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    Cadungog - Tumbaga - Virtudazo - Sta Iglesia

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    Jovanie Cadungog
    This document discusses various types of preferred stock and convertible securities. It provides details on: 1) The key characteristics of preferred stock, including that it has non-voting rights, lies between equity and debt, and dividends can be cumulative or non-cumulative. 2) The advantages and disadvantages of preferred stock from the perspective of both the issuing corporation and corporate investors. 3) How convertible securities like convertible bonds can be exchanged for common stock at a specified conversion price or ratio, and how these terms may change over time. 4) The component costs of bonds issued with warrants or convertible features, and how these hybrid securities allow companies to appeal to broader investor groups.

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    Cadungog - Tumbaga - Virtudazo - Sta Iglesia

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    Jovanie Cadungog
    123 views40 pages
    This document discusses various types of preferred stock and convertible securities. It provides details on: 1) The key characteristics of preferred stock, including that it has non-voting rights, lies between equity and debt, and dividends can be cumulative or non-cumulative. 2) The advantages and disadvantages of preferred stock from the perspective of both the issuing corporation and corporate investors. 3) How convertible securities like convertible bonds can be exchanged for common stock at a specified conversion price or ratio, and how these terms may change over time. 4) The component costs of bonds issued with warrants or convertible features, and how these hybrid securities allow companies to appeal to broader investor groups.

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    Hybrid Financing

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    This document discusses various types of preferred stock and convertible securities. It provides details on: 1) The key characteristics of preferred stock, including that it has non-voting rights, lies between equity and debt, and dividends can be cumulative or non-cumulative. 2) The advantages and disadvantages of preferred stock from the perspective of both the issuing corporation and corporate investors. 3) How convertible securities like convertible bonds can be exchanged for common stock at a specified conversion price or ratio, and how these terms may change over time. 4) The component costs of bonds issued with warrants or convertible features, and how these hybrid securities allow companies to appeal to broader investor groups.

    Copyright:

    © All Rights Reserved
    Download as PPTX, PDF, TXT or read online from Scribd
    Download as pptx, pdf, or txt
    123 views40 pages

    Cadungog - Tumbaga - Virtudazo - Sta Iglesia

    Uploaded by

    Jovanie Cadungog
    This document discusses various types of preferred stock and convertible securities. It provides details on: 1) The key characteristics of preferred stock, including that it has non-voting rights, lies between equity and debt, and dividends can be cumulative or non-cumulative. 2) The advantages and disadvantages of preferred stock from the perspective of both the issuing corporation and corporate investors. 3) How convertible securities like convertible bonds can be exchanged for common stock at a specified conversion price or ratio, and how these terms may change over time. 4) The component costs of bonds issued with warrants or convertible features, and how these hybrid securities allow companies to appeal to broader investor groups.

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    CADUNGOG | TUMBAGA | VIRTUDAZO | STA IGLESIA

    • Preferred stock has non-voting rights

    • Preferred stock lies between equity and debt

    • Viewpoint of Issuing corporation (tax disadvantage)


    Preferred Dividends are non-deductible

    • Viewpoint of Corporate Investor (tax advantage)


    Preferred dividends are deductible
    • Cumulative
    Unpaid preferred dividends must be paid before dividends can be
    paid on the common stock shareholders.
    Arrears do not earn interest

    • Non-cumulative
    In contrast with cumulative
    • Preferred stock can be Callable or Puttable
    • Callable – issuing corporation has the option to call the preferred stock

    • Puttable – Investor has the option to return the preferred stock

    • Other types of Preferred stock


    Adjustable Rate Preferred Stock – dividends re tied to the rate on treasury
    securities

    Market Auction Preferred Stock – interest rates are reset through auctions,
    • Advantages (issuers viewpoint)
    1. Preferred dividends cannot force a firm to bankruptcy

    2. It avoid the dilution of common equity that occurs when common stock is
    sold.

    3. It reduces the cash flow drain from repayment of principal that occurs with
    debt issues.
    • Disadvantage
    1. Higher cost of capital

    2. It increases financial risk and hence the cost of common equity


    Leasing

    • Types of Leases:
    • Sale-and-leaseback arrangements;
    • Operating leases;
    • Financial, or capital, leases.
    • Often called off balance sheet financing.
    Lease vs. Borrow-and-purchase Analysis
    Data:
    • New equipment: cost = $10,000,000, life = 5 years
    • Salvage value or purchase option = $715,000.
    • Annual maintenance = $500,000
    • Tax rate = 40%.
    • Loan interest rate = 10%.
    • After-tax cost rate=10%(1 – T)=10%(1 – 0.4)= 6%.
    • Annual lease payment = $2,800,000
    • 5-year MACRS class life, The MACRS depreciation rates are 20%, 32%,
    19%, 12%, 11%, and 6%.;
    Depreciation schedule

    Depreciable basis = $10,000,000


    MACRS Depreciation Depreciation
    Year Rate Expense Tax Savings
    1 0.20 $2,000,000 $ 800,000
    2 0.32 3,200,000 1,280,000
    3 0.19 1,900,000 760,000
    4 0.12 1,200,000 480,000
    5 0.11 1,100,000 440,000
    6 0.06 600,000 240,000
    1.00 $10,000,000 $4,000,000
    Cost of Owning Analysis
    Cost of Leasing Analysis
    Cost Comparison

    • Net Advantage to Leasing (NAL) = PV cost of owning – PV cost of


    leasing

    • NAL = $8,023,000 - $7,611,000


    = $412,000

    • Since leasing costs less, so lease should be done.


    Other Factors That Affect Leasing Decisions

    • Estimated Residual Value

    • Increase Credit Availability


    – long term option from a company that gives the holder the
    right to buy a stated number of shares of the firm’s common
    stock at a specified price for a specified length of time.

    – generally distributed with debt.


    In 2012, Infomatics Corporation
    $50 million of 20-year bonds – would require 10% coupon rate
    8% coupon rate – 20 warrants with each $1,000 bond

    Each warrant having 10-year life and entitling the holder to buy
    one share of common stock at an exercise price of $22 per
    share at any time during their 10-year life.

    Stock was selling $20 per share at the time and warrants would
    expire in 2022 if not exercised.

    Warrants are long term call options that have value


    INITIAL MARKET PRICE OF A BOND WITH WARRANTS
    Present Value of Bonds

    PV of 1 at 10% for 20 periods is 0.149


    PV of ordinary annuity of 1 at 10% for 20 periods is 8.514

    PV of principal ($1000 x 0.14864) $148.64


    PV of of interest payments ($80 x 8.51356) $681.08
    $829. 72
    PV = $829.72 ≈ $830
    Price paid for bond = Straight-debt Value of
    +
    with warrants value of bond warrants
    $ 1,000 = $830 + $170

    Implied value of each warrant $170/20 = $8.50

    Detachable warrants – a warrant that can be detached


    from a bond and traded independently of the bond.
    If bonds and warrants were priced correctly,

    Bonds = $830 Warrants = $8.50 Package = $1,000

    If bonds and warrants were priced incorrectly,

    Bankers can estimate the straight debt value accurately but it


    is more difficult to estimate the proper value of warrants.
    For example, if estimated value is too low, $6
    170/$6 = 28.3333

    When it is offered to the public, price will rise from $1,000 to:

    Market price of bond = $830 + $8.50 (28.3333) = $1,070.83

    Thus, firm would sold for $1,000 instead of $1,070.83


    More warrants would be outstanding than necessary;
    Ifwhen warrants
    the value are exercised,
    is overestimated, $10 there would be more
    dilution of the original shareholder’s equity than
    necessary.
    The issue would fail – it could not be sold at the $1,000 offering
    price and the firm would not obtain the funds it needed.
    Major difference between call option and warrants

     When call option is exercised – stock provided to option


    holder comes from secondary market
     When warrants is exercised – stock provided are newly
    issued.

    As a result, exercise of warrants dilutes value of original


    equity, which could cause the value of original warrant
    to differ from value of similar call option.
    USE OF WARRANTS IN FINANCING

    • Small, rapidly growing firms use warrants as “sweeteners”.


    • A hybrid security that provides financial manager with an opportunity to
    expand the firm’s mix of securities and thus to appeal to a broader group
    of investors.

    3 conditions which encourages holders to exercise their warrants:

    1. If the warrants are about to expire and the market price of the stock
    is above the exercise price.
    2. If the company raises the dividend on the common stock by a
    sufficient amount.
    3. Warrants sometimes have stepped-up exercise price.

    Stepped-up exercise price – an exercise price that is specified to rise


    if a warrant is not exercised before a designated date.
    COMPONENT COST OF BONDS WITH WARRANTS

    When Infomatics issued its debt with warrants, the firm received $50 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 pretax cost of the money would have been 10% if no warrants
    had been attached; but each Infomatics bond had 20 warrants, each of
    which entitled its holder to buy one share of stock for $22. What is the
    percentage cost of the $50 million? As we shall see, the cost is well above
    the 8% coupon rate on the bonds.
    Note when the warrants expire in 10 years from now, stock is expected to
    sell for $51.87, given the $20 intial price and the 10% expected growth
    rate:

    𝑃10 = $20 (1.10)10 = $51.87

    Therefore, investors could exercise their warrants and receive one share of
    stock worth $51.87 for each warrant exercised.

    Thus if investor held the complete package, realized profit in Year 10 would
    be = $51.87 - $22 = $29.87 on each warrant.

    Since each bond has 20 warrants attached, investors would have a gain of
    20 ($29.87) = $597.40 per bond at the end of Year 10.
    0 1 9 10 11 20

    -1,000 80 80 80.00 80 80
    597.40 1,000
    677.40 1,080

    IRR = 10.66% which is investor’s overall pretax rate of return on the issue.
    This return is 66 basis points higher than the return on straight debt.

    The issue is risker to investors..


    1. Part of return is expected to come in the form of stock price appreciation.
    2. Part of return is riskier than the interest payments on the bonds.
    CONVERTIBLES SECURITIES

    are bonds or preferred stocks that, under


    specified terms and conditions, can be
    exchanged for common stock at the
    option of the holder.
    CONVERSION RATIO AND CONVERSION
    PRICE
    Conversion Ratio (Cr)
    the number of shares of Conversion Price (Pc)
    common stock that are
    obtained by converting a the number of shares of
    convertible bond or share common stock that are
    of convertible preferred
    obtained by converting a
    stock
    convertible bond or share
    of convertible preferred
    stock
    Silicon Valley Software Company’s
    $1,000 par value convertible
    debentures issued in August 2008
    where the holder can exchange a CONVERSION
    bond for 20 shares of common stocks. RATIO

    AND

    CONVERSION
    PRICE
    • Like a warrant’s exercise price, the
    conversion price is typically set at from
    15% to 30% above the market price of
    the common stock at the time the issue
    is sold.

    For example, the 2008 convertible


    debentures for Breedon Industries are
    convertible into 12.5 shares until 2018;
    into 11.76 shares from 2019 until 2028;
    and into 11.11 shares from 2027 until
    maturity in 2038.
    The conversion price thus
    starts at $80, rises to $85, and then goes
    to $90.
    Other Factor That Cause Change
    In Conversion Price And Ratio

    -Stock splits
    -Stock dividends
    -Sale of common stock @ Price
    below Conversion price
    The Component Cost Of
    Convertibles
    Use Of Convertibles In Financing

    Two Important Advantages (issuers standpoint): Disadvantages (issuers standpoint):


    1) If the stock greatly increased in price, the firm
    1) Convertibles, like bonds with warrants, offer would probably find that it would have been
    a company the chance to sell debt with a
    low interest rate in exchange for a chance better off had it used straight debt in spite of its
    to participate in the company’s success if it higher cost and then later sold common stock
    does well. and refunded the debt.

    2) Convertibles typically have a low coupon


    2) Convertibles provide a way to sell common
    interest rate, and the advantage of this low-cost
    stock at prices higher than those currently
    prevailing. debt will be lost when conversion occurs.
    3) If the company truly wants to raise equity
    capital and if the price of the stock does not rise
    sufficiently after the bond is issued, the company
    will be stuck with debt.
    Convertibles Can Reduce Agency Costs

    -Gains to shareholders from taking on high-risk


    projects must be shared with convertible
    bondholders. this sharing of benefits lowers agency
    costs.
    Convertible debt Warrants

    • Straight debt with non • Straight debt with detachable


    detachable warrants. warrants.
    • Conversion of convertibles • Exercise of warrants brings in
    results in replacing debt with new equity capital.
    equity in firm’s balance sheet. • Most warrants are not
    • Most convertible issues callable, so firms must wait
    contain a call provision that until maturity for the
    allows issuer to refund the warrants to generate new
    debt, which could force equity capital.
    conversion if the conversion • Typically have much shorter
    value exceeds the call price. lives and typically expires
    • Typically have much longer before accompanying debt
    lives. matures.
    • Less risky. • Firms that issues bonds with
    • Lower flotation costs. warrants are smaller and
    risker.
    • Require higher flotation costs.
    Basic EPS - Ebit/outstanding shares

    Diluted EPS

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