FINANCIAL MANAGEMENT
THEORY & PRACTICE
ADAPTED FOR THE SECOND CANADIAN
EDITION BY:
JIMMY WANG
LAURENTIAN
UNIVERSITY
CHAPTER 16
CAPITAL MARKET FINANCING:
HYBRID
AND OTHER SECURITIES
CHAPTER 16 OUTLINE
• Warrants
• Convertible Securities
• A Final Comparison of Warrants and
Convertibles
• Reporting Earnings When Warrants or
Convertibles Are Outstanding
• Securitization
• Credit Derivatives
• The 2007 Credit Crisis
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Warrants
• A warrant is a long-term call option issued
along with a bond.
• Warrants are generally detachable from the
bond and trade separately.
• When warrants are exercised, the issuing firm
receives additional equity capital, and the
original bonds remain outstanding.
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Initial Market Price of a Bond
With Warrants
• Current stock price P0 = $20
• Coupon rate of a regular 20-year annual
payment bond without warrants rd=10% (i.e.,
ongoing rate)
• 20 warrants with a strike price of $25 each are
attached to bond.
• The bond has an 8% coupon rate.
• The total package is sold for $1,000.
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Step 1: Find the Bond Price
20
10
N
I/YR
PV
80
1,000
PMT
FV
Solve for bond price = -830
Because the 8% coupon rate is lower than the
one (10%) associated with a regular bond
without warrants, its price is lower than the
regular bond price.
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Step 2: Calculate VWarrants
VPackage = VBond + VWarrants = $1,000
VWarrants = $1,000 – VBond
= $1,000 – $830
= $170
Vwarrants = $170 = W(20)
W = $170 / 20 = $8.50
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Impact on the Package Value from
Warrant Prices
• After issue, if the warrant price goes up to $10
each, the package will be worth:
V = $830 + 20($10) = $1,030.
• Since this is $30 more than the selling price,
the firm could have set lower interest
payments whose PV would be smaller by $30
per bond, or it could have offered fewer
warrants and/or set a higher strike price.
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Exercising Warrants
• 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 can’t sell for less).
• Therefore, warrants tend not to be exercised
until just before expiration.
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Exercising Warrants (cont’d)
• In a stepped-up strike price (also called a
stepped-up exercise price), the strike price
increases in steps over the warrant’s 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 stock’s
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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Expected Return to the Bond-WithWarrant Holders (And Cost to the Issuer)
• To take the privilege, you need to estimate when
the warrants are likely to be exercised and the
expected stock price on that exercise date.
• Although warrants give investors the right to buy
stock at a predetermined price, investors make
certain concession by accepting a lower return
on the securities purchased with less protection.
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Benefits to the Issuing Firm
• The issuing firm obtains more money in
addition to the funds received from the
original issue of bonds because investors have
to pay for the stock when they exercise the
warrant.
• Gains by being able to sell the bond at a lower
cost of capital than is incurred by selling
straight bonds
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Use of Warrants in Financing
• There is some dilution of EPS when warrants
are exercised because of the increase in the
number of outstanding shares.
• Both the par value and the capital surplus of
the firm increase.
• The debt stays on the balance sheet.
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Convertible Securities
• A bond or preferred stock that can be
exchanged for a common stock at the option
of the holder
• Convertible normally has a call feature that
enables the issuing company to force investors
to turn in the bond for a given number of
shares of stock at a specified price.
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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 > $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?
Par value
Pc =
# Shares received
= $1,000
40
= $25
Like with warrants, the conversion price is
typically set 20% to 30% above the stock price on
the issue date.
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What is (1) the Convertible’s Straight Debt Value
And (2) the Implied Value of the Convertibility
Feature?
Straight debt value:
20
N
10
I/YR
PV
85
PMT
1,000
FV
Solution: -872.30
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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 Bond’s
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 Value at
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 = max[SV, CV] =
max[872.3, 800] = $872.30
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Convertible: Straight Bond Price,
Conversion Value, and Stock Price
Price
Convertible bond
market price
Conversion
Value
Convertible
floor value
Straight bond
price
Convertible
floor value
Option or
Time value
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Stock
Price
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What Is Meant By the Floor Value of a
Convertible? What is the Floor Value at
T = 0? At T = 10? (cont’d)
•
•
•
•
At t = 10, 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 > $1,200, When
is the Issue Expected to Be Called?
Use the growth rate of 8% and the current version value
of $800 for the calculation.
N
8
I/YR
-800
PV
0
PMT
1200
FV
Solution: n = 5.27
Bond would be called at t = 6 since call must occur
on anniversary date.
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What is the Convertible’s Expected
Cost of Capital to the Firm?
0
1,000
1
-85
2
3
4
5
6
-85
-85
-85
-85
-85
-1,269.50
-1,354.50
CV6 = 40($20)(1.08)6 = $1,269.50.
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 < rc < rs
• Why?
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Check the Values:
rd = 10% and rc = 11.8%
rs =
D0(1 + g)
P0
$1.00(1.08) + 0.08
+g=
$20
= 13.4%
Since rc is between rd and rs, the costs
are consistent with the risks.
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Use of Convertibles in Financing
• From the issuer’s view:
• Advantages:
– Sell debt with a low interest rate
– Sell common stock at prices higher than those
prevailing when convertibles are issued
• Disadvantages:
– If the stock price rises significantly in the future,
conversion occurs at cheaper prices
– Low-cost debt lost if conversion happens
– The firm will be stuck with debt if no conversion
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Convertibles and Agency Costs
• Conflict between bondholders and
shareholders: asset substitution (“bait and
switch”)
• To protect themselves, debtholders will charge
a higher interest rate regardless of the risk of a
project.
• This agency cost can be reduced by using
convertibles at lower rates.
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A Final Comparison of 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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A Final Comparison
of Warrants and Convertibles (cont’d)
• 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.
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A Final Comparison
of Warrants and Convertibles (cont’d)
• 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.
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Reporting Earnings When Warrants or
Convertibles are Outstanding
• Two possible methods for reporting EPS when
warrants/convertibles are outstanding:
– basic EPS: number of shares actually outstanding
– diluted EPS: all those “sweeteners” are exercised
• Diluted EPS is a hypothetical number.
• Investors are concerned with the “what if”
questions on the dilution of earnings by option
securities.
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Securitization
• A process of pooling and repackaging of assets
such as mortgages into securities, which are
sold to investors.
• Securities have greater liquidity.
• Refers to publicly traded financial instruments
rather than to privately placed instruments.
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Asset Securitization
• Usually financial institutions are the companies
called originator
• Originator sets up special purpose vehicle (SVP)
that issues securities to investors
• Cash flows, such as interest and principal
payments from the underlying assets, are then
bundled and passed through to the holders of the
securitized assets.
• After selling the asset to their affiliates,
originators still act as the servicing agent.
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Asset-Backed Securities (ABS)
• Asset securitizations provide investors a wider
choice of investable assets and more diverse
portfolios to meet their needs.
• Examples include:
–
–
–
–
–
automobile loans
credit card receivables
equipment leases
residential mortgages
commercial papers
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Housing Market
• Asset securitization is extremely important in
the housing market because banks free up
capital in order to make more mortgages.
• While loan originators are free from illiquidity
tied with mortgages, prepayment risk is an
issue.
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Benefits for Investors
• Investors get access to financial assets such as
car loans and mortgages that were not
investable before.
• They can achieve portfolio diversification
effect.
• They are able to choose a specific level of
investment risk (choice of different tranches).
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Credit Derivatives
• Is a contract that transfers credit risk from
buyer to another seller
• It reduces credit risk for the banks, enabling
them to increase the amount
they can lend.
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Credit Default Swap
• Done to ensure payment in case of default by
company
• The protection buyer makes a quarterly
payment to the protection seller.
• The protection seller will make a lump sum
payment to the protection buyer in case of
default.
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Collateralized Debt Obligation (CDO)
• Bank CDOs are backed by loans,
• Credit enhancement:
– Subordination: Senior tranches are established
that have payment priority over junior tranches;
the senior tranches have less default risk.
– Cash collateral and cash reserves: Hold cash
sufficient to pay some portion of the obligations.
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Credit Hedges
• Banks bundle their loans and asset
securitization together as a means of passing
the risk and return of corporate loans onto
investors.
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The 2007 Credit Crisis
• Occurred when the flow of funds from
investors slowed significantly.
• Banks could not raise enough funds for
borrowers.
• Asset securitizations, CDOs, and credit
derivatives are complicated, and people have
misunderstood and misused them,
contributing to the problems on the market.
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Lessons from Credit Derivatives
• Flawed correlation forecasts can have disastrous
consequences.
• Relatively risky illiquid assets can be combined
into new, lower-risk securities to attract investors
and increase the availability of capital.
• As securities become more complex, they can
outpace the market’s ability to properly assess
their risk-return trade-off, which may result in
huge losses.
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