S*ek, i:
r
trre$errcq! #yEsnEd Fece*aeeErcg: Werrsert*" *srd C@**srertEfues
hc use of corveriible securitiesbonds or prcfcrred stocks that can be exchange.lfor common stock of thc issuing corporation-has soart'd durht thr last deca(te. Why do companicliLrse convert' ibles so heavilv? To .rnswer ihis ctucstiqr, first recognize that converlibles f.irlually ratcsthat arc lol\,erlhan ahlayshavecouporr rvould be requircd on siraighi, nonconvertible bcnrds prefcrrd stocks.Therefore,if a or compiny raisesXi100 million by issujng con' vcrtible bonds, its interest expcnse will tre lolver than if it financcd rvith nonconveriible debt. But rvhy wollcl inlcstors bc willing to bu)' such.rbonLl,Biven its b{,er inlerestpnyments?Thc ans{er lics in the conversior fea ture if thc price of the issucr's stock riscs, ihe converiible bondholder clrn cxchangc it Ior sbck nnd rcalizc a capital gain A convertiblebond's valuc is basedpartly on inierc$tratesin ihc econo y, partly on tLre issuin8conpanv'srq+rlarbond risk,ard paftl)' on the price of the sbck into N'hich it is con vertible. In conirasi,a nonconvertibleboncl's pricc is based cntirely on intcrest ratcs a d companv risk. Thorcfore,convcrtibles'prices are much nore lolafilc than rc$lar bonds' prices, \^,hichmake convcrtiblcsriskier than reported siraight bonds. An aticle in ir(r'/rcs jncrcases iI that if a corrpany'sconlmorrsk)ck value, the reiums on its convortiblesalso rise, but bv only 70ti of ihe siock's perccntage the incrense. vcver iJ the sbck declincs, conFl vertiblc wi]1declineblr only 50"/" tho siock's of dechre. Thus, r'hiie convcrtibles arc more risk!, than straight bonds, thc), are lessriskt ihan commol sbcks. To illusirate, colsider Arnazon.com, which inJanuary l99q issuedljl.25 billion ofcon vertible bonds, thc largest srlch offeflntsLn hisk)ry. ADrazon'sbonds had a par vallreof !j1,000 and a 4.75% coupor ratc. During 1999Amazor's conlertibles took thcir holders on a r{'ild ride. Amazon's stock rose about 70% durnrg the first four months, causing its converiiblcs io risc to li],500. During the ncxt four months, the stock lost nrore than 60% of its value, to a lcvel 30% below where it had bccn tradjn8 rvher rhe Jur,\.rrihl.. sc'e i.-rr'rl. Thr. r.ru.ed thc convertiblcs' price to be cut in half, to tj750. Three nonths later Amazon's stoc( rebo nded, and its convortibles oncc igain tradod above 51,500.But thc)' droppcd once more, and by year-cnd 1999,the converiibles issuc price. Thus, rvcre back io their $1,0U0 sorreone holdint lhe convertiblcs for the entirc l,ear rvould have ended up close to where hc or she siarted, with a toial rcturn just shy of the 4.7570 coupor rate, but probably also wiih a bnd caseof hearib rn and a fe\,gray hairs.
s.vr..r John Go,hom, tilreSb.ls,' Forbe5, 0e.ember 1999,200. 27, "Cl\iclsn
743
Inprevious chapters we examined common stocks and various types of long{erm debt.In this chapter, we examine three other securities used to mise tong+erm caplta\ 11) prct'etaed stocft, which is a hybrid security ihat represents a cross betweendebt and common equity; (2) u,ntfints, which arc drivative secudties issued firms to facilitate the issuance someother type of security,and (3)corby of irllibles, which combinethe featuresof debi (or preferredstock)and warrants.
e-IesouIce
Therexlbook!WBb site contoins Er.6/ fi e lhat oi rhechop|e,'scolculolons. Thefile Io, i5 choprs it
fMl2 Ch2l bl KnrL,
2l.l Preferred Stock
lreferled etock is a hybrid-it is similar to bonds in some respects and io comnon stock in other ways. Accountants classify prefe ed stock as equity, hence showit on th balance sheet as an equity account. However, Irom a finance per spectiveprefered stock lies somewhere berween debt and common equity-it imposes fixed dlarge and thus increasesthe firm's financial leverage, yet omiF a tint the prefened dividend does not for're a company into bankruptcy. Also, unlike intereston debt, prefelred dividends are not deductibleby the issuirg corporation, preferredstockhasa higher costof capitalthan debi.We fi$t describe so thebasicfeatures o{ prefered, after which we discuss the i}?es of pfefered stock andihe advantages and disadvantages prelered siock. of
ond we encouroge you to open lhe fil6 oid {ol'
Basic Features
Prefend stock has a par (or liquidatint) value, often either $25or $100.The dividend issiatedas either a percentageof par, as so many dolla$ per share,or bodl ways. For example, severalyears ago Klondike PaperCompany sold 150000sharesof !j100par valueperpetual prIerred stock for a total o{ $15milion. This prcfened had a stated : annual dividend of $12per share, the preferd dividend yield was $1219100 so 0.12, 12%,at the time of issue.The dividend was set when the stock 1^'as or issued; it rvill not be changed in the future. Thereforc, if the requircd rate of return on prefened,r" changesfrom 12%after the issuedate---asit did-then the market price of theFefefied stock will go up or down. Currently, re for Klondike Paper's preferred : is97d, ihe price of the prefenedhasdsen from $i100 $1210.09 $133.33. and to lf ihe preferreddividend is noi eamed,the companydoesnot have to pay it. However, most pre{ered issuesare cumulative, meaning that ihe cumulative total ofunpaid preferreddividends must be paid beforedividends canbe paid on thecommonstock.Unpaid preferfed dividends are called arrearages, Dividends in arrearsdo not eam intercsti thus, arearages do not grow in a compound intere6tsens-they only grow from additional nonpayments of the preferred dividend.AIso, many preferred stocks accrue arrearagesfor only a limitd number of years, say, 3 years, meanirrg that the cumulative feature ceases after 3 yeals. Howeverthe dividends in auee$ continuein forceuntil thev are paid. frefcrred sto,I normally hasno vol:1g.ight-.Howevcr. mo.t prererrcd iicuestipulate that the prefened stockholders electa minority of the directors-sat can tiree out of tn-if the preferreddividend is passed(omitted).Someprelerreds evenentitle their holdeG to elect a mai)riry of the board. Although nonpa).rnent of preferred dividends will not banlcupt a company, corporationsissue preferred with every intention of payilt the dividend. Even if passingthe dividend does not give the prefened stockholders control of the compan, failure to pay a prefered dividend predudes paymert oI common dividends. In addition, passin8 the dividend makes it diJficult to raise capital by selling
744
Hybrd F non.,ng: Prele'ed Srocl, wo(on,3. ond Convedibles
Jg; *J
Suppose yo!r cohpony needs coshro linonceo sure s il1er e' pols i o 1 . I o q e v e r..ts o rd .o v e ro n r rorb bid ony oddiilonol botrowing,ond ihesecovenonrs olso p.ohibii the poymenrof cdsh diyideid5, which rulesoui convenrionol preferredsrock lo moke nror tersworse, the compony's slockprice is rrod ng ieor ils 52.week low, so yo! don'r woni io issle new common siock. s ihere ony woy yo! con roise lhe Twoconipo niescomeup wlih lnnovoiive oisweB niemdioComm!nicorions Corp issued $300 millon of - hor c eob l e e fe (e d .to .l v i L o p o l r.rt i l p | . d lP lKd v dq d ' h e 1 3 .)' , d . d -.d 5 p o l o bp i , l odditionol shores the prefered stockrotherthon n of cosh.Iherefore, lhis innrumerl provided Iniermedio wiJhlhe coshit needed sli compledwith ihe bono yet covenoik In oddirion,,he exchongefeor!.e ollows liiefmedio ,o .oiverr rhe prefe(ed siock into debr when irsf roncio siiLrdiion mproves ihe poiniwhere ro ihe debl covenork dre no longerbinding. S i mi l orl y, exi elC ommui cori oi si ssued N $150 mlllionof onorherfi6ilime eversecurily, zero co!pon converlibleprefetredsiock.The slockhod o ls-yeor moturiry, $98 moiuriiyvo ue per shore,ond o $26 o per shore issle price, giv ig ii o y eld of 9 25% or lhe time ol i$ue Becolse ii isn'rdebi ond i doesn't po/corpon, rhe.e" Jr,l ovo ded l -F A di .' or Nexrelt debtcovenonk.Theprefe(ed siockcoi o so be cofverled inlo comnroi stock,ond the prefeneo siockholders exercise oprion if Nexlels siock wi rhk eiioys o shorp increose
Sour.dt !n Sprilgsreel,TokeY.rPK," CFO, De.ember1997, p 30roid.l6eph Mccollert 'Les or More rhonZe,o,'CFO
I
For updores, io htip:// go tinonce,yohoo,coh ond gei quores DDPA, Du lor
bond yied, 6e rheb.nd
boncls, an.1virtuallv impossiblcto sfll more preFcrrcd conlDron or slock exccplal ro.k botkrn |rices. llo\r,ever;h.rvirrgprcfcrcd sbck ouistandingdo0sgive a inm the chancek) overc('meits difficulti!-if bo'rds hrd been us.'d xrstencl pr. of forc.:t siock,:r compnnvco!ld bc forcedinb b.rnkruPtcy beftno it could straiilhten our iis protrloms. Trrls, frot thr"Jit:J,t)trhltaftltLissltittsto"l\)rlttinti.thltncdst..kit [,ssrrshT ihtrr l,olds Ilowcvcr ior nn investof preferredsbck is iskicr than bonds: (l) I'reicfred sn)ckholclrrsclajrns.rresubordhatcd to th(,seofb(m(lholdcrs nr tlre fvcnt ol lq riidntion, and (2) bondholdefsdrc m(rrelikelv to c(ntnrue reccivnrgin.o t dur nrg harc:t linrcs than arc prc'lerredlk)ckhddofs. Accorclindy, irlvcsh)rsre.luirea hi8hcr after inx rate of rctun on a given ftjn's prelcrrcclstock thnn on iis bonds Howver sincc 70e;of pfeictre.i Llnidends is exempt toom.orporatr inxcs,fr fcrrod stock is attrnctivc n) corpornte nrvosbrs. Indced, high-gr.tLlcprctlrred sh)ck,on avorage,scllson .r loucr pre tar yjol(t basis than lri8h-gradpbonLls. As nn o\ampl(', Du Porrt'! 3.51iciiv cn(i pret(.rrcdsto.k h mid-2006hicln pricc oi for lj{r7.52, i market yield ol rbolr! 5.l8%. Du l,oni's l( g-terli bonds tha! nrntur in 2(128 proli.lcd .r vield of 5.5.1ft,or 0.36 pcrcerrl.gepoilts rr(r" than ils prc lerred. The h\ treahnentaccouniedfor tiris differenlkrl; ih.,{7cf n,r vi./.1b .orporutc invc'siors$,nsgreakr on ihe prcferrdsbck than on ihe bonds.r Abotlt hiif of.rll prefcrcd slock issuedin recert vears hns be(n conleriiblc rtlF,r lrl! \1.1,n2.(,, ,ir* lItrnrt,,'rllFd r-.u,.1 'r.. i l,',\, million of mand.rtorycoLrvertiblc preferfcd snr.l( lvith .r 7,/"arnual .:lividcnd Sjs(l(l r.lt. Theissue nlirrdatorilv is convcrtible trctr!rcnappi)\iDMtely nrto 25,1nrllli(nl and :ll:l illiolr sh.res.Colr\criibics nrc ctis.Lr!5e.l iengih in Sectron rt 1i.3.
Ilr e o lr e r r o xycd o n o 5 l,r ' !b .id r .o.orpororenvei ori ni re34.:m.gi r.rorrorcbro.l er 55J4:;i t Il 3 6 6 ' . r h e o r kr o r yicr d o ' o 5 r 3 ' .p,el etredn.t (030J1o3r)l 55l 3'"(r E H ed,erl =513".1 ,1651; Also i.rc thol.r ow prchibtr lrm5 from $u r! debr dirlrhen B no rhe pr.ceedsb pr.lrare cnorhcr fnm'Jp,efere.lio.| f dehr 5 trlen for slo.t pur.hoses lhei rre To.r riv de;d exdr on i v. tad rhn p,ov 5 o, s d sg icd to p cv ilo fn m to n e n g o g nO i 1ax o,bi oee'u!nq rardeJrrbe dchrb pur.hoscorgayr.r
Prele(edStock
745
*+'-t
Wol Street's "finoncol enginee6" orc consiontly try' ing t o dev eop n e w s e c u rl l i e s ,h o tp p e a ll o i s s l ers and lnv es lor sn th e mi d 1 9 9 0 sGo l d n i o n a c h s . S ue ored o specio lype of prefe ed srockwhose divi' dendsor e dedu c u b efo r $ e i s s u i n g mp o n y /lu! .o r l. r a- e, I d" d . rb l - l !6 6 .6 L i a Io d 6 ' .o er o v o' ieiyof c oorf!l ro me s ,i n c l u d i nM IPS(Mo d i fi ed g I nc om e P r ef er r e dSe c !ri i l e s ),A U IP S l o u o r,e ry li.ome Preleffed Securitles), TOPIS(Tru, O'ig ioied Prefeifed Sioc[), ofd OU DS (auorrery licome Debr - L- \ o ,p o o l o sl o ro rl .' o o ." ' o p i ' i- ) iol lihe " por ent" )e s i o b i s h e s tru t, w h i c h l $ u es o lixed dividendprefetred slock.The porentthenlssues bonds(o' debi of somerype)to lhe irust,ond the irust poys tor the bondswiih lhe cosh roisedfrom rhe so e of preferred. ihol poini, ihe porenthqs the cosh it Ai needs,rhe trusthods debi issled by lhe porent,ond the invesiingpublic holds preferiedsrockissuedby lhe lrusl.The porenrrhenmdkeslnlerest poyments lo lhe irust,ond ihe irusi lses lhol incometo mokerhe prefered divldend poymenh. Becouselhe porent compony hos issueddebt, its interesipoymenisdre f ihe dividendscould be excfuded from roxooe i.cone by corporoielnvesto6,this prefetredwourd reo ly be o greol deol-the issuercolld deduc he inieresi, corporcleiFvetorscou d exc ude moslo{the div dends,ond the RSwould be rhe oser.Ihe corpo role porenidoesgel lo deductthe interest poid to ihe h us i,bul I RS d o n o i o l o w th e d i v i d e nds ' eg !l to o n s o on thesesecuriiies l ibe excluded Becouse ,here s oiy o.e dedlciion, why ore ihesenew securllies oitroctive? The onswer is os ,o ows: (l) Becouse porent conrpory geh to toke lhe the deduclion,ils cost ol furds from ihe prefered is rf(l T ) , ius ios l r w o u d b e i f i r u s e dd e b i . (2 )The poreir genefoiesrox sdvings,and it con thusofford lo poy a re otvey high roie on irlsrreoted prefetreo; ihoi ls, lr con poss o. sonre ot lis lox savlngslo invesloFio indlce ihem io bLryihe new seclriiles. (3)Tfe primorypurchoser ol ihe p,efe(ed are Iow tox-brocketlndivlduals ond loxexempr instllulions slch qs pension lunds. For such purchosers,noi bei ns obe ro excude rhe dvi dend from i oxobl e incomeis unimporianl. Due io lhe dlfferefliol lox (4) rotes,i l re onangemeni resuh i n ner i dx sovi ngs. Comperilion copiiol morkelsresurs in o shdringoi in the sov igs belweenlnyestots ond cofpororions n lhe mid-1990sihe Treosury oiiempiedunsuc .- r,l v.o do o,or di l rheded ,b , 01 l . lnsiruments, drgu ig lhol they were more hke equity l han debi Fo' exdmpl e,i 1993 E nrof i ssued i MIP S lhrough o subsidiory, dedlcted rhe interest, bur described rhemos prefenedsiockwhen reporiingro shorehodere.Enront stoied i.ie.uon wos to use thesesecurities decreose debl/eqully rorio ofd lo iis i mpfovetscredi troung,opporenl l y l ss!i ngw hat i by omounted equily,bll slil deducungihe poymeiis io Bli how does issulng thesesecurities ly of{ecrihe reo compony'srnk? The debi ls sull cn ob lgoilon of ihe porerl coirpony qnd so moy increoseihe poreiJ's i l l o de' Foer.l fo..tl -, " dt oi -goS .ci esdei ermi ned E nron' s thot MIP Sl ncreosed rsk, rs ike debi would, ond worned thot theseshenon gons wou d not improvelrs crcdit foiing.
Jo,r.e5i Kery Cope , 'llg, Ya.ls, L.v Con, F!iiy Nahes," B,5ine$Weel,Seplembe,9 1996 p l22r Lese HdgOi, "SmonMone/Oi re MP5, OU|D5,ond OUIPS,'Smdr^,loDey lnrero.nve, Ap,l 6 1999;lo,.D McKlinor oid Crcq Hilr, "Doube Pioy How Treorry Loi rn B.[e ro O!.sf o Dlb our Sa.mry-intumenl l5:uedby En,anond Orher Co, Be Used.! B ofi D e& .i d E q! r) Wi torF.rl .ol Lobbynr, fte w ol Sttcct Jajnal, FebN,Jtf4, 2402, p Al
Some preferre(l stocksafe sinilar to pcpcfual bon.ls in ihtri they have no maturitv date, bot most nc1\'issucsnow hnve specitiect nutffiues. For examplc, many preferredshareshave a snlkin:i fund provision lhai callsfor the retirement ol2'ii of the jssre eachvcar mcrning thflt the issrre$.i11 "nlahlre" in a rna\im m ot 50 years.Also, manv prefcrrcd issucsire callablebv Llreissujnil corporatnrn, 'lich carl also llmit the lifc of thc prcft:rred.,
, P , io, t o r r e e l 9 / 0 s v t l a ly. p e te n ,.Jn .cl{ .5 p e r p e lu o ,a n d omonno$ui ro.l 5nl nqfl ndsor.. pro !5.ni Thcn,inaron.e .ompony ,eq!l.bA, wor ad.6odr eureolued o*er iecomponi.shod bcei in(finq o. " "t I 01 - t. Lo - o .o.r.,"b., o" d, o , d ,a o o.".p..:.d ,1.. -|p,
746
2l Chopler
Hybrld Finonclng:PfefetredStoc[, Wdronts, dnd Converl]bles
l\,hictr Nonconveltiblepreferredstockis virtually all owned by corPorations, higher aftertax can take advantageof the 70% dnjdend excltlsjonto obtain a )'ielct on preferred stock than on bonds. lndividuals should not own preferred stocks(except convertiblepreferreds) they can get higher yields on saferbonds, As so it is not logical for them to hold preferreds.r a result of this o\^'nership Pat tern, the ldumc of preferredstock financ g is gearedto the suPPlyof moneyin the the hancts olcorporate investors.l 4rerlthc supPly ofsuch money is Plentifrd, bankerssug stocksarebictup, their yields fa]],anctinvestncnt pricesof prefcrrccl test that companicsthat need financirg considerissuing Prefered stock. relaiive to dcbt-intelEst For issuers, prcferred stock has a tax tlisddLrantage but expense deductible, preferreddividendsarenot. Sti]],firms with low tax rats is may have an ircenfivc to issue prefened stock that can be boriEht by corPorate investors with high iax rates,who can take advantage of the 70%divjdend cxclusion. buyers,the 6ml rnightbebet Ifa firm hasa lowcr tax ratethan potentialcorPorate toa ter off issuin8prcferrcdstockthan debt.Thc kcy hereis that the iar advantage low-tax rate high tax rate coryoration is $eater than the tax disadvantageto a issuer.To ilhrstra te, assumethat risk diflren tials between debt and preferrcd \a'ouid requirean issuerto set thc interestrate on new .lebt at 10%and the dividend yield on neh' preferredat 2% highcr,or 12%in a no-iax world- However, 'hen taxcsarc miShtbe willing io buy considered, corporate a buyc'rwith a high tax raie,say,40%, jt has an il% before-tax yield. This would Producean 8%(1ihc prefeffedstockif = Effective : 8%[1 0.30(0.40)l 7.04%afteriax rctum on the preferredvcrsus T) 10%(1 0.40)= 6.0%on thc debt.If the issuerhasa lou/ tax rate,say,10%,iis aftcr: tax costswould be 10%(1 T) = 10%(0.90) 97. ol thc bondsand 8% on the Prc' ferrcd. Thus, the secuity with loh'er isk to the issuc't Prefered stock, also has a lowcr cost.Suchsituations can makeprefeffedstocka logicalfinancingchoice.a
Stock 0fherTVpes Freferred of
stocks,sevemlvadationsare In addition to the "plain vanilla" variety of Preferred also used.T\ .o of these,floating Iate arrd market auction Prefened,arc discussed in the folowing sectiolrs. Adju5tablcltitc frelerred Shck Instead of paying fixed dividenlts, adjustabl rate preferred stocks (ARPS)have their dividends tiect to the rate on Trcasury ARPS issred mainly by utilities and large commercialbanks.When secudties. arc ARPSwere firsi dcveloped,they were touied as nearly perfectshorFienn corporate investmentssincc (1) only 30% oI the dividcnds are taxableio corPorations, and (2) the noating latc fcature was supposedto kccP the issue tmdinil ai ncar par.The ner{'secu !]' provcd to be so popular as a short-terminvestmentfor firms rvith idle cash thai mutual funds desiged jusi to invest in ihem sprouted like Howevct in weeds (shares the turnds, turn, rverepurchascdby corporations). of in of the ARPSstill had somc pdce volatility due (1) to changes the riskirress thc
isome new preferieds orto.rivero indivduo nv6ro6 see [ b.x,'MIPS, oU Ps,TOPr5,oid OUDS A role o,e _o'do O ol p"4'"o o '"'o ,por " 'obo8dp.l o .o ^ a ) . t . . .ot P -."o h ,! o 4 o "dd''d o' 4,o-pho 01-rp _ o ,.r o1 a,d.oooto p..o ^" r4o .or h1o1 ,s^rpJ."d(.o | l "l B a,, o,d ,..a p Da l' a ol --M.!.. ^1",o, 4..9m- 03 oo oA -. M \.4 o . " io ;%""J" o i.' ". .,0o"q""'"d .'dl ! l ' o..r^ o ot'o.' Af o ,o ,o D.,.,o -o" "." P ". Adlurcbe RolePEbiied Sb.l," F noncto/ ,1on.irenedr,Summs 1993, pp 61 75; ond Beirod.l ' Wlnge,eto, Sp, Sbcl, F non.tdlMonogeme,r, n! 1936, pp 43 57 q "4 ' ,"d o.
issues(some big banks that had issued ARPS,such as Cofitinental Illinois, Ian into serious loan default problems) and (2) to the fact that Treasury yields fluctuated between dividend rate adjustments dates. Thus, the ARPS had too much p ce insiability to be hld in the liquid assetportfolios of many corporate investors.
Market Aucti0n Prefetred Stock In tgg+, tnvestment bankers inhoduced money
market/or market auation,prelefied. Here the underwriter conductsan auction on the issueevery sevenweeks (to get the 70%exclusionfrom taxableincome, buye$ must hold the stockat last46days).Holderswho want to selltheir shares canput them up for auction at par value. Buyersthen submit bids in the form of theyields they arewilling to acceptover the next 7-weekperiod. Theyield seton the issuefor the coming period is the lowest yield 6uf6cientto seuaUthe shares being oflered at that auction. The buyerc pay the sellers the par valuei hence, holdersare vhtually asswedthat theh sharcscanbe sold at par. The issuerthen must pay a dividend rate over the next 7-weekperiod as determinedby the auction.Fmm the holder's standpoint,marketauctionpreferrdis a low-risk,laely tax-exempt, 7-weekmaturity security that can be gold betweenauction datesat closeto par. However,if therearenot enouth buyersto matchthe sellers(in spite of the high yield), then the auctioncan fail, which hasoccurrdon occasion.
Advantages Disadvantages and of Preferred Stock
Therc are both advantages and disadvantaSes to financing with preferred stock. Here are the major advantates from the issuer's standpoint: 1. In contrast to bonds, the oblitation to pay preferrd dividends is not firm, and passing a preferred dividend cannot force a firm into bankruptcy. 2. By issuinS prferd stock the firm avoids the dilution of common equity that occurs when common stock is sold. 3. Since prcfurred stock sometimes has no maturity, and since preferred sinking fund payments, if present, are typically spread over a Iong period, preferred issues rcduce the cash flow drain from repayment of principal that occurs with debt issues. There are two major disadvantages: 1. Prcfe d stockdividends arc not normally deductibleto the issuerihencethe after-tax cost oI prefe ed is typically higher than the after-tax cost of debt. However, the tax advantage of prefefieds to corpomte purchasers lowe$ its prc tax cost and thus its effective cost. 2. Although prefered dividnds can be passed, investors expect them to be paid, and firms intend to pay the dividends if conditions permit. Thus, pref ed dividends are considered to be a fixed cost. Therefore, their use, like that of dbt, increases financialdsk and ihus the cost of common equity.
sir-rrsr preferrd:tockbeconsidered equityor dob? Exploin. should oi
prefered siork?why? who cre fte moior purchosers nonconvertible of preferred Briefyexplcin mechonics odiustoble ond morketoucrion the ol rote sl,ock. preferedslo<k lhe i$'ier? Whotore lheadvonhges diiodvdntoges ond io ol yieldof 7e.,Ihe compony's hoso pre-toxyieldof A (omponyl preturred siockhoso pre-bx dividend debt 89". f an invesior in lhe 34e.morsinol|ox bro(ket,whot ore fre oftrtox yieldr of tfie pre{enedrtock is ond debl?16.2Y/.; 5.28%l
HybridFinoncing: P,eferred Srock, Worronh,ond Convenibtes
31"2 bVarrants
A warrant is a ccriificate iss cd bv a companv thr givcs the holdcr rhe right to buy a stnied numbcr of sh.rfcsof thc company's stock nt a spccificd price for some specilicd lcngth of tirnc. Ccrlcrnll, warrants arc issued along with dti, nnd thev arc use.l to induce irvc'stors to buv 1dt-term debt with a lorLer co(pon rate iharl \a,ouldotherlvisc be reqLrired. For cxample, i{,hcn tnfonatics Corporati(n1, rapidly growing high-tech conlpany,wnnted ro scll Ssil nrillior a of 20 vearbonds in 2007,the compani,'sinl'eslmentbaikers inforrrcd thc'finan cinl ',,icepresident that the bonds K)uld be.lilficult n) sll, antl thar a coupon rntc of 10%rvould bc requlred.Ho\ ,ovcr,as an alternativcthe bankcrs suggest.I lhai investorsmi8ht be willing Lobuy the bonds rvith .r couporrr.ie of (Dly E!t" if the companv r\,orld offer 20 irarrnnts r^'ith each Sl,{)00bond, each {,,rrrant cntitling the holder b buy olre sharcof.omnron sh)ckat a strike pricc (also c,rllcdan cxerciscprice) of $22per shrrc. The sbck \a,as selling Iof 920pcr shar at the time, and tho warrants s'ould c'xpirenr the year 2{)17 thev had not been if c\ercised previously. Why would invcsbrs bc wilhg k) buy Intumatics' bonds ai a l,ield of ortt il', in a 10li markrt just brcauseil.arrints l\rerc also offurcd as pnrr ot th(, pactasr? lt is becausetlte v!,ar..rnts kntg telnl r?// rprn,rs that hn\' valuc,shce are holdcrs .a n b ut ihe firn1'scommonsto.k at the strike prirc rcgarcl ol hol{, high less thc markct price climbs.This option offsotsthc'low intercstrate oll rheborrdsrnd Drakes packageof loi{-vicid bonds plus warrants aurnctilc b investors (Sce thc Chapter 9 for a disclrslionoi options.)
I
Initial Nlarket ofa Ilond Prir:e rvith \,Varranis
'l'he Infonraticsbonds,if they had bccn issued as straight debt, would have car ric.l a 101,nriercstrnte.IIo\^,cver with warrantsattachcd,the bonclswerc sold to yicld 8%. Solneoncb ying the bcDdsni their 51,000 hitial offrnr8 pficc \ortd thlrs be receivingi pa.kage consistingof an 89;,20-)'carbond plus 20 r,arranc. IJccause gonrg intcrestrnte or boncisas risky as rhosoof Infor)rarics thp r,,as10t", $e can fnlll the shailjht clebt\.a]ueoi ihc bon.ls,assumingan innLratcoupon nt cnseoi illustratior, ns follo\^,s:
PV
+...-------{
20
80
80
8o
80 1000
= Usingatin.rncialcalcdator inputN = 20,I/YR = I0,l'MI 80,,rncJFV 10{10 'lhen, pr'ss IrV kcy to obianrihc bond'sval!c,5j829.73, app()xinrarcli, thc or 9930 l'hus, a Pcrson bu),ing the bondsjn tho initial !nder{,riting 'ould pav S1,0(l0 nnd r$cive nr exchan8c'n straight bond worth aboul 5830plus 20 r|rranis presulr1, .bly rvorthaborit$ 1,000 $u30:$170: I"icepaid for bond rvith warrants Straighr-debr Value of * valuc of bond wanants
{2r-rl
s r, 0 0 0 = $ 8 3 0 + lli1 7 0 .
Bccauscinvcstors receive 20 \{auants $ith each bond, each lvarrant has an = inplicd valucof S170/20 $8.50. Thc l<cyissucin sctting the terrnsof a bord-with-\,'alrants deal is valuing ihe !!ananis. The siraight-debivalrie can be estimatedquite accumtely, il.as done as above.Ho$.ever,it is nore difficult io estimaleihe \.alue of the warrants. The Black-Scholes OptionPricing Model (OPM),h'hich rve discussed hChapter9, can be used to fhd the value of a call option. Thereis a temptationto usethis model to lind ihe value oI a wanant, sincecall options are similar to H'arrantsin manv respects: Both give the in\.eslor the right to buy a shareof stock at a fixed strike price on or before lhe expiration dale. However, there arc major differences bet$.eetl options and warrants.When call optionsare exercised, stockpro call the vided to the option holder comesfrom the secondar)r market,but when wauants ar exercised, stock provided to the warrant holders is either newly issued the shares treasury stockthe companyhas previousl)'purchased. or This meansthat Lhe exercise lr'arrants of ctillLtes \-allreofthe original equit,v, the rvhich could cause Lhe\.alue of the orijlhal .arrant to differ from the value of a simitar call option. Also, call options q'pically have a life of just a ferv months,\,'hile warrants often havelives of 10 )rears more. Finallt the Black Scholes or model ass mes that the underl]ring stock pa)rs no c:liridend, which is not unreasonablover a short pedod but is unreasonable 5 or 10vears.Therefore, for investmentbankerscannotusethe BlackScholes model to determinthe value of l\.allants. Even though the Black Schols model cannotbe use(l to determlnea precise value for a 1\'arrant,there are more sophisticatect moc:lels that work reasonabl)r rvell. In addition, investmentbankerscan simp\, contactportfolio managersof mutual funds, pensionfunds, and other organlzations that $'ould be interested in buyhg the secudtiesand get an hdication of ho$' many they would buy at diflerentprices.ln effect,the bankershold a presaleauctionand determhe the set of tcrmsthat $rilljrstclcar thc markct.lf thcy do this jobproperlv thcy will, in cffcct, bc lctting thc market dcterminc the value of th(] lva ants.
Use ldarrants Financing of in
hlranls genemlllrare used by sm.ll, rapidltr gro\ .ing firms as sweeteners when ihey se1l debt or preiered stock.Suchftms Irequentlyare reg.rded blr in1'estors as behg highly skt so their bonds can be sold on\' ai extremeltrhigh coripon mtes and .ith vef' restrictiveindenture provistuns.To avoid sucb resticliors, lrms such as Inlomatics olten ofer warants almg rvit]r the boncls.However, someyears ago,AT&T raised$j1.57 billim blr sellingbonds wiih h'arrants.Ai thc g oI any tl'pe e\.er undertaken by a busnress ilme, this was lhe largest tinanc .rrm..rnJ m.,fk.J thF lI- u-.F\e ol \.rrr,rrF b).r..rrEF-U.rg,u p,' ,li,"r r Gettintrvarrantsalong.ithbondsenablesnrvestorstoshareinthecompantr's gro\,vth,assumlrg it does nl fact grow and prosper. Therefore, investors are \,'illing to accepta lo\ ,'er interest rate and lessrestrictive indenture pro\,'isions.A bon.l .ith
ob-o" o94 o" P o "a ,& "," ". o ,L o t.. .,1b.o.. I. w ,,d8l od. b nled wo,'oih,lDwever, the E{&ise cfoised h pony,.sGe is r. d wd rdds fi.rmerceno i raqliramenh i/.iy orherwo ,onh hdvesin.e beai hted l is oio inle,erns 1onorc rhol, p, o,1o rheso e, AT&TI lreoaryralt, wo,liinswilh Ma,loi Sro^ey.noyrs, The p..loaa wos supp.sedr. seif., o et moredlr,e voue ol tfe {o',od! o! o po ol the nlrwdlins !aroi ror. pri.a n r,e ieish6o,,ood.f $1,000 La 6.nd vdue.oud be neb,m ied !(!rcrey, so rre tick wos ro eii pos blc exer.nc p.nc5 ond yco6 ro erF nlion, ond then mrb fie equiibrilm voue ol fie waronrun.lr dflerenl + W.(oir'ol!e wa, od p,.iio ro 6e on erercne pri.e ond ife rola.!d cou5eBoid - $1,000 Urjio o 'o!e moda, fie ATATlMo,g.n Srony.n. yls 3errems r,or.aused fie worcn . se loi r,e oper mo,ler or o p,.e fiorwos only 35,r off fom fie eimored p, ce.
750
Chopler 2l
Hybid Finoncins: Prclered Stocl, Woi.onb, Converlibl, ond
warrants has some characteristicsof debt and some characteristics of eauity It is a hybrid securiwthat providsthe fin.rncial rnandter with dn opportuniry to;xpand the 6lm's mix of secuiiies and thus io appeal to a broader $oup o{ invesiors. Virtualy all wanants is6ued today arc detachable. Thus, after a bond with attached wa ants is sold, the warrants can be detached and traded separately ftom the bond. Fulther, even after the wanants have been exercisd, the t}ond' (with iis low corpon mte) remains outstandint. The stdke price on wanants is generally set some 20% to 30% above dre market price of the stock on the date the bond is issued. If the firm grows and pro6prs, causing its stock pdce to dse above the strike price at which sharcs may be p rchased,warant holde$ could exercisetheir waranis and buy stock ai the stated pice. However, without some incentive, warranis would never be exercisedprior to maturity their value in the open market would be grater than their value if exercised,so holde$ would sell warrants rather than exercisethem. There are thfte condifions that cause holde$ to exercise iheir wanants: (1) WaIIaIlt holders wil surely exedse and buy stock i-f the wanants are about to expirc aJld the market price of the stock is above the exercisep ce. (2) Warrant holders will exercisevollmtaily if the company miss the dMdend on the common stock by a sufficient amount. No dividend is eamed on the warant, so it prcvides no curent income. However, if the common stock pays a high dividend, it provides an attractive divi dend yield but Iimits stock price gmwth. This inducEs warant holde$ to exercise their option to buy the stock. (3) Warrants sometimes have stepped-up exerose pricee, which prod owners into exercisingthem. For example, Williamson Scientific Company llas wa{ants outstandjng with an exerciseprice of S25until December31, 2011,at which time the exercisepdce rises to $30. If the price of the common stock is over $25iust before December31, 2011,many warrant holders will exercisetheir options before the stepped-up price takes eflect and the value of ihe warrants Ial1s. Another desirablefeature of warrants is that they generallybring in funds or']y if tunds are needed. If the company grow' it will probably need new equity capital. At the same time, growth will cause the price of the stock to rise and the warnnts to be exercised; hencethe firm will obtain the cashit needs.lf the company is not succ$stul, ard it carurot profitably employ additional monet the pdce of its stock will probably not rise enouth to indurc exercise of the warrants.
Wealth Effects Dilution toWarrants and Due When Exercised
e-resoulce SeeFMl2 Ch2I Iool Kirxlsoi thetextbook's
Assume that the total value of Infomatics' operations and invesfments, wh.ich is $250 million immedialely after is-uing Lhebonds wilh warrants. is e\pecied io 8row, and dos trow at 9% per year-WIen the wa$ants arc due to expire in 10years, the total value of Infomaticsis expected be $250(l-09)10:S591.841 to million. How will this value be allocated amongthe original stockholderc, thebondholders,and the warrant holders? When the warrants expire, the bonds will have l0 years remaining until matudt, with a fixed coupon payment of $80.If the expected market interest rate is still 104,, then lhe lime I ine of cash{lows will be
10 80
80
80
80 1,000
751
Usnrga financialcalculatoanrpu! N : l0,I/YR : 10,PMT = 80,and FV - 1000. Prcssthe PV kev kr obtanr the bond's value, 1j877.11. ioial value of all of the The = is 50.000(5877.11)$43.856 bords million. The value rema nrS for ihe o g al siockholders and the \\'anant holders is qual to the remainingvalue of the finn, alier dectucting amount owed to the the : bondholcters. This remaining value is 1j591.841 $j13.856 5547.985 million. iI ihere had been no {'arrants. then the orisinal stockholders \\roulct have beenenti tled to all oI this renuinins value. Recallthat thereare 10 million shares stock, of so re price per share would be $547.985/10 =- $54.80,see Table 21 1 for a sununarv of lhesecalculatiorls. lvhatwould the earningsper shareb if therewere no rvarrants? Suppos the (recallthat BEP EBIT/Totalassets) companyhasabasic earningpower of 13.5% = an.:ltotal assetsof 5591.8,11 million.r'This meansthat EBIT is 1r.135($591.iJ41) (SE0 million, interestpaymentsare 54 million corpon paymentperbond x $79.899 50,000 bonds),and earninssbeforetaxesare $79.899 $4 : $75.E99 million. With a tax rateof40'2, after tax earningsareequalto $75.899(1- 0.4): $45.539 million, : and earningsper shareare $45.539/10 $4.55. To summarize,iJ Infomaticshad no h'arrants,the stockprice would be 554.80 per share,and the earningsper sharewould be $4.ss. But Infomatics does have wallants, and $'ith a stock price much Ngher than the exerciseprice of $22, the $.arfant holders h'i]l exercise thei wrurants. lible 21-1 sho$'shoh' the exercise\,vill affect the stock price relative to the caseof no warrants. Infomatics $'i recei\' $22 mi ion when the 1 milion wanants are exercised at a
(Milionsol Dollors, Dilurion Effecis Worronls I0 Yeors of in Excepl Shore Per Doto)
Expected ue o{ operoiionsond invesimenls' vo Pus new copilol from exerclse worontsb of Toto volue ol fjrm (ond ioio copiio J Mi nusv o ue of bond s Vo[e remon]rg for shoreholdere
$591.841
8/r $59r
.43856 $517.985
$ 5 9 r. 8 4 1 22.OaO $ 6 ' , r3 . 8 4 r 43.856
$569.985 ll $ 51.82
t0 $ 54.80
s " I he v d u e o l o F e r d l l o no^ d id ve tm e il5r e &e d e d b sr o w fr o m l s cw e
$2J0ml i onorarareol 9?.r$25011 0tl '0=
Llhe w o r a d s w i l l b e e x e r cn e d o n lyflh e slo ckp ,n e o le r p n a r o n isobove$22 l f fi c no.k pri cei s e$ l hon $22, l he w oi onl 5 q 6xpnewdlh e* ond Ere wll be no iew copilo. Ou ccLcu olonJ show d $e expe. ed tocl p, ce s s,edra' $oi 522, 30 fie wor 'wit h o u i w o r o n t , l h e r e o r e l0 m lio n 3 h o r e so fio cl I' h swtr r cnl smB rs.i sedl ssenoreb),rhen$e,ew l l bel 0+l =l l hi .
' ir, is . d s e r f e b t l m o * e r v o ue e q lo sr h b .o kv.u e o fo $ t,b u r fie some.oc!ori onsw oudfoow evenf m.,lel ond bool vol!es qere nol equo.
Chopler 2l
Hybdd finoncing: Prcfercd Sbck, Wononts, Conveibles ond
price of $22 per warrani. This wil] make the total value of Infomatics equal to million (the $591 .841million existing vaiue plus the $22 million raisedby $613.841 the exercisof the warrants). The total value rcmaining for stockholders is now miltion ($513.841 million lessthe $43.856 million al.locatedto bondholdeE). $569.985 There are now 11milion sharesof stock (the original 10 million plus the new 1 million due to the xerciseof the warrants), so the stock price wi[ be $569.985/11=' $51.82per sharc. Note that ihis is lowI than the $54.80price per shaie ihat Infomatics would have had if there had been no warrants. Thus, the warrants diluie ihe value of tlle siock. A similar dilution occurs with earninSs per share. After exercise. the asset base would increasefrom $591.841 ion to $613.841 mi million, with the additional $22 million coming from the sale of I million shares of stock at $22 per share.If the new funds had the samebasicearning power as the exisiing funds, = then the new EBIT would be 0.135($613.841)$82.869 million. Interestpaymenis would still be $4 millior! so eamjngs before taxes would be $82.869- $,4= $78.869milUon, and after-tax eamings would be $78.869(1- 0.4) = 547.321 million. With 10 + 1 = 1l million shares now outstanding, EPS would be W.321/11 = $4.30, down from $4.55. Therefore, exercisint the warrants would dilute EPS. Has this wealth transferharmed the original shareholden? The answeris ys and no. Yes/becausethe original shareholders clearly are worse off than they would have been if there had been no warrarts. However, iJ ihere had beenno warants attachedto the bonds, then the bonds would have had a 10% coupon rate instead of the 87o coupon rate. Also, if tlie value of the company had not increased as expected, then it mEht not have been profitable for the warant holders to exercise their wa ants. In other words, the odsinal sharcholders werc wiUing to trade off the potentialdilufion for th lower ( oupon rate. In this eyample, the original stockholders and the investorcin the bonds with wa antswould be getting whai they expected. Therefore,the answer is nor The wealth transfer at the time of exercisedid noi harm the orieinal shareholders, becausethev elpected an eventudltransferand were fairly ciompensaled the lower inrere;l by Payments. Note, too, that invstors wor d rmgnize the situatioq so the actual wealth hansfer would occur tmdually over time, not in one fell swoop when the warrants were exercised.Firci, EPSwould have been reported on a diluted basis over the years,and on that basis,therewould be no declinein repo ed EPS.(We discussthis in a laier sectionof this chapter.) Also, investorswould know what was happening, so the stock pice, over time, would reflect the iikely fuiure dilution. Therefore, it too would be stable when the warrants were exercised. Thus, the effects of the warrants would be rcflected in EIIS and the stock price on a tradual
The Component ofBonds Warrants Cost with
When Infomatics issued its bonds with warrants, the firm received $1,000for each bond. Simultanously, the company assrmed an obligation to pay $80 interest for 20 years plus 51,000at the end of 20 years. The pre-tax co6t of the money worild have been 10%if no warrants had been attached, but eachInfomaticsbond had 20 warrants,each of which entitles its holder to buy one share of stock Ior $22. What is the percentage costof the debt?As we shall see,the costis well abovethe 8% coupon rate on the bonds.
As we demonstrated earlier,when the warrantsexpire10 yearsftom now and the The areexercised, expectedstockprice is $51.82.7 companywould then have to issueone shareof stockworth $51.82 eachwarant exercised for and, jn reiun, Infomatics would receivethe strike pice, $22.Thus, a purchaserof ihe bonds,if !e or she holds the completepackage, would expectto realizea profit in Year 10 of $51.82 $22 : $29.82 eachcommon shareissued.s for Sinceeachbond has 20 wa ants attached, and each warart entitles the holder to buy one share oI com= per monstock,jnvestorswould have a cashflo1^. 20($29.82) $596.40 bond at of theend of Yar 10. Here is a time line of the expectedcash flow stream io an
' 10
2A +$80 +$ 80
- $1, 000
.F$80
+$80
..s 80,00
. . 596, 4 0
..$676,40
1 tr9q
+ $1080
The IRR o{ this streamis 10.7%, which is the investor's overall expected prctaxraie of rciuln on the issue.This return is 70 basispoints higher than the 10% rcium on straight debt. The higher retum rcflects the Iact that the issue is riskier to investo$ than a straighFdebt issue becausemuch of the return is expected to comein the form of stock price appreciatio& and that part of ihe reiurn is morc isky than interesi income. The expected rate of retum to investom is the same as the before tax cosi to th company this G true of common stocks, straight bonds, and prefered stocks, and it is also true of bonds sold with wa ants.e
5ETF.TE5T
Describe how o ns bond issue with woront, is vo,ueo. How q.e worronts u5edin (orporoiefinon(ing? The use of worronts lowers ihe couDon.ote on Ae correspondinq debt irsue. Doesthir meon thqt the (omponentcostof o debFplu*woninrs pockoseii le$ t n the ;st of troight debt? txploin. Shonton Corporotion couldissuels-yeor rtroigh deb oi o roie of 8%. Insteod,Shontonissusl5-y4r debtwith o;oupon rote of 6?", bureich bond 6os 25 worrcnh ohoched. Thebofldscon be issued oipor (51,000 per hondi. Assumingonnuol inte,e't poyments, whot is lhe implied volue of eo& worront?
{56.85)
p o r ' \e r e r o l pobobl G,s ls"p---dsro^\o. t.,o ' e o l' L e ( o o er.no al .eo 1" 'o F d 1."'"o" L \- .o ' o r ' .b ""," 00'.p'obobl r c o1po , , l o . i , - . . " ,...r 1 , ""o ' "o fi01lhewarcn,s wi beexercised. , lLnol n r l . f y o c c u r c r e r o sd yfio l$ e e xp e d e d p r o fillr o m $ e wd fto nl pdi l l ons$eexpecE dsbckprcee$,he shlepdce $2932:$51.32 $22 Tfh is be.ouseilfie $o.l pri. d,opsbelow fie sti[e prce, ]n this.Ge $. / lq , " , d ' o r p o l ' S0 o l5 o , ' rs"phdpo,ar'l b" ' "q o ' d ". p e c! o ' co lb e ( o c.o ?d.)i qop'oi rc i qu",aa o\.$, s , lo r 0 . 6 5 a , $ 2 a . 82 a r o la t+ ise o i , b e o ' d \- 1 .p d o ' I i hC op e o p b h .r e .4 ' \"""o.-r.mo po6ob rror" oLp,. I d, o p b " o , r L " " , " ' p " r "1 $ .4 3 ) . l- r "s.ps,sdpoo' " "' ,,o - b . o ' o p ' i .' , q o " M n \o lC tlL o d o d Do o ld t.5\'e.es I e -poc orw o'o'ao_d " lo' rc" o ' ie N o.- 6- oor pp 34 3 o Co el b e , e . L I i a o.,.Jer r' q' Ben tode.boch ond Pollschurz, "PricinsWorcnls: An 'Empnco sludy of fhe B ocks.hoes Modlond rh Aremo r v e s , " . / o u r n o l . l r i n o n cs,Se Dlsm b o r l9 9 0 ,p o .llSl- 1 r 0 9;D dvdC .GonardondMchdeE .S ol r,'On lshs the Bloc[Scho$ !1ode ro Vq ue Worctris,".]o0r,o/offiroDciolRese.ri, summr1990, pp. 3l 92;and Kofierie L Phep3,Wilicm I Moo,e, ond Rodney Roenfedl, L. "Eqllry Vo uollonEtucr: ol Woronl Dsbt Ftn nclns,".lautnolal Financiol Ressorcb, Summd I 991, pp. t3-1 03.
754
Chdpter 2l
Woroih, ond Coiverribles Hyb.d tinonclng:Prefeed Stock,
2 .3 Carr-vertihlc $ecawitles
Convcrtible se.urities are bonds or preferredsbcks that, under specifiedierms and conditidrs, can be exchangedIor (that is, convertedinto) common siockat the optbn of th,: holder. Unlike lhe erercisc of (,arrants, which b ngs in additional tunds to the firrn, conversiondoes not pmvide new capital, debt (or prferled siock) is simpl]' reptaced on the balancc sheet by conmon stock. of course,nducing the debt or prelened siock will i prove the firm's fhanciaL strength and make it easierto raise additional capital, but that requires a sepa
Pt Ralio fonverriunire fonrer'rion anrl
Onc of the most importanl provisjonsof a convertiblesecurity is the conversion ratio, C& definedas the number ofsharcsof sto.k a bondholdervrill receiveupon l{elatedto the conversion raiio is thc conversionpdce, P.,r'hich is ile convcrsion. effcctivcplic(r investorspay for the conrnon stock when coN'ersion occurs.Th relafionshipbetweenthe convenion raiio and thc .onversion price can be ilh$ tratcd by Silicon Valley Sofh\.areCompany's convertible debenturesissued at their $1,000 par value in luly oI2007. Ai any timc prior to maturitl, on luly 15, 2027,a dcbcnture holc:ler can exchange bond for 20 sharesof common slock a Thereforc,thc coN'ersionratio, CR, is 20. Thc bond cost a puchaser 9r,000,ih par value, rvhcn it rvas issued.Dil.iding the 51,000par valte by the 20 shares a receivedgives a conversionprice of $j50 share: Par valuc of bond given up ^, 5-LrL. rLLer\ Ld
aonver.iorpri,e
'
f
121-2)
, $1,000 $1,000 clt 2{)
ConveFely, by solving for Clt, $'e obtain the conversion ratio:
s1,000 Convcrsionratio = CR =
$r,000 = 20 shares. $50
(2r-31
and vice versa. Orce CR is set,the value of + js esiablished, p Like a .arrant'sexercise ce,ihe conversionprice is typically set some207. to 30%abo\'the prevailing market price of the common stock on the issuedate. Generally,the conversionprice and convcrsionratio are fixe.t for the life of ihe bond, although sometimesa sicppcd-up.onversion price is used. For exanrple, th 2007 convertible deberlhrcs for Breedon Industries are cort'erlible into 12.5shares until2016; into 11.76 sllarcslrom 2017untj]2027;and into I1.11shnrcs
Conve.lible Securities
fiom 2027 until matudty i 2037. The conve$ion price thus siats at S80,dses to and then goes to $90.Breedon'sconvertibles, like most, have a 10-yearcall$B5, period. Fotection Another Iactor that may cause a change in the conversion p ce and ratio is a standard Ieature oI almost all convefiibles the clause protecting the convertible againstdilution ftom stock spliis, stock dividends, and the sale of common stock at pdces below the convenion pnce. The typical prcvision states that if common stockis sold at a p ce below the conve$ion p ce, then the conversion pice must be lowered (and the conve$ion mtio raised) to ihe price at which ihe new stock was issued. Also, if the siock is splii, or iJ a stock dividend is declarcd, the conver sion p ce mllst be lowered by the percentage amount of th stock dividend or split. For example, if Brcedon Industries were io have a 2 for-1 stock split duing fte first 10 yeam of its convertible's life, the conversion mtio would automatically be adjustedfrom 12.5to 25, and the conversionprice lowered ftom $80to $40.ff this prctection were not contained in the coniract, a company could completely thwat conversion by the use oI siock splits and stock dividends. Wa ants are similarly protected against diluiion. The standard protection against dilution from seiling new stock at prices belowthe convrsionp ce can,however,get a company into trouble. For example, assumethat Breedon'sstock was seling for $65 per share at the tlme the convetible was issued. Furthr, suppostlle market went solll, and Breedon's siockpice dropped to $30 per share.If Breedonneedednew equiiy to support operations,a new common stock sale would rqrire the company to lower the conversionprice on the convertible dbenturesfrom $80 to $30. That would raise th value of the convertibles and, in effect, transfer wealth ftom curent shareholdem th convertibleholdels. This trans{erwould, de facto,amountto to an additional flotation cost on the new common stock.Potentialproblems such as this m11st kept in mind by firms considedng the use of convertiblesor b bondswith warrants.
The Component of Convertibles Cost
In the spring of 2002 Silicon Valley Software was evaluating the use of the con vertible bond issue descdbed eariier. The issue would consist of 20 vear convert h ould .eUdt .r priceot $..000 rblebond. per bond:rhi. $..000would al"o be e-res0urce 'hdt ihe bond's par (and maturity) value.The bonds would pay a 10%annual coupon SeeFMl2 Ch2l lool interesirate, or $100per year. Eachbond would be convertibleinto 20 sharesof Kitx,i ot the texrbook's stock, = ihe convenion pdce would be S1,000/20 $50.The stockwas expected so io pay a dividend oI $2.80 during the coming year, and it sold at $35 per share. Further, the stock price was expecied to Brow at a constant rate of 8% per year. + Therefore, = D1lP0 + g: $2.80,/$35 8% = 8% + 8% : 16%.If the bonds were is not made convertible, they would have to provide a yield of 13%,given their dsk and the seneml level of inierest rates. The conve ible bonds would not be callable Ior 10 years, after which ihey could be called at a pdce of 91,050,with this pdce declining by $5 per year therafter. It after 10yearc, the convemion value exceds the call pdce by at least20%,management will probably call the bonds.rtr Figure_ 21-1 shows the expectationsof both an average investor and the company. d dh 'irtoro o oF or more eid led cr s onof c d * dieoiess * W eblx bnr ion 2 l A o i $ e b x i b o o k ! w e b 5 l e morc compleie disusionofhowthele;s ofoconveibleoffe,lrc delermined are seeM Wovne Motron! ORodneyTiom;son,'Th6PrciisofNaConvs Bond bls ksus5,F,no;c,o/ Monossms,l, Suhmdi 98.l,pp 3 l -3 7. "
756
Chopie.2 |
HybrldF noncing: Prefened Srock, Woronts,ond Converllbles
SiliconVolleySohwore:Convertible Eond Mooei
ExpectedMarkeiValueal
c{=$i,sil \
M = 1,000
I I
Slraighl-Bond
Siroighl' sond
Malurity
Morket Volue
Floor Volue
Prcmium
o
I 2 3 5 6 7 8 9 t0 tl
$ 789 792 795 798 802 806 8t l 816 422 829 837 846
$ 700 756 816 882 952 1,429 t , t ll 1.200 1,296 r, 3 9 9 1,632
$r ,000 1.000 I,000 r,000
1,000 1,000 I,000 1,000 r,000 1,o00 1,000 1,000
$r,000 $ 789 792 1,o23 't,o7l 816 1,147 882
1,192 I,241 1,293 1,344 1,398 1,453 t , 5 tl 1,632
952 1,429 t, l 1,200 1,296 1,399
r ,5Il 1,632
$21l 231 255 265 244 212 182 144 102 5A 0 0
20
1,000
3,263
Convedible Secunhes
The horizontal line at M = $1/000 represents the par (and matudty) value. Also, $1,000is the pdce at wldch the bond is initially offered to the public. The bond is protected against a call for 10 years. It is initially callable at a price of $1,050,and the call pnce declines thereafter by $5 per year. Thus, the call price is represented by the solid section of the line V0M". Since the convertible has a 10% coupon raie, and since ihe yield on a nonconvertible bond of similarrisk is 137,.ihe expecied"shaitht-bond" value of the conveftible, B, must be less than par At the time of issue, assuning an annual coupon,Bois $789: Pure-debtvalue at time of issue Coupon interesi Maturity value
(1 + rd)N
-
(1 + rd)'
{2r -41
+ 'bloo $l.ooo
,3 tt.ljli o \1.13/
- -
Note, however, that the bond's shaight-debt value musf be $1,000at maturity, so the stnighldebt value dses over time. Br follows the line B0M" in the 8raph. The bond's initial conversion value, C,, or the value oI the stock an investor wouid receive if the bonds were converted at t : 0, is Pn(CR)= $35(20shares)= $700. Since the stock price is expected to grow at an 8% mte, the conversion value sho{ld rise over tirne. For example, j.n Year 5 it should be PJCR) = = The conversionvalue $ven the expectedstock price $35(1.08)5(20) $1,029. over Limeis given by the line Ct in Figure 21-1. The actual market pdce of the bond can never fal below the higher oI its straight-debt value or its conve$ion value. U the market price dropped below the straight-bond value, those who wanted bonds would rccognize ihe bargain and buy the convertible as a bond. Similarl, if ihe markei p ce dropped below the conversion value, people would buy ihe convertibles, exerciseihem to tei stock, and ihen sell the sio& at a profit. Therefore, the higher of the bond value and conversion value cuwes in the graph rcprcsents a lool p/tcr for the bond. In Figure 21 1, the 1'loorp ce is rcpresentedby the thicker shaded line Blq. The bond's market value will b?ically exceedits floor value. It will ex.eed the straighFbond value becausethe option to convert is worth something-a 10% bond with conversion possibilities is woth more than a 10% bond without this option. The convetible's p ce will also exceed its conversion valu because holding ihe convertible is equivalent to holding a call option, and, p or to expiration, the option s true value is higher than its exercise (or conversion) value. We cannot say exactly where the market value line will iie, but as a rule it will be at or above the floor set by the straight-bond and conversion value lines. At som point, the market value line will converge with the conversion value line. Tllis convergence will occur for two reasons-Fi$t, the stock should pay higher artd higher dividends as th years go by, but the interest palrrents on the convertible are fixed. For example, Silicon's convertibles world pay $100 in interest annually, while the dividends on the 20 shares received upon conve$ion would initially be 20($2.80)= $56.However, at an B%growth rate, tlle
754
Cftqpier 2l
Hybid fi.oncing: Prefered Stock,Woronrr, ond Conv ible,
but dividends after 10 year6would be up to $120.90, the interestwould still be $100.Thus, dsing dividends will push atainst the fixed interest palrents, causing the premium to disappear and investors to convert voluntarily. Second. once the bond becomes calable, its market value cannot excedthe higher of the conversion value and the call price without exposing invstoE to the danger of a call. For example/ suppose that 10 yeals after issu (when' the bonds becom callable), the market value of the bond is $1,600,the conI{ version value is $1,500, and the call pice is $1,050. ihe company calledthe bonds the day after you bought l0 bonds for $16,000,you would be forced to convert into stock worth only $15,0m, so you would suJfer a loss of $1m pr bond, or $1,000,in one day. Recognizing this danger, you and other investo$ would simply not pay a premium over the hiSher of the call price or the mn' version value after th bond becomes callable. Therefore, in Fiture 21 1, we assume that the markt value line hits the conversion value line in Year 10, when the bond becomescallable. 8. Let N represent the year when investors expect conve$ion to occur, either voluntarily betause of rising dividends or becausethe company calls the convertibles to sEengthen its balance sheet by substihrting equity for debt. tn our example, we assume that N : 10, the first call date. x 9. SinceN = 10, the expectedmarket value at Year 10 is $35(1.08)10 (20)= An investor can find the expected mte of return on the convertible $1,5'11. bond, rc, by finding the IRR of the Iollowing cash flow streami
i0 $1,00o
+st00
+$ro0
+$ 100
r_1,911
+ $1,611
The solution is r. = IRR = 12.87o.1': 10. The return on a convertible is expected to come partly frcm interest income and paftly ftom capital gains; in this case,the total expected retum is 12.8%, with '1070 rcFesenting interest income and 2.870rcpresenting the expected capital gain. The interest component is relatively assured, while th capital gain component is more risky. Therefore, a convertible's expected rciurn is more risky than that of a straight bond. This leads us to conclude thai r. should be larger than the cost of straight debt, rd. Thus, it would seem that the expected rate of rcturn on Silicon s convertibles, r., should lie between its cost of shaitht debt, rd = 1370,and its cost of common stmk, rs = 1670. 11. lnvestment banlers use the type of model described here, plus a knowldge of the market, to st the terms on convetibles (the convercion mtio, coupon interestrate,and year6of call protction)suchthat the secudtywill just "clear
',As n fi coro wiih wo.Enh, he oxpd.d @nver on voluek norpEkdy oquol,o $e expchd,ok p ce nulldiedby i6re'$n fkr. tr EEn lf ofts Io't.Gfi.trtprehappmibb.lo*o|ld6e gfulJ mr.Jlre .lllMdm hlu. ii les !fion 'do bnd fi.n il'" t-'dh",Lld b. tu-i.!h/ |llry qD'id
'fi.611 5ucn&r |hn bo.d5 ililE (omp.ny @ll.d fi.m. ln d,n *m*, non.ftaion @6 il th6 ,|&l pn.e;fia I o yaR n 16$ fton $ I .050/20 - $52.50 Sire fte @mpony nol6 o .oll b Io'@ (oMuion, fi. @mp.n/ ws1.oll rhb6nds I'c sdt D',c. 6l.$ o' t52 50 ftp'.{q.. wh.n $eF B o ls sbct D C. lh. bondhoHeB 'l willkoep ih6 bondr, who$ voluawil d.p.nd primo y on iir.rcn roE! or$otrme. riidiis fi..rp*rsd vous in (op or.\, r r i.r r .o .io n .o \o .yd flic.l.p ,o b l6 m{oi I bovord o"e.e, rr\6\p.c..d rbcL p.i (e i 5 '\e 'n) 56bo d.os,ol l .d tr'|n...F r' oal o - t7556 ."u,1 - u c' s' .a r d r r d . I a .o ,q r o 1 p c.\\.1 pardconrto.'oueo b q ce r \o r 9 5 2 5 Ol tg d i%r e ' 6 b N s.i t\6rus6 d ho .o.,ni ol !o ue I o 16 calcuoi.d 6ins th. exp{b! sbcL p c wllbo vory 3mol. Iherchr, wo con $rimole fie cohpon.ni co, very eurordy unn ft. oppmch in th..edpl6.
Coiverrible Secuties
the market" at its $1,000ofledng pdce. In o11r example, the required conditions do not hold-the calculatedrate of rctum on the convertibleis onlv 12.8%. whi.h ;s les. tidn ihe l30; .o.l or .lr.Li8hl debr. lherefore,the term'son the bond would have to be made more attractive to investors. Silicon Vallev Software would have to increase the coupon intercst rate on the convertible above 10%,raise the conv$ion ratio above 20 (and thereby lower the conversion price from $50 to a level closer to the cunnt $35 market p ce of the stock), lengthen the call-protected pedod, or use a combiration of these changes such that the resulting expected raie of retun on the convrtible is between13%and 15%.r3
of Use ConvertiblesFinancing in
Convertibles Ilave two impotant advantages from the issuer's siandpoini: (1)Convertibles,like bonds with wa ants, offer a company the chanceio sell debt with a low interest rate in exchangefor giving bondholderc a chanceto participatin the company's success it does well. (2) In a sense,convetibles if provide a way to sell comrnon stock at prices higher than those culrently pre vailing. Somecompaniesactually want to sell common stock,not debt, but feel that the price of their stock is temporarily depressed. Managementmay know, for example, that eamings are depressdbecauseof start-up cosis associated with a new project.but fhey expecteamings to rise sharply during the nexi year or so, pulling the pice of the stock up with them. Thus. if the company sold stocknow, it would be giving up more sharsthan necessaryto raise a given amount of capital. However, if it set the conversionprice 20% to 307. abovethe presentmarket p ce of ihe stock,then 20% to 30% fewer shareswould be givn up when the bonds were conveted than if stock were sold directly at the current time. Note. however, that managmentis counting on ihe stock's pric to rise above the convercion p ce to make tlle bonds attractive in conversion.If eamings do not se and pull the stock price up, hence conversion does not occut then the company will be saddled with debt in the face of low earnings, which could be disastrous. How can the company be sure that convercion will occur iJ the price of the stock rises above the conversion pdce? Typically, convenibles contain a call provision that enables the issuinS firm to Iorce holders to conven. Suppose the conversion p ce is $50, th conversion ratio is 20, the market price of the common stock has risen to $50, and the call price on a convetible bond is $1,050.If the company calls the bond, bondholders can either convert into common stock with a market value oI 20($60) : $1,200or allow the company to rcdeem the bond for Naturaly, bondholdersprefer$1,200 $1,050, conversion to so would occur $1,050. The cal provision thus gives the company a way to lorce conversiorL provided the market price of the stock is Sreater than the conveEion pdce. Noie, however, that most converiibles have a {airly long pedod of call prctection 10 yearc is typical. Thercforc, if the company wants to be able to force conversion fairly early, then it wili have to sei a short call-protection period. This will in tur& rcquire that it set d hiBher,ouponraleor a lowerconver,ion pfi(e. Frcm the standpoint of the issuet convertibles have three important disadvantagesr(1) Although the use oI a conve ible bond may give the company the
rlnrid i . ( L * o ,eoo,6 l r ,o d o b ss eltuds.ould resur i r l;nq les 6.n i
-
o f ."o
o o o "o!.h.pi .qo
11\ome s ro i ons.b/
760
2l Cfiqplel
Hybrld Finonclns: Prelered Stock, Wo.ionls, Convertibles o.d
opportunity to sell stock at a pnce higher than the pdce at which it could be sold currently/ if the stock greatly increases in pdce, the firm would have been better off if it had used siraight debt in spite of jts higher cost and then later sold common stock and refunded the debt. (2) Convertibles typically have a low coupon interest rate, and the advantage of this low-cost debt will be lost when conversion occurs, (3) If the company truly wants to raise equity capital and if the price of iie' stock does not .ise sufficiently after the bond is issued, then the company will be stuck with debt.
Convertibles Agency and Costs
A potential atency conllict between bondholdeE and stockholders is assetsubstitution, also known as "bait and switch." Suppose a company has been investing in low-risk projects, and because risk is low, bondholders charge a low interest mte. What happens if the company is consideint a very risky but hithly prof' itable ventue, but potential lendeE don't know about it? The mmpany might decide to mise low-interst-nte debt without spellinS out that the funds will be invested in the risky pmject. After ihe funds have been raised and the investment is made,the value ofthe debt shol d fall because interestrate will be too low its to compensate debtholders for the high risk they bear This is a "heads I wi4 tails you lose" situatio& and it results in a wealth transfer frcm bondholders to stockholders. Let's use some mmbers to illustrate ihis scenario.The value of a company, based on the present value of its future free cash flows, is $800 million. It has $300 million of debt, basdon market value. Thereforc, its equity is worth $800 - $300= $500 million. The company now undertakes some very risky plojects, with high but risky expected returns, aDd its expected NPV remains unchanged. In other words, the actual NPV wiU probably end up much higher or much lower than under the old situation, but the film still has the same expected value. Even though its total value is stjll $800million, ihe value of ihe debt falls becauseits risk has incrcased.Note that the debtholdersdon't benefit if the venture's value is higher than expected, becausethe most they can receive is the contracted coupon and the principal repayment. However, they will suffer if the value of the projecls turns out to be lower than expected, since they might not receive the ft1ll value of their contractedpayments.In other words, risk doesn't give them any upside potential, but it does exposethem to downside losss,so the bondholders expected value must decline. With a constanitotal firm value, if the value oI the debt Ialls from $300to from $500to $800 - $200= $200million, then the value of equity must increase million- Thus, the baiFand-switch tactic causesa wealth transler of 9100mil$600 lion from debtholders to stockholders. If debtholdersthink that a company might employ the bait-and-switchtactic, they will charge a higher interest mte, and this higher inierest rate is an agencycost.Debtholderswill chargethis hitherrate even jf the company hasno intention oI engagint in bait-and-switch behavior, since they don't know the company's true intentions. Therefore, they assume the worst and charge a higher intercst rate. Convertible securities arc one way to mitigate this iype of agency cost. Supposthe debt is convertible and the company does take on the high-risk proi'(l. If the value of the company turns out to be hither than expected, then bondholders can convert their debt to equity and benefit from the successful investment.
Convedible Secudtio3
761
bondholdersarc willing to chargea lower interestlate on convertibles, Therefore, wlich serves to minimize the agency costs. in behaviorby swapNoie that if a companydoesnot engage bait-and-switch ping low-risk projects for high-risk projects, the chance of hitting a home run is rcduced.Because thereis lsschanceof a home run, the convertiblebond is less likely to be converted. In this situation the convertible bonds are actually similar to nonconvertible debt, except that they carry a lower interest rate. Now consider a different agency cost, one due to asymmetdc information beh{een the managers and potential new stockholders. Suppose its managers know that a company'sfuture prospects not as good as the markei believes, arc which means that the ctrrent stock price is too high. Acting in the interests of exlstifig stockholdeff, manage$ can issue stock at the current high price. Whe[ thepoor future prospecis are eventually revealed. the stock price will fall, causing a transfer of wealih from the new shareholdrs to old shareholders. To illustrate this, suppose the market estimates an $800 million prcsent value of future free cash flows. For simplicity, assume that the firm has no nonoperating assets and no debt, so the total value of both the firm and the equity is $800million. Howevet its managers know that the market has overestimated the future free cashflows, and the true value is only $700million. When investo$ eventually discoverthis, lhe value of the companywill drop to S700 million. Bui beforcthis happens,suppose the compary raises $200 million of new equity. The company uses this new cash to invst in projectswith a presentvalue of $200million, which shouldn't be too hard, since theseare prcjects with a zero NPV Right after the new stockis sold, the company will have a market value of $800 + $200 = $1,000 million, based on the market's overly optimistic estimate of the company's Iuture prospects.Note that the new shareholdersown 20% of the company = ($200/$1,000 0.20),and the odginal sharcholders own 807.. As time passes,tlle market will rcalize ihai the prcviously esiimatd value of million for the company'soridnal sei of projects was ioo high, and that these $800 prcjects worth only $700million. The newprojectsare still worth $200million, are soihe toialvalue ofthe companywill fall io $700+ $200= $900million. The oritinal shareholders' value is now m% of $900million, which is $720million. Note that this is $20 million higher than it would have been if the mmpany had issued no new stock. The new shareholders' value is now 0.20($900) : $180 million, which is $20 milion Iess than their original investment. The net effect is a $20 million wealth tmnsfer from the new shareholders to ihe ori8inal sharelloldels. Becausepotential shareholders know this might occur, they interpret an i6sue the ol new stock as a si8nai oI poor Iuture prospects, which causes stockp ce io whose future prospects fall.Note also tllat this will occu even for companies are actuallyquite good, becausethe market has no way oI distinguishing between wilh good versuspoor prospecis. companies A company r^,ith good future prospecls might want to issue equity, but it tnows the market will interpret tlus ar a negative signal. On way to obtain equity and yt avoid this signaljng effect is to jssue convertible bonds. Becausethe company knows its tnre future prospects are bette! than the market anticipates, it knows that the bonds will likely end rp being converted to equity. Th{s/ a companyin this siluafion is issuing equity through the back door when it issusconve(ible debt. lnsummary, convertibles loglcalscurities usein at leastlwo situations. are to First, if a company would like to finance with straight debt, but lmders are afraid the funds will be invested in a manner that increases the fim's risk Drofile, then convertibles r good choice.Second,if a company wants lo iss;e slock bul are
2l Chapler
Hybrid Proteiied Sbck,Wdtun|s, Convedibl, finoncing: ond
thinks such a move would causinvestors to interprt a stock offerint as a signal of tough times ahead, then again convertibles would be a good choice.ra
SEtF-TE5T is o (onversion A conversion A stroighrbond price? Whot roiio? volue?
whdl i, mantby o (ofterlible'r floor voloe? Whdt ore th ddvdnlEges disodvonhges converlibles hsuers? invesiors? ond of io To How do convertibles red'rceogencycolrs? priceof S25.Thesiockcurrenlt hodej A <onverrible bond hoso por vdlueof 51,000ond o ronversion for $22 o rlwe. r$ot ore the bondt conversion rolio ond (onversion vdlle at t : 0? lao; 58801
2t.4 A Final Comparison ofWarrants and Convertibles
Converrible debt can be thought of as straight debt with nondetachable warranls. Thus, at fiIst blu6h, it might appear that debt with warants and convetible debt However, a closerlook revealsone major and are more or less interchangeable. several minor differnces between these two securities-ts First, as we discussed previously, the exerciseof warrants brings in new equity capital, while the conversion of convertibles rcsulis only in an accounting tmnsfer. A second differcnce irvolves flexibility. Most conveitibles contain a call provision that allows the issuer either to rcfund the debt or to force convercion, depending on the relationship between the convercion value and call pdce. Howevet most warrants are not callable, so firms must wait untjl maturity for the warrants to genemte new equity capital. Generally, maturities also differ between warrants and convertibles. Warrants typicauy have much shorter maturities than convertibles, and wamnts typically expire befor their accompanying debt matures. Furthet warrants provide for fewer fufure common shares than do convertibles, because with convertibles all of the debt is converted to stock whereas debt remains outstanding when wanants are exercised.Together,thesfacts suggst that debt pluswarrant issueE are actually more interested in selling debt than in selint equity. ln general, firms that issue debt with warrants arc smaller and riskier than those that issue convertibles. One possible rationale lor the use oI option securi" tier especially the use of debt with wafiants by small firms, is the diffio ty investoE have in assssingthe risk of small companies. If a start up with a new, untested prcduct seeksdebt financin& it is very difficult for potntial lendels to judge ihe riskiness of ihe veniure; hence it is difficult to set a fair interest mte, Under thes circumst-dnces,many potential investors will be reluctant to invest,
!!seoCrci Lew il.hordl. Rososk, M s, ondldm$ K Sword, ih "Undiliondins DassnofConw ibleDebl," rrutnot.tawt4 caryo.obt,"a. s. vo I I -o lsefie oo3l, eF a5-5 ro -o rtch5 i1o.o^eribe prici o.d ure, s PoulA.qu'rfiond DovidW ullid, , , 'cdMrr,bl. De6r'corpo'or. call Polf,yond volunbry Conwuid,' ,ournor r,iEre, Seprmb.r ^ pp. I27!1289, RondollS. ot 1991, Billi'Ell.y ondDovid sm'fi, M $,rry Do Fi,m,rsue co'Bribh Dcba" [e-mail] l,t@ogrfti, sunnd 1996,pp.93-9e. Dougtd R.Em.rv rroit s r a . M o r o s " m - n o M o i 'o r o - l o rC o l r q C o n , 6 d i bD e b ' l\ o1d6"D. t oi. or Cr u P\ m . C o p b 6 l r lat"atar Fnai.talD.E.t h.tpting e94 pp.o -10!.-.fo lJ-o. o.fodopol\.- ai Ponald 5-9"' 'co-?.-iblo Deb. hv.r.e r ncniEr,'lourdorortaoa(jolPer&r4Sprir'99,1 pp. l5-29,Vol.o d-d loni'sion. 'Tne bsag. Chang'nsconsq@ ol Codbl" DbrF,noncins.'r,'o'cb, Autumi o87. pp. I 12 | j ond V S'wEm K shmnond R6m.thP Rm, 'finon.'ol Dnhs CGh ond Dployld Coll3oI ^lorcssnr, I core"iHo Bods,"f,DoE,olRd,fl NNmber 1996,DD. 913-925. ' ' t o' on. . aeolc dc oapa' r o1. r w o - . f . o 1 o . o r , . - . l c . . e " M i c r | 5 t o T o r o S r e p F n S e '. k . L Po- ic ipo ' . o. c s : AConp. s o l o r '\ . / l . o 6 . r f t i . . o C o n ! . . r b a e b l o n d r . ' l B o i . s , a d i 1 iol D S Conunclion Woro nh,' finoncidl orogemenr, wlrh /V Auiumi1990,pp.23-34
Repo'llng Eorninss When Wotronls Corvedibles Ouhtonding or Are
763
making it necessaryto set a very hiSh interest mte to attract debt capital. By issuing debt with warranis, investo$ obtain a packate that offers upside potential to offsetthe risks of loss. Finall, therc is a significant difference in issuance costs btwn debt with warrants and convertibl dbt. Bonds with warmnts typically rquire issuance co6ts that are about 1.2 prcentagepoints more than the flotation costsfor convertibles. In general, bond with warant financings have underwriting fees that approximate the weighted average of the fees associated with debt and equity issues,while underwriting costs for convertibles are mor like tho6e associated with straiqht debt.
5EI.F.TE5T ore somedifbrencesbetweendebFwith-worront Whdt finoncingdnd <onvertible debt?
Expldin how bonds wi$ mrronrs mishthelp3noll,riskyffrm' selldebtsecuritiei.
21.5 Earnings Warrants Reporting When Are or Convertibles 0utstanding
II warants or converhbles outstanding/a firm could theoreticallyreport eamare ingsper sharein one of threeways:
BasicEPS, calculated as eaninSs available to common stockholdeE divided by the averate number of sharesactually outstandint durinS tlrc period. Pritttary EPS,caloiated as earnings available divided by tlrc average number of 6hare6 that would have been outstanding if warrants and convertibles "likely to be converted in the near tuture" had actually been exercised or conve ed. In calculating primary EPt eamints arc fir6t adjusted by "backing out" the interest on the convertibles, after which the adjusied earnings are divided by the adjusted number of shares. Accountants have a formula that basically compares the conversion or strike (o! exercise)pdce with the actual market valu of the stock to determine the likelihood of conve$ion when deciding on the need to use tlis adjustment procedure. which is similar to pdmary EPSexceptthatail warrantsand conDifutedEPS, vertibles are assumed to be exercised or convertd, leeardless of the likel; hood of exerciseor conversion. Under SEC rules, firms are rcquircd to report both basic and diluted EPS.For firms with large amounts o{ option scurities outstandin& therc can be a substan tial difference between the basic and dilutd EPS dgurcs. For financial statement purposes, firms reported diluted EIrS until 1997,when the Financial Accounting StandardsBoard (FASB)charyed to basic EPs. According to FASB,the change was made to give investors a simpler picture of a company's underlyint pefformance. Also, the change makes it easier lor investors to compare tlle perfomance oI U.S. firms with their foreig counterparts, wllich tend to u6e basic EPS.16
6P! oo n o l r h . F s B t + o . o r \p ' a "1 - .' o e . i T -rr" Fi "d wi lA5 3 b m.ro\. t oa! w " i ' . c 6 n . - r a . r r a i - i 1 o r .! n o ' :o o a ' ll".sl," o sva .n US GA A P 'i i on.i ol Goo' ol arb'ror.1or,a.E l epd ns doido'di, ho fASB s.xp6dod b issue flnolshiamgnrmoLns oddiiiono .honsr ro FASS,1281$uod in o f.bruory r99zl, whch i! rh6 bd! s lor the discus oi in fi s Fd.i
764
Choplel2l
HybrldFinonclng: Prafetred Siock, Wo(dnis, ond Converllbls
5EI.F.TE5T orelhlhrepossible Whal mlhod3 reporling whenworranliondconvertibles oul'l,onding? for EpS or
Whi(hmelhods mosr ore usedin Drodi(e? Why sho'ildinvesrorib concerned oboul o finn's oulsldnding woffontsond convertibles?
Summary
While common stockand long-termdebt prcvide most of the capital usedby cor' porations, companies also use several forms of "hybrid securities." The hybrids include Feferred stoclt convertibles, and warrants, and they generaly have some characteristics of debt and some of equity. We discussd the pros and cons oI th hybrids frcm the siandpoints oI both issuers and investors, how to determift when to use them, and the factors that affect their values. The basic ntionai for ihese securities. and the procedures used to evaluate them, are basd on conceph developedin earlierchapters. The key concepts coveredare listed below: . . Prfened stock is a hybrid it is similar to bonds in some respects and to common stock in other wats. Adiustable rate preleEed stocks (ARPS)are ihoswhose dividends are tied io ihe rate on Treasurysecu iies. Market auction (money market) prefened i6 a low risk, largely tax-exempt, 7-wek-maturity security that can be sold between auction dates at close to par A warrant i6 a long-tem call option issued along with a bond. Warrants are 8enerally detachabie from the bond, and they hade separately in the market. When warants are exercised, the firm receives additional equity capital and the original bonds rcmain outstanding. A convertible secudb' is a bond or preferred stock that can be erchanged for common stock ai the option of the holder When a secudty is converted, debt or prefered stock is replaced with common stock, and no money changeshands. Warrant and convertible issues are generally structured so that the stlik (exercise) price or conversion price is 20% to 30% above the stocks pdce at time of issue. Althou8h both h'arrants and conve ibles are option secudties, there are several differcnces between the two, including separability, impacf when xIctue4 callability, maturity, and flotation costs. Warrants and converfibles are sweetenIs used to make the underlying debt or preferredstockissuemoreattractiveto investors. Alftough the coupon rate or dividend yield is lower when options ar part of the issue, the overall cost of the issue is hither than the cost of stmight debt or prcferred, because ootion-related securiLiesarc riskier.
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Questions
(21-ll Define eachof the following tenns. a. Preferrd stock b. Cumulativedividendsjarearages
Warranedetachable warrant
d. Stepped-up price f.
a.
l2l-21
Convertiblesecurity Convercionlatio; conversion pdce; conversion value Sweetener
Is preferred stock more like bond6 or common stock? Explain.
to {21-3) What eflect does the trend in stock prices (subsequent issue)have on a firm's ability to raise tunds ihrough (a) convertibles and (b) wanants? {21-41 ff a firm expects to have additional financial rqu ments in the tuture, would you rcommend that it use convetibls or bonds with warrants? What factors would influence your decision? l2l-51 How doesa firm's dividend policy affecteachof ihe following? a. The value of its lons-t.,rm warants b. The likelihood that its convertible bonds will be conveted c. The likelihood that its warrants will be exercised {21"6) Evaluate the following statemenl "Issuing convertible secu ties represents a means by which a firm can 6ell common stock at a pdce above the existing
l2l-4
Why do coryoratrons often sell convefiibles on a lights basis?
(21-8) Suppose a company simultaneously issues $50 million of conve ible bonds with a couponrate of 10%and $50million of straightbonds with a coupon rate of 14%. Both bonds have the samematudty. Does the fact that the convefiible issue has th lower coupon rate suggest that it is less risky than the shaight bond? Is the co6t of capital lower on the convertible tha[ on the straight bond? Explain.
Self-TeSt PrOblgm soluiion Appeors inappendix A
of {ST-ll CormorCompanyrecentlyissuedtwo typesof bonds.The first issueconsisted woroih lo-yearstraightdebt$1tha6%annualcoupon. Thesecond issueconsisted lo-year of bondswith a 4.5%annualcouponand attached warrants.Both i$ues sold at their par values. Whatis the implied valueof the warrantsattached each to bond? $1,000
PfOblemS Answers in Appeor Appendix B
Problems1-2 {21-l} GreSg Company recently issued two typs of bonds. The tust issue consisted of Wordnls 2Gyear straitht debt with an 89. annual coupon. The second is6ue consisted of 2o'yearbonds with a 5% annual coupon and attachedwarrants.Both issuessold
Chopi* 2I
Hybdd Fino.cins: P.ehred Slock. Wotronlr, Convedible3 ond
par values-What is the implied value of the wanants attached at theil $1,000 to eachbond? (21-21 PetersonSecuritiesrecently issued convertible bonds with a 1j1,000 value. par convedibles The bonds have a conversion price of$40 a share. W]rat is the convertible issuds conve15ion rariol
{21-31Maese Industies Inc. has warrants outstanding that permit the holders to purchase1 shareoI stockper warrant at a price of S25. a. Calculatethe exercise value oI the firm's warrants if the common sellsat each of the following prices: O) $20, (2) $25, (3) $30, (4) $100. (HinL A wananrs exercisevalue is the difference belween the stock pdce and the purchase price specifiedby the warant if the warrant were to be exercised.) b. At what approximate pric do you think the warrants would actually sell under each condition indicated above?lvhat time value (price minus exercjse valu) is implied in your price? Your answer is a guess, but your p cesand time values should bear reasonable relationships to one another. c. How worild each of the followinS facto$ affect your esfimates of the warranis' pricesand time valuesin part b? (1) The life oI the warant (2) Expected variability (oJ in the stock's price (3) The expected growth rate rn the stock's EPS (4) The company announcesa cllange in dividend policy: whereas it formerly paid no dividends, henceforth it will pay out all earnings as dividends. d. Assume the firm's stock now slls for $20 per share. The company wants to sell some 20-yeat annual interest/$1.000par value bonds. Each bond will have attached 50 warrants, eacl, exercisableinto 1 sharc oI siock at an exercis pdce of $25. The firm's straight bonds yield 12Eo. Regardlessof your answer to part b, assume that each warrant will have a market value of $3 when the stock sells at $20. What coupon interest rate, and dollar coupo& must the company set on the bonds with warrants if they are to clear the market? Company was planning to finance an expansion.The p ncipal 12r.4) The Tseisekos executives of the company ali ageed that an indust al company such as theirs should finance grcwth by means of common stock mther than by debt. However, they felt that the price of the company's common stock did not teflect its true wofth, so they decided to sell a convertible secudty. They considered a convert' ible debenture but feared the burden of fixed interst chaEes if the common stock did nol rise in price to make (onversion dnractive.They decided on an issueof convetible preferredstock,which would pay a dividend of $2.10per share. The common stock was selling for $,12a share at the time. Management projected earninSs for 2006 at $3 a share and expected a fuhrle growth rate of 10%.It was agreedby ihe investmentbanke$ and the managementthat the common stock would sell at 14 time6 earnings, the cu[ent price/eamings ratio. a. The conveEion ratio will be 1.0; that is, each share of convertible preferrd can be converted into 1 share of common. Therefore, the convertible's par value (and also the issuepdce)willbe equalto the convercionprice,which. in iurn, will be determined as a premium (i.e., the percentageby which the conversion
Problems
767
price exceedE stock pdce) over the curent market pdce of the common the stock.What will the conversionprice be if it i6 set at a 10%premium? What will ihe conversionpdce be if it is st at a 3070 premium? b. Should the preferredstockinclude a call provision?Why?
Challenging
12r,5lFilteen years ago, Roop Industries sold $400million of convetible bonds. The
bonds had a 4o-yearmatu tt a 5.7576 coupon rate, and paid interest annually. They were sold at their $1,000 par value. The converion price was set at $62.75; the common stock p ce was $55 Der share, The bonds were subordinated debentures, and they were given 6; A ratin& straight nonconvertible debentures of the same quality yielded about 8.7570 the time Roop's bonds werc at issued. a. Calculate the premium on the bonds, that is, the percentage excessof the conversion pdce over the stock price at the time of issueb. What is Roop's annual beforetax interest savings on the convertible issue versus a shaight-debt i$ue? c. At the time the bonds were igsued, $/hat was the value per bond of ihe convelsion feafure? d. Suppoethe price of Roop's common stock fell from $55 on the day the bonds were issued to $32.75now 15 yeals after the issue date (also assume drat the stock pdce never exceeded $62.75).Assume intelest Jatesremained constant. wllat is the crrrent price of the straitht bond portion of the convertible bond? What is the crrrent value if a bondholder convelts a bond? Do you think it is likely that the bonds will be converted? e. The bonds originally sold for $1,000.If interst rates on A-rated bonds had rcmained constant at 8.7590and the stock price had fallm to $32.75,what do you think would have happned to the price of the convertible bonds? (Assume no change in the standard deviation of stock return6.) f. Now suppoGethe price of Roop's common stock had fallen ftom $55 on the day the bonds were issued to 532.75 at presnt, 15 years after the issue. Suppose also that the rate of interest had fallen ftom 8.75E to 5.75q". Ur.der these conditions, what is the current price of the straBht bond potion of the convertible bond? What is the current value if a bondholder convefts a bond? What do you think would have happened to the p ce of the bonds?
(21-6t The Howland Carpet Company has grown rapidly durjng the past 5 years.
Recentl, its commercial bank ulted the company to consider increasint iis per manent financing. ItE bank loan under a Iine of credit has risen to $250,000, carrying an 8% interest late. Howland has been 30 to 60 days late in payint trade creditors, Discussions with an investment banker have rcsulted in the decision to mise $500,000at this time. Invegtment banke$ have assured the firm that the followinq alternatives feasible(floraiioncostswill be ignored): are . Alteraahue Sell.ommon stockat $8. 1. . Alfernaliue 2i Sell convertible bonds at an 8% couDon. convertible into 100shares commonstockfor each$1,000 of bond {that i;, the conver.ion pri, e is $10per share). . Alfetfiatiae3: Sell debenturesat an 8% coupon, each $1,000bond carrying 100warrants to buy common stockat S10.
75a
choptlr 2l
Hyb d Finoncing: Prehred Stock, Woiionls,ond Conwdiblss
John L. Howland, the president,owns 80% of the common stock and wishesto maintain conhol of the company. On hundrd thousand shares are outstandinS. The following are exEacts of Howlard's latest financial statements: Balance Shet
Current liabilihes Common stock, par $1 Retainedeamings 9550,000 Toial claims
_
!j400,000 100,000 50,000 $550,000
Sales A1l cosisexcPiinterest EBIT EBT (40%) Taxes
91,100,000 990,000 $ 110,000 20,000 $ 90,000 36,000
!__1499
100,0m
Ea.ningsper share Price/earningsratio Meket pdc of stock
$ $
0.54 15.83x 8.55
Show the new balance sheet under each alternative. For Altematives 2 and 3, of show the balancesheetafter conversionof the bonds or xercise the warrants. Assume that half of the tunds 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 alternative, assuminS that he doesnot purchasadditional shares. What is the elfect on eandngsper shareof each alternative,if it is assumed that profits befor intere6t and taxes will be 207. of total assets? d . What will be the debt ratio OL/TA) under each altemative? Which of the thre altematives would you rccommend to Howland, and why? Niendorl lncorporatedneedsto raise $25 million to consiruct production facilil2l-l conw.tibleBdd ties for a new type of USB memory device. The firm's straiSht nonconvertible Aiorysis debenturcs currently yield 9%. Its stock sells for 923 per sharc and has an expectedconstantgro th rate of 670. lnvestment bankers have tentatively pro' posed that the firm raise the $25 million by issujrrg convertible debentures. These convertibles would have a $1,000 par value, carry a coupon rate of 8%, have a 2Gyear matuiry, and be convertible into 35 shares of stock. Coupon payments would be made annually.The bonds would be noncallablefor 5 years, alter which they would be callable at a price of 91,075,this call pdce would declineby $5 per year in Year6 and eachyear thereafter.For simpljcitt assume that the bonds may be called or converted only at the end of a year, iinmediately after the coupon and dividend paymenF. Assume that managementwould call 20%olpar value (not 20%ofcall elitibLebondsif the conve$ionvalue exceeded
DIICE).
At what year do you expect the bonds will be forced into conversion with a call? What is the bond's value in conversion when it is converted at this time? What is the cash flow to the bondholder whm it is coN.erted at this time? (Hint The cash flow includes the conversion value and the coupon payment, becausethe conveEion is immediately after the coupon is paid.) b. What is the expectedrate of retum (i.e.,before+axcomponentcost) on the proposedconvertibleissue?
Spreadsheet Problem
12t-8) Staft with the partial model in the file FMI2 Ch 21 P08 Build a Model. s lrcrj
the textbook'sWeb site.Using the data from Prcblem21 7, answer the following (1) a. For eachyear,calculate the aniicipatedsiockprice, (2) the anticipatedcon versionvaluei (3) the anticipatedstrajghf-bondprice, and (4) the cashflow to the investor assuming coflversion occuts. At what year do you expect the bonds will be forced into conve.sion with a ca ? What is the bond's value in conversion when it is converted at this time? What is the cash flow to the bondholder when it is converted at this time? (Hint The cash flow includes the conversion value and the coupon payment, trecause the conveEion is immediately after the coupon is paid.) b. What is the expected rate of rcturn (i.e., beJoretax comf'onmt cost) on the proposed convertible issue? c. Assume that the convertible bondholders rcqu e a 127. rate of return. If the coupon mte is set at 87o,then what conversion ratio will give a bond price of $1,000?Given a conveBion rafio of 3590,what coupon rate will give a bond Drice of $1,000?
Cyberproblem
"Ies0ulce
Please to the textbook'sWeb site to access Cyberproblems. go any
i,iil"ll =l
PaUlDuncan,financialmanagerofEdusoft lnc., is facinga dilemma.The firm was founded 5 yea$ ato to provide educational software for rhe rapidly expanding pnmary and secondary school markets. Although Edusoft has done wel, tlle firm's founder believes that an industry shakeout is imminent- To survive, Edusoft must glab market shar now, and this will require a larye inlusion of new capital. Becausehe expectsearnings to continue dsing sharply and looks for the stock price to folow 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 ctllrntly high by
770
Chopler 2l
Hybrid Finonclns: Prefered Stock, Woiionis, Convedlbles ond
Idsto cal standards, and with the firm's B rating, the intercst paymenis on a nw debt issue r .ould be prohibitive. Thus, he has narrowed his choice of financing alternatives to two secuities: (1) bonds with warrants or (2) convertible bonds. fu Duncan's assistant,you have been asked to help in the decision processby answe nt the following questions: a. How does prcfened stock differ from both common equity and debt? Is pre' ferrd stock more risky than common stock? What is floating rate pr{elled siock? b. How can a knowledge of call options help a financial manager to better understand warrants and convertibles? c. One of the firm's altematives is to issue a bond rr'ith warants attached. Edusofi's cunent stockprice is $20,and its investmentbanker estimaies that the cost of a 20-yar, annual coupon bond withoui warrants would be 107d. The bankers sutSest attaching 45 wanants, each with an exerciseprice of S25, to each $1,000 bond. It is estimated that each warant, when detached and traded sepaFtely,would have a value of $3. (1) Whai coupon rate should be set on the bond lvith warrants iJ ihe total package is to sell for $1,000? (2) Suppose the bonds were issued and the warants immediately traded on the open market for $5 each. What would this imply aboui the terms of the issue? Did the company "win" or "lose"? (3) Whm would you expect the wanants to be exercised?Assume they have a lO-yearlifei that is, they expire 10 yarsaftI issue. (4) Wili the warants bdng in addiiional capital wherr exercised? so, how lf much, and what type of capital? (5) Becausewarrants lower the cost of the accompanying deb'tissue,shouldn't retum to the holdall debtbe issuedwith warrants?What is ihe exoected with wdrrants rheexpecled rhecompanyr rhe if ersof thebond tor costto rn l0 years? Edusoffs stock pdce is warrants are expectd to be exercised currently $20 per sharc and is expectedto giow at 8% per yar How wouid you expect the cost of the bond with warrants to compare with tlL cost of straight debt? With the cost of common stock? d. As an altenative to the bond with warrants, Mr- Duncan is considering convertible bonds. the {irm's investment banlcrs estimate that Edusoft could sell a 20-year,8.5%arurual coupor! callable convertible bord for its $1,000par value, whereas a straightiebt issue would require a 107, coupon. The conveftibls would be call protected for 5 years, the call price would be $1,1m, and the company would probably call the bonds as soon as possible aJter their conversion value exceeds an $1200.Noie, ihough, that ihe call must occur o11 issuedate anniversary. Edusoffs currnt stock price is $20, its last dividend was $1.00, and th dividend is expectd to $ow at a constant 8% rate. The convrtible could be converted inio 40 sharesof Edusoft stock at ihe owner's option. (1) What conversionprice is built into the bond? (2) What is the convertible's straight-debt value? What is the implied value of the onvetibility feature? (3) What is the formula for the bond's expected conversion value in any year? What is its conve$ion value at Year 0? At Year 10? (4) What is meant by the "floor value" of a convertible? Wllat is the convert" floor value at Year0?At Year10? ible's xpected (5) Assume that Edusoft intends to force conversionby calint the bond as soon as possible after its conversion value exceeds 20% above its par = value, or 1.2($1,000) $1,200. tvhen is the issue expectedto be called?
Addilonol Slctd coses
771
(Hint Recal that the call must be made on an anniveGary date of the (5) What is the expected cost of capital for the convertible to Edusoft? Does ihis cosi appearto be consistent with the dskinessof the issue? Edusoft's market value capital structureis as follows (in millions of dollars)l
Debt Equity
$ s0 50 $100
I
t
ff the companyraises$20million in additional capital by selling (1) convertibles or (2) bonds with warants, wllat would its WACC be, and how would those figures comparc with its current WACC? Edusoft's tax rate is 40%. Mr. Duncan believes that the costs of both the bond with warrants and the convertible bond are clos enouth to one another to call them even, and also consistent with the risks involved. Thus, he witl male his decision based on other facto$. What are some of the factors that he should consider? How do conveftible bonds help reduce agency costs?
Additional Selected Cases
The faUowing cises fom Text hoice, Thonsa LearninS's onlinelibrary,covermany of the concepts dic ssed in this chapterand are aLtilable at http;// ulmt,textchoicA.?ofi. Klein-Brigham Series: Case 2Z 'TirSinia May Chocolate Companr" which illustmtes converrible bond valuation, and Case 98, "I-evinger Oryanic Snack " which iUustrates the use of convrtibles warrants.