CHAPTER 20
Hybrid Financing: Preferred
Stock, Warrants, and Convertibles
1
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Topics in Chapter

Types of hybrid securities
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Preferred stock
Warrants
Convertibles
Features and risk
Cost of capital to issuers
2
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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 firm
from paying common dividends when
the preferred is in arrears.
Usually cumulative up to a limit.
(More...)
3
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


Some preferred stock is perpetual, but most
new issues have sinking fund or call
provisions which limit maturities.
Preferred stock has no voting rights, but may
require companies to place preferred
stockholders 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? To
issuers?
4
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Advantages and Disadvantages of
Preferred Stock

Advantages

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Dividend obligation not contractual
Avoids dilution of common stock
Avoids large repayment of principal
Disadvantages

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Preferred dividends not tax deductible, so typically
costs more than debt
Increases financial leverage, and hence the firm’s
cost of common equity
5
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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.
6
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
However, if the issuer is risky, the
floating rate preferred stock may have
too much price instability for the liquid
asset portfolios of many corporate
investors.
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How can a knowledge of call options help
one understand warrants and
convertibles?


A warrant is a long-term call option.
A convertible consists of a fixed rate
bond (or preferred stock) plus the
option to convert the bond into stock.
8
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Bond With Warrants
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Consider a 20-year bond with 27 warrants.
Each warrant has a strike price (also called an
exercise price) of $25 and 10 years until
expiration.
Each warrant’s value is estimated to be $5.
rd of 20-year annual payment bond without
warrants = 10%.
What coupon rate must be set on the bond
with warrants to make the total package sell
for $1,000?
9
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Step 1: Calculate the value of
the straight bond, VBond
VPackage = VBond + VWarrants = $1,000.
VWarrants = 27($5) = $135.
VBond + $135 = $1,000
VBond = $865.
10
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Step 2: Find Coupon Payment
and Rate
20
10
-865
N
I/YR
PV
1000
PMT
FV
Solve for payment = 84.14 ≈ 84
Therefore, the required coupon rate
is $84/$1,000 = 8.4%.
11
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When would you expect the
warrants to be exercised?


Generally, a warrant will sell in the open
market at a premium above its exercise
value (it would never sell for less).
Therefore, warrants tend not to be
exercised until just before expiration.
(More...)
12
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Stepped-Up Strike Price


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.
13
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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.
14
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The firm will receive cash when
the warrants are exercised.
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Data:
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Number of warrants/bond = 27
Number of bonds = 100,000
Strike price = $25
Cash = (Number of warrants/bond) x
(Number of bonds) x (Strike price)
Cash = 27 x 100,000 x $25
Cash = $67,500,000
15
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How many shares of stock will be outstanding
after the warrants are exercised (there are 20
million shares at Year 0)
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Shares before exercise = 20 million.
New shares = (Number of
warrants/bond) x (Number of bonds)
New shares = 27 x 0.1 million
New shares = 2.7 million
Shares at Year 10 = 20 + 2.7
Shares at Year 10 = 22.7 million
16
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Because bonds with warrants have a
lower coupon rate, should all debt be
issued with warrants?

No. As we shall see, the warrants have
a high required return, which drives up
the bond-with-warrants package’s true
cost of capital.
17
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Estimating the Cost of Capital for the
Bond with Warrants, rBwW
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
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Estimate the percentages of the
“package” that are due to straight debt
and warrants.
Estimate the required rates of return on
the straight debt and warrants.
Find rBwW as the weighted combination
of the expected returns on straight debt
and warrants.
18
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Estimate the cost of straight
debt (rd).

The cost of debt is the rate on
nonconvertible debt: rd = 10%.
19
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Estimate the cost of warrants
(rw).
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The exact solution is very complex, but
we can get an approximate solution
that works well.
We know the cost of the warrants, so
we need to estimate the expected
payoff in 10 years.
Therefore, we need an estimate of the
stock price in 10 years.
20
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Apply Intrinsic Valuation
Model at Year 10
The inputs to the model
are shown to the right.
Each of these must be
estimated before the
intrinsic price can be
estimated.
Vop,10
+ ST Inv.
VTotal
− Debt
S
÷n
P10
21
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The Value of Operations
at Year 10
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The value of operations (currently Vop,0
= $500 million) is expected to grow at a
rate of 8% per year.
Vop,10 = Vop,0 (1+g)10
Vop,10 = $500 (1+0.08)10
Vop,10 = $1,079.46 million
22
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Short-Term Investments
at Year 10
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
The firm will receive cash when the
warrants are exercised, as calculated
previously:
Cash = $67.5 million
23
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Total Bond Value
at Year 10
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For each bond:
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N = 10; I/YR = 10; PMT = 84; FV = 1000
Solve for PV = −$901.6869
The total value of debt is:
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Debt = (# of bonds) x (Price per bond)
Debt = (0.1 million) x ($901.6869)
Debt = $90.169 million
24
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Apply Intrinsic Valuation
Model at Year 10
Vop,10
$1,079.46
+ ST Inv.
67.50
VTotal
$1,146.96
− Debt
90.17
S
$1,056.79
÷n
22.70
P
$46.55
25
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Net Payoff to Warrant-Holder
at Exercise
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For each warrant:
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+$46.55 for value of each share
−$25.00 paid to exercise warrant
+21.55 net payoff per warrant
For each bond:
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Payoff = (Payoff/warrant) x (Warrants/Bond)
Payoff = ($21.55) x (27)
Payoff = $581.85
26
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Expected Rate of Return to
Warrant-Holder

Pay initial value of warrants in bond and
receive net payoff at exercise:


N = 10; PV = −135; PMT = 0; FV =
$581.85
Solve for I/YR = rw = 15.73%
27
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Expected Rate of Return to
Bond with Warrants, rBwW
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rBwW = (% straight debt)x(rd) +
(%_warrants)x(rw)
rBwW = ($865/$1,000)x(10%) +
($135/$1,000)x(15.73%)
rBwW = 10.77%
28
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Comparing Component Costs
(Assume rs = 13.4%)

Rank by risk:

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Expected returns should have same
rank:
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Str bnd < Bnd w Wnts < Stock < Wnts
rd < rBwW < rs < rw
10% < 10.77% < 13.4% < 15.73%
Note that cost of bond with warrants is
much greater than its coupon of 8.4%.
29
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After-Tax Cost of Bonds with
Warrants (T = 40%)
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
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Because the bond was issued at a discount
($865 and not $1,000), the after-tax cost of
debt is not rd(1-T).
Find bond yield using its after-tax payments:
N = 20, PMT = $84(1-0.4) = $50.4,
PV = -$865, FV = $1,000; solve for
I/YR = AT rd = 6.24%.
There is no tax implication to the warrant
exercise.
30
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Expected After-Tax Cost of
Bond with Warrants, rBwW


AT rBwW = ($865/$1,000)x(6.24%) +
($135/$1,000)x(15.73%)
AT rBwW = 7.52%
31
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Some Caveats

rw and rWwB are just approximations.


These approximations work well in most
cases where there is a long time until
expiration.
Financial engineering models are required
to provide exact solutions.
32
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Assume the following
convertible bond data:
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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; rs = 13.4%; g = 8%.
Conversion ratio = CR = 40 shares.
33
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What conversion price (Pc) is
built into the bond?
Par value
Pc =
# Shares received
= $1,000
= $25 .
40
The conversion price is typically set
20%-30% above the stock price on the
issue date.
34
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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
1000
FV
Solution: -872.30
35
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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.
36
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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.
37
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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 = $872.30.
38
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
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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.
39
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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?
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.
40
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What is the convertible’s
expected return to the investor?
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.
N = 6, PV = 1000, PMT = −85, FV = −1,269.50;
solve for I/YR = 11.8%.
41
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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?
In this example:

10% < 11.8% < 13.4%
42
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Find the after-tax cost of the convertibles
using the after-tax coupon payment.
0
1
1,000
-51
2
3
-51
-51
4
5
-51
-51
INT(1 - T) = $85(0.6) = $51.
With a calculator, N = 6, PV = 1000, PMT =
−51, FV = −1269.5:
rc (AT) = I/YR = 8.71%.
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6
-51
-1,269.50
-1,320.50
43
WACC Effects


Assume the firm’s tax rate is 40% and its
capital structure consists of 50% straight
debt 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. What
effect will the two financing alternatives have
on the firm’s WACC?
44
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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, which
muddies our assumption of rd = 10% when
convertibles are used.
When the convertible is converted, the
debt ratio would decrease and the firm’s
financial risk would decline.
45
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Besides cost, what other
factors should be considered?

The firm’s future needs for equity
capital:



Exercise of warrants brings in new equity
capital.
Convertible conversion brings in no new
funds.
In either case, new lower debt ratio can
support more financial leverage.
(More...)
46
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
Does the firm want to commit to 20
years of debt?


Convertible conversion removes debt, while
the exercise of warrants does not.
If stock price does not rise over time, then
neither warrants nor convertibles would be
exercised. Debt would remain outstanding.
47
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Recap the differences between
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.
(More...)
48
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


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. Why?
49
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How do convertibles help
minimize agency costs?

Agency costs due to conflicts between
shareholders and bondholders



Asset substitution (or bait-and-switch).
Firm issues low cost straight debt, then
invests in risky projects
Bondholders suspect this, so they charge
high interest rates
Convertible debt allows bondholders to
share in upside potential, so it has low
rate.
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50
Agency Costs Between Current
Shareholders and New Shareholders

Information asymmetry: company
knows its future prospects better than
outside investors


Outside investors think company will issue
new stock only if future prospects are not
as good as market anticipates
Issuing new stock send negative signal to
market, causing stock price to fall
51
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
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
52
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