The growth in the use of various forms of hybrid finance has

complicated the financial process, and has provided no real

benefit the companies and investors

The use of hybrid finance has been a subject of considerable debate in

corporate finance and still continues to challenge the researchers to come up
with reasonable explanations about why and when companies consider its use,
and what are the potential benefits and risks that it involves. The aim of this
paper is to discuss different forms of hybrid financing such as warrants,
preference shares, convertible bonds, convertible preference shares, callable
and puttable bonds, while critically assess their role in the current economic
climate.

Hybrid securities represent a combination of both equity and debt, and are
widely used by corporations and banks in financing as they could offer
flexibility to both firms and investors. An example of a form of hybrid finance
are warrants. Warrants are call options giving the holder the right, but not the
obligation, to purchase shares of common stock directly from the company at a
fixed price within a specific time frame. When they are exercised the number of
shares outstanding increases and as a result, fresh cash comes into the firm.
The reasons why and when firms issue warrants in seasoned equity offerings is
an important area of research for corporate finance, however the evidence to
support the implications and conclusions are still quite mixed. Warrants can be
attached to loan stock, thus providing loan stock holders with an opportunity to
participate in the future growth and propensity of the company. As a result,
they act as a ‘sweetener’ to the investor. Whether or not warrants give rise to
additional finance by holders taking up their option to purchase, depends on
the future trading success of the firm and on the market price of its ordinary
shares compared with the exercise price (Neale & McElroy,2004). Thus,
managers will work harder in order to increase the share price, so that
investors can exercise their warrants and get the extra shares.
One of the potential reasons why firms issue warrants is closely connected to
the agency cost hypothesis (Schultz , 1992). According to his research firms
issue IPOs packaged with warrants in order to mitigate agency costs, by
reducing the probability of the surplus cash being invested in negative net
present value projects. As stated in the article managers have strong
incentives to invest in not profitable project in order to retain their jobs.
However, when issuing units rather than shares, the management receives
only part of the total cash needed to invest in the project and no cash flow is
left to be squandered. As a result, managers are more motivated and have an
incentive to insure the successful survival of the project, so that the stock price
rises enough to allow exercise of the warrants. Consistent with this theory firms
that choose unit IPOs tend to be smaller, have fewer assets and are less likely
to remain in the business than firms that issue only shares. Moreover, warrants
carry a certain risk. When they are exercised they can dilute the earnings of
each existing share and thus lower the share price. The signalling model
developed by Chemmanur and Fulghieri (1997) is essential when discussing
why companies issue warrants because it analyzes information asymmetry and
managerial risk aversion. In general, issuing new stock send negative signals
to market, causing stock prices to fall. This could be avoided if outside
investors issue stock ''through the back door'' by issuing warrants. One of the
predictions Chemmanur and Fulghieri found is that in unit IPOs and in IPOs
without warrants, the percentage in underpricing is increasing in firm riskiness,
which is also stated by Schultz (1992). The signalling model argues that in a
market characterized by asymmetric information, where company knows its
future prospectus better than outside investors, high quality and risk
companies will issue a packaged of underpriced equity and warrants. Low risk
firms, on the other hand, will issue underpriced equity alone.
As a whole, it could be argued that warrants, as a form of hybrid finance, are
issued for two main reasons. First, to lower agency cost by reducing the
probability of cash invested in not profitable projects, and second warrants with
underpricing tend to be signalling mechanism for companies to show their
good value and potential under asymmetrical information in the market. Still
there are general factors such as changes in legislation, interest and
exchanges rates, volatility and economic conditions that could affect negatively
any stock market investment. For instance, as Schultz (1992) discussed in his
research ''firms issuing unit IPOs are far more likely to fail than those issuing
shares alone. '' thus when warrants are exercised the number of shares
outstanding will grow, reducing the stock price. Moreover, the
expected negative impact, dilution, will make warrants less valuable
compared to other call options.

Another form of hybrid finance are preference shares. An advantage is that

preferred dividends are paid before ordinary share dividends, and preference
capital precedes ordinary share capital when assets are sold in liquidation and
the sale proceeds are distributed. However, in the UK preference share do not
normally carry voting rights and they do not qualify for tax relief. Significant
use of preference shares is quite rare nowadays, largely because the lack of
tax shield. However, preference shares represent a considerable portion of
Canadian capital markets, over 5 billion new preferred shares were issued in
2005. It could still be argued that preference shares tend be more attractive to
risk-averse investors who are aiming to get a relatively reliable income stream
and are not very interested in participating in company's affairs. A hybrid type
of preferred stock are convertible preference shares, which allow preferred
stock to be converted into ordinary shares usually at some specific date,
having quite strong equity characteristics. The option to convert into common
stock gives the investors the opportunity to gain from an increase in share
price, but they have to consider whether the higher yield of convertible
preferred stock compensates them for the higher risk of an equity security.
According to Dunning and Abhyankar (1999) the issue of convertible
preference shares and convertible bonds has negative effects on shareholder
wealth.

In the current economic climate the form of hybrid financing that is most
popular are convertible bonds. As stated in many recent financial articles
the market for convertibles is making a strong comeback. Why companies
issue convertible debt is examined in both theoretical and empirical corporate
finance literature, but still there are pros and cons that investors should
consider when making a financial decision. A benefit is that convertible bonds
have the option to change and turn into common stock, which makes them
quite attractive for many investors. A current market research by Veld, Horst
and Loncarski (2008) suggests that convertibles appeal to different businesses
because of their flexibility in matching the financing needs of individual firms,
and the investment needs of different investors.
Furthermore, convertibles are particularly suitable for companies facing high
risks but strong potential growth because they offer investors the possibility of
participating in future propensity.
The financing cost of a convertible bond issue is attractive because since there
is a conversion option, the coupon is lower than on a traditional bond. Issuing
convertibles sends a better signal to investors than the issue of common stock.
According to Stein (1992) company's willingness to issue a convertible and take
the chance that the stock price will rise enough and then be converted also
signals a management confidence for the future prospectus of the
organization. Another rationale for the issuance of convertible debt by a firm
relates to agency costs. Convertible bonds can resolve agency problems
associated with raising money. For instance, shareholders prefer to invest in
high risk projects which is in conflict with bondholders 'preference for low risk
projects. Undoubtedly, convertible debt allows the bondholders an option on
converting their bonds to the underlying stock and consequently, mitigate their
concerns about risk shifting. Stein (1992) argues that if firms know that their
stock is undervalued, they might prefer not to issue equity but will also want to
minimize the distress costs that come along with debt issuance. The evidence
Stein's model suggests is that convertibles resolve this financing problem
through ‘backdoor equity’. It forces investors to exercise their option early in
order to benefit from lower distress costs than debt financing and also smaller
undervaluation compared to equity financing.
Without the option to convert, lenders might demand extremely high interest
rate to compensate the probability of default. If the share price performs well
and becomes more than the face value investors will convert the bond. In this
case, the firms sold the shares at a much better price than they could sell.
However, the bondholders have the decision to convert or not. The issue of
convertibles may amount to a deferred stock issue. Thus, if the firm needs
equity capital, convertible bond is an unreliable way of getting it.
A potential risk and downside for companies is that payment of interest must
be paid every year and the principle requires repayment if the holders do not
convert. The disadvantage for shareholders is quite similar to warrants. The
prospect of diluting not only the earnings per share of its commons stock but
also the control of the company. For instance, if a large part of the issue is
purchased by one person, the conversion might shift the voting control of the
company which could create significant problems for small businesses who just
gone public. Another complication arises because conversion increases the
number of outstanding shares. So, exercise means that each shareholder is
entitled to a smaller proportion of the firm’s assets and profits. This problem of
dilution never arises with traded options. (Corporate finance, 8th ed., Brealey,
Myers, Allen, 2006)`
Overall, there are a couple of arguments as to why firms issue convertible
bonds. The lower financing costs is attractive to young, high-growth firms that
may not be able to afford the costly issuance of equity. Convertibles are also
useful for new firms as they can protect against mistakes when evaluating the
risk of the issuing company as opposed to when one is issuing straight debt.
Convertible debt can also mitigate agency problems associated with raising
capital.

As future share prices cannot be predicted in an efficient market, hence it

cannot sufficiently be argued whether issuing convertible bonds is better or
worse for a firm than issuing straight equity.

A recent study suggested that ... another research on hybrid financing considering
convertibles and warrants is ..
Undoubtedly,
To summarize, Overall
the evidence they produced suggest that ...

- In conclusion, it therefore can be seen that there are a couple of arguments as to why firms issue
convertible bonds.
identify issuer motives

Hybrid securities are examples of long-term financing strategies involving debt securities

that convert to equity securities at a specified time in the future. Hybrid securities provide financing

for investments that have a long-term value.

In summary, financial theories are basically ones concept of what would

make companies run at its highest efficiency. Theories are intended to be a

way of making companies grow and is a means of reshaping industries, in other

words, they are motivating forces. Without the theories, businesses would not

advance and the economy would be low.

There are many reasons why corporate management might choose hybrid
financing and why recently, there has been a boom in issuing convertible debt
and how the market is making a strong comeback.

Bibliography:

Billingsley, R.S., Lamy, R.E. and Thompson, G.R. (1988). The choice among debt, equity and
convertible bonds, The Journal of Financial Research, 11(1), pp 43-55.

Stein, J.C. (1992). Convertible bonds as backdoor equity financing, Journal of Financial
Economics, 32, pp 3-21.