INTRODUCTION TO
CORPORATE FINANCE
SECOND EDITION
Lawrence Booth & W. Sean Cleary
Prepared by Ken Hartviksen & Jared Laneus
Chapter 19
Equity and Hybrid Instruments
19.1 Shareholders’ Equity
19.2 Preferred Share Characteristics
19.3 Income Trusts
19.4 Warrants and Convertible Securities
19.5 Other Hybrids
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Learning Objectives
19.1 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.
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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
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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
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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
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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.
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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.
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The Preemptive Right and Residual Rights
The 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
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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
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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
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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
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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
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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
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Preferred Share Characteristics
• Table 19-2 shows yields on
three different types of
preferred shares in Canada:
• Straight preferreds
• Retractable preferreds
• Floating rate preferreds
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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
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Preferred Shares
The 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 seriously
Preferred 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
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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
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Preferred Share Ratings
DBRS Preferred Share Rating
DBRS Bond-Equivalent Rating
PFD - 1
AAA or AA
PFD – 2
A
PFD – 3
Highly Rated BBB
PFD – 4
Lower Rated BBB or BB
PFD - 5
B or Lower Rated Bonds
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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
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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
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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
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Warrants Versus Options
Warrants
• 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 value
Exchange-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
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Warrant Valuation
Warrant
Value
0
Stock Price
$50 exercise
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
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Payoff to Warrant Holders
Equation 19-1:
 m 
Payoff to warrant holders  (V  mX ) 
 mX

n  m
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
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Payoff to Warrant Holders
Equation 19-1 reduced to Equation 19-2 when we multiple the
exercise value by (n + m) / (n + m):
 m 
Payoff to warrant holders  (V  nX ) 
 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)
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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
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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
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Par
CP 
CR
CV  CR  P
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Convertible Premium and Straight Bond Value
• The convertible premium is the percentage the share price must
increase in order for conversion to be advantageous
P  CV
Convertibl e Premium 
CV
• 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.
I
SBV 
kb
Booth/Cleary Introduction to Corporate Finance, Second Edition


1
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
1 
n 
n
(
1

k
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(
1
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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)
FV  max( SBV , 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
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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
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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 finite
2. Subordination – priority of claims against income and assets
3. Legal – enforceability of any claim on income and assets
4. Subjective – company’s purpose when it issues the securities
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A Financing Hierarchy
• Table 19-6 uses a
rating system to
show how equitylike 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
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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)
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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)
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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
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Creative Hybrids:
Cash Flow Bonds and Commodity Bonds
Cash 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 thresholds
Commodity Bonds
• Commodity bonds have their interest or principal tied to the
price of an underlying commodity, such as gold
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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
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Creative Hybrids: LYONs and ARCS
Liquid 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 time
Adjustable 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
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Creative Hybrids:
Preferred Securities and COINs
Preferred 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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