Chapter 20 - 1 CHAPTER 20 Hybrid Financing Preferred Stock...

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Unformatted text preview: 1 CHAPTER 20 Hybrid Financing: Preferred Stock, Warrants, and Convertibles 2 Topics in Chapter Types of hybrid securities Preferred stock Warrants Convertibles Features and risk Cost of capital to issuers 3 How does preferred stock differ from common stock and debt? Preferred dividends are specified by contract, but they may be omitted without placing the firm in default. Most preferred stocks prohibit the firm from paying common dividends when the preferred is in arrears. Usually cumulative up to a limit. (More...) 4 Some preferred stock is perpetual, but most new issues have sinking fund or call provisions which limit maturities. Preferred stock has no voting rights, but may require companies to place preferred stockholders on the board (sometimes a majority) if the dividend is passed. Is preferred stock closer to debt or common stock? What is its risk to investors? To issuers? 5 Advantages and Disadvantages of Preferred Stock Advantages Dividend obligation not contractual Avoids dilution of common stock Avoids large repayment of principal Disadvantages Preferred dividends not tax deductible, so typically costs more than debt Increases financial leverage, and hence the firm’s cost of common equity 6 Floating Rate Preferred Dividends are indexed to the rate on treasury securities instead of being fixed. Excellent S-T corporate investment: Only 30% of dividends are taxable to corporations. The floating rate generally keeps issue trading near par. 7 However, if the issuer is risky, the floating rate preferred stock may have too much price instability for the liquid asset portfolios of many corporate investors. 8 How can a knowledge of call options help one understand warrants and convertibles? A warrant is a long-term call option. A convertible consists of a fixed rate bond (or preferred stock)plus a long- term call option. 9 What coupon rate must be set on the following bond with warrants if the total package is to sell for $1,000? P = $20. r d of 20-year annual payment bond without warrants = 10%. 45 warrants with an exercise price of $25 each are attached to bond. Each warrant’s value is estimated to be $3. 10 Step 1: Calculate V Bond V Package = V Bond + V Warrants = $1,000....
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Chapter 20 - 1 CHAPTER 20 Hybrid Financing Preferred Stock...

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