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 finance
2.1. 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 features
Difference 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.
•