20 CHAPTER HYBRID FINANCING: PREFERRED STOCK, WARRANTS, AND CONVERTIBLES
(Difficulty: E = Easy, M = Medium, T = Tough)
True/False Easy:
(20.1) Preferred stock Answer: b Diff: E 1 . The "preferred" feature of preferred stock means that it normally will provide a higher expected return than will common stock. a. True b. False (20.1) Cost of preferred stock Answer: a Diff: E 2 . Unlike bonds, the cost of preferred stock to the issuing firm is the same on a before-tax and after-tax basis. This is because dividends on preferred stock are not tax deductible, whereas interest on bonds is deductible. a. True b. False (20.2) Warrants Answer: b Diff: E 3 . A warrant is an option, and as such it cannot be used as a "sweetener." a. True b. False (20.2) Warrants Answer: b Diff: E 4 . A warrant holder is not entitled to vote, but he or she does receive any cash dividends paid on the underlying stock. a. True b. False (20.2) Warrants Answer: a Diff: E 5 . The problem of dilution of stockholders earnings never results from the sale of call options, but it can arise if warrants are used. a. True b. False
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(20.2) Detachable warrant Answer: a Diff: E 6 . A detachable warrant is a warrant that can be detached and traded separately from the bond with which it was issued. Most traded warrants are originally attached to bonds or preferred stocks. a. True b. False (20.3) Convertibles Answer: a Diff: E 7 . The owner of a convertible bond owns, in effect, both a bond and a call option. a. True b. False (20.3) Convertibles Answer: b Diff: E 8 . A convertible debenture can never sell for more than its conversion value or less than its bond value. a. True b. False (20.3) Convertibles Answer: a Diff: E 9 . Most convertible securities are bonds or preferred stocks that, under specified terms and conditions, can be exchanged for common stock at the option of the holder. a. True b. False (20.3) Convertibles Answer: a Diff: E 10 . Firms generally do not call their convertibles unless the conversion value is greater than the call price. a. True b. False
Medium:
(20.1) Preferred stock Answer: a Diff: M 11 . Many preferred stocks extend voting rights to preferred shareholders if the preferred dividend has been omitted for some specified period, for example, 4 quarters. a. True b. False (20.1) Preferred stock Answer: b Diff: M 12 . Preferred stockholders have priority over common stockholders with respect to dividends, because dividends must be paid on preferred stock before they can be paid on common stock. However, preferred and common Page 2 Chapter 20: Hybrid Financing
stockholders normally have equal priority with respect to liquidating proceeds in the event of bankruptcy. a. True b. False
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(20.1) Preferred stock Answer: a Diff: M 13 . Preferred stock typically has a par value, and the dividend is often stated as a percentage of par. The par value is also important in the event of liquidation, as the preferred stockholders are generally entitled to receive the par value before anything is given to the common stockholders. a. True b. False (20.1) Preferred stock Answer: a Diff: M 14 . Preferred stock can provide a financing alternative for some firms when market conditions are such stat they cannot issue either pure debt or common stock at any reasonable cost. a. True b. False (20.1) Floating-rate preferred stock Answer: a Diff: M 15 . Corporations that invest surplus funds in floating-rate preferred stock benefit from getting a relatively stable price, which is desirable for liquidity portfolios, and they also benefit from the 70% tax exemption on preferred dividends received. a. True b. False
Multiple Choice: Conceptual Medium:
(20.1) Preferred stock 16 . Which of the following statements is most CORRECT? Answer: c Diff: M
a. Preferred stock generally has a higher component cost of capital to the firm than does common stock. b. By law in most states, all preferred stock must be cumulative, meaning that the compounded total of all unpaid preferred dividends must be paid before any dividends can be paid on the firms common stock. c. From the issuers point of view, preferred stock is less risky than bonds. d. Whereas common stock has an indefinite life, preferred stocks always have a specific maturity date, generally 25 years or less. e. Unlike bonds, preferred stock cannot have a convertible feature.
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(20.3) Convertibles Answer: e Diff: M 17 . Which of the following statements about convertibles is most CORRECT? a. The coupon interest rate on a firms convertibles is generally set higher than the market yield on its otherwise similar straight debt. b. One advantage of convertibles over warrants is that the issuer receives additional cash money when convertibles are converted. c. Investors are willing to accept a lower interest rate on a convertible than on otherwise similar straight debt because convertibles are less risky than straight debt. d. At the time it is issued, a convertible's conversion (or exercise) price is generally set equal to or below the underlying stocks price. e. For equilibrium to exist, the expected return on a convertible bond must normally be between the expected return on the firms otherwise similar straight debt and the expected return on its common stock. (20.4) Warrants and convertibles Answer: c 18 . Which of the following statements concerning warrants is CORRECT? Diff: M
a. Bonds with warrants and convertible bonds both have option features that their holders can exercise if the underlying stocks price increases. However, if the option is exercised, the issuing companys debt declines if warrants were used but remains the same if it used convertibles. b. Warrants are long-term put options that have value because holders can sell the firms common stock at the exercise price regardless of how low the market price drops. c. Warrants are long-term call options that have value because holders can buy the firms common stock at the exercise price regardless of how high the stocks price has risen. d. A firms investors would generally prefer to see it issue bonds with warrants than straight bonds because the warrants dilute the value of new shareholders, and that value is transferred to existing shareholders. e. A drawback to using warrants is that if the firm is very successful, investors will be less likely to exercise the warrants, and this will deprive the firm of receiving any new capital. (20.4) Warrants and convertibles 19 . Which of the following statements is most CORRECT? Answer: c Diff: M
a. Warrants have an option feature but convertibles do not. b. One important difference between warrants and convertibles is that convertibles bring in additional funds when they are converted, but exercising warrants does not bring in any additional funds. c. The coupon rate on convertible debt is normally set below the coupon rate that would be set on otherwise similar straight debt even though investing in convertibles is more risky than investing in straight debt. d. The value of a warrant to buy a safe, stable stock should exceed the value of a warrant to buy a risky, volatile stock, other things held constant. e. Warrants can sometimes be detached and traded separately from the debt Chapter 20: Hybrid Financing Page 5
with which they were issued, but this is unusual.
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Multiple Choice: Problems Easy:
(20.3) Convertible features: straight-debt value Answer: d Diff: E 20 . Volunteer Vegetables common stock currently sells for $33, and its 8% convertible debentures (issued at par, or $1,000) sell for $850. Each debenture can be converted into 25 shares of common stock at any time before 2017. What is the conversion value of the bond? a. b. c. d. e. $707.33 $744.56 $783.75 $825.00 $866.25
(20.3) Conversion price Answer: a Diff: E 21 . Chocolate Factory's convertible debentures were issued at their $1,000 par value in 2007. At any time prior to maturity on February 1, 2027, a debenture holder can exchange a bond for 25 shares of common stock. What is the conversion price, Pc? a. b. c. d. e. $40.00 $42.00 $44.10 $46.31 $48.62
Medium:
(20.1) Preferred stock vs. bond yields Answer: a Diff: M 22 . Plowman Industries can issue a 25-year, 8.1% annual payment bond at par. They also stated that the company can sell an issue of annual payment preferred stock to corporate investors who are in the 40% tax bracket. The corporate investors require an after-tax return on the preferred that exceeds their after-tax on return the bonds by 1.0%, which would represent an after-tax risk premium. What coupon rate must be set on the preferred in order to issue it at par? a. b. c. d. e. 6.66% 6.99% 7.34% 7.71% 8.09%
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(20.2) Bonds with warrants Answer: b Diff: M 23 . Atchley Enterprises stock price is $42 per share. The company wants to sell some 20-year, annual interest, $1,000 par value bonds. Each bond would have 75 warrants attached to it, each exercisable into one share of stock at an exercise price of $47. The firms straight bonds yield 10%. Each warrant is expected to have a market value of $2.00 given that the stock sells for $42. What coupon interest rate must the company set on the bonds in order to sell the bonds-with-warrants at par? a. b. c. d. e. 7.83% 8.24% 8.65% 9.08% 9.54%
(20.2) Bonds with warrants Answer: d Diff: M 24 . Reynolds Industries is planning to issue bonds with warrants. The bonds will have a 30-year maturity and annual interest payments. Each bond will come with 20 warrants that give the holder the right to purchase one share of stock per warrant. The investment bankers estimate that each warrant will have a value of $10.00. A similar straight-debt issue would require a 10% coupon. What coupon rate should be set on the bonds-with-warrants so that the package would sell for $1,000? a. b. c. d. e. 6.75% 7.11% 7.48% 7.88% 8.27% Answer: a Diff: M 50 warrants attached. The coupon of 12%, and they current yield on similar value of each warrant?
(20.2) Bonds with warrants 25 . E. Thompson Utilities has issued a bond with bonds have a 20-year maturity and an annual were issued at their $1,000 par value. The straight bonds is 15%. What is the implied a. b. c. d. e. $3.76 $3.94 $4.14 $4.35 $4.56
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Tough:
(20.3) Convertibles Answer: d Diff: T 26 . Seery Services, Inc. is considering issuing a 10-year convertible bond that would be priced at its $1,000 par value. The bonds would have an 8.00% annual coupon, and each bond could be converted into 20 shares of common stock. The required rate of return on an otherwise similar nonconvertible bond is 10.00%. The stock currently sells for $40.00 a share, has an expected dividend in the coming year of $2.00, and has an expected constant growth rate of 5.00%. What is the estimated floor price of the convertible at the end of Year 3? a. b. c. d. e. $794.01 $835.81 $879.80 $926.10 $972.41
Multi-part:
(The following data apply to Problems 27 through 30. kept together.) The problems MUST be
The following data apply to Saunders Corporation's convertible bonds: Maturity: Par value: Annual coupon: 10 $1,000.00 5.00% Stock price: Conversion price: Straight-debt yield: Answer: b $30.00 $35.00 8.00% Diff: E
(20.3) Convertible features: conversion ratio 27 . What is the bond's conversion ratio? a. b. c. d. e. 27.14 28.57 30.00 31.50 33.08
(20.3) Convertible features: conversion value 28 . What is the bond's conversion value? a. b. c. d. e. $698.15 $734.89 $773.57 $814.29 $857.14
Answer: e
Diff: E
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(20.3) Convertible features: straight-debt value 29 . What is the bond's straight-debt value? a. b. c. d. e. $684.78 $720.82 $758.76 $798.70 $838.63
Answer: d
Diff: E
(20.3) Convertible features: floor price Answer: e Diff: E 30 . Based on your answers to the three preceding questions, what is the minimum price (or "floor" price) at which the Saunders' bonds should sell? a. b. c. d. e. $698.15 $734.89 $773.57 $814.29 $857.14
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CHAPTER 20 ANSWERS AND SOLUTIONS
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1.(20.1) Preferred stock 2.(20.1) Cost of preferred stock 3.(20.2) Warrants 4.(20.2) Warrants 5.(20.2) Warrants 6.(20.2) Detachable warrant 7.(20.3) Convertibles 8.(20.3) Convertibles 9.(20.3) Convertibles 10.(20.3) Convertibles 11.(20.1) Preferred stock 12.(20.1) Preferred stock 13.(20.1) Preferred stock 14.(20.1) Preferred stock 15.(20.1) Floating-rate preferred stock 16.(20.1) Preferred stock 17.(20.3) Convertibles
Answer: b Answer: a Answer: b Answer: b Answer: a Answer: a Answer: a Answer: b Answer: a Answer: a Answer: a Answer: b Answer: a Answer: a Answer: a Answer: c Answer: e
Diff: E Diff: E Diff: E Diff: E Diff: E Diff: E Diff: E Diff: E Diff: E Diff: E Diff: M Diff: M Diff: M Diff: M Diff: M Diff: M Diff: M
Response e is correct. From an investors standpoint, convertibles are normally more risky than straight debt but less risky than common stock, hence the expected return on the convertible lies between that on the stock and that on the straight bond. 18.(20.4) Warrants and convertibles 19.(20.4) Warrants and convertibles Answer: c Answer: c Diff: M Diff: M
Answer c is correct; convertibles do normally have a relatively low coupon because the opportunity for capital gains provides part of their expected total return. The other responses are all incorrect. Statement d is incorrect because like other options, the value of the warrant is increased by price volatility in the underlying asset. 20.(20.3) Convertible features: straight-debt value Stock price: Bond price: Conversion ratio: $33.00 $850.00 25.00 Coupon rate: Par value: Answer: d Diff: E
8.00% $1,000.00
Conversion value = Conversion ratio Stock price = $825 21.(20.3) Conversion price Par value: Conversion ratio: $1,000.00 25.00 Answer: a Diff: E
Conversion price = Par value/Conversion ratio = $40.00 22.(20.1) Preferred stock vs. bond yields Maturity: Coupon rate: Risk premium 25 8.10% 1.00% Pfd. exclusion: Tax rate: Answer: a Diff: M
70% 40.00%
Bond yield AT = BT yield(1 T) = 4.86% Preferred yield AT = AT bond yield + RP = 5.86% AT pfd yield = BT pfd yield BT pfd yield(1 Exclusion)(Tax rate) Preferred yield BT = 5.86%/[1 (0.3)(0.4)] = 6.66% Check: base case AT pfd yield = 6.66% Tax = 6.66% 6.66%(1 Exclusion)(Tax rate) = 6.66% 6.66%(1 0.7)(0.4) = 6.66% 6.66%(1 0.7)(0.4)= 5.86%. 23.(20.2) Bonds with warrants Stock price: Exercise price: No. of warrants: Value of warrants: $42.00 $47.00 75 $2.00 Bond par value: Bond maturity: Straight-debt yield: Answer: b Diff: M
$1,000 20 10.0%
Total value = Straight-debt value + Warrant value = $1,000 = Bond value + $150 VB = $1,000 $150 = $850 Now set N = 20, I/YR = 10, PV = -850, FV = 1000 and solve for PMT: $82.38 To get this payment on a $1,000 bond, the coupon rate must be: 8.24% 24.(20.2) Bonds with warrants Bond par value: Bond maturity: Straight-debt yield: $1,000 30 10.0% No. of warrants: Value of warrants: Answer: d Diff: M
20 $10.00
Total value = Straight-debt value (VB) + Warrant value = $1,000 VB = $1,000 $200.00 = $800.00 Set N = 30, I/YR = 10, PV = -800, and FV = 1000. Then solve for PMT: $78.78 To get this payment on a $1,000 bond, the coupon rate must be: 7.88% 25.(20.2) Bonds with warrants Bond par value: Bond maturity: Straight-debt yield: $1,000 20 15.0% No. of warrants: Convertible coupon: Answer: a Diff: M
50 12.0%
Find the straight-debt value: N = 20, I/YR = 15, PMT = -120, and FV = -1000. PV = $812.22 Total value = Straight-debt value + Warrant value. $1,000 = Straight-debt value + 50(Warrant value) Warrant value = ($1,000 Straight-debt value)/50 = $3.76 26.(20.3) Convertibles Bond par value: Bond maturity: $1,000 10 Answer: d Conversion ratio ( Shares): Convertible coupon: Diff: T
20 8.0%
Evaluation year: Straight-debt yield: Dividend per share:
3 10.0% $2.00
Stock price: Growth rate:
$40.00 5.0%
Find the straight-debt value at N=10-3=7: N=7, I/YR=10, PMT=-80, and FV=-1000. PV = VB = $902.63 Conversion value at t = 3: CV = (Shares) (Stock price) (1+g)3 = $926.10 The floor value is the higher of the bond value or the conversion value, so it is $926.10. 27.(20.3) Convertible features: conversion ratio Years to maturity: Par value: Annual coupon: 10 $1,000.00 5.00% Stock price: Conversion price: Straight-debt yield: Answer: b Diff: E
$30.00 $35.00 8.00%
Conversion ratio = Par/Conversion price = $1,000/$35 = 28.57 28.(20.3) Convertible features: conversion value Conversion value = Conversion ratio Market price of stock = $857.14 29.(20.3) Convertible features: straight-debt value Answer: d Diff: E Diff: E Answer: e Diff: E
Inputs to find the straight-debt value: N = 10; I/YR = 8; PMT = 50; FV = 1,000. $798.70 30.(20.3) Convertible features: floor price Answer: e
The floor price is the higher of the bond's conversion value or straight debt value. Those values as calculated above are as follows: Conversion value: Straight-debt value: $857.14 $798.70
Max of the two = minimum price = floor = $857.14