®2002 Prentice Hall Publishing 1 Chapter 21 Hybrid Financing Through Equity-Linked Securities

®2002 Prentice Hall Publishing 2 Warrants Option to purchase a specified number of common stock at a stated priceOption to purchase a specified number of common stock at a stated price FeaturesFeatures –Number of shares the holder can buy for each warrant –Price at which the warrant is exercisable –Exercise price may be either fixed or “stepped up” over time –Date the option expires –Not entitled to cash dividends or vote –Some warrants are callable Report earnings per share on two basesReport earnings per share on two bases –Basic EPS –Diluted EPS

®2002 Prentice Hall Publishing 3 Exercise of Warrants Common stock is increasedCommon stock is increased Debt issued with warrants remains outstandingDebt issued with warrants remains outstanding Exercise price usually is set in excess of the market price of the common stockExercise price usually is set in excess of the market price of the common stock

®2002 Prentice Hall Publishing 4 Valuation of Warrants Trading out of the moneyTrading out of the money –Theoretical value of the warrant is zero Trading in the moneyTrading in the money –Theoretical value of the warrant is positive Cash is brought into the firm on the exercise of a warrantCash is brought into the firm on the exercise of a warrant Same factors that affects the valuation of an option affect the valuation of a warrant after adjustmentsSame factors that affects the valuation of an option affect the valuation of a warrant after adjustments

®2002 Prentice Hall Publishing 5 Convertible Securities Bond or preferred stock that can be converted at the option of the holder into common stockBond or preferred stock that can be converted at the option of the holder into common stock Conversion price and conversion ratio both express the formula for conversion into common stockConversion price and conversion ratio both express the formula for conversion into common stock Some provide for increases in the conversion priceSome provide for increases in the conversion price Conversion value is the conversion ratio times the market price of common stockConversion value is the conversion ratio times the market price of common stock Conversion premium is the premium of conversion price over share price at the time of issuanceConversion premium is the premium of conversion price over share price at the time of issuance –The greater the conversion premium, the less the dilution on conversion May be subordinated to other creditorsMay be subordinated to other creditors

®2002 Prentice Hall Publishing 6 Financing with Convertibles Delayed equity financingDelayed equity financing Creates less dilution in EPSCreates less dilution in EPS Interest rate or preferred dividend rate is lowerInterest rate or preferred dividend rate is lower May be able to reduce the need for costly monitoringMay be able to reduce the need for costly monitoring May reduce agency costsMay reduce agency costs Resolves certain sequential financing problemsResolves certain sequential financing problems –Controls the overinvestment problem

®2002 Prentice Hall Publishing 7 Forcing or Stimulating Conversion Calling the security once share price rises sufficiently to afford a moderate safety cushion over the call priceCalling the security once share price rises sufficiently to afford a moderate safety cushion over the call price Means for stimulating conversionMeans for stimulating conversion –Establish an acceleration in the conversion price at steady intervals in the future –Increase the dividend on common stock Calling the issue may be the only means for ensuring conversionCalling the issue may be the only means for ensuring conversion Overhanging issuesOverhanging issues –Share price does not rise sufficiently for the company to force conversion

®2002 Prentice Hall Publishing 8 Valuation of Convertible Securities Debt plus option characteristicDebt plus option characteristic –Conversion feature becomes more valuable as the firm’s risk increases Bond value is the price at which a straight bond of the same company would sell in the open marketBond value is the price at which a straight bond of the same company would sell in the open market –Creates the floor price of the security Both interest-rate and credit-risk changes cause changes in the bond-value floorBoth interest-rate and credit-risk changes cause changes in the bond-value floor

®2002 Prentice Hall Publishing 9 Convertibles Frequently Sell at a Premium Premium-over-conversion valuePremium-over-conversion value Premium-over-bond valuePremium-over-bond value Trade-off between the two premiums determines the value of the option to investorsTrade-off between the two premiums determines the value of the option to investors Market value trade-offMarket value trade-off Option nature of convertibleOption nature of convertible –Partial protection on the downside coupled with upside potential of rising share price

®2002 Prentice Hall Publishing 10 Other Factors Affecting Valuation Lower transactional costs on convertible bondsLower transactional costs on convertible bonds Certain institutional investors are restricted with respect to investing in common stockCertain institutional investors are restricted with respect to investing in common stock Length of time to expiration of the optionLength of time to expiration of the option Dividend on the common stockDividend on the common stock

®2002 Prentice Hall Publishing 11 Exchangeable Debt Involves an option on the stock of a company other than the issuerInvolves an option on the stock of a company other than the issuer FeaturesFeatures –Exchange price and ratio –Typically callable –Most issues are subordinated Usually occur only when the issuer owns stock in the company in which the bonds can be exchangedUsually occur only when the issuer owns stock in the company in which the bonds can be exchanged Exchangeable debt value = Debt value + Call option value

®2002 Prentice Hall Publishing 12 Reasons for Hybrid Securities Market incompleteness is the foundation for the proliferation of equity-linked instrumentsMarket incompleteness is the foundation for the proliferation of equity-linked instruments Tailor security’s design to demands of the marketplaceTailor security’s design to demands of the marketplace Profitability and prestige to the promoterProfitability and prestige to the promoter Regulatory and tax changesRegulatory and tax changes Volatility, asymmetric information, and agency costsVolatility, asymmetric information, and agency costs

®2002 Prentice Hall Publishing 13 Some Hybrid Securities

®2002 Prentice Hall Publishing 14 Preferred Equity Redemption Cumulative Stock (PERCS) Form of redeemable convertible preferredForm of redeemable convertible preferred Convertible into common only at a specified future dateConvertible into common only at a specified future date Cap the upside, but provide a higher dividend paymentCap the upside, but provide a higher dividend payment Corporation has a long position in a call option on its own stock while the PERCS holder has a short positionCorporation has a long position in a call option on its own stock while the PERCS holder has a short position Offered to common stockholders in exchange for common stock they holdOffered to common stockholders in exchange for common stock they hold

®2002 Prentice Hall Publishing 15 Dividend Enhanced Cumulative Stock (DECS) Constrain returns in the mid-portion of share price movementConstrain returns in the mid-portion of share price movement Keeps downside exposure and participates in the far upsideKeeps downside exposure and participates in the far upside Higher dividend than that provided on the common stockHigher dividend than that provided on the common stock Mandatory conversion occurs at the exchange dateMandatory conversion occurs at the exchange date Appeal to the income- and growth-oriented investorAppeal to the income- and growth-oriented investor

®2002 Prentice Hall Publishing 16 CEPPS and YEEDS Convertible Exchangeable Principal-Protected Preferred SharesConvertible Exchangeable Principal-Protected Preferred Shares –Designed to protect the investor on the downside if the far upside is given up –Dividend greater than that on the common Yield Enhanced Equity-Linked Debt SecuritiesYield Enhanced Equity-Linked Debt Securities –Additional design patterns are possible

®2002 Prentice Hall Publishing 17 Liquid Yield Option Notes (LYONs) Very successful product developed by Merrill LynchVery successful product developed by Merrill Lynch Embed several different options in the contractEmbed several different options in the contract Zero-coupon note, with maturities ranging from 10 to 20 yearsZero-coupon note, with maturities ranging from 10 to 20 years Convertible by the investor into a fixed number of shares at any timeConvertible by the investor into a fixed number of shares at any time Conversion price increases over timeConversion price increases over time Investor has a put option of the security back to the corporation at increasing put prices over timeInvestor has a put option of the security back to the corporation at increasing put prices over time Issuer has a call option at increasing call prices over timeIssuer has a call option at increasing call prices over time

®2002 Prentice Hall Publishing 18 Convertible Exchangeable Preferred Stock (CEPS) Starts as convertible preferred stockStarts as convertible preferred stock Issuer has the option of exchanging the convertible preferred shares for convertible bondsIssuer has the option of exchanging the convertible preferred shares for convertible bonds Cash flows to the investor and conversion terms are identicalCash flows to the investor and conversion terms are identical Advantage to the corporation is a tax timing optionAdvantage to the corporation is a tax timing option