CHAPTER 19

Hybrid Financing: Preferred

Stock, Warrants, and Convertibles

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Topics in Chapter
 Types of hybrid securities
 Preferred stock
 Warrants
 Convertibles
 Features and risk
 Cost of capital to issuers

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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...)
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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?
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Advantages and Disadvantages of
Preferred Stock
 Advantages
 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.

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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.

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Bond With Warrants
 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?

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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.

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 Step 2: Find Coupon Payment
and Rate

20 10 -865 1000
N I/YR PV PMT FV
Solve for payment = 84.14 ≈ 84

Therefore, the required coupon rate

is $84/$1,000 = 8.4%.

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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...)
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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.

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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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The firm will receive cash when
the warrants are exercised.
 Data:
 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
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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)

 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

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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.

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Estimating the Cost of Capital for the
Bond with Warrants, rBwW

 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.

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Estimate the cost of straight
debt (rd).
 The cost of debt is the rate on
nonconvertible debt: rd = 10%.

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Estimate the cost of warrants
(rw).
 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.

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Apply Intrinsic Valuation
Model at Year 10
The inputs to the model Vop,10
are shown to the right. + ST Inv.
Each of these must be
VTotal
estimated before the
intrinsic price can be − Debt
estimated. S
÷n
P10

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The Value of Operations
at Year 10
 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

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Short-Term Investments
at Year 10
 The firm will receive cash when the
warrants are exercised, as calculated
previously:
 Cash = $67.5 million

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Total Bond Value
at Year 10
 For each bond:
 N = 10; I/YR = 10; PMT = 84; FV = 1000
 Solve for PV = −$901.6869
 The total value of debt is:
 Debt = (# of bonds) x (Price per bond)
 Debt = (0.1 million) x ($901.6869)
 Debt = $90.169 million

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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
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Net Payoff to Warrant-Holder
at Exercise
 For each warrant:
 +$46.55 for value of each share
 −$25.00 paid to exercise warrant
 +21.55 net payoff per warrant
 For each bond:
 Payoff = (Payoff/warrant) x (Warrants/Bond)
 Payoff = ($21.55) x (27)
 Payoff = $581.85

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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%

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Expected Rate of Return to
Bond with Warrants, rBwW
 rBwW = (% straight debt)x(rd) +
(%_warrants)x(rw)
 rBwW = ($865/$1,000)x(10%) +
($135/$1,000)x(15.73%)
 rBwW = 10.77%

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Comparing Component Costs
(Assume rs = 13.4%)

 Rank by risk:
 Str bnd < Bnd w Wnts < Stock < Wnts
 Expected returns should have same
rank:
 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%.

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After-Tax Cost of Bonds with
Warrants (T = 40%)
 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.
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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%

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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.

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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; rs = 13.4%; 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 = $25 .
40
The conversion price is typically set
20%-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 10 85 1000
N I/YR PV PMT 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 = $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.
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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?

8 -800 0 1200
N I/YR PV PMT 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 return to the investor?

0 1 2 3 4 5 6

1,000 -85 -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%.
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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%

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 Find the after-tax cost of the convertibles
using the after-tax coupon payment.

0 1 2 3 4 5 6

1,000 -51 -51 -51 -51 -51 -51

-1,269.50
-1,320.50

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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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?
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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
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.

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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...)
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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?

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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. 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

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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

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