CHAPTER 20
Hybrid Financing: Preferred
Stock, Warrants, and Convertibles
1
Topics in Chapter

Types of hybrid securities





Preferred stock
Warrants
Convertibles
Features and risk
Cost of capital to issuers
2
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...)
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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
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


Preferred dividends not tax deductible, so typically
costs more than debt
Increases financial leverage, and hence the firm’s
cost of common equity
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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

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.
7
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 a longterm call option.
8
What coupon rate must be set on the
following bond with warrants if the total
package is to sell for $1,000?

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P0 = $20.
rd of 20-year annual payment bond
without warrants = 10%.
45 warrants with a strike price (also
called an exercise price) of $25 each
are attached to bond.
Each warrant’s value is estimated to be
$3.
9
Step 1: Calculate VBond
VPackage = VBond + VWarrants = $1,000.
VWarrants = 45($3) = $135.
VBond + $135 = $1,000
VBond = $865.
10
Step 2: Find Coupon Payment
and Rate
20
12
-865
N
I/YR
PV
1000
PMT
FV
Solve for payment = 84
Therefore, the required coupon rate
is $84/$1,000 = 8.4%.
11
If after issue the warrants immediately
sell for $5 each, what would this imply
about the value of the package?
At issue, the package was actually worth:
VPackage = $865 + 45($5) = $1,090.
This is $90 more than the selling price.
(More...)
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

The firm could have set lower interest
payments whose PV would be smaller
by $90 per bond, or it could have
offered fewer warrants and/or set a
higher strike price.
Under the original assumptions, current
stockholders would be losing value to
the bond/warrant purchasers.
13
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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
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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.
15
Will the warrants bring in additional
capital when exercised?

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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.
16
Because warrants lower the cost of the
accompanying debt issue, should all debt
be issued with warrants?

No. As we shall see, the warrants have
a cost which must be added to the
coupon interest cost.
17
What is the expected return to the bondwith-warrant holders (and cost to the
issuer)?

You need to estimate when the
warrants are likely to be exercised and
the expected stock price on that
exercise date.
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The stock (currently $20) is expected
to grow at a rate of 8% per year


The company will exchange stock worth
$43.18 for one warrant plus $25. The
opportunity cost to the company is
$43.18 - $25.00 = $18.18 per warrant.
Bond has 45 warrants, so the
opportunity cost per bond = 45($18.18)
= $818.10.
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Here are the cash flows on a
time line:
0
1
+1,000 -84
9
-84
10
11
-84 -84
-818.10
19
20
-84
-84
-
1,000
-902.10
-
1,084
Input
the cash flows into a calculator to
find IRR = 11.93%. This is the pre-tax
cost of the bond and warrant package.
(More...)20
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The cost of the bond with warrants
package is higher than the 10% cost of
straight debt because part of the
expected return is from capital gains,
which are riskier than interest income.
The cost is lower than the cost of equity
because part of the return is fixed by
contract.
(More...)
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
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When the warrants are exercised, there
is a wealth transfer from existing
stockholders to exercising warrant
holders.
But, bondholders previously transferred
wealth to existing stockholders, in the
form of a low coupon rate, when the
bond was issued.
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
At the time of exercise, either more or
less wealth than expected may be
transferred from the existing
shareholders to the warrant holders,
depending upon the stock price.
At the time of issue, on a risk-adjusted
basis, the expected cost of a bond-withwarrants issue is the same as the cost
of a straight-debt issue.
23
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; D0 = $1.00; g = 8%.
Conversion ratio = CR = 40 shares.
24
What conversion price (Pc) is
built into the bond?
Par value
Pc =
# Shares received
= $1,000
= $25 .
40
Like with warrants, the conversion
price is typically set 20%-30% above
the stock price on the issue date.
25
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
26
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.
27
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.
28
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.
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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.
30
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.
31
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%.
32
Does the cost of the convertible appear to
be consistent with the costs of debt and
equity?


For consistency, need rd < rc < rs.
Why?
(More...)
33
Check the values:
rd = 10% and rc = 11.8%
rs =
D0(1 + g)
P0
+g=
$1.00(1.08)
$20
+ 0.08
= 13.4%
Since rc is between rd and rs, the costs
are consistent with the risks.
34
WACC Effects
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
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?
35
Convertibles Step 1: Find the
after-tax cost of the convertibles.
0
1
1,000
-51
2
3
-51
-51
4
5
-51
-51
6
-51
-1,269.50
-1,320.50
INT(1 - T) = $85(0.6) = $51.
With a calculator, find:
rc (AT) = IRR = 8.71%.
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Convertibles Step 2: Find the
after-tax cost of straight debt.
rd (AT) = 10%(0.06) = 6.0%.
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Convertibles Step 3: Calculate
the WACC.
WACC (with
convertibles)
= 0.4(6.0%) + 0.2(8.71%)
+ 0.4(13.4%)
= 9.5%.
WACC (without = 0.5(6.0%) + 0.5(13.4%)
convertibles)
= 9.7%.
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Some notes:
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
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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.
39
Warrants Step 1: Find the after-tax
cost of the bond with warrants.
0
+1,000
1
...
-50.4
9
-50.4
10
-50.4
-818.10
-868.50
11
-50.4
...
19
20
-50.4 -50.4
-1,000.0
-1,060.0
INT(1 - T) = $84(0.60) = $50.4.
# Warrants(Opportunity loss per warrant)
= 45($18.18) = $818.10.
Solve for: rw (AT) = 8.84%.
40
Warrants Step 2: Calculate the
WACC if the firm uses warrants.
WACC (with
warrants)
= 0.4(6.0%) + 0.2(8.84%)
+ 0.4(13.4%) = 9.53%.
WACC (without = 0.5(6.0%) + 0.5(13.4%)
warrants)
= 9.7%.
41
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...)
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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.
43
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...)
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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?
45
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.
46
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
47

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
48