CHAPTER 20

Hybrid Financing: Preferred

Stock, Warrants, and Convertibles

Topics in Chapter

Types of hybrid securities

Preferred stock
Warrants
Convertibles

Features and risk

Cost of capital to issuers

How does preferred stock differ

from common stock and debt?

Preferred dividends are specified by

contract, but they may be omitted
without placing the firm in default.
Most preferred stocks prohibit the firm
from paying common dividends when
the preferred is in arrears.
Usually cumulative up to a limit.
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Some preferred stock is perpetual, but most

new issues have sinking fund or call
provisions which limit maturities.
Preferred stock has no voting rights, but may
require companies to place preferred
stockholders on the board (sometimes a
majority) if the dividend is passed.
Is preferred stock closer to debt or common
stock? What is its risk to investors? To
issuers?
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Advantages and Disadvantages of

Preferred Stock

Advantages

Dividend obligation not contractual

Avoids dilution of common stock
Avoids large repayment of principal

Disadvantages

Preferred dividends not tax deductible, so typically

costs more than debt
Increases financial leverage, and hence the firms
cost of common equity
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Floating Rate Preferred

Dividends are indexed to the rate on

treasury securities instead of being
fixed.
Excellent S-T corporate investment:

Only 30% of dividends are taxable to

corporations.
The floating rate generally keeps issue
trading near par.
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However, if the issuer is risky, the

floating rate preferred stock may have
too much price instability for the liquid
asset portfolios of many corporate
investors.

How can a knowledge of call options help

one understand warrants and
convertibles?

A warrant is a long-term call option.

A convertible consists of a fixed rate
bond (or preferred stock)plus a longterm call option.

What coupon rate must be set on the

following bond with warrants if the total
package is to sell for $1,000?

P0 = $20.
rd of 20-year annual payment bond
without warrants = 10%.
45 warrants with a strike price (also
called an exercise price) of $25 each
are attached to bond.
Each warrants value is estimated to be
$3.
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Step 1: Calculate VBond

VPackage = VBond + VWarrants = $1,000.
VWarrants = 45($3) = $135.
VBond + $135 = $1,000
VBond = $865.
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Step 2: Find Coupon Payment

and Rate
20

12

-865

I/YR

PV

1000

PMT

FV

Solve for payment = 84

Therefore, the required coupon rate

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

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If after issue the warrants immediately

sell for $5 each, what would this imply
about the value of the package?
At issue, the package was actually worth:
VPackage = $865 + 45($5) = $1,090.
This is $90 more than the selling price.

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The firm could have set lower interest

payments whose PV would be smaller
by $90 per bond, or it could have
offered fewer warrants and/or set a
higher strike price.
Under the original assumptions, current
stockholders would be losing value to
the bond/warrant purchasers.
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Assume that the warrants expire 10 years

after issue. When would you expect them
to be exercised?

Generally, a warrant will sell in the open

market at a premium above its value if
exercised (it cant sell for less).
Therefore, warrants tend not to be
exercised until just before expiration.

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In a stepped-up strike price (also called a

stepped-up exercise price), the strike price
increases in steps over the warrants life.
Because the value of the warrant falls when
the strike price is increased, step-up
provisions encourage in-the-money warrant
holders to exercise just prior to the step-up.
Since no dividends are earned on the
warrant, holders will tend to exercise
voluntarily if a stocks payout ratio rises
enough.
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Will the warrants bring in additional

capital when exercised?

When exercised, each warrant will bring in an

amount equal to the strike price, $25.
This is equity capital and holders will receive
one share of common stock per warrant.
The strike price is typically set some 20% to
30% above the current stock price when the
warrants are issued.

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Because warrants lower the cost of the

accompanying debt issue, should all debt
be issued with warrants?

No. As we shall see, the warrants have

a cost which must be added to the
coupon interest cost.

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What is the expected return to the bondwith-warrant holders (and cost to the
issuer)?

You need to estimate when the

warrants are likely to be exercised and
the expected stock price on that
exercise date.

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The stock (currently $20) is expected

to grow at a rate of 8% per year

The company will exchange stock worth

$43.18 for one warrant plus $25. The
opportunity cost to the company is
$43.18 - $25.00 = $18.18 per warrant.
Bond has 45 warrants, so the
opportunity cost per bond = 45($18.18)
= $818.10.
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Here are the cash flows on a

time line:
0

+1,000 -84

9
-84

10

11

-84 -84
-818.10

19

20

-84

-84
-

1,000
-902.10

1,084
Input

the cash flows into a calculator to

find IRR = 11.93%. This is the pre-tax
cost of the bond and warrant package.
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The cost of the bond with warrants

package is higher than the 10% cost of
straight debt because part of the
expected return is from capital gains,
which are riskier than interest income.
The cost is lower than the cost of equity
because part of the return is fixed by
contract.
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When the warrants are exercised, there

is a wealth transfer from existing
stockholders to exercising warrant
holders.
But, bondholders previously transferred
wealth to existing stockholders, in the
form of a low coupon rate, when the
bond was issued.
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At the time of exercise, either more or

less wealth than expected may be
transferred from the existing
shareholders to the warrant holders,
depending upon the stock price.
At the time of issue, on a risk-adjusted
basis, the expected cost of a bond-withwarrants issue is the same as the cost
of a straight-debt issue.
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Assume the following

convertible bond data:

20-year, 8.5% annual coupon, callable

convertible bond will sell at its $1,000 par
value; straight debt issue would require a
10% coupon.
Call protection = 5 years and call price =
$1,100. Call the bonds when conversion
value > $1,200, but the call must occur on
the issue date anniversary.
P0 = $20; D0 = $1.00; g = 8%.
Conversion ratio = CR = 40 shares.
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What conversion price (Pc) is

built into the bond?
Par value
Pc =
# Shares received

= $1,000

= $25 .

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Like with warrants, the conversion
price is typically set 20%-30% above
the stock price on the issue date.
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What is (1) the convertibles straight debt

value and (2) the implied value of the
convertibility feature?

Straight debt value:

20
N

10
I/YR

PV

85
PMT

1000
FV

Solution: -872.30
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Implied Convertibility Value

Because the convertibles will sell for $1,000,

the implied value of the convertibility feature
is:
$1,000 - $872.20 = $127.70.

The convertibility value corresponds to the

warrant value in the previous example.
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What is the formula for the bonds

expected conversion value in any year?

Conversion value = CVt = CR(P0)(1 + g)t.

For t = 0:
CV0 = 40($20)(1.08)0 = $800.
For t = 10:
CV10 = 40($20)(1.08)10
= $1,727.14.
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What is meant by the floor value of a

convertible? What is the floor value
at t = 0? At t = 10?

The floor value is the higher of the

straight debt value and the conversion
value.
Straight debt value0 = $872.30.
CV0 = $800.

Floor value at Year 0 = $872.30.

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Straight debt value10 = $907.83.

CV10 = $1,727.14.
Floor value10 = $1,727.14.
A convertible will generally sell above
its floor value prior to maturity because
convertibility constitutes a call option
that has value.
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If the firm intends to force conversion on the

first anniversary date after CV >$1,200, when is
the issue expected to be called?

8
I/YR

-800
PV

0
PMT

1200
FV

Solution: n = 5.27
Bond would be called at t = 6 since
call must occur on anniversary date.
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What is the convertibles expected

cost of capital to the firm?
0
1,000

1
-85

-85

-85

-85

-85

-85
-1,269.50
-1,354.50

CV6 = 40($20)(1.08)6 = $1,269.50.

Input the cash flows in the calculator

and solve for IRR = 11.8%.
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Does the cost of the convertible appear to

be consistent with the costs of debt and
equity?

For consistency, need rd < rc < rs.

Why?

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Check the values:

rd = 10% and rc = 11.8%
rs =

D0(1 + g)
P0

+g=

$1.00(1.08)
$20

+ 0.08

= 13.4%
Since rc is between rd and rs, the costs
are consistent with the risks.

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WACC Effects

Assume the firms tax rate is 40% and its

capital structure consists of 50% straight
debt and 50% equity. Now suppose the firm
is considering either:
(1) issuing convertibles, or
(2) issuing bonds with warrants.
Its new target capital structure will have 40%
straight debt, 40% common equity and 20%
convertibles or bonds with warrants. What
effect will the two financing alternatives have
on the firms WACC?
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Convertibles Step 1: Find the

after-tax cost of the convertibles.
0

1,000

-51

-51

-51

-51

-51

6
-51
-1,269.50
-1,320.50

INT(1 - T) = $85(0.6) = $51.

With a calculator, find:

rc (AT) = IRR = 8.71%.

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Convertibles Step 2: Find the

after-tax cost of straight debt.

rd (AT) = 10%(0.06) = 6.0%.

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Convertibles Step 3: Calculate

the WACC.
WACC (with
convertibles)

= 0.4(6.0%) + 0.2(8.71%)
+ 0.4(13.4%)
= 9.5%.

WACC (without = 0.5(6.0%) + 0.5(13.4%)

convertibles)
= 9.7%.
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Some notes:

We have assumed that rs is not affected by

the addition of convertible debt.
In practice, most convertibles are
subordinated to the other debt, which
muddies our assumption of rd = 10% when
convertibles are used.
When the convertible is converted, the
debt ratio would decrease and the firms
financial risk would decline.
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Warrants Step 1: Find the after-tax

cost of the bond with warrants.
0
+1,000

...

-50.4

9
-50.4

10
-50.4
-818.10
-868.50

11
-50.4

...

19

20

-50.4 -50.4
-1,000.0
-1,060.0

INT(1 - T) = $84(0.60) = $50.4.

# Warrants(Opportunity loss per warrant)
= 45($18.18) = $818.10.
Solve for: rw (AT) = 8.84%.
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Warrants Step 2: Calculate the

WACC if the firm uses warrants.
WACC (with
warrants)

= 0.4(6.0%) + 0.2(8.84%)
+ 0.4(13.4%) = 9.53%.

WACC (without = 0.5(6.0%) + 0.5(13.4%)

warrants)
= 9.7%.
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Besides cost, what other

factors should be considered?

The firms future needs for equity

capital:

Exercise of warrants brings in new equity

capital.
Convertible conversion brings in no new
funds.
In either case, new lower debt ratio can
support more financial leverage.
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Does the firm want to commit to 20

years of debt?

Convertible conversion removes debt, while

the exercise of warrants does not.
If stock price does not rise over time, then
neither warrants nor convertibles would be
exercised. Debt would remain outstanding.

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Recap the differences between

warrants and convertibles.

Warrants bring in new capital, while

convertibles do not.
Most convertibles are callable, while
warrants are not.
Warrants typically have shorter
maturities than convertibles, and expire
before the accompanying debt.
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Warrants usually provide for fewer

common shares than do convertibles.
Bonds with warrants typically have
much higher flotation costs than do
convertible issues.
Bonds with warrants are often used by
small start-up firms. Why?
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How do convertibles help

minimize agency costs?

Agency costs due to conflicts between

shareholders and bondholders

Asset substitution (or bait-and-switch).

Firm issues low cost straight debt, then
invests in risky projects
Bondholders suspect this, so they charge
high interest rates
Convertible debt allows bondholders to
share in upside potential, so it has low
rate.

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Agency Costs Between Current

Shareholders and New Shareholders

Information asymmetry: company

knows its future prospects better than
outside investors

Outside investors think company will issue

new stock only if future prospects are not
as good as market anticipates
Issuing new stock send negative signal to
market, causing stock price to fall
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Company with good future prospects

can issue stock through the back door
by issuing convertible bonds

Avoids negative signal of issuing stock

directly
Since prospects are good, bonds will likely
be converted into equity, which is what the
company wants to issue
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