FI.Chapter21
30 Pages

FI.Chapter21

Course: FI 601-602 FI601-602, Spring 2009

School: New Haven

Word Count: 21953

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i: r trre$errcq! S*ek, #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...

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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 $1,0U0 sorreone holdint convertiblcs lhe for the entirc l,ear rvould have ended up close to where hc or she siarted, with a toial rcturn just shy of the 4.7570 coupor rate, but probably also wiih a bnd caseof hearib rn and a fe\,gray hairs. s.vr..r John Go,hom, tilreSb.ls,' Forbe5, 0e.ember 1999,200. 27, "Cl\iclsn 743 Inprevious chapters we examined common stocks and various types of long{erm debt.In this chapter, we examine three other securities used to mise tong+erm caplta\ 11) prct'etaed stocft, which is a hybrid security ihat represents a cross betweendebt and common equity; (2) u,ntfints, which arc drivative secudties issued firms to facilitate the issuance someother type of security,and (3)corby of irllibles, which combinethe featuresof debi (or preferredstock)and warrants. e-IesouIce Therexlbook!WBb site contoins Er.6/ fi e lhat oi rhechop|e,'scolculolons. Thefile Io, i5 choprs it fMl2 Ch2l bl KnrL, 2l.l Preferred Stock lreferled etock is a hybrid-it is similar to bonds in some respects and io comnon stock in other ways. Accountants classify prefe ed stock as equity, hence showit on th balance sheet as an equity account. However, Irom a finance per spectiveprefered stock lies somewhere berween debt and common equity-it imposes fixed dlarge and thus increasesthe firm's financial leverage, yet omiF a tint the prefened dividend does not for're a company into bankruptcy. Also, unlike intereston debt, prefelred dividends are not deductibleby the issuirg corporation, preferredstockhasa higher costof capitalthan debi.We fi$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 prefened

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