[PPT]Chapter 1: An Introduction to Corporate Finance · Web viewBooth/Cleary Introduction to Corporate Finance, Second Edition Author Brown, Gail - Toronto Created Date 07/28/2010

INTRODUCTION TO

CORPORATE FINANCESECOND EDITION

Lawrence Booth & W. Sean Cleary

Prepared by Ken Hartviksen & Jared Laneus

Chapter 19Equity and Hybrid Instruments

19.1 Shareholders’ Equity19.2 Preferred Share Characteristics19.3 Income Trusts19.4 Warrants and Convertible Securities19.5 Other Hybrids

2Booth/Cleary Introduction to Corporate Finance, Second Edition

Learning Objectives19.1 Explain the basic rights associated with share ownership.19.2 Identify and describe the various classes of shares and the

shareholders’ rights associated with each.19.3 Explain how preferred shares differ from common shares and

outline the various features associated with preferred shares.19.4 Explain how combining warrants with debt issues or issuing

convertible bonds or debentures can provide firms with attractive financing options.

19.5 Identify and describe the various hybrid financing options available to firms, and explain how they are constructed.


Shareholders’ Equity• Equity securities represent an ownership interest in an underlying

business, usually a corporation• We often call common shares those shares with both voting and

residual rights to earnings and assets, but all of those rights do not technically have to vest in a single share class

• The 1980 revision of the Canada Business Corporations Act (CBCA) removed “preferred share” from Canadian legal terminology

• “Par value” was also removed in 1975• The CBCA now allows corporations to issue any number of classes of

shares, however there must be:• One share class with voting rights• One share class with residual rights to dividends• One share class with residual rights to assets upon dissolution


Preferred Versus Common Shares• Although no longer described in the CBCA, preferred shares are

those which have some preference or priority over the common share class

• There can be any number of share classes with different rights and voting privileges


Preferred Shares• Although no longer described in the CBCA, preferred shares are

those which have some preference or priority over the common share class

• There can be any number of share classes with different rights and voting privileges

• Preferred shares refer to a share class that:• Has no voting rights, unless the fixed dividend is in arrears for a given

period of time• Offers to pay a “fixed” dividend, although such dividends are not a

legally enforceable claim• Has a prior claim to be “residual” share class to assets upon dissolution

• Additionally, most preferred shares also offer a cumulative feature where dividends in arrears must be paid before the common share class can receive dividends


Shareholder Rights and Voting Rights• When a corporation has only one share class, the rights are

equal in all respects and include:• To vote at any meeting of the shareholders of the corporation• To receive any dividend declared by the corporation• To receive the corporations’ remaining property upon

dissolution• Firms incorporated under provincial legislation instead of

the CBCA operate under similar provisions.


Shareholder Rights and Voting Rights• At an annual general meeting (AGM) the standing agenda

includes a shareholders vote to:• Elect members of the board of directors• Appoint the firm’s external auditors• Receive the audited financial statements

• If major changes are proposed, a special shareholders meeting may be called and the shareholders may be asked to vote on the proposals. The proposals could include: changes to the articles of incorporation, bylaws, operations, financial structure, acquisition of another firm, etc.


The Preemptive Right and Residual RightsThe Preemptive Right• The preemptive right is the right of shareholders to maintain

proportional ownership in a company when new shares are issued• When companies raise new capital under these conditions, they do so

through a “rights” offering which gives the current shareholders the “first right of refusal” on the issue of any new shares

• If preemptive right exists, it is usually contained in the articles of incorporation

• Removal of the preemptive right from the articles of incorporation requires approval by the shareholders at a special meeting

Residual Rights• Residual rights are the rights to receive a dividend, if declared by the

board of directors, and the right to receive a pro-rata share of any remaining property upon dissolution of the corporati0n after all other claims have been satisfied


Limited Legal Liability• Implicitly, investors in the shares of corporations have limited legal

liability. • In practice, this means that if the corporation fails, the worst-case

scenario for shareholders is that their shares will become worthless• If the firm’s activities exhaust its financial resources (i.e., not even

the liquidation of the firm can pay off its liabilities), then shareholders are not liable for the unpaid amount and cannot be asked to inject more funds into the firm

• Limited legal liability ensures limited “downside” risk for shareholders while, at the same time, they enjoy unlimited “upside” potential for growth in their investment

• Members of the Board of Directors and the management team, however, can be found liable for damages or illegal acts through decisions and/or errors of omission or commission even if they are shareholders


Different Share Classes• The articles of incorporation spell out the number of share

classes and the rights of each share class• The CBCA says that the three rights of shareholders do not

have to reside in one share class if there are multiple share classes; each right can be assigned to a different share class, or shared between classes

• Under the CBCA, the firm will not use the terms “common,” “preferred,” or “non-voting,” but instead will designate different share classes with different rights.• Example: Class A, Class B, Class C


Different Types of Shares• Non-voting or restricted shares participate in dividends with

the common share class and usually do not have voting rights

• Common shareholders have full voting rights, receive dividends and are the residual share class after other creditors and share classes

• Preferred shareholders receive a stated dividend with a preference to dividends over the common share class, have latent voting rights in the case of arrearage, and have preference to assets upon dissolution over the common share class


Tim Horton’s Shareholders’ Equity• Table 19-1 presents financial information and ratios for Tim

Horton’s, including book value per share, diluted earnings per common share, and common dividend per share


Dividends and Taxes• In Canada, dividends are attractive from an income taxation

point of view, because:• Dividends received by one corporation from another

corporation are not subject to tax at the corporate level• Dividend income received by Canadians is subject to the

“gross-up dividend tax credit” system results in very low rates of tax on individuals with low to moderate marginal tax rates


Preferred Share Characteristics• Table 19-2 shows yields on

three different types of preferred shares in Canada:• Straight preferreds• Retractable preferreds• Floating rate preferreds


Types of Preferred Shares• Straight preferred shares have no maturity date and pay a

fixed dividend at regular intervals (quarterly)• Retractable preferred shares give the investor the right to

sell the shares back to the issuer, usually after five years• Floating rate preferred shares reset their dividends

periodically (usually every three to six months) by an auction mechanism so that the yield will remain consistent with current market interest rates. In some cases, the dividend is connected to the prime lending rate and changes as the prime rate changes


Preferred SharesThe Cumulative Provision• A stipulation that no dividends can be paid on common shares until

preferred share dividends, both current and in arrears, are paid• This feature is the reason that boards of directors take the payment

of preferred share dividends seriouslyPreferred Share Dividends• Although preferred share dividends are not legally-enforceable

financial obligations, issuers take the payment of dividends seriously because:• Failure to pay could jeopardize the firm’s future ability to issue

securities in the financial markets because of a damaged reputation• Normally, arrears in dividends need to be addressed before the

common share class can receive dividends and, as arrearages grow, increasingly the common shareholders will get concerned


Preferred Shares as a Hybrid Instrument• Although preferred shares are equity securities, they are often

seen as a higher yield (and risk) substitute for fixed income securities

• Preferred shares can be regarded as a hybrid security because , while they are equity from a residual claim point of view and therefore have significantly higher default risk, they do promise to offer a steady stream of dividends (similar to a debt instrument, but treated preferentially from a taxation perspective)

• The higher the quality of the issuer, the more like debt preferred stock is because of the lower likelihood of default and the greater the likelihood of an uninterrupted stream of dividends in a high quality issuer


Preferred Share Ratings

DBRS Preferred Share Rating

DBRS Bond-Equivalent Rating

PFD - 1 AAA or AAPFD – 2 APFD – 3 Highly Rated BBBPFD – 4 Lower Rated BBB or BBPFD - 5 B or Lower Rated Bonds


Income Trusts• Income trusts are a tax efficient financial structure allowing

the distribution of pre-tax corporate cash flows to trust investors resulting in:• Greater cash distributions to unitholders than the same firm

using a traditional capital structure involving debt and equity• Elimination of double-taxation

• Represents a popular form of equity financing representing more than half the IPOs in Canada in the early 2000s.

• As of March 2006 there were 238 income trusts listed on the TSX with a total market capitalization of $192 billion or 10% of the market value of the TSX


Income Trust Changes in Tax Treatment• The Department of Finance changed the taxation rules for

income trusts in an October 31, 2006 announcement• Existing income trusts, those created prior to November 1,

2006, would continue to enjoy the tax benefits of that structure until 2011

• Newly created income trusts, after November 1, 2006, would be taxed like normal corporations

• In the first few days following the announcement almost $30 billion in market capitalization was lost as income trust units fell dramatically to adjust for the new additional tax on cash distributions


Warrants and Convertible Securities• Warrants are long-term options to purchase new shares in a

corporation at a specified price, and are therefore the corporate finance equivalent of call options used to raise new capital for a firm

• As long-term options, warrants trade at significant premiums over their intrinsic value

• Warrants usually have long maturities and can even be perpetual (with no maturity date) and are issued by the firm

• The warrant’s exercise price at the time of issue is normally greater than the current share price

• Warrants are often packaged with the sale of other new securities as “equity sweeteners,” allowing the holder to exercise them to buy new shares in the company and thereby participate in the growth of the firm

• If warrants are not detachable, issuing bonds plus a warrant is similar to issuing convertible bonds, where the holder has a traditional bond and an option to purchase equity


Warrants Versus OptionsWarrants• Issued by the firm to investors in order to raise new capital for the firm

(i.e., for capital formation)• Traded in the secondary market between investors• Long-term or perpetual option• At the time of issue, the exercise price typically exceeds the share price

so the warrant does not immediately have intrinsic valueExchange-traded Call Options• Created by investors interacting with the options exchange as the

counterparty• No capital formation and instead used as an instrument of hedging or

speculation• Short-term option• May be created out-of-the-money, at-the-money or in-the-money


Warrant Valuation

$50 exercise price

Warrant Value

0 Stock Price

• At the time of issue, the warrant will have a speculative (time) value only because the market value of the stock is less than the exercise price

• Over time the stock price may increase and, when it exceeds the exercise price of the warrant, the warrant’s value will have both intrinsic and speculative value


Payoff to Warrant HoldersEquation 19-1:

where:• n = the existing number of shares• m = number of shares issued on exercise of the warrants• X = exercise price of the warrant• V = stock price of the firm without the warrants

• This equation says that, after the warrants are exercised, the value of the firm must be the value without the warrants V plus the proceeds to the firm from the exercise of the warrants mX

• This is a weighted average of the former stock price and the warrant’s exercise price

mXmnmmXV

)(holders warrant toPayoff


Payoff to Warrant HoldersEquation 19-1 reduced to Equation 19-2 when we multiple the

exercise value by (n + m) / (n + m):

• The term m / (n + m) is the dilution factor.• Therefore, the value of the warrant is the dilution factor

multiplied by the value of the secondary market call (whether you use the Black-Scholes model or the binomial option pricing model)

mnmnXV )(holders warrant toPayoff


Convertible Bonds• Convertible bonds are bonds that are convertible into a specified

number of common shares at the option of the holder• When converted, the bonds are exchanged for common shares

and the bonds are no longer outstanding• The firm does not obtain any additional financing through

conversion, although conversion reduces its debt level.• The convertibility feature is a “sweetener” used to encourage

investors to invest in the convertible bond and so convertibles tend to be issued by higher risk firms

• Convertible bonds are issued with a maturity date, however they are also usually callable to ensure conversion does eventually occur


Conversion Price and Value• The conversion price (CP) is the price at which

the bond can be converted into common shares based on its conversion ratio

• The conversion ratio (CR) is the number of shares for which the convertible bond can be exchanged

• The conversion value (CV) is the value of a convertible bond if it is immediately converted into common shares

• Conversion value is denoted as “parity” in convertible bond listings

• If CV < Bond Price, conversion is not advantageous to the convertible bondholder

PCRCV

CRParCP


Convertible Premium and Straight Bond Value

• The convertible premium is the percentage the share price must increase in order for conversion to be advantageous

• Straight bond value (SBV) is the price that a convertible bond would sell for if it could not be converted into common stock. The conversion feature is considered an option, in addition to the basic bond value.

CVCVP

Premium eConvertibl

nb

nbb k

Fkk

I)1()1(

11SBV


Floor Value• The floor value (FV) is the lowest price for which a convertible

bond will sell, and is equal to the larger of its straight bond value (SBV) and its conversion value (CV)

• Every convertible bond will always have a floor value (FV) because it will always sell for no less than the larger of the straight bond value and its conversion value

• In practice, convertibles usually sell for higher prices because of the time value of the conversion option

),max( CVSBVFV


Convertible Bond Financing• Convertible bond financing helps firms obtain capital at a lower coupon

rate at the time of issue, because the buyer is receiving an “equity call option” equal to the time premium in addition to the bond

• If the value of the stock remains below parity, the firm has obtained cheap debt

• If the value of the stock exceeds parity, the firm receives cheap equity since they sold equity at a price greater than what they could have sold it for at the time of issue

• The outcome, whether in the firm’s favour or not, depends on the subsequent movement of the stock price until conversion/maturity/call


Other Hybrids• Warrants, convertible bonds and convertible preferred shares are the

most common hybrid securities• Financial innovation takes place in order for companies to issue

securities that meet the needs of investors in the marketplace• In this manner, firms that might not be able to raise capital with

traditional means of financing are able to, or they are able to raise capital in a form that better suits their cash flow preferences

Categorizing Hybrids• DBRS uses four factors to determine whether a hybrid instrument is

more like debt or like equity:1. Permanence – common stock is perpetual, debt is finite2. Subordination – priority of claims against income and assets3. Legal – enforceability of any claim on income and assets4. Subjective – company’s purpose when it issues the securities


A Financing Hierarchy

• Table 19-6 uses a rating system to show how equity-like the securities discussed in this chapter are. Equities are rated as 100% because they are equity, and commercial paper is rated -100% because it is the most debt-like


A Financing Hierarchy• Figure 19-2 shows the spectrum of financing options available to

corporations and expresses them in terms of risk to the investor, and the required return investors demand (i.e., the returns the firm must offer in order to access that type of capital)


Some Examples of Creative Hybrids• Income bonds• Cash flow bonds• Commodity bonds• Original issue discount bonds (OIDs) or low-yield notes• Liquid yield option notes (LYONs)• Adjustable rate convertible subordinated securities (ARCS)• Preferred securities• Canadian optional interest notes (COINs)


Creative Hybrids: Income Bonds• Income bonds are bonds issued after a reorganization where

interest payments are tied to some cash flow level for the firm

• Income bonds generally have long maturities• Payments are not tax deductible in Canada, and are instead

treated as dividends by the CRA• Seen as a “desperation play” because the issuer may not

have much tax incentive to issue real bonds, because it may have little taxable income because of losses carried forward under the provisions of the Income Tax Act


Creative Hybrids:Cash Flow Bonds and Commodity BondsCash Flow Bonds• Cash flow bonds are bonds sold in the United States that

have the same objects as income bonds do in Canada• Like income bonds, cash flow bonds usually have long

maturities• Interest payments are conditional on the firm meeting

certain thresholdsCommodity Bonds• Commodity bonds have their interest or principal tied to the

price of an underlying commodity, such as gold


Creative Hybrids: Original Issue Discount Bonds• Original issue discount bonds

(OIDs) or low-yield notes are bonds that sell at a discount from par value when issued

• Interest is not paid regularly, but instead as a bullet payment on maturity

• Investors must report “accrued” interest income if the bond is held in a taxable account

• Some investors like non-coupon bearing bonds because there is no reinvestment rate problem since the ex post yield on the bonds will equal the ex ante forecast if there is no default on the issue


Creative Hybrids: LYONs and ARCSLiquid yield option notes (LYONs)• LYONs are low-yield notes that are combined with a

convertibility feature.• LYONs are accretive convertibles, because the principal

accretes, or increases, over timeAdjustable rate convertible subordinated securities (ARCS)• ARCS are securities that are typically convertible into

common shares• Principal and maturity are fixed, and interest normally

comprises a fixed interest rate plus some function of the dividend paid in the previous six months


Creative Hybrids:Preferred Securities and COINsPreferred securities• Preferred securities are not preferred shares, but rather securities

generated by a company creating a 100% owned subsidiary that issues the shares and then loans the proceeds of the share issue to the parent company for whom the interest is then tax deductible

• Interest flows to the subsidiary, where it is not taxed and used to make dividend payments

Canadian optional interest notes (COINs)• COINs are 99-year bonds sold at par values of $100 on which the

firm immediately pre-pays the interest from years 11 to 99 on the issue, leaving it with a net inflow and allowing it to continue to deduct annual interest payments of $100 even though it has effectively borrowed less


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[PPT]Chapter 1: An Introduction to Corporate Finance · Web viewBooth/Cleary Introduction to Corporate Finance, Second Edition Author Brown, Gail - Toronto Created Date 07/28/2010