1. © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 1 CHAPTER 20 Hybrid Financing: Preferred Stock, Warrants, and Convertibles

2. © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 2 Topics in Chapter Types of hybrid securities Preferred stock Warrants Convertibles Features and risk Cost of capital to issuers

3. © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 3 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...)

4. © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 4 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?

5. © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 5 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

6. © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 6 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.

7. © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 7 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.

8. © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 8 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.

9. © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 9 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. r d 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?

10. © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 10 Step 1: Calculate the value of the straight bond, V Bond V Package = V Bond + V Warrants = $1,000. V Warrants = 27($5) = $135. V Bond + $135 = $1,000 V Bond = $865.

11. © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 11 Step 2: Find Coupon Payment and Rate PMT PV I/YR N FV 20 10 -865 1000 Solve for payment = 84.14 ≈ 84 Therefore, the required coupon rate is $84/$1,000 = 8.4%.

12. © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 12 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...)

13. © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 13 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.

14. © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 14 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.

15. © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 15 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

16. © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 16 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

17. © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 17 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.

18. © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 18 Estimating the Cost of Capital for the Bond with Warrants, r BwW 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 r BwW as the weighted combination of the expected returns on straight debt and warrants.

19. © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 19 Estimate the cost of straight debt (r d ). The cost of debt is the rate on nonconvertible debt: r d = 10%.

20. © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 20 Estimate the cost of warrants (r w ). 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.

21. © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 21 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. V op,10 + ST Inv. V Total − Debt S ÷n÷n P 10

22. © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 22 The Value of Operations at Year 10 The value of operations (currently V op,0 = $500 million) is expected to grow at a rate of 8% per year. V op,10 = V op,0 (1+g) 10 V op,10 = $500 (1+0.08) 10 V op,10 = $1,079.46 million

23. © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 23 Short-Term Investments at Year 10 The firm will receive cash when the warrants are exercised, as calculated previously: Cash = $67.5 million

24. © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 24 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

25. © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 25 Apply Intrinsic Valuation Model at Year 10 V op,10 $1,079.46 + ST Inv. 67.50 V Total $1,146.96 − Debt 90.17 S$1,056.79 ÷n÷n 22.70 P$46.55

26. © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 26 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

27. © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 27 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 = r w = 15.73%

28. © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 28 Expected Rate of Return to Bond with Warrants, r BwW r BwW = (% straight debt)x(r d ) + (%_warrants)x(r w ) r BwW = ($865/$1,000)x(10%) + ($135/$1,000)x(15.73%) r BwW = 10.77%

29. © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 29 Comparing Component Costs (Assume r s = 13.4%) Rank by risk: Str bnd < Bnd w Wnts < Stock < Wnts Expected returns should have same rank: r d < r BwW < r s < r w 10% < 10.77% < 13.4% < 15.73% Note that cost of bond with warrants is much greater than its coupon of 8.4%.

30. © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 30 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 r d (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 r d = 6.24%. There is no tax implication to the warrant exercise.

31. © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 31 Expected After-Tax Cost of Bond with Warrants, r BwW AT r BwW = ($865/$1,000)x(6.24%) + ($135/$1,000)x(15.73%) AT r BwW = 7.52%

32. © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 32 Some Caveats r w and r WwB 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.

33. © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 33 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. P 0 = $20; r s = 13.4%; g = 8%. Conversion ratio = CR = 40 shares.

34. © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 34 What conversion price (P c ) is built into the bond? The conversion price is typically set 20%-30% above the stock price on the issue date. P c = Par value # Shares received = $1,000 40 = $25.

35. © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 35 PVFV 20 10 85 1000 Solution: -872.30 I/YR PMT N Straight debt value: What is (1) the convertible’s straight debt value and (2) the implied value of the convertibility feature?

36. © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 36 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.

37. © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 37 What is the formula for the bond’s expected conversion value in any year? Conversion value = CV t = CR(P 0 )(1 + g) t. For t = 0: CV 0 = 40($20)(1.08) 0 = $800. For t = 10: CV 10 = 40($20)(1.08) 10 = $1,727.14.

38. © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 38 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 value 0 = $872.30. CV 0 = $800. Floor value at Year 0 = $872.30.

39. © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 39 Straight debt value 10 = $907.83. CV 10 = $1,727.14. Floor value 10 = $1,727.14. A convertible will generally sell above its floor value prior to maturity because convertibility constitutes a call option that has value.

40. © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 40 PVFV 8 -800 0 1200 Solution: n = 5.27 I/YRPMT N Bond would be called at t = 6 since call must occur on anniversary date. If the firm intends to force conversion on the first anniversary date after CV >$1,200, when is the issue expected to be called?

41. © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 41 N = 6, PV = 1000, PMT = −85, FV = −1,269.50; solve for I/YR = 11.8%. 01234560123456 1,000 -85 -85 -85 -85 -85 -85 -1,269.50 -1,354.50 CV 6 = 40($20)(1.08) 6 = $1,269.50. What is the convertible’s expected return to the investor?

42. © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 42 Does the cost of the convertible appear to be consistent with the costs of debt and equity? For consistency, need: r d < r c < r s. Why? In this example: 10% < 11.8% < 13.4%

43. © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 43 0 12 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: r c (AT) = I/YR = 8.71%. Find the after-tax cost of the convertibles using the after-tax coupon payment.

44. © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 44 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?

45. © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 45 Some notes: We have assumed that r s is not affected by the addition of convertible debt. In practice, most convertibles are subordinated to the other debt, which muddies our assumption of r d = 10% when convertibles are used. When the convertible is converted, the debt ratio would decrease and the firm’s financial risk would decline.

46. © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 46 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...)

47. © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 47 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.

48. © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 48 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...)

49. © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 49 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?

50. © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 50 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.

51. © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 51 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

52. © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 52 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