562 Chapter 14 LEASE FINANCING

6xtensdons
PERCENTAGE COST
ANATYSIS
Anderson's lease-versus-purchase decision could also be
analyzed using the percentage cost approach. Here we
know the after-tax cost of debt, 6.0 percent, so we can find
the aftcrlax cost rate intpliecl in the lease corlract and com-
pare it with the cost of the loan. Signing a lease is similar
to signing a loan contract- the firm has the use of equip-
ment. but it must make a series o[ payments under either
type of contract. We know the rate built into the loan; it is
6.0 percent after taxes for Anderson. There is an equiva-
lent cost rate built into the lease. If the equivalent after-tax
cost rate in the lease is less than the after-tax interest rate
on the debt, then there is ari advantage to leasing.
Table 14E-1 sets forth the cash flows needed to deter-
mine the equivalent loan cost. Here is an explanation of
the table:
1. The net cost to purchase the equipment, which is
avoided if Anderson leases, is shown on Line 1 as a
positive cash flow (an inflow) at Year 0. lf Ander-
Year 0
l.Avoidednetpurchaseprice $10,000
2. After-tax lease payment (1,650)
3, Lost depreciation tax savings
4. Avoided after-tax maintenance cost 300
5. Lost after-tax residual value
Lee, Wayne Y.,
]ohn
D, Martin, and nndreir
l.
Senchack, "The Case for Usinp
Evaluate Saivage Values in Financi alLeases," Einancral Managenrort, Autumn".
For a discttssion of the impact of the AMT on lease decisions, sae
"The Effect of the CorporateAltemative Minimum Thx: Amount, Duration, qnd
Lease versus Buy Decision." T[e
/ournal
of Equipment Lease Eiuanchry,Spring
is also
an oPPortunity cost of Ieasing, and it is
,n on Line 5 as an outflow in Year 5.
6 is a time line of the annual ne[ cash flows. lf
leases, there is an inflow at Year 0 fol-
Exiensions 5b3
Andrrson should nevcr borrow-all "debt" ii-
nancing should come from leasing. lf it had a capi-
tal budEet of 5100 million, .rnd if its optimal capit.ri
structure called for 50 percent tlcbt, thcn i1 5ll1rukl
le.rsc assr'ts lvith a cost of $50 nrillion nnd lin,ln(r
the remainder rvith equitl,. All projccts shouid [.c
evalu.rted at a WACC bascd on the debt cost inL
plicd in the' lcirse contracts, 5.5 percent in our cr-
ample. Thus ftlr all average-risk projccts,
WACC for usc in
-.,
-..
."pii"r i,.ii.'i,,,i
= 0's(s s')') + 0 s( Is"")
=
10 25""
Anderson's capital budgeting director should nor'
recalculate thc proiec!'s Nl'V using .1 cost of capi-
tal of 10.25 percent versus the ave'rage proiect cost
of capital, ignoring leasing, of 10.5 percr'nt. .\s-
sunlL. that thc projcct's NPV is now +$20,000. Thc
availability of lt'ase financing has made the projcct
acceptable.
2. The project under consideration is unique-it is
the only one for which favorable lease terms arc
available. In tllis case, with the furthe'r assunrptirrrr
that tlie cost of the project does not exceed the conr-
pany's incrcmental debt capaciiy, the NPV ol thc
project for capital budgeting purposes should [,r
cieterminccl as folkrvs:
Adiustcd Nt,v = -Nl'v
based on NAL fronr
,
regular" WACC
*
Tobl" U-:
= -$50,000
+ $10.1,000 = $5+,00(t.
Flere tlre firm hirs cntrugh dcbt capacity k) financc ilie
prolect cntirely by leasing, so the fimr rvill get thc entirr
NAL. (lf all prolects were suitable for leasing, they still
could not all be leasc'd because some ecluity would be ru-
quired. Therefore, under the conditions of the precerling
paragraph, this procedure would not be appropriale.) Tire
entire NAL should be allocated to this project. All other
prolects should be evaluated on the basis of the Wr\CC
with "regular" debt.
If neither polar position holds, or if different projects
can be leased on diffcrent lease terms with different etltriv-
alent loan rates, tlren no simple rule can bc used. Nt,te.
though. that as a pr.rrtic.rl mnttof lve raroly neqt{ to gtr irrto
thc feedlrack effccts oi le.rsing on capilal bLldgctinE in tir(
first place, because fcrv proiects thnt arc not accefrt;ri.rlc
under onc'financinu metlrod lvoulcl be acceptable urrrlcr
another. Given all the urcert.rinties about cipital budiict-
ing cash florvs, few nran.rgr'rs wotrlcl ch;rngt' their rrrirrrl.
about the acceptability of a projcct as a rcsult o[ a fer' [,,r-
sis points ch.rnge in thr' IVI\CC. Still, for certain typcs oI
businesse's the'availability of kase financing could rn.rkr
the diflerence in t[.rr'go/no-go dccision. Thr.refore. it is inr-
port.rnt for financial m.tnagers to knolv horv leasing nright
nffcct cnFitdl bu(lgctinE arrrlysis.
Tfte. Cas:s in Financial Management Dryden Reques t series contai,$ the
following
ileal with lease analysis:
Case 25, "Environmental Sciences, lnc.," Case 25A, "Agro Chemical Corporationi
258, "Friendly Food Stores, Inc.," Case 26, "Prudent Solutions, Inc.,i'
and ci;
'?groGrow, L::rc..," all of which examine the lease decision frorn the perspectives;
the lessee and the lessor. ,!
rather than buying, or Line 11 minus
7 in-Table
14-2.
the cash flows on Line 6 into the cash flow
a cilculator
and then pressing the lllll button,
the II{R for the stream; it is 5.5 percent, and
uivalent
after-tax cost rate implied in the lease
ll
rson leases, it is using up $10 million of
and the irnplied cost rate is 5.5 percent.
rite is less than the 6.0 percent after-tax cost
loan, this IRII analysis confirnrs the NPV
Anderson
should lease rather tlran buy the
t. The NPV and IRR approaches will always
l'same
decision. Thus, one method is as good as
from a decision standpoint.r
BACK EFFECT ON
AL BUDGETING
we have assumed that the potential lessee has
le a fum decision to acquire the new equip- e a rum
qecrsron
ro acqulre rne new equlP-
the lease analysis was conducted only to de-
the equipment should be leased or pur-
{owever, if the cost of leasing is less than the cost
il
is possible for projects formerly deenred turac-
lo beconre acceptable.
this point, assume that Anclerson's targel
calls for 50 percent debt and 50 percent
y, that Anderson's cost of debt. kd, is 10
C
= 0.s(10%)(0.60) + 0.5(1s%)
=
0.5(6.0%) + 0.s(15%)
=
10.5%.
that the firm's initial capital budgeting
bv outflows'in Years 1 to 5. Note that the
n6t cash flows are simply the net cash flows
this equipment, using a 10.5 percent proiect
ll lor average-risk projccts, resultecl in an NPV
As we saw in the prececling section, the irfter-
leasing for this projlct is 5.5"percent, comparecl
rson's after-tax cost of debt of 6.0 percent. Thus,
debt
component of all projects can be fi-
ed by leasing on similar temrs. Iu this case,
son leases, it avoids having to pay the net pun
price for the equipmcnt-the lessor pavg
cost-so Anderson saves $10 million.'Tliat
positive cash flow at Year O.
,,
Next, we must determine what Andersn'
give up (or "pay back") if it leases. As we
liet Anderson must make annual lease
oI $?,750,000, which amount to $1
ter-tax basis. These amounts are reported ao
outflows on Line 2, Years 0 through 4.
4. If Anderson decides to lease rather than
and buy, it will avoid the maintenance
$500,000
per yea! or $3000@ after taxes
shown on Line 4 as an inflow, or benefit of
5. Finally. if Anderson leases the uqrrip^enf
give up the net after-tax residual.value of$E
I that its cost of equity. k,, is 1.5 percent. Thus,
weighted average cost of capital is
Year 1
($1,650)
(800)
300
w,
Year 2
($1,6s0)
(1,280)
300
rg&!3ol
Year 3 Year 4
(91,6s0) ($1,6s0)
(760) (480)
300 300
6. Net cash flow
gz!s, r@r
$ 8,650
*n,
= i
ffi
=o
whenkL= rRll=s.s%. I he.net
cash llowi shorvn on Line 6 are the incremental cash florvs to Andersur if it lcascs r.rthLr th.rn [rorrorvs .rnti Lrrrr:.
rvY,
ot th(5e flows is the net ad\lrntage to leasing. Whcn discountcd nt r rrtr oi 6.0 perccnt, the NI,V ot thL Linr 6 t'lrr'. ,r
lct can be financed at a lotver cost than other proi-
$ involve
equipnrent that cannot be leased.
'
should
we iiu iow? There are lrvo
possiblc'
rrolrr
nould
we do now? There are two possible polirr
depending
on Ande.rson's opporiunity to'sub-
,e lhancing
for regular debt financin6:
except for a rounding differenci, is the same as we obtained in thc Tablc .l.l-f, Ni,V iln.tl\.sis
564 Chapter 14 LEASE FINANCING
LEVERAGED LEASE
ANALYSIS
When leasing began, only two
Parties
were involved in a
leasc transaciion-the lessor, who put up the money, and
the lessee. In recent years, however, a new type of lease, the
Ineraged lense, has come into widespread use. Under a
leveriged lease, the lessor arranges to bonow part ofthe re-
quired funds, generally giving the lender a first mortgage
on tlre plant oiequipment being leased. The lessor still re-
ceives ihe tax benefiis associated with accelerated deprecia-
tion. However, the lessor now has a riskier position, be-
cause of the use of financial leverage.
Such leveraged leases, often with syndicates of wealthy
individuals seeking tax shelters acting as owner-lessors,
are an important part of the financial scene today. Inci-
dentally, whether or not a lease is leveraged is not impor-
tant to ihe lessee; from the lessee's standpoint, the method
of analyzing a proposed lease is unaffected by whether or
not thelessor borrows part of the required capital'
The examplc in T.rble l4E-1 is not set uP as a leveraged
lease. However, it would be easy enough to modify the
analysis if the lessor borrows all or part of the required
$10 million, making the transaction a leveraged lease
First, we would add a set of lines to Table 14E-1 to show
the financing cash flows. The interest component would
represent another tax deduction, while the loan repay-
ments would constitute additional cash outlays. The ini-
tial cost of the asset would be reduced by the amount of
the loan. \ryith these changes made, a new NPV and IRR
could be calculated and used to evaluate whether or not
the lease represents a
Sood
investment.
$25,000 NPV for the unleveraged lease. Note,
thiir,
the lessor has spent only $3.55 million
on
t]d
Therefore, the lessor could invest in a total of 2^f
leveraged leases for the same $8.65 million inveshi
quired to finance a single unleveraged lease, prrdri
total net present value of 2.37(526,000)
= 5,5,1,Ur0.
-
The effect of leverage on the lessor's refum ir rr The effect of leverage on the lessor's retum
isJ
flected in the leveraged lease's IRR. The IRR is [ur
count rate which equates the sum of the present
vatu
the Line 3 cash flows to zero. We find the IRR of rtr"i
lion of the $10 million net purchase price at a rar
cent on a five-year simple interest loan. Table tj
tains the lessor's leveraged lease NPV analvsisltj
of the leveraged tease ilnvestment U"sea oi-ttsff
has been developed for analyzing them in a rir
framework. However, sophisticated lessors are
flows shown on Line 3 is $26,000, which is the
aged lease to be about 8.5 percent, which is
lai of invested capital than unleveraged leases. Hbrn
such leases are also riskier for the same reason th{
leveraged investmnt is riskier. Since leveraged
a relaiively new development, no standard
To illustrate, assume that the lessor can
veloping Monte Carlo simulations similar to
scribed in Chapter 8. Then, given the aPparent
of the lease investment, the lessor can decide wl
retums built into the contract are sufficient to
for the risk involved.
higher than the 5.5 percent after-tax retum on tq
leveraged lease.' .r, leverageq reabe.
:.il
Typically, leveraged leases provide lessors withhi
expected rates of rehrm (IRRs) and higher NPVs pe
2Note
two additional points conceming the leveraged lease analysis- First, in this situation, leveraging had no imPact on t!.
perlease NpV This is'because the cosiof the loan-to the lessor_(5-4 percent after tax6) equals the__dirount rate, and hmce-u
'aging
cash flows are netted out on a present value basis. Second, the leveraged lease has multiple IRRs, one at 0.0 percent and
HYBRID FINANCING
6r
(-./n
earlier chapters, we examined common stock, various types of long-term
debt, and leasing. In this chapter, we examine three other sources of long-term
capital: preferred stock, which is a hybrid security that represents a cross between
debt and common equity; warrants, which are derivative securities; and convert-
ibles, which are hybrids between debt (or preferred stock) and warrants.
RRED STOCK
Preferred stock is a hybrid-it is similar to bonds in some respects and to com-
mon stock in other ways. Accountants classify preferred stock as equity, hence
show it on the balance sheet as an equity account. However. from a finance per-
spective preferred qlq-ck-lies.someruhere-between-deAl anilcommon.
eg!4!y--
it
imposeT a fi-xe{ q!ra1g9 a1{ t!1us inc.rease5
-!J,rq firmlq,finanqigl !-e_y91ag9,,y.q1-oq-!t-
t!19
!!g
p1gferlq{.d-i.vr!ead doep_nqt forcs-a
qoqp,any_
i$to tl3!*ryptcy..
We first
describe the basic features of preferred, after which we describe some recent in-
novations in preferred stock financing.
Basic Features
Preferred stock has a par (or liquidating) value, ofien eiiher $25 or $100. The
dividend is stated as-Eithei aaglcsl@{olp-ii, as so,many dollars per
!b1le,
or
Soth- ways. For example, several years ago Klondikc Paper Company sold
150,000 shares of $100 par value perpetual preferred stock for a total of $15 mil-
lion. This preferred had a stated annual dividend of $12 per share, so the pre-
ferred dividend yield was $12l$100 =
0.12, or 12 percent, at the time of issue.
The dividend was set when the stock was issued; it will not be changed in the
future. Therefore, if the required rate of return on preferred, ko., changes from
12 percent after the issue date-as it did-then the market price of the pre-
ferred stock will go up or down. Currently, ko. for Klondike Paper's preferred is
9 percent, and the price of the preferred has risen from $100 to $1210.09 =
$133.33.
If the preferred
{i_v_!.{qaql
is
1q1
earned,. the-company.-dpes not
-hove, !o p_ay_
it.
However,-most
_pre-f
er.red
-issues
are cu mul ati-ve/ mea n ing tha t the cu mulative to-
tal of all nni;aiApieTeiiJa divideniis nrtr+ bd paicl before diviclencis can be pairl
on the common stock. Unp_ild
ryef1A_gd.divi_de'ndla-rel4!ed
affql_rageg.
Divi-
dends in arrears clo nof eiin in-teresT thiG, ir[iiages do not groru in a com-
pound interest sense
-they-o.nl-y
gf.;
_ftSyl. l:ldjlLQf'.4l"nqnpnymcnts--ol-the.pne-
ferred dividend. Also, many prefc'rred stocks_accrue arreirrages for only a limited
aiap"proximatety 8.5
Percent.
Leveraged leases frequently have two IRRs.
Year 0
1. Net cash flow from Tablc 14E-1
($8,650)
2. Leveragingcash flows" 5,000
3. Net cash florv ($31150)
5 ----
NPV =Ztffi=
s?5when k =5.4%.
(270)
_-Q?9 _Q79)
$2,360 $1,840 $1,560
Year 1 Year 2
$2,150 $2,630
(270)
$1,880
Year 3 Year 4
$2,110 $1,830
nThe
lessor borrows 55 million at t
=
0 and repays it at t
=
5. lnterest exPense,
Payable
at the end of each year, is 0.09($5,000)
"s
ii is tax deductible, so the after-tax interest cish flow is
-5450(1 -
'D
= -$'150(0
6)
= -$270' .l;
:,1;,.l
,
t
"l
I
t,
l
,t i-7 ,
(
i ..,,, i
.,,
i
Lt.
1,:
.t.:hl tr,,lt,t:
)
,t
',',
.tj;i
I
!
:11
5ob (-traFrL'r
l5 IIYBRID FINI\NCINC
Passed.
[]Tl,'.'bTJfl:'ir'i*#;",il:T;il:xlT?"':I"'l'.:
:ffi lil n'",*x
ff
ry
are paid.
Preferred stock normallylal-
lollqli4g.
rights. However, most oref.,,^, .
Iulate that the preferred
stockholderJcai plpct
a rrinnr+,,
^r'.il"lltot*,t
\
stipulate' that thc preferrei iiock],old"rr".ri ur"., n,"i."'.ii"
"rYil'liltd'*"
\ s.lv. tlrrce orrt of tpn-if thn n..f.,"-.I ,{i,,;r-^r i^
-^^-^r
, I ;.
'...':"efloR-
\
supul(ltLt flrat thc preferred stockholders can elect a rninoritv.f'rr"- r,"qt
\;3i,1']fi
ru';lL1l;l:?:#::":::"*:'i.":'"::ff
u:iJ:i:i,:t;,i,ft
id/, urrce uur or ren-lr rne preteiled dlvldg,Ild is passed (om
tral Power & Light, one of the companies tliii o-neid ilnire
;:ij#ffi;,T#:i::ffi
:;'ff.';ffiT:T,tXl"".Ti:"i;ff
t;Ii,,:$fi g.wnich
could
epq]
'
::? :' :!,
"i: ":!",:i:::i"i:
i.lii:. r:r: :::1
.,
i:t 1:"9
*o:
o;'"a
r". i"
"'
ffi
i,ll".xiii"j,l;Hillr:;"fi
:"\;l'.lilJ.r,'il,on,:1";'.:1,::l*"::i:yffi
thc dark days following the TMI accidcn*t. Hacl thc pr
--
-" "(rr otrt*
to elcct a nrri.r+rr nf rhn rriro.r^"c +1,- .r;.,;r^-i .:. .:.i"1'-:1
ttot,been
enbtd
1::,"T,
a majority of the directors, the dividend woutd probably-ilffi
l'rclcrrrll >tr)cR 5b/
Some preferred stocks arc sinrilar to pg1p9lqaf
!-r1qd9
i1 thirt thcy lrar-c rro ma-
turity date, but most new issues norv havc specificd maturities. For cunrplc,
manv preferrecl shares Iiave a sinking funci provision which c.rlls for thc rctirc-
ment of 2 percent of thc issur: each yeir, rlcarring itr.it ttrc issrre rvill "nraturr." irr
a maximum of 50 years. Also, nrarry prcferred issuc.s are callatrlc by thc issuing
corporation, which can also linrit the liti of tltc p11.for1cd.'
Nonconvertible prcfgrrelil, stock is virtuallv all ouncrl b)'-corptrratjons, r,vhich
can take advantage of thc 70 percent rlividrnrl exclusion kr obt.riu a hichcr a[tr.r-
tax yield on prefcrred stock tlran on L.onds. lnrliridr.rals shoultl nrtt on,n prgfgllqqi
stocks (except convertihlc prtfcrrecls)-thov c.)lt qet hieher yiclLls-irn s.rfcr
bonds, so it is not logical for them to hoLl prcfcrrerls. As a rcsuit of tiris rtu'rrer-
ship pattern, the volum_e of preferred stock financirrg is ge.rred to thc sup;rly of
money in the hands of corporate invcshrrs. Wlrcn thc supplv of such mrtr.rcy is
plentiful. the prices of preferred stocks aic Lritl up, theil yickls fall, aud invest-
ment bankers suggest that companios rvhich ncecl financirrg consider issuing pre-
ferred stock.
_F-o,q.isqi,rgrs,
preferred stock has a tax disadzrrrrrtrrtr relativc to debt-intercst ex-
pense is i-leductible,br-ii preferrcil d
jvideiirls;rro
lrot.-Stiil, fir:rns witlr Iorv Lr\ ntcs
may have an incentive to issue prtfcrrcd stock n'hich can be bor.rght lry corproratt'
investors w'ithhigh tax rltes, rvho carr takc advant.tr:e of the 70 pcrccnt clir.iclctrtl
exclusion. If a firrn has a lowe'r tax ratc than potcrltial corporatL. brryers, thr finu
might bc better off issr"ring preferred stock thirn tiebt. The ke1,, lle1e is that the tar
advantage to a high-tax-rate corporition is grt'.ttt'r than thc tax tlisath'.rntate to.r
low-tax-raie issuer. To illtrstrate, assrrnlc that risk rliffererrtials Lrctu'een dr'L.t.rui{
piefeired woulcl require an issuer to sct the interest rate on nerv clebt at l0 prsl-
cent and the dividend vielcl on nerv preferred at 12 percent in a no-t.rr norkl.
Flolvever, when tarxes arc considert,tl, a corporatc br,ryer u'ith a lrigh trx rnto, sa\',
40 percerrt, might be willing to buv the preferred strlck if it has an I percent Lrcfore-
tax yield. This rvould produce an 8%(1
-
Effectivc T)
=
8'z;,[1
-
0.30(0.{0)l
=
7.012"
after-tax return on the preferred verstrs 109/"(1
-
0.10)
=
6.094, on thc debt. If tirc is-
suer has a low tax rate, say, 10 perccnt, its after-tax costs lvoultl bc 10'1r,,(1
-
T) =
10%(0.90)
=
9% on thc boncls and 8 percent on the preferrerl. Thus, thc sccuritr'
rvith lower risk to thc issuer, preferrt'd stock, also has a lon,er cost. Srrch situ.r-
tions can make preferred stock a logical financing choice.l
Other Types of Preferrcd Stock
In ac'lclition b the "plain tlanil!{' r,ariety of prcfcrretl strrck-s, ser,cral variations
are also used. Tlvo of thesc', floating ratc antl nr.rrkct auction
irrcfcrletl,
alr'rlis-
crrsstd in the Extelrsions to this ch.rptcr.
2Prior
to the late 1970s, virtuallv all preferred skrck rvas pcrpr'luil, arrr.l rlmost no issut's hatl sinling
funds or c.rll provisions. Tlrcn, insorancc, compnnl, rcgulatr)rs, r\,orriuLl ahcrut tlrr urrrcalizctl loss.s thr,
comparries had been incurring on preferred lrolclings as a rcsult (rf risirlc interest rates, put into elfcct
some regulitorv changes u'hich essentialh m.rndnted that insurance conlp-.ini{rs tiuv onl_v Ijnritcd lifr
preferreds. From th.rt tinlc on, virtually no nerv preferred lr.rs been pcrpt'ttr.rl. Tlris t,xamplr illustratcs
the rtny securities change as a result of ch.rngrs in the e(orlonric envir(rnmcnt.
rFor
a more rigorous treitment of thr'tax hvpothesis ol prcicrre.l stt)ck, sec lraj Frtrladi arrrl GrrrrL,u
S. Roberts, "On Preferretl Stock," /ournrtl
ttf Firtrntitl Rrscor'/r,
lvtiItt'r
1
()S1r,
3 I
c)-3:.t.
For .rn r,\.1 rn plc ot
an enrpirical test of the hvpothcsis, st'c Aithur L. !lou\ton, lr., rrr.l Car,rl Olsol tloushrn, "l:inricinr
with Preferrcd Stock," Firlrnr:inl r\'ld[tLr)r.ll, r\utunn 1990, {2-a-1.
4ltho:g!
rlonplylrg-r1t of prefelregl <liviclends will nrrt bankrupt
a comhi
corpolations,isstrc_ pre(erred with every intc.ntion of pray;,.,* tt.r" airiia.ni. i,t}
pasi4ing the dividcnd does not give the preferred stockriolcl"ers
-.,roi
o'r-*,.'.H
pan,v., failure.to pay a preferred..dividend precludes payment of .o**niil
dends. In addition, passing trre dividend makes it diffictrit to raisc capitar iuli
ing borrds, a.d virtually impossible to sell more preferrecl
". "";;;;,r,il Ilowever, having preferred-itock outstandi.g an"!
lir"
. fi..'th.-;;;:
overconre its difficulties-if bonds had been uscd instcacl of preferred
stock_'t
sey Central would have been in danger of being forced into trankrupt.y befr.i
could straiglrten.out its problems. Thus,from tli aieiopoittt of tt"
"rrig
i,1n ;td
preferretl
.stock
is less r;isky thnn bonds.
However, for investors plgfgrryd qtock
!s iiq!5i91
th,r4 bonds: (1)
prefern{
stockholders' ctaimi iie suuoiainatea io ttrose of ronarroiJn* in lt,. uu.nt oiEl
uidation. and (2) bondholderJ are more likely to continre receiving income d,*
ing hard_times ihan are preferred stockholders. Accorclingly,
iffy_"jtpfr-tSglS_-f
higher after-tax rate of return on
"4
giye(r firm's preferred
siock ilrin onlii 6c,rrii
However, since 7O pepcent of preferied dividends is exenrpt from colporaie ta*r
preferred Stock is.attractive to corporate invcstors.. lrr rccent yurrr, high_grr*
prelerred.stock/_on average, has sold on a lower pre-tax yield basis thanlurt
high-grade bo.ds. As an example, Du
pont,s
prefeired stoik recently had a rn'
ket yield of about 7.0 percent, wlrereas its boncls provided .r yield oi
g.3
p,ertrt
or_ 1.3 percentage points nrore than its preferred. The tax trc.rt'menlaccountcd,k
this cliffqre.ntial; the after-tnx yield to corporate investors ivas greater on the
Jr
ferred stock than on the bonds.l
.
About half of all preferred stock issued in recent ycars has beelr conl'erflk
iuto
_common
stock. For example, Enion Coiporatitn issued preferred
st,r{
which stipulated that one share of preferred could bc converted into threeslutrr
of contnton, at the opiion of the preierred stockholcler. Convertibles are disnrcrd
at length in a later section.
rThr'
.titcr-tax yield on an 8.3 percent boncl to a corporate invcstor in t6. J.l pcrccrrt mnrginal-ur ''-
hrncket is S.3"i,( I - T)
= 8.3rt'o(0.66)
=
5.48%. The a fter-ir r v ield on a 7.0 percurr
,;.:,ferrc.l skik
is 7f::
Elfccti\ e T)
=
7.0"i,[l
- (0.30)(0.3.1)l
= 7.0""(0.8"8)
= 6.2Si:;,. A l.o. norr tl]n r ,.r{ 1.1. o^1L;1,;15
firrr-f]
irsr rinA riebt rnd lhcr*sing thr pr()ceeds to purch.rsc another firnr's nrcicrre.r or c,inrnrm strrL
! FJ
i. rrsrd fc'r sh'ck
l.urchascs, then the 70 percflrt dir-iricnti orclusit,'n is r.,ri,lerl. fhis p(ilrsiNs
siirn('d tn
llr('r'rnt
i firm from en6aging in "t.r\.rrbitr.r6c,"
rrsin6 t.rr-,re,rrrttrhrc rretl
t,'lut'F
lJr8r'l! t.1\-e\r-nrpt preferred skxk.
568 chaPter 15 HYBRID FINANCINC
WARRANTS
Advantages and Disadvantages of Preferred Stock
There are both advantages and disadvaniages to financing with preferred
o-
Here are the major advantages from the issuers' standpoint:
-qL
1. In contrast to bonds, the obligation to pay preferred dividends
is
not *
tractual, and passing a preferred dividend cannot force a firm
into
b;
ruptcy.
2. By issuing preferred stock, the firm avoids the dilution of common
eqrrr
that occnrs when comnron stock is sold.
3. Since preferred stock sometimes has no maturity, and since prefenod
s.,"
ing fund payments, if present, are typically spreatl over a long period,
gf
ferred issues reduce the cash flow drain from rePayment of principal'du
occurs with debt issues.
There are two ma;'or disadvantages:
1. Preferred stock dividends are not deductible to the issuer, hence the al1o.
tax cost of preferred is typically higher than the after-tax cost of debt.
g6*.
evet the tax advaniage of preferreds to corPorate purchasers lowers ibpt
tax cost and thus its effective cosi.
2. Although preferred dividends can be passed, investors expect them to\
paid, and firms intend to pay the dividends if conditions permit. Thus,;'rr.
ferred dividends are considered to be a fixed cost. Therefore, theiruse,&
that of debt, increases financial risk and thus the cost of common quiS:.
Should preferred stock be considereci as equity or debt? Explain.
Who are the major purchasers of nonconvertible preferred stock? Why?
What are the advantages and disadvantages of preferred stock to the issrs!
than rvoulcl o$erwise be requirt'd. For example, when Infontatics Corponurt'
r.rpitlly growing high-tech .n*pony, wanted to selt $50 million of 2O-yearhttr
W.urants 569
value because trglderC c.lqbgy
thg
f1;4!qo-n_mg-rl9!$k
t!_!bg3x9,r9_ii-S-p!9-e-le--.
sr.q"lJ_iijhoty-h-isb f[a_l3casi.pL.c-c1Gus,.1riffipti;n
oiiG; t$l;;;i"6;"st
I
rate on the bonds and makes the package of low-yield boncls plus rvarrants at-
I tractive to investors. (See Chapter 19 for a more complete discussion of options.)
Initial Market Price of a Bond with Warrants
The Infomatics bonds, if they had been issued as straight debt, worrld have car-
riecl a 10 percent interest raie. However, with warrants attached, the bonds were.
sold to yield B percent. Someone buying the bonds at their $1,000 initial offering
price would thus be receiving a package consisting of an 8 percent, 20-year bond
plus 20 warrants. Since the going interest rate on bonds as risky as those of Info-
matics was 10 percent, we can find the straight-debt value of the bonds, assum-
ing an annual coupon for ease of illustration, as follows:
0l?320
PV 80 80 80 80
1,000
Using a financial calculatot input N
=20,1=
10, PMT
=
tj0, and FV
=
1000. Then,
press the PV key to obtain the bontl's value, $829.73, or approxinr.ttely $830.
Thus, a person buying the boncls in the initial underwriting woulcl pay $1,000
and receive in exchange a straight bond worth aborrt $830 plus 20 warrants pre-
sumably worth about $1,000 - $830 = $170:
Price paid for
_
Straight-debt
*
Value of
bond with warrants valr.re of bond warrants
$1,000 = $830 + $170.
Since investors receive 20 warrants with each boncl, each warrant has an implierl
value of $170/20 = $8.50.
Th,e_\ey isque,in setli1glh9-te1m!
9_il !ond;wilh.-wqgasr"ts_.is-yglu.utg'tbs_W.ar:
rants. The straight-debt value can be estimated quite accurately, as was done
above. However, it is more difficult to estimate the value of the warrants. The
Black-Scholes Option Pricing Mot'te'l (OPM), which we discuss in Chapter 1c), can
be used to find the value of a call option. Therc' is el temptation to use this motlel
to fincl the value of a warrant, since call options are similar to warrants in many
respects: Both give the investor the right to buy a share of stock at a fixed exer-
cise price on or before the expiration date. Hcxvever, the19
!9 4 Illqior diffe194q9
between call options and warrants. If call options are exercised, the stock pro-
viaea-to the optionholde? aomes from the secondaiy-market,'6ut whdn waiiarits
are eieiCiSed, tha st-oak pr<ivicied to the wiiiiinf hioldrlts are newly issuecl'shares.
This means that-the exeicise ofwarianis Aiitttes the valtrt of the original-equi.-qy.
which could cause tlie i;;iliie-of'the-iriil'irial warrani to cliffei fionr the valtre of a
similar call option. Therefore, inveshrent bankers cannot Lrse the lllack-Scholes
model to deterrnine the value of warrants.
It is extremely important to assign the correct value to the warranis. lf, when
the issue is originally priced, the value assignetl to the warrants is greater tharl
their true market valtre, then the coupon rate on the boncls will be set too loir,,
and it will be imposiible to sell the bond-rvitlr-rvarrants package at its par value..
In this case, lnfomatics rvill not lre able to raise the full $50 million that it needs
to fund its grolvth.
in 1998, the company's investmentbankers informecl U't" iinon.int vi5i11{
that tl.re boncls wouid be difficult to sell, and that a coupon rate of 10
[tttF
rvorrlcl be rer},riretl. However, as an alternative the tralikers suggested
d$
1
vestors mighi be willing to buy the bonds with a couPon rate of only
B
PtlX
the conrpaiy rvor.tlcl off"er 20 warrants with each $1,0-00 boncl, each
rvan't1lf
tling the holder to buy one share of common stock at an glgrctsgi!49:=..! tling the holcler to buy one snare oI comnlon stocK at an exercrse -l]::l::-J,
shaie. The stock rvas ielling for $20 per share at tlrO tiine, anct tfiewaffanF-f,F
exp!1e.
i5r
the year 2008 if they had not been exercised pre'" iously.
r
-r
fitry *o"ti investors Ue witting to buy Infomatics' bontls at a yield
ole:
pu.."nt i.r a 10 percent market juslbecause warrants were also off;red
asiu'
ihe package? Iiis becarse th9 yq.ra!t! ary
!o-gg:-teru,r--calt-opflonr{la9I
.
i::
,:.
ir' i: ii.i:{'i:,11:.ii::J:,T;i{i1;iiri:-ri'r:
:;"+'.
'
j
..
., . , :,,r;,:
:"
;
, I
570 Clui.11'p 15 IIYIllill) IjINANCINC
the projects is )ess than zera.
Conversely, if the value of the warrants is undercstimated.
tlrpn +L^
rate will be set too high. This means that the truc valuc of tf.," U".i.'li.,Lqp"
;xL': xli1nlis:n"J, IlT":x.',"'ff
*f iliii,ilxl,1x"",[:,Ynr:::"i *
lil
];
the bonds with warrants at the issue price, and Infomatics will ...."#ir'i *,
il:'|fl ,iIi J:
;ff*,ll::T';:.1T.',;:.1 iliffi i:l"liHIXli**1!riil:
At the time of the bond offering, Infomatics had 10 milrion .t utu.
"i.l]it
stock outstanding and no other debt or preferred stock. The,t..[
-i"',].5
5,11.*i;,xlJ}1,i".:*H"il,1H:j::"il:i'i::fl;i,l:11,1?;:iilTl*:i
in projects. Therefore, immediately after the offering the totaI i,.tr"'"if"i'.,"T
is $250 million ($200 million in stock plus $50 million in cash).a If investn^';Il
bonds with warrants pay only $50 million for securities that are *o.tr,*^*'I
lion, then the result i.s; $10 million tiansfer of w-ealth.from tfrg g.iginui;t#
YYnrrJnts 5,/l
-an
opportunity
!o
cxpaprl thc firnr's nrix of sccr.rr.itics ancl thr,rs to apprL,ll 16 ,1
tttl*"t,?:n
:j
ji';"#
iL
",
a rc derach ab l e.
-rtr
us. a f t.r n r,n,.,.r *i tr,' n,t".r.,"a
warrants is sold, thc lval'rants can bc dctaclrcri antl trarlcd sepnrntoly frorn thc
borrd. Fr.rrthcr eucn ai[cr t'iiJ n'arrants hayc lrcen r,\rrciscLl, tirc tr.,r.t (nith its
low coupon rate) remains outstantlirrg.
Jh.g
exercise price ou warrarrts is gcnerally set somc 20 b 3tl pcrccnt .rbove tht'
nla-r\-e-!..prige of thg steek_oD tlre date thc'bond is issued. If ihe finn gro*s i".i
prospers, and if its stock pricc rises above thc. cxt'rcisc pricc at which illn.", *.-1,
bc purchased, warrant holders coulc'l exercisc their warrauts and buy stock at the
stated price. However, witho__ut some incenti'e, l\,arrants rvould never be exer-
cised prior to maturity-their'aluc in thc open nrarkr.t rvoulcl be greater than
their r.'aluc if exercised, so holders worrld sell n,arrants ratlrer than ex-ercise them.
Therc are three conclition.s which cncouragc holders to exr-rcisc thcir w.rrrants:
(1) Warrarrt holcleri will surely exercise o,.,,1 b,-,y stock if the warrants are ab.ut
to expire and the market price of the stock is above the exercisc pricc. (2) Warrant
holders will exercise voluntarilv if the company raises the diviJend on tlrc com-
mon stock by a sufficient ahount. No dlvideid is earned on the warrant, so it
provides no current income. However, if thc courmon stock pays a high divi-
dend, it provides an .lttractive divirlend yirld trut limits price grorvth. This in-
duces warrant holclers to exercise their option to buy thc stoin
1e;
Warrants
sometimes have stepped-_up-exercise prices, rvhich prod owners into exqrci,sing
them. For example, Williamson Scierrtific Company has warrants outstandin[
with an exercise price of $25 urrtil Decembc'r 31, 2002, at which time the exercisc
price rises to $30. If the price of the conrnrorr stock is over 925
just bcfore De-
cember 31. 2002, many warrant holciers will exercise their options before the
stepped-up price takes effect arrd the valut'of tht_. rv.rrrants falls.
Another desirable featurc of warrants is tl1.1t they generally bring in fr.rncls only
if funds arc nceded. If the company grows, it will protrably neecl nov equiiv cap-
ital. At the same time, gro\,vth rvill causc thc pricc of the stock to rise and the rvjr-
rants to be exercised, hence the firrn will obt.lin additional cash. If the conrpany is
not successful, ancl it cannot profit,rbly cnrploy addition.rl money, the price of its
stock will probably not rise sufficiently to inducc exercise of the rvarrants.
Wealth Effects and Dilution Due to Warrants
Assume that the value of Infomatics' operatiorrs arrcl irrvcstnrents, tvhich is $250
million immediately after issuing thc bontis with rvarrants, is expectt'rl to groi\,,
and does grolv, ai 9 percent pcr year. Whtn tlrc !v;lrrrnts arc duc to expire in terr
years, the total valuc of Infonratics will bc $250(1.09)1') - $591.841 million. Horv is
this value allocated armong the original stockholrlers, the bondholclcrs, anrl thL'
warrant holders?
The bonds will havc ten years remaining until maturity, with a fixed coupon
payment of $80. If thc cxpected nlarket irlterL.st rate is still 10 percent. thcrr:
0 1 2 3 10
PV so Eo Eo
,.ol8
Usingafirrarrcial calcr.rlator,inputN=10, I-10,PNIT=E0,arrrlFV=1000.prr.ss
thc PV key to obtairr thc bond's valrrr-, SS77.11. Tht krtal valuc of all of thr. bonrls
is 50,000($877.11) = ${3.E56 million.
holders to the investors iir the bonds with warrint!- Therefore, it ir
"*?..."i.7 poita-nt foi Lifomatiis to iorrectly e.stiiirate thC value of the warrants
.iil6[
the bonds with warrants are issued.
Use of Warrants in Financing
!V_qa1ts
generally are usgd by sm3!1, rapidly growing f!1-mq as
,,sweererrr.
wlen theyyll debt oi pieferred qtod. Such iirmi frequently are regarded bri+
vestors as beinghighty
llgky,
so their bonds can be sold only at exlremelyirS
coupon rates and with very restrictive indenture provisions.-To avoid this;firrl
such as Infomatics often offer warrants along with the bonds. However, rq
years ago, AT&T raised'$1.57 billionb/ sellin[ 6onds with w*irrants. This nar.t
pany's growth, assuming it does in fact grow and prosper. Therefore, inre+u
are willing to accept a lower interest rate and less restrictive indenture pnri
sions. A bond with warrants has some characteristics of
deb-t-.and
qomq durrJ
!9{9t!cs
of equ-!!y. It is a hybrid security that provides the financial managerrif
the tirne, the largest financing of any type ever undertaken by a busines fta
and it nrarked the first use ever of warrants by a large, strong corporation.s
Cetting warrants along with bonds enables investors to share in the co
lwe
ass,tme that the.lvcrage expected net present vah,e of thesc proiccts is zero. If the Nt{r{t
proiccts is
trealer
than zerol then the total vilue of Infomatics rvill be qicaler than $250 millim
b
',
case, there will be little chan6e in the price of the bonds, sincc horrdirolders receive a [rt{cS
payment.no matter how well"the company does. Howevcr, thc skrk price ancl thc valueo{dtrr
iants wjll incrcasc, since tlrc tolal valie of th" comolnu h". in..o.r.,,lt ,lrirtr,r,,r.i .n^*.".rq !
crcase in the valrre conrmitted to the brrndholders. il
"'.nr"r..'
uoulcl occur if the expxd
lF'
ilt
is intresting to note that before the AT&T isue, the Nerv York Skrck Exchange's slated [$fj
tllit lvarr.lnts could not be listed because they lvere "speculative" instrumtrrti r.ither
ths
r
572 Chapter 15 t-lYBRlD I;lNr\NCINC
$75.899 million. With a tax rate of 40 percent, after-tax earnings
uru
*u,iJ
fi:::.111
-.
9 i] ; 1*-1??'":":":i ::1 :T''rc' r: :,:Yr" :'-
s+s sse
7 1 s i
G,
Therefore, if Infomatics had no warrants, the stock price would Ue
55.1ii[
share, and the eamings per share would be $4.55.
But Infomatics dorr have lvarrants, and with the stock price over
$50 ilre r-
rant holders surely will choose to exercise their warrants. Infomatics
will reri
$22 million when the 1 million warrants are exercised at a price of
$22p,err
rant. This makes the total value
$613.841 million (the
$591.841 miltion valu
operations plus the $22 million raised by the exercise of the warrants)
T}e6i
value remaining for stockholders is now $569.985 million (9613.841
millionltr
the $43.856 million allocated to bondholders). There are now 11 million
stock (the original 10 million plus the new 1 million due to the exercise of
rants), so the stock price is $569.985/ 11
= $51.82 per share. Notice that this is hra
than the $54.80 price per share that Infomatics would have had if therehad
no warrants. In other words, the warrants have dilr,rted the value of thestffL
A similar diiution occurs with earnlngs per s'[iaie. Aftii
"idiG;ihetsslr
worrld increase from $591.841 million to $613.841 nillion, with the additional
million coming from the purchase of 1 million shares of stock at 922 per shrl
the new funds have the same basic earning power as the existing funds, thsrt
new EBIT would be 0.135($613.841)
= $82.869 million. Interest payments
still be $4 million. so earnings before taxes would be 682.869
-
$4 = $78.869
lion, and after-tax earnings will be 978.869(7 - 0.4)
=$47.321 million. Wth 10+
Warrants 573
Note too that investors would recognize the situation, so the actual wealth
transfer would occur gradually over time, not in a fell swoop when 16e-rvarrants
were ex-riiiiieil Flr5t, EPS w-ould [ave been reported on a fully dilutecl basis over
the years, and on that basis, there would be no decline whatever in EPS. Also, in-
vestors would know what was happening, so the siock price, over time, would re-
flect the likely future dilution, so it too would be stabie when the warrants were ex-
ercised. So, whereas our calculations show the effects of the warrants, those_g(ecLs
would-actually
!g tA"g{11
EP|:$j!,S
{qC!
p1rSg o{.4raduaL.ba-s[ over time.
The Component Cost of Bonds with Warrants
lrVhen
Infomatics issued its debt with warrants, the firm received 950 million. or
$1,000 for each bond. Simultaneously, the company assumed an obligation to pay
$80 interest for 20 years plus $1,000 at the end of 20 years. The pre-tax cost of the
money would have been 10 percent if no warrants had been attached, but each
Infomatics bond had 20 warrants, each of which entitles its holder to buy one
share of Infomatics stock for $22. \alhat is the percentage cost of the $50 million?
As we shall see, the cost is well above the 8 perceni coupon rate on the bonds.
As we demonstrated earliet when the warrants expire ten years from now, the
expected stock price is $51.82. The company would then have to issue one share
of stock worth $51.82 for each warrant exercised and, in return, Infornatics would
receive the exercise price, $22. Thus, a purchaser of the bonds, if he or she holcls
the complete package, would realize a profit in Year 10 of $51.82 - fi22= $29.82
for each common share issued. Since each bond has 20 warrants attached, in-
vestors would have a gain of 20($29.82)
= $596.40 per bond at the end of Year 10.
Here is a time line of the cash flow stream to an investor:
The vah.re remaining for the original stockholders and the warrant
h^rr
equal to the remaining value of the firm, after deducting tne ,otuu
j,lT.l
bondholders. This remaining value is $591.841 - $43.856
= 55a7.g95
j,],.4t
there had been no warrants, then the original stockholders wouta
n*.'ff
t
titlec'l to all of this remaining value. I{ecall that there ;rre 10 million.-r.-]'e.
stock, so the price per share would be $547.895/1.0 = $5a.80. Srpoo..,*l'td
pany has a bisic eirning power of 13.5 percent (recall that BEi,:tB;"^:
Assets) and total assets of $591.841 miilion.6 This means
that-ilJl
0.135($59i.841)
= $79.899 million; interest payments are
gt
miilion (gg0ll
payment per bond x 50,000 bonds); and earnings before taxes are g79.g99-_l4l
0191011
t_-___--+--_---...#.
-$1,000
+$80 +$80 +$ 80.00 +$80
+ 596,40
l$OTfr
20
+g 80
+ 1,000
+T1pm
11 million shares now outstanding, EPS would beg47.32l/71=$4.30,dosnks
$,1.55. Therefore, exercising the warrants would dilute EI)S.
Has--thlq
lyqal-lh transfer har-me-d.the-ortgtr,alqh"Eii",lclErs? The answerir-ra
and
-no.
Yes, because the original sharehoiclers ct;a.ly ;re;;rse off than &q
*oricl ha:i6been if there had been no warrants. However, if there had be$r
warrants attached to ihe bonds, then the boncls would have had a 10
Pdrd
coupon rate instead of the 8 percent colrpon rate. Also. if the value of the conPtl
pectecl, leading to a real transfer of wealth from one .t rt;iiJ";,;ri
to r"+l
6ln
lhis case, the total marke't value equals the book value of assets, but thc silme caldlJi(r$
follorv even if market and book values tvere not equal.
The IRR of this stream is 10.7 percent, rvhich is the investor's overall pre-tax
rate of return on the issue. This return is 70 basis points higher than the retum on
straight debt. This reflects the fac!..!hat the issue is riSkigt to investqrq.than a
s_t!aig\!:debt issuebe-iause some of the return is expected to come in the form.of
stock price appreciation, and thai part of the return is
qelatively risky.
The expected rate of return to investors is the before-tax cost to the com-
pany-this was true of common stocks, straight bonds, and preferrecl stocks, and
it is also true of bt'rnds sold with warrants.
Problems with Warrant Issues
Although warrants are bought by investors with the expectation of receiving a to-
tal return commensurate with the overall riskiness of the package of securities
being purchased, things do not always work out as expected. For example, in
1989 Sony paic'l $3.4 billion for Columbia Pictures, a U.S. movie studio. To help fi-
nance the cleal, in 1990 Sony sotd $.170 million of four-year bonds with warrants
at an incredibly low 0.3 percent coupon interest rate. The rate was so low because
the warrants, which also had a maturity of four years, allowed investors to pur-
chase Sony stock at 7,670 yen per share, only 2.5 percent above the share price at
the time the bonds with warrants were issued.
had not increased as expected, then it might not have been profitable for thtr'r'
rant holders to exercise their warrants. In other words, the'original shareh{la
r^ra.-,^,illi-- r^ +r-l^
^rr
r!.^
-^r^-!:^r
f,:r..r:^-.^- !L^ r^-..^-
-L:-^^
'"fp
tnil
were willing to trade off the potential dilution for the lower coupon
rate.
ln
r
example, th"e original stockholders ancl the investors in ttre boncli with
n2tr'o
got what they exfected. Therefore, the answer is no, the wealth trals. f.el at tlt{
of ex.'rcise .licl n-ot hlrm the origirral shart'holde!'bec.rtrse'they exp._"cied
anac
hrat transfer nna'**r" f.i.lti;;;;il4*i t y ir-'; i;;; ir.,p".ffi5f*."q,*'1
shorv latcr, thcie arc othcr initanit's when t(e wealth trinsfir is clifterent
tlusc
)
574 Chapter 15 I-iYBRID FINANCING
CONVERTIBLES
Investors snapped up the issue, and many of thc warrants werp
,,h*,
.
1i,1fl ',i"::r"-H"}":l;Hl"*.t,,i[:l;iiil:::*
jirT,:Ti;*1,:ffi
that Sony's stock would climb well above the exercise price. From
Son/r'*}.
view, the bond-with-warrants package provided , r".y^,lT::::t "Uiiaffi
(the bonds) that would be replaced with equity financing wh"n
th"}'S,
il:'"::::'i::*,*"::,T::y,i3::rnxi""'^:i:,i,:*
j:':::.*:il'H
low cost capital encouraged Japanese
firms to acquire foreign .o*puni"ill
invest huge amounts in new plant and equiptnent
However, the willingness of investors to buy
Japanese
warrants
sufferrd
r-:
vere blow when the
Japanese
stock market fell by 40 percent. By 199a,
wf* f
warrants expirecl, Sony's stock sold for only 5,950 yen versus the 7,670-yenlJr
cise price, so the warrants were not exercised. Thus, Sony's planned
i^'f,**;
equity capital never materialized, and it had to refinance the four-yearbcrdi
sue at much higher rates.
Both Sony and its investors lost on the deal. Thc investors lost beca6e
did not get the return they expected on the issue. Sony lost because it tudbj
ter its financing plans due to the fact that the warrants were not exercised.
spite of presumably good planning by both the company and investon,6i
bond-with-warrants issue, and many like it, did not work out as anticipated
What is a warrant?
Describe how a new bond issue with warrants is valued.
How are warrants used in corporate financing?
The use of warrants lowers the coupon rate on the correspondingdebtiw
Does tl'ris mean that the component cost of a debt-plus-warrants packrgi
less than the cost of straight debt? Explain.
rir"ngir.""a ;a"ke'ir easier to riise additionir crpitur.
-r1"[ .t.4-
i igt]rirqg,a
tef'{
action.
Conversion Ratio and Conversion Price
Convertible securities are bonds or prefqrred stockq w.hig!,
Undel
gpeqq
terms and conditions, can be exchanged for (that is, converted into).c9.{
stock ai the option of the holder. UnlG the exercise of w.riiants,
Yhtqlg
,additional
funds to the firm, colver_spn_dge1-not provide-capital: debt
(r{
f
ferred stock) is simply replaced ori the 6"iance itteeiuy iommon
stod\
1.6,.,rr",
..d*ing ihJ iebt o. preferrqd stqct w!11 i[ptoy! tne ritm!
6ru"'
L OIlvtrtlLrlC| ), l
prior to nt.rtrrrity on
JLrly
15,2018, a dcbcnturL. llol(lcr can cxclr.irrqe.r torr.l fol
20 shares of contmon stock; thercfore, thc conr.crsi.rr ratirt, CR, is 10. Tlrr. borrrl
would cost a ptrrchascr
$1,000, thr. par'",alue, r,.,hon it rvrs issuccl. Dir.irlin,: thc
$1,000 par value. by thc 20 sh.rrcs rcct'ir.ct1 gives ..r ctuvorsion prri61 of i5tt ..,
slra re:
_C91y919iqr1price
=
P.
=
I'.rr r'.tluc rri borrcl
Slrares rcccivo.l
=
$!Tn
=
$,:,1,,0
= srr.
CR 2I)
Converselv, by solving for CR, rve obtain the convcrsion ratio:
Conversion ratio
=
Cli
=
!l
i!()
= +P =
2() slrar.os.
I" $50
Once CR is set, thc value of P. is establishcrl, arrti vicc vcrsa.
L**g_q yaffant'q.qxe-1qisc-p,r!ce, tht'convcrsion
[rrice
is typical)v stt at fronr
20 to 3O percerrt above thc p.cvailing urarkct prict, o[ the conrr:r.r.t skrck at the
tinre the co.vcrtible issrre' is sold. Lra,'rlv h.rv tlrt' c.rr't'rsiorr
Pricc
is t'st,rlr-
iis'hecl cin bJst be r,urde'rstoocl .rftt'r'cranrirrirrq s.r'rL. of the. re.riurs rirrrrs usc
convertibles.
Cenerally, the conversion pliqq a4d conver,sion ratio arc fixerl for the iiic ot'thc
br:nd, although Someiirnei a steppe.l-up conversion price is used. For exanrpic,
the 1998 convertibie debenturcs for Brcerltrrr Industries arc convertible ilrk) i2.-5
shares until 2008; into 11.76 shares from 2008 trntil 2018; and into 11.11 sh.-rres
from 2018 until maturity in 2028. Thc convcrsitrrr pricc thus stirrts at $80, rises kr
$85, and then goes to 990. Breedon's convt'rtiblc.s, like most, havr'a tcn-voar c.rll-
protcction period.
Another factor that may cause a change in thc conversion pr.ice an(-l ratio is
a standard feature of almost all convcrtiblcs-the clausc pnrtccting the-con-
vertille again-st dilution from stock splits, stock dividends, anr'l the s.rlc of
common stock at prices belorv tht'
.convcrsion
price. The typical provisirtrr
states that if common stock is solJ at ;r pricc belou llrc convrysi(\ll
[,iict,
then
the conversion pri-e miist br lox,ertd
lancl
ihe' conversiorr ratio raiscrl) to thc
qlilg_gt
which
!f9 19w
stock u'as issued. Also, if thr' stock is_split, or i! a slgqk
dividend is declareid, thb cii.r'crsit'rn
Pr:ict
must-Lr[ iorveier{ by tlrc pciceritrgc
amount of the stock di.",idcrrd or split. For exanrplc, iI Brr.edorr Iurlustries n'err.
to have a two-for-one stock split ilr,rring tho firit tcrr years of its conr.crtiblc's
life, the conversion ratio wotrld .rrrtomatica)ly bc.rrljusterl fronr 12.5 to 25, antJ
the conversion price lolverecl from 980 to ${0. If tlris protcctiorr !\.erc not con-
tainecl in the ccxrtract, a compant' coulcl completelr,' thlvart convorsiLrn br. thc
use of stock sprlits anti skrck divirlencls. lVarrants arr'sinrilarlr'frrotcctt'.1
against dilution
The sthndaid protection against diltrtiorr fr:om selling nelv stock .rt pri6g5 lrp-
low the cont,ersion pricc catr, lrou'evcr, gct a courpanv irrtrr troulrlc. For cxrnr!rlr,
assllmc'th.rt Breetlon's sto('k lr'irs scllins ior 565 pp1 slr.rrr:.tt thc tinrc tlte c()r'l-
vertiblc n'as issr"rcd. Furthcr, supposr'tltc rn.rrkct \\'cnt sollr, alttl Brer'rlon's stock
price droppgcl kr $50 pcr sh.ire. If Brr:r'tlorr ncedcd n(.\\'cqr.litv t() support (r[)L,r(r-
tions, a tterl' conlmorl stock s.rlc rvottlrl rctlrrire thc conrp.rrr,, tp lo1.rr t[c crruycr-
siorr price on the convertiblc dttrenturos front SS0 to 550. Th.rt rvoukl r.risr' thc
One of the most important provisions of a convertible security
is-thecd
sion ratio, CR, definecl as th! number of shares of stock a bondholdernu''
."iuu l,po,', conversion. ReTaiecl 16"the aonveisiil iltio is ihe,qonygtsLln
l:
P., wliicliis 0r'e iff6ctive price investors pQy- fqf..-tlte-compron-stock
*t:$
;;;#::.il.:'fi I;"1.;#ffi
J';.'il:;""1;'.;;;;*[ii'l;ii.","Jm;{
sion price cin be illustrated by the Silicon Vallev Softrvare Conrpanl's-ct'';
ible debentures, issued at their $1,000 par valtie in july of 199.9.
At
anI
576 Chaptc'r 15 HYBIIID FINANCINC
I
valr,re of the convertibles and, in effect, transler wealth from current
to the convertible holders. This transfer would. de facto, amount
to un.iil\
flotation cost on the new common stock issue. Potential
nrllt5rns ,d;X
;::.t
0":J"0, in mind by firms considering the use of convertibles
or bon4lfi
In the spring of 1998, Silicon Valley Software was evaluating the use of rL
-.
,
vertible bond issue described earlier. The issue would consist of 20-year
[.I1
ible bonds which would sell at a price of $1,000 per bond; this
$1,000 woull
t
be the bond's par (and maturity) value. The bonds would pay a 10 p.*-T
nual coupon interest rate, or $100 per year. Each bond would b^e.onu.rtibt
il
The Component Cost of Convertibles
20 shares of stock, so the conversion price would be $1,000/20
= $50. Ih
n,as expected to pay a dividend of $2.80 during the coming year, and
it
$35 per share, Further, the stock price was expectect to grow at a constant
8 percent per year. Therefore, }q
=
k,
=
DrlPo + g
= $2.80/$35 + 8%
=
g|"
1 6l
16%. If the bonds were not made convertible, they would have to offer a
13 percent, given their riskiness and the general level of interest rates. IL
vertible bonds would not be callable for ten years, after which they curld
called at a price of $1,050, with this price declining by $5 per year thereahr
after ten years, the conversion value exceeds the call price by at least 20
management would probably call the bonds.
Figtrre 15-1 shows ihe expectations of both an average investor ud
comPany.T
1. The horizontal line at M
= $1.000 represents the par (and ma
Also, $1,000 is the price at which the bond is initially offered to the
2. The boncl is protected against cali for ten years. It is initially cathb&
price of $1,050, and the call price declines ihereafter by $5 per year
the call price is represented by ihe soiid seciion of the line Vslvl'.
3. Since the convertible iras a 10 percent coupon rate, and since the yidJ
r
nonconveriible bond of similir risk was stated io be 13
Percent,
lh
pected "straight-bond" value of the converiible, B,, must be less tlra
At the time of issue, assnming an annual coupon, Bo is $789:
,.=iffi*ffi=r,r,
Note, however, that the bond's siraight-clebt value must be Sl,Ot
prior to maturity, so the straight-debt"value rises over time.
B, foll'xl
Pure-Bond
Value, B,
$ 789
792
795
798
802
806
811
816
9)1
829
837
846
Conversion
Value, C,
$ 7oo
756
815
882
952
1,029
1,111
1,200
1 )qA
1 ?OO
1,511
1,632
Maturity
Value, M
$1,000
$1,000
$1,000
$1,000
$1,000
$1,000
$1,000
$1,000
$1,000
$1,000
$1,000
$1,000
Market
Value
$1,000
1,,023
1.,077
7,1.47
7,192
L,21L
1 ?O?
1 ll-t
1,398
1.,453
1,511
1,632
Floor
Value
$ 789
792
816
882
952
7,029
1.111
1,200
1.,296
7,399
1,51i
1.,632
Premium
$211
231.
,qq
265
240
212
782
144
102
54
0
0
line BgM" in the graph.
4. The boncl's initial conversion value, or the vaiue of the stock
the
rvoulcl receive if the boncls lvere convertecl at t
=
0, is $700:
8r
conversion value is P,(CR), so at t
=
0, conversion value =
Po(CR);
shirres) - $700. Since ihe stock price is expectecl to grow
at an
I
i.*. *-,**i,' ,{i<.r'Lqlri
^f
h,rtr thp lonrt rrf
'r
11M\1,.rihl,,.ili,ri., aru d"tcm'irrtl 'For a nrorc c()npl(.te discussion o[ horv the ternrs of rr convcrtibL, oifcring
.rru ot"''-,
!\'lavnc Nlarr anri C. llodncy Ilromlrson, "Thc Pricing trf Nr,rv Convertibl.i
Bond
Isus
,\l,rirrrgrulrrl, Sunrmor l9ti.1, 3l-37.
)
Convertibles 577
Expected Market Value at
Time of Conversion,
C,o
=$1,511
\
1,500
vo=1,100
M
=
1,000
Bo
=
789
Co
=
700
Market Value
Call Price
I
1
Straight-Bond
Value, Bl
10
t
n
J,ZO5
$1,000 3,263 3.263
578 ChaPter
15 HYBRID FINANCING
ConrtrtiLrlt's 579
9. Since n
=
10, thc expcctcd nt,lrkct viihrc .rt \t,tr 10 is S35(1.0S)r,'(10)
=
$1,511. An investor carr fintl thc cxpcctctl r..rto of roturrr orr thc corrvt'rtiblc
L.orrd, k., by finding tlrc lRIi of thr. follorving cash florv strcam;
0 1 9 10
#'.'---F*_-_.-.]
-$1,000
+5100 +5100 +S 100
+ 1,51I
;S1"6x
T'he solution is k.
=
111p
=
12.8 pcrccrrt.
10. The return on a convertilrle is exptctcd t() cr)n1o
Frrtl),
fttur iutrrcst incorno
arrcl partly fronr capital unins; ii1 this casc, tlrr' tot.rl cxpcctorl rctrrrrr is ll.S
percent, with l0 percent rcprq5o611,1s irrtcrcst incomc anri 2.ti pcrcerrt rcp-
resenting the expectr:d capitnl gaitr. Thc irrtcrcst conlfrot.tent is r.cl,rtivcly as-
sured, while thc capital g.rin contpttncnt is morc riskt'. Thcrcforc, a con-
vertible's expected returrr is morc risky th;rn th.rt of a straight bond. This
Ieads us to concludc that k. shoulcl bc Iarijc'r than tl.rc cost o[ straiglrt ciebt,
k.1. Thus, it wor"rld scent that thc expcctcrl riitr. of return orr Silicon's con-
vertibles, k., should lic bctrvecn its cost oI straight clcbt, k,,
=
13,)i,, arrrl its
cost of commorl 51o6lq, k =
1$')i.
Note too that drrc to the fixcrl interost p..rvment, an increasing percent-
age of a convertible's yielcl conres fronr crpcctcd capit.rl rains as the- pricc
of the convertible rises. Thereforc, thc higher the virlue of C,, iire riskitr the
convertible. This factor also motivatcs volunt.rry convorsion.
'11.
Investment bankers use the. typc of motlcl rloscrilretl here, plus a krron'l-
edge of the market, to sct thc tornls on corrvcrtilrlc.s (thc cortversiorr ratip,
coupon interest r;ltc, and vcars of L-all protoction) such that the sccuritv rr.ill
just "clear the nrarkct" at its $1,000 offcr.ing price'. In our cxanrplc, thc rc-
quired conditions do ltot holtl-tht calculatcd ratc of rctrlrn orr tht'corr-
vertible is only 12.8 pclcerrt, whicl-r is less than thc 13
ircrcerrt
cost ol
straight debt. Therefrrrc, thc ternrs on thL. bonrl must bc madc ntorL. attr.rc-
tive to investors. Silicon Valley Softlvare tvor.rlcl havc to increast thc coupon
interest rate on the convcrtible abovc 10 percent, raisc the conversion ratio
above 20 (and thereby [o*'er the conversion pricc fronr $50 to a level cltrsr.r
to the current $35 market price of thc stock), lenethen the call-protocted pe-
riod, or use a combirration of these tlrrec such that the cxpectr-tl r.tte of rc'
turn on the convertible ends up betrveerr 13 and 16 prercent.E
Use of Convertibles in Financing
Convertibles have. tu'o important ad\Bntages flonr tllrl
!:.ltlr..lj-
sllndpoir.!t: (1)
Convertibles, Iike bonr{s rvith n,arr.ruts, offer a conrpanv i]rc ili.rirce to scil cltbt
with a low interest.rate in exch.rnge for_a chancc to participilto in ilrc-con,-
pany's success if it does rvell. (2) In .r sensc, convL.rtibles provitlo .r l..rv to sell
conlmon stock-at prices higher.tharr thosc cur_rlenth, pret-ailing. Sttmc compra-
nies actually $.ant to sell common stock, not rlolrt, [.ut fctl that thc plicg 6i
"ln this tlirtrssiorr, rre islrrrt lhr't.r\ nd\ilhl,lAcs h] ill\('st(I.\ rrsocirterl u.ith ailitnl.{lilr: ln s\rnre
situ.rtiorrs, tax t'flects could rdsrrlt in k. Lrcing loss th.rrr Lr.
I
:ik,iil?:ci';'=''*#,\H\fi
11tI,!}:!tq:,ffi
:"Ili:I"',trI
;;;; ,L; is" gi"en by the line C' i. Figure 15-1'
The actual market price of the bond can never fall below tlt
ligh"t
c
t
,i.ri*f.,ua"U,
value or its convcrsion
valuc. If thc market price
droppo:f
'#'iii
u'rwni-bond
v,lue, those who. want* o:,19,:.ry:11'"toq'q
i
uorgoin ancl
"b
uy. the conve rtible as. a
Tll;^t .Tll?lv;, ll, lt'" Tlsn"
and conversion
value lines'
i
7. At some point, the market
value line will
lcrt1tl,*
t-?1".t'::?""fi:[r:
fi1""ff,I""iJ'J;:J
*,''i..,,.ili
*o
'"n'o"''
First' the stock should
r:,i;h*;;f; ;r.,,-erdividendsa.-lh"I:-i'-F^.?y;,11,1,5"'ll*:,i,,.1'l
:f H:';X;:?i;i.",;;;'
ro' &n*pi"'
siricon's
colve'i'!r?
.a
pay $100
in interest. ann"
jif
lI:, :l:"i#f;lii
jilr;HHf#;
pay Druu
rrt urlsrEo!.qru'--ria
ini,iuffy be 20($2.g0) =
956.
Howeverl
;T:,1"TT.:';,1:1':il
ff. dividend's
arter ten
vears
wourd
be q
$i20.90,
while the inte'"st
*o]'ii stitt U"
gtoo'.rt'"t':t,t:f:IT|I
dividends
could be expecteJ
io push against tl:
-fif1
t"**u
::ffi ;"inJi'"*i,*
^to
ai'up p'u",.'
I *
t
i." "1::'"
j:,:":il1;
causlng
ttrc
PrErr'u,r '" -
t"it"t-t"il'ble'
its market
value
cannol
o
Second, once the bond becr
the higher of the conversi";;;it';;;;
the call price without
exPosa
vestors to the danger ot
'
t"ir' it'-"xaio'",ti-'f:.t^:,::1,t:il'ffI
I{#f:ffi:l*xl[x'
;,"tr *[kl,t
: r1ll ;
tr'ffi
Hi;il?$i:I;.'"'H[p1;^-::1r.-#;[*pffi
f#i+i{d+';#d,iil*ffi
*'fl
til'-i
ffi f #il:1".1',1'#l'.:T':l:,T"0',"d;"'i';-i,;1:;'J.fl :1#H
ket value line hits the conversion
valuc linc in Year 10'
comcs
callable. .
-- ,. *tut
d
l:ni:Xffi
::i*LT:,x["'"ffi
::'T::ln:":""]"'"':;tf
il*
Ililil*iffi
;;;th"
"
i t! r' a I a n ce. s lr ee'
1l-'."!-'li :]':
-,,
8.
couveruL,rE)
r\,'rtsr\6!..--' -
that n= 10, thc first call
date.
In our examPle,
we assume
5tl0 chapter 15 HYBRID FINANCINC
,/
their. stock is tr'nrporarily clepressecl. Management may know, for
examnl-
-
',
earnings are depresscd becausc of startup costs associated with
^ ^-._.v",q
/, earnings are depresscd becausc of startup costs associated with
a n6*vlh
i but they expect L,arnings to rise sharply during the next year
o..^
^..,,f'h
i but they expect L,arnings to rise sharply during the next year o.,o.
",,ulF
'
price of the stock up with them. Thus, if the cJmpany rria r*o.t
ni*I",',Tg
A
be giving up rllore shares than necessary to raise a given u*orn,
li'l'{
Horvcver- if it sct thp conversi,rrr nricp )O tn ?O norronr rk^.,^ rr^
-' *Pqd.
11-,tG
f.:::H',ilr',.::i:i'",il':';fi^plii'^::"::,'1..0::li:l'::{&;H
$l"lr:i:ft *:::'s;L:li",f"'.T:"Tl'il:J;l,XT,.::,*."111,f;
;l::,.il;,:""i:"J:::::lH::l:iT":l::::,::::'::d.E':."y,..;h:'.ff
l,T:"T;*:lil"y":::'J.Yi il"::?:T:';::'""::T"s^::-'i: ::."..I. fi
.;T
*:: :..1n:::: ::'::T r:f :.': ::f
j9
o
:lo1 lttlactw
e i.' .o"u"."i.,'
v*fi
A Final Comparison of Warrants and Convertibles 581
-Test
What is a conversion ratio? A conversion price? A straight-bond value?
What is meant by a convertible's floor value?
What are the advantages and disadvantages of convertibles to issuers? To
investors?
How do convertibles reduce agency costs?
AL
COMPARISON OF WARRANTS AND CONVERTIBLES
Convertible debt can be thought of as straight debt with nondetachable warrants.
Thus, at first blush, it might appear that debt with warrants and convertible debt
are more or less interchangeable. However, a closer look reveals one major and
several minor differ-errce_q between these two securities.e Iirst, as we discussed
previously, the eiercise of warranti brings in new equityGpiial, while the con-
version of convertibles results only in an accounting transfer.
A..seconddifference involves flexibility. Most convertible issues contain a call
provision that allows the issuer either to refund the debt or to force conversion,
depending on the relationship between the conversion value and call price. How-
ever, most warrants are not callabie, so firms generally must wait until expiration
for the warrants to generate new equiiy capital. Generaliy. maturities also differ
between warrants and convertibles. Warrants typically have much shorter matu-
rities than convertibles, and warrants typically expire before their accompanying
debt matures. Further, warrants provide for fewer future common shares than do
convertibles because with convertibles all of the debt is converted to common
whereas debt remains outstanding when warrants are exercised. Together. these
facts suggest that debt-plus-warrant issuers are actually more interested in sell-
ing debt than in selling equity.
In gengjal,
l_rgp1s
thai issue debt with warrants are smaller and riskier than
those that issue convertibles. One possible rationale for the use of option securi-
ties, especially the use of debt with warrants by small firms, is the difficulty in-
vestors have assessing the risk of small companies. If a startup with a new,
untested product seeks debt financing, it is very difficult for potential lenders to
iudge
the riskiness of the venture, hence it is difficult to set a fair interest rate.
Under these circumstances, many potential investors will be reluctant to invest,
making it necessary to set very high interest rates to attract debt capital. By issu-
ing debt with warrants, investors obtain a package that offers upside potential to
offset the risks of loss.
Jtglly
there is a significant difference in issuance costs between debt with
warrants and convertible debt. Bonds with warrants typically reguire issuance
costs that are about 1.2 percentage points more than the flotation costs for con-
vertibles. In general, bond-with-warrant financings have underwriting fees that
closely reflect the weighted averate of the fees associated with debt and equity
issues, while underwriting costs for convertibles are substantially lower.
'For
a more detailed comparison of warrants and convertibles, see Michael S. Long and Stepixn E.
Sefcik, "Participation Financing: A Comparison of the Characteristics of Convertible Debt and
Str.riEht Bonds Issued in Conjunction with Warrants," Finonciil Maragenrrf, Autumn 7990, Z!-34.
ings do not rise and pull the stock price up, hence conversio"
ao..."1,3
then the company will be saddlecl with debt in the face
"f
f.* *ffi)ffi
cor.rlcl be disastror,rs.
Fjg.yr.
,can-therompany be-.wr-e.Lhit caqyels!_oq
w-rll
qqcur if the orice.re-
stock rises above the con'ersio,n pli-ce? Typically, cor,u"itibGs .;ilt,;;
tLi'is,ign
th;airialilEithe-iisiiiirgTrm to foice hotders to convert.
ilril-;
con'e'rsion price is $50, the conversion ratio is 20, the market p.i.u ofi,..J
.rorr sttlck hirs rist'n kr 960, and ttrc call price on a convertible bond is
ltd
lf the c.mparry calls the b..r1, bo^rlholt{ers can either convert irrto .or[
stock with a market value of 20($60)
= $1,200 or allow the co^puny to rcdI
the bond for $1,050. Naiurally, bondholders prefer $1,200 to
gt,OSO,
so cooni
sion vyould <,rccur" The qlll p-Ig"v-i.q.l-gl--Sj,/99
l\S
"cpngany-a-wny-te
faJcsE0$;
sion, prgvi{qct
!!-r9
mar\qt price of the stock is greater than the conveml
price. Note, however, thai inosi-ionvertitiles have=a Tailly ldng'pniiod oid
lirofection-ten
years is typical. Therefore, if the co^pur,y *urlt, to bu rbLi
force conversion fairly early, then it will have to set ishort call-protctioop
riocl. This will, in turn, require that it set a higher coupon rate oi a loweri
vL'rsion
Pricc.
Fronr the stantlpoint of the issuer, convertibles have three important disrl'
vantages: (1) Althongfi the-u-#-b-f a ioiiveifibl'e'bond-mayElvE the compnye
opportunity to sell stock at a price higher than the price at which it couldL
sold currently, if the stock greatly increases in price, the firm would probr&f
fincl that it would have been better off if it had usecl straight debt in spite6{l
highcr cost and then later sold common stock and refunded the debt.
(2)Cr
vertibles typically have a low cor.rpon interest rate, and the advantageolSi
Icxv-c<:rst debt will be lost when cont,ersion occurs. (3) If the company
urf
wi.utts ttr raise equity capital, ancl if the price'of the stock does not risecy'b
cic'ntly after the bond is issued, then the company will be stuck with debt.
Convertibles and Agency Costs
One of the potential agency problems between bondholders and stockhcljd
rliscussed in Chapter I is asset sr,rbstitution. Stockholders have an 'dt
relrted" incentive io take on proiects with high Lrpside potential even
thrf
thcy increase the riskiness of the fi.m. When sJrch ai action is taken,
theEirf
tc.utial for a rve.alth transfer between bondholclers and stockholclers.
Hoxs!
rvhr'n convertilrlc clebt.is issuecl, actions which increase. t1.," ,irti"*r
of tlrA.
p,rnv nlay also incrr'ase the value of the convertible clebt. Thus, some
of
ttr
kr shareholdcrs fronr takirrg on high-risk pro.iects have to be sh.rred
wiu
ve'rtible borrrlholders. This sharing of benefits lowers agencv costs.
The
srllf I
cral logic applies to convertible preferred anrl to bondi rviih lvarrants.
, li
)
Questions/Problems
583
582 (h2p1s1
15 HYBRID FINANCING
What are some differences between debt-with-warrant financing
and
ible debt?
Explain how bonds with warrants might help small, risky firms
sell
d{
curities.
OTHER TOPICS IN HYBRID TINANCING
When warrants or convertibles are outstanding, the firm has several
formats for reporting earnings per share. The chapter's Extensions provide
discussion of these choices.
Although the exercise of warrants is typically triggered by expiration,
sion is generally forced by a call. Thus, firms that issue convertibles
aE
with making a call decision. Such decisions are also discussed in the
Finally, in recent years investment bankers have created some unusual
hybrid securities which are tax deductible to the issuer. These securities in
discussed in the Extensions.
SUMMARY In this chapter, we discussed preferred stock, warrants, and
concepts are listed below:
I
Preferred stock is a hybrid-it is similar to bonds in some
comrnon stock in other ways.
r
A warrant is a long-term call option issued along with a bond.
generally detadrable from the bond, and they trade separately in
When warrants are exercised, the firm receives additional
and the orighal bo:rds remain outstanding.
r
A convertible security is a bond or preferred stock that can be e
d. Stepped-uP
Price
e. Convertiblesecuritv
f. Conversion ratio; cbnversion price; convcrsion valuc
g. "Sweetener"
Is preferred stock more likc bonds or common stock? Explain'
\ /hat effect does the trentl in stock prices (subsequent to issuc) have on a firm's ability to
raise funds through (a) convertibles and (b) warrants?
If a firm expects to have .rdditional financial requiremt'nts in the hrturc' would you rec-
.**""a itt it use convertibles or bonds with iarrants? What f.ectors would inlluence
your decision?
How does a firm's dividend policy affect each of thc following?
a. The value of its long-term warrants.
b. The likelihood thatits convertiblc bonds will be convcrtc'd'
c. The likelihood that its warrants will be exercised'
Evaluate the following statement: "Issuing convertiblc securities represmts a means by
-t
i"fr a fitnt can sell iommon stock at a piice above the cxisting market'"
Why do corporations often sell convertibles on a rights basis?
Suooose a company simultaneously issues $50 million of convcrtible bonds with a coupon
;:t";10-;;";i
""rJsso
mipion 6f straighr bonds with a coupon rarc of l4 perccnr. Both
bonds haie the same maturity. Does thi fact that the convertible issue has lhc lower
"""r".
trt" suqqest that it is tJss risky than thc str.light bond? Is the cost of capital lower
on the converti'bfe than on thc strligtrt bond? Explain
Problems
Gress Companv recently issued two types of bonds' Thc first issue consisted of 20-year
,i"ig'tia"6t *th in
g'percent
o*uli coupon. The second issue consisted of 2.-vear
bond"s with a 6 percent innual coupon and'atta-ched warrants. Both issues sold at their
6i^000 p;;';"ild. Wh"t i" the implild value of the warrants attacled to each bond?
Peterson Securities recently issued convertible bonds with a $1'000 par value'.The bonds
have a conversion price of$40 a share- What is the convertible issuc's conversron raho'
Maesc Industries Inc. has warrants outstanding that
Permit
the holders to purchase 1
share of stock
per warrant at a price of $25'
,."e'ri;ri;i; i{;*"r.i." rrir" Jirf,e firm's warrants if the common sells at each of the fol-
-
fo*ln*
prices: (1)
$20,
(2) $25,
(3) $30, (4) $100'
(Hint: A warrant's excrcise valuc is the
;t;.""t":;;;il;!^
tiiJii".l'p:ir'." ntd iltt p"thot" price spccified bv the warrrnt if
the warrant were to be exercised.)
b. At what approximate
price ao you think the warrants would actually sell.under each
"
:;;i;iJffiiiii"J uiio""z w{at premium above exercise value is.implied in your
;;i;;?
Y;; iniwer is a guess, but your prices ancl prcmiums should bear reasonablt'
relationshiPs to one another.
.. iio* *orfh each of the following factors affect your estimates of thc rvarrants'prices
and premiums in Part b?
(1) The life of the warrant.
iZ) Exoected variability (o") in the stock's pricc'
i:i
rn! expectea growih rite in the stock's EPS'
(4)
The company announces a change in dividencl policy: rvhereas it formerly paicl no
'
-'
iiuia"na'., hinceforth it will pa/out nll earnings as dividends'
d, As.;;; the iirm's stock no,v selis ior $20 per shaie Thc c-omP.aty s'ants to sell some
20-vear,annualinterest,$l,0O0parvalucbonds'Eachbondtvillhaveatt'rched50rvrr-
;;^6;*h;;;.itiur"'lntn
I ihare of stock at an excrcisc price.of $25 Tht firms
straight bonds yield 12 percent Regardless of your answcr to l'art b' assume tnat eacn
Questions
15-1 Define each of the following terms:
a- Preferred stock
b. Cumulative dividends; arrearages
c. WarranU detachable warrant
15-2
15-3
15-4
15-5
75-6
15-7
15-8
. 15-1
Warrants
75-Z
Convertibles
15-3
Warrants
for common stock at the option of the holder. When a security is cot
debt or preferred stock is replaced with common stock, and no-
changes hands. i.lill
r
Warrant and convertible issues are generally structured so that
conversion price is 20 to 30
Percent
above the stock's price at time
r
Althoughboth warrants and convertibles are option securities, therc
eral dilferences between the two, including separability, impact
cised, call?rbility, maturity, and flotation costs.
r Warrants and convertibles are "sweeteners" which are used to malG!
derlying debt or preferred stock more attractive to investors'
Artlqua
couiorirate or dividend yield is lower when options are part oj.S
the overall cost of the issue is higher than the iost of straight
de$
ferred, because option;related securities are riskier.
The Extensions section to this chaptei discusses several new types
of
curities. It also discusses how earnings per share are reported when'
or warrants are outstanding, as well as information regarding when
bonds should be called to force conversion.
)
584 Chapter 15 HYBRID FINANCINC
l5-4
Convertible Premiunrs
15-5
Convertible Bond Annlysis
15.6
Warra ut,/ Conv e r t ib le'
Dccisions
warrant will have a market value oI $3 when the stock sells at 920. What
couu,
est rate, and dollar coupon, must the company set on the bonds with warrd;:l
are to cle,ar the market?
Thc Tsetsckos Company was planning to finance an expansion in the summer
of 1o
principal executives of the conrpany all agreed that an industrial.ompuny.u.i"S
should finance growth by means of common stock ratller than by debt. Hciwevei.il
that the price of the company's common stock did not reflect its true worth,
so if,
Total assets
Balance Sheet
Current liabilities
Common stock, par $1
Retained eamings
$550,000
Total claims
Income Statement
Questiors/Problems
585
$400,000
100,000
50,000
$s:1qq9
cictcd to ietl a convertible security. They considered a convertible debenturebut
btrrden of fixetl interest charges if the common stock did not rise in price to mi
sion attractive. They decided on an issue of convertible preferred stock, which
a dividend of $2.10
per share. ,lvlclend ol $l.lu
Per
snare.
The common stock was selling for $.12 a share at the time. The common stock was selling for $.12 a share at the time. Management pr
ings for 1998 at 93 a share and expected a future growth rate of 10 percenia
ane{ bevond. It was asreed bv the investment bankers and the manaeement l
mon stock would sell at i4 times eamings, the current price/earnings ratio. .:
a. What conversion price should be set by the issuer? The conversion ratio wil
that is, each share of convertible preferred can be converted into 1 share oI
Therefore, the convertible's par value (and also the issue price) will be equal I
version price, which, in ttrrn, will be determined as a percentage over the
ket price of the common. Your answer lvill be a
Buess,
but make it a
b. Shoulcl the preferred stock include a call provision? Why?
In
lune
1986, A.A. Steel sold $400 million of convertible bonds. The bonds had a
maturity, a 5% percent coupon rate, and were sold at their $1,000 par value. The
sion price was set at $62.75 against a current price of 955 per share of common. Th
were subordinated debentures, and they were given an A rating- Assume shai
convertible clebentures of the same quality yielded about 8% percent at the time.
a. Calculate the premium on the bonds. that is, the percentage excess of the
price over the current stock price.
b. What is A.A. Steel's annual interest savings on the convertible isstre versus a
debt issue?
qeor
l55ue,
c. A.A. Steel's current stock price is $37.75. On the basis of this price, do yoil
likely that the bonds would have been converted? (Calculate the value of the si
would receive by converting a bond.)
constant at U7{ percen
convertible bonds?
you tNnk would have happened to the pi
e. Assume that the price of A.A. Steel's common stock had fallen from $55 on
a. Show the new balance sheet under each altemative. For Altematives 2 md 3, show the
balance sheet after conversion of the bonds or exercise of the warrants. Assume that
half oI the funds raised will be used to pay off the bank loan and half to increase total
assets.
b. Show Mr. Howland's control
Position
under each altemative, assuming that he does
not
purchase additional shares'
".
Whit ir the effect on eamings per share of each altemative, iI it is assumed that
Profits
before interest and taxes will be 20
Percent
of total assets?
d. What will be the debt ratio under each altemative?
e. Which of the three altematives would you recommend to Howland, and why?
Nlendorf Incorporated needs to raise $25 million to construct production facilities for a
nerw model disliette drive. The fum's straitht nonconvertible debentures currently yield 14
percent. Its stock sells for $30
per share; the last dividend was $2i and the exPected growth
iate is a constant 9 percent. lnvestment bmkers have tentatively proposed that the firm
raise the $25 million by issuing convertible debentures. These convertibles would have a
91,000
par value, carry a couP6n rate of 10 percent, have a 20-year maturity, and be con-
vertibl6 into 20 share! of stoik. The bonds would be noncallable for 5 years, after which
they would be callable at a
Price
of $1,075; tNs call price would decline by $5 per year in
Vea'r O and each year thereaiter. Management has cailed convertibles in the past (a1d p5'
sumably it will iall them again in the future), once they were eligible for call, when the
bonds"conversion value wis about 20 percent above the bonds' par value (not their call
price).
i. Oi"* an accurate graph similar to Figure 15-1 representing the expectations set forth
above. (Assme an arutual couPon.)
b. What is the expected rate of reaum on the proposed convertible issue?
c. Do you think lhat these bonds could be successfully offered to the public at par? That
is, does $1,000 seem to be an equilibrium price in view of the stated terms? If not, sttg-
pest
the Wpe of chanqe that would have to be made to cause the bonds to trade ai
$1,OOO in ilie secondar"y market, assurnin8 no change in capital market conditions.
--
d. Suppose the proiects outlined here work out on schedule for 2 years, but then the firm
Ueiins to exi"rience extremely stront comPetition from
Japanese
fims. As a result,
NGndorf's expected growth rate drops from 9
Percent
to zero' Assume that the dit'i'
dend at the ti-me of the droP is $2.38. The company's credit strength is not imPaired,
and its value of k" is also unihanged. What would happen (1) to the stock
Price,
and (2)
to the convertible bond's
Price?
Be as precise as you can.
Sales
All costs except interest
EBIT
Interest
EBT
Taxes (40%)
Net income
Shares outstanding
Eamings per share
Price/eamings ratio
Market price of stock
$1,100,000
990,000
$ 110,000
20,000
$ 90,000
36,000
$ s4,000
100,000
$0.54
15.83x
$8.ss
7s-7
Bond Analysis
bonds were issued to $32.75 at present. Suppose also that the rate of interest
from 8% to 5% percent. Under these conditions, what do you think would
pened to the price of the bonds?
f. bc* up a graphic model to illustrate how investors valued the A.A. Steel conr
'i'he
Howland Carpet Company has grown rapidly during the. past 5 years._Rq
commt'rcial bank urged the company to consider increasing its permanent llnan
bank loan unrler a line of credit has risen to $250,000, carrying an I percent intei
Howland has been 30 to 60 days late in paying trade creditors. I
Discussions with an investment ban(er'have resulted in the decision to raise
1986. How well were these expectations realized?
1;
at this time. Investment bankers have assured the firm that the follolving
feasible (flotation costs lvill be ignored):
.
Altcrilititc i: Sell common stock at SB
t Allernatiua 2: Sell convertible boncls at an 8 percent corrpon, convertible into
of comnron stock for each $1,000 bond (that is, the conversion price is $10
r
Altzrrrrtiru 3: Sell tiebentures at an 8 percent coupon, each $1,000 bond car{in$
rants kr bttv common stock at $10.
John
L. Horr'lancl, the pre'sirlent, owns B0 pcrc!'nt of the comnron stock
al9
maintain control of the company. One hrrndiecl thousanrl slrtrres itre outstandir maintain control of the company. res Ire oLrtstandin8'
lorv ing arr' cxtr.rcts of H orv l arrtl's l.r test f inincial sta tL'ml'nts:
586 Chapter 15 HYBRID FINANCING
fufrna
Case
Pau) Duncan, Iinancial manager of EduSoft Inc., is facing
a dilemma. The firm w.rs founded 5 years ago to provide
educational software for the rapidly expanding primary
anh secondary school markeis'. Aithoigh fdudoft hat
dohe well, the firm's fbunder believes that an industry
shakeout is iminenl. To suruive, EduSoft must grab
market share now, and this will require a large infusioin of
new capital.
Because he expects earnings to continue rising shalply
and looks for the stock price to follow suit, Mr Duncan
does not think it would be wise to issue new common
stock at this time. On the other hand. interest rates are
currently high by historical standards, and with the firm's
B rating, the interest payments on a new debt issue would
be prohibitive. Thus, he has narrowed his choice of fi-
nancing alternatives to two securities: (1) bonds with war-
rants, or (2) convertible bonds. As Duncan's assistant, you
have been asked to help in the decision process by an-
sweriflg the following questions:
a. How does preferred stock differ from both cofiunon
equity and debt? Is preferred stock more risky than
common stock?
b, What is a call option? How can a knowledge of call op-
tions help a financial manager to better understand
warrants and convertibles?
c. One of the firm's altematives is to issue a bond with
warrants attached. EduSoft's current stock price is $20,
and its investment banker estimates that the cost of a
20-year, annual coupon bond without warrants would
be 12 percent. The bankers suggest attaching 50 war-
rants, each with an exercise price of $25, to each $1.000
bond. It is estimated that each warraht, when detached
and traded separately, would have a value of $3.
(1) Ufhat coupon rate should be set on the bond with
warrants if the iotal package is to sell for $1,000?
(2) Suppose the bonds were issued and the warrants
immediately traded on the open market for $5
each. What would this imply about the terms of the
issue? Did the company "win" or "lose"?
(3) When would you expect the warrants to be exer-
cised? Assume they have a 1O-year life; that is, they
expire 10 years after issue.
(4) Will the warrants bring in additional capital when
exercised? Ifso, how much,and what type ofcapital?
(5) Since warrants lower the cost of the accompanying
debt issue, shouldn't all debt be issued with war-
rants? What is the expected return to the holders of
the bond with warrants (or the expected cost to the
company) if the warranis are expected to be exer-
cised in 5 years, when EduSoft's stock price is ex-
pected to be $35.75? How would you expect the cost
of the bond with warrants to cornpare with the cost
of straight debt? With the cost of common stock?
d.
*:T',::"#*I""r :i:f""i't,yH#::,il.-,
H
Se'lected Additional References and Cases 587
Selected Additional References and Cases
For additional discussiors on preferred stock, see
Alderson, Michael
J.,
and Donald R. Fraser, "Financial lnnovations and Excesscs Revisited:
The Case of Auction Rate Preferred Stock," Financial Mnrngement, Summer 7993,61J5.
Alderson, Michael J.,
Keith C. Brown, and Scott L. Lummer, "Dutch Auction Ratc Pre-
ferred Stock," Financinl Managclrcnf, Summer 1,987, 68-73,
Fooladi, Iraj, and Gordon S. Roberts, "On Preferred Stock," /orrrrlal
of FinLtncinl Rescorch,
Winter 1985,319124.
Wansley,
James
W, Ftryez A, Elayan, and Brian A. Maris, "Preferred Stock Rcturns, Ctedit
Watch, and Preferred Stock Rating Changes," Tlre Iirrancial ReoictLr, May 1990,26!-285.
Winger. Bernard
J.,
et al., "Adjustable Rate Preferred Stock," Financial Marrageirerrt, Spring
1986,48-57.
Quite d bit of work has been done on warrant pricing. Sotna of thc artigles ittclttdc
Ehrhardt, Michael C., and Ronald E. Shrieves, "The Impact of Warants and Convertible
Securities on ihe Systematic Risk of Common Equily," Finnncinl Rezsiew, November
1995,843-855.
Galai, Dan, and Mier L Schneller, "The Pricing of Warrants and the Value of the Firm,"
lounml
of Finance, December 7978,133!-7342.
Lauterbach, Beni, and Paul Schultz, "Pricing Warrants: An Empirical Study of the Black-
Scholes Model and lts Alternatives," lourtnl
oJ Finance, September 1990, 1181-1209.
Leonard, David C., and Michael E. Solt, "On Using the Black-Scholes Model to Value War-
ranls,"
lornul
of Financinl Research, Summer 1990, 81-92.
Phelps, Katherine L., William T. Moore, and Rodney L. Roenfeldt, "Equity Valuation Ef-
fects of Warrant-Debt Financing,"
lournal
of Finnncial Researclt, Summer 7997,93-703.
Schwartz, Eduardo S,, "Thc Valuation of Warrants: Implementing a New Approach,"
/our-
nal of Financial Econorrics, January
1977,79-93.
For ntore insights irtto cotnscrtiblc pricitrg and ust, see
Alexander, Gordon
J.,
and Roger D. Stover, "Pricing in the New Issuc Convertible Debt
Market," E inancial Mannganent, Fall 1977, 35-39.
Alexander, Gordon J.,
Roger D. Stover, and D. B. Kuhnau, "Market Timing Strategies in
Convertible Debt Financing," lournal
of Fimnce, March 1979, 143-155.
Asquith, Paul, and David W Mullins, Jr.,
"Convertible Debt: CorPorate Call Poliry and
Voluntary Conversion,"
Iournal
of Firrance, September 7991,, 7273-1289.
Billingsley, Randall S., and David M. Smith, "V/hy Do Firms Issue Convertible Debt?" Fi-
nnncial Managemerxl, Summer 1996, 93-99.
Brennan, Michael, "The Case fot Convertibles," lssues in Corpomte Finance (New York:
Stem Stewart Putnam & Macklis, 1983),102-111.
Emery, Douglas R., Mai E. Iskandor-Datta, and
Jong-Chul
Rhim, "Capital Structtre Man-
agtment as a Motivation for Calling Convertible Debt,"
/ountni
of Filnncial Resenrch,
Spring 1994, 91-104.
Harikumar, T., P. Kadap.rkkam, and Ronald F. Singer, "Convertible Debt and Investment
Incentives,"
lountal
oJ Finnncial Research, Spring 1994, 15-29.
Ingersoll, Jonathan
8., "A Contingent Claims Valuation of Convertible Sccuritit's,"
/ournal
oJ Financinl Econoltics, May 1977,289-322.
Janiigian,
Vahan, "The Leveragc Changing Conscquences of Convertible Debt Financing,"
Financial Managcruc,ll, Autunm 1987, 1,5-77.
Krishnan, V. Sivarama, and Ramesh P. Rao, "Financial Distress Costs and Delayed Calls of
Convertible Bonds," Firmrrcrnl Rerrieur, November 1995, 913_925.
The
folloioitrg
cnse
t'ront
tlr Cases in Financial Management: Dryden Rcquest st'ric.q cozrer-s
nwiy of the issues presenterl in this chapt$:
Case 27, "Virginia lvlay Chocolate ComPanli" illustrates convertiblc bond valuation.
2o-year, 10.5 percent annual coupon, callabls-
i!l-e Ugna for its- $1,000 par value, whereas
i
debt issue would require a 12 percent
corr-i
convertibles would be call protected
for S
call price would be $1,100, and the comn
vestment bankers estimate that EduSoft
probably call the bonds as soon as
conversion value exceeds $1,200.
the cali must occur on an issue date
option.
(1) What conversion price is built into the
(2) What is the convertible's straight-debt
version value in any year? What is its
value at Year 0? At Year 10?
at Year 0? At Year 10?
(5) Assume that EduSoft intends to force
by calling the bond as soon as possible
(4) What is meant by the "floor value" of i
ible? What is the convertible's expected flr
Soft's curent stock price is $20, its last dividl
$1.48, and the dividend is expecred to grow
ii
stant 8 percent rate. The convertible ior-rld te
verted into 40 shares of EduSoft stock at the.dl
is the implied valtre of the convertibilitv feifr
(3) What is the formula for the-.b,ond's exircctd
conversion value exceeds 20 percent abo
value, or 1.2($1,000)
= $1,200, When is the
pected to be called? (Hint: Recall that thd
be made on an anniversary date of the is
(6) What is the expected cost of capital
vertibie to EduSoft? Does this cost
e. EduSoft's market value capital stnrcture is d
(in millions of dollars):
::
Debt $ 50
Equity 50
$100
If the company raises $20 million in additiot
by sellingjl) ionvertibles or (2) bonds with
.r.,ihrt
*o"uld its WACC bc. and how would
consisient with the riskiness of the
ures compare with its currerrt WACC?
decision based on other factors. What are
factors which he should consider?
rate is 40 percent
Mr. Duncin believes that the costs of both
with warrants and the convertible bond
enough to one another to call them even, and
sisten"t with the risks involved. Thus, he will
)
588 Chapter 15 HYBRID FINANCING
6xtensions
ADJUSTABLE RATE AND
MARKET AUCTION
PREFERRED STOCI(S
Instead of paying fixed dividends. adjustable rate
Pre-
ferred stocks (ARPs) have their dividends tied to the rate
on Treasury securities. The ARPs, which are issued
mainly by utilities and large commercial banks, were
touted as nearly pcrfect short-term corporate investments
since
(1) only 3O percent of the dividends are taxable to since (1) only 30 prcent of the dividends are taxable to
corporations, and (2) the floating rate feature was sup- corporations, and (2) the floating
posid to keep the issue trading at near pan The new se-
curity proved to be so popular as a short-term investment curity proved to be so popular as a short-term investment
for firms with idle cash that mutual funds designed
iust
to invest in them sprouted like weeds (shares of the
funds, in trrrn, were purchased by corporations). How-
evet the ARPs still had some price volatility due (1) to
changes in the riskiness of the issues (some big banks
which had issued ARPs, such as Continental Illinois, ran
into serious loan default problems) and (2) to the fact that
Treasury yields fluctuated between dividend rate adjust-
ments dates. Thus, the ARPs had too much price instabil-
ity to be held in the liquid asset portfolios of many cor-
porate investors.
To solve tNs problem, investment bankers introduced
money markct, or market auction, preferred. Here the
underwriter conducts an auction on the issue every seven
weeks (to get the 70 percent exclusion from taxable in-
come. buyers must hold the stock at least 46 days). Hold-
ers s'ho want to sell their shares can put them up for auc-
tion at par value. Buyers then strbmit bids in the form of
the yields they are willing to accept over the next seven-
week period. The yield set on the issue for the coming pe-
riod is ihe lowest yield sufficient to sell all the shares be-
ing offered at that auction. The buyers pay the sellers the
par value, hence holders are virtually assured that their
shares can be sold at par. The issuer then must pay a div-
idend rate over the next seven-week period as deter-
mined by the awtion. From the holder's standpoint, mar-
ket auction prefe.rrtt is a low-risk, largely tax-exenrpt,
seven-week maturity scrcurity which can be sold between
auction dates at clos to par. Flowever, if there are not
enough buyers to match the sellers (in spite of the high
yield), then the auction can fail, which has occurrecl on
occasion. For example, a few years ago, an auction of
Mcorp (a Texas bank holding company) failed to attract
enough buyers. Analysts attributed the failure to the
downgrading of lvlCorp's preferred stock from double A
to single B, which causetl potcntial buyers to think (cor-
rectly, as it tumed out) that the company rvould go bank-
rupt and not pay the tlividencis expecteel.
Atljustable rate and nrarkel auctiorr prcferrerls are also
issued by industrial and service companies. For example,
Texas lnstruments recently issued $2?5 nrillion of market
auction pre{errecl. About the only thing invcstors do not
like about ARPs and auction market preferreds is that, as
stock, they are more vuherable to an issuer,s
problems than debt would be, as evidenced by
fti
example.
REPORTING EARNINGS
WHEN WARRANTS
OR
CONVERTIBLES ARE
OUTSTANDING
If warrants or convertibles are outstanding, a fim-
'
theoretically report earnings per share in one
ways:
1. Bnsic EPS, where eamings available to
stockholders are divided by the average r
shares actually outstanding during the period.
2. Primary EPS, where eamings available are
by the average number of shares that would
been outstandin8 if warrants and
"Iikely to be converted in the near future" had
ally been exercised or converted. ln
mary EPS, earnings are first adjusted by
out" the interest on the convertibles, after
adjusted eamings are divided by the adjwted
ber of shares. Accountants have a formula'r
basically compares ihe conversion or exercis
lvith the actual market value of the stck to
mine the likelihood of conversion when
on the need to use this arliustment
3. Dililed EPS, which is similar to primary
that rll warrants and convertibles are
exercised or converted, regardless of the
of exercise or conversion,
Under SEC rules, firms are required to rePort
sic and diluted EPS. For firms with large amoult
tion securities outstanding, there can be a
ference between the basic and diluted EPS
financial statement purposes, firms reported
of a company's underlying pe.rform.ince. Also,
makes it e.lsier for invcstors to conrpnre the
of U,S. firnrs with their foreign courrterparts,
to use basic EPS.
i
CALLING CONVERTIBL]
ISSUES
i,,
Most convertiblc issrres hrve provisions thdt
allolv
s
suer to call the issue
Prior
to mrtrtrittr tn srrch
cas'*
issuing finn must nr.rfe tL" .i*.i;i;'tii .:., if rl{
the co-nvertible. lf a convertibtc is calte.l njhen
iEl
is less than the stock price, convertible holders
the call and receive the call price. The firm will
.fav cash
to redeem the issue, and no new equity
I"l on the balance sheet. If the call is made when
liion
pri." exceeds the stock
Pdce,
holders will
theh
securities
into common stock.
In this case,
ivill not have a cash outlay, and a balance sheet
will be made from debt (or preferred) to common
should
a convertible be called? To begin, con-
situation
where the conversion value is less than
r tall price. In our Chapter 15 convertibie
assume that Silicon Valley's stock price
mple,
assume that Silicon valtey's stock
Price
rise, and that the conversion value at Year 10 is
Extensions 589
agers "kill" the conversion option, and hence remove the
opportunity for convertible holders to share in future
stock price increases,
Interestingly, several studies have shown that firms do
not call convertibles when conversion value reaches call
price, but rather tend to wait until th conversion value is
well above the call price.' One reason proposd to explain
this observed behavior is that the firm may want to save
near-term cash flow. For example, Silicon Valley's com-
mon dividend might be $6 per share when the convertible
bonds become callable. Assuming a
,10 percent tax rate,
current after-tax interest on each bond is $100(0.60)
=
$50
per year, while conversion into 20 shares of common
would require $120 of amual dividend payments. An-
other possible explanation involves sitnaling-if a Iirm
calls its convertibles at the earliest posoible time, then in-
vestors will be less interested in future convertible issues
it mitht decide to use.
SOME INNOVATIVE
NEW HYBRIDS
Over the past three years, investment bankers have de-
vised some new preferred stock hybrids having signifi-
cmt appeal to both issuers md investors. For example,
RJR Nabisco recently issued trust-oriented preferred secu-
rities (TOPTS), which combine features of
futh
preferred
stock and bonds. TOPrS are sold at
iust $25 h share, which
makes them more accessible to small investors than cor-
porate bonds with $1,000 or $5,000 par values, although
most buyers purchase round lots of 1@ shares. Several
versions of these securities have been isstred by different
companies under names such as montNy income pre-
ferred securities (MIPS) and quarterly income preferred
securities (QUIPS). [n fact. in recent years these new hy-
brids have accounted for more than half of the total pre-
ferred stock issued.
Unlike conventional preferred, these new hybrids offer
yields higher than those set on the firm's debt securities,
which makes them attractive to individual investors. For
example, RJR Nabisco's TOPIS were st at 8 percent while
its bonds yielded about 7.2 percent at the time. The key to
the higher yield is the securities' tax deductibility for the
issuer. The deal works in this way: The parent company
creates a partnership or trust that actually issues the secu-
rities. Then the proceeds are loaned to the parent. which
repays the loan with tax-deductible interest payments.
These payments, in tum, are timed to coincide wiih the
dividend payments made to the hybrid holders.
The new securities tend to have long maturities-
typically 30 to 40 years-so holders are subict to con-
siderable price risk,
iust
as on any long-term fixed-rate
investment. The hybrids have call provisions, but most
offer five years of call protection. After that, a sharp drop
in interest rates would likely trigger a call. Most of these
= 9700, mtrch less than the $1,050 call price.
assume
that interest rates have stayed the same,
the firm has no incentive to call the con-
because
the convertible couPon rate is less than
required on straight debt. However, if in-
iates f;ll, and new straight debt costs less than the
a ne\ry straight-debt issue would cost 13 percent,
ove the convertible's 10 percent coupon rate. In
coupon rate, the convertible should be called.
le here is the same as for calling a nonconvert-
non stock, resulting in a wealth transfer of (Stock
Conversion pricel(Number of shares)
=
($60
-
= $200 per bond. If the call were not made, and
about the situation when the issuer's stock price,
nversion value, has riserl? When a convertible is
into common stock, thie difference between the
price and the convertible's conversion
a wealth transfer from current stock-
to convertible holders. Since managers are moti-
act in the best interest of current stockholders,
to minimize the amount of wealth transfe! the-
that the call should be made as soon as the
ion value reaches the call price, assuming the de-
eriod has ended. (In reality, because of transac-
the call should be made when the conversion
slightly above the call price.) To illustrate, if after
r. Silicon Valley's stock price has risen to $50, then
rersion value is $60(20)
=
$1,200, and a call at
force holders to convert to get $1,200 worth
trice
subsequently rose to $75, the wealth trans-
increase to ($75
- $50)(20) =
$500 per bond.
'this
from another perspective, a firm's value is
I
its securitv holders. As a firm's fortunes rise,
of its debt securities are fixed, but the value of
stock rises, and so does the value of its con-
which have a call option on the stock. However,
of the convertible issue lowers the value of
stock, and the greater the value of the call
(of
the convertible), ihe lower the value of the
stock. By calling the convertible as soon as the
value equals the call price, the firm's man-
until 1992 when the Financial AccountinB
Stal
Board (FASB) changed to basic EPS. According
to
the change was maie to give investors a simPlerl
see
Jonathon Ingersolt, "An Examination of Corporate Call Policies on Convertible Securities,"
lournal
o/ Finance. May
)