outstanding.


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Recap the differences betweenwarrants and convertibles.

Warrants bring in new capital, whileconvertibles do not.

Most convertibles are callable, whilewarrants are not.

Warrants typically have shorter

maturities than convertibles, and expirebefore the accompanying debt.

(More...)


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Warrants usually provide for fewercommon shares than do convertibles.

Bonds with warrants typically havemuch higher flotation costs than doconvertible issues.

Bonds with warrants are often used bysmall start-up firms. Why?


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How do convertibles helpminimize agency costs?

Agency costs due to conflicts betweenshareholders and bondholders

Asset substitution (or bait-and-switch).Firm issues low cost straight debt, theninvests in risky projects

Bondholders suspect this, so they chargehigh interest rates

Convertible debt allows bondholders toshare in upside potential, so it has low

rate.


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Agency Costs Between CurrentShareholders and New Shareholders

Information asymmetry: companyknows its future prospects better than

outside investors Outside investors think company will issue

new stock only if future prospects are notas good as market anticipates

Issuing new stock send negative signal tomarket, causing stock price to fall


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Company with good future prospectscan issue stock through the back door

by issuing convertible bondsAvoids negative signal of issuing stock

directly

Since prospects are good, bonds will likelybe converted into equity, which is what thecompany wants to issue

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IFM10 Ch20 Lecture