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Unformatted text preview: Chapter 21 Hybrid Financing: Preferred Stock, Warrants, and Convertibles ANSWERS TO END-OF-CHAPTER QUESTIONS 21-1 a. Preferred stock is a hybrid security, having characteristics of both debt and equity. It is similar to equity in that it (1) is called “stock” and is included in the equity section of a firm’s balance sheet, (2) has no maturity date, and (3) has payments which are considered dividends--thus, they are not legally required and are not tax deductible. However, it is also similar to debt in that it (1) sets a fixed rate for dividends, (2) affords its holders no voting rights, and (3) has priority over common shareholders in the event of bankruptcy. b. Cumulative dividends is a protective feature on preferred stock that requires all past preferred dividends to be paid before any common dividends can be paid. Arrearages are the preferred dividends that have not been paid, and hence are “in arrears.” c. A warrant is an option issued by a company to buy a stated number of shares of stock at a specified price. Warrants are generally distributed with debt, or preferred stock, to induce investors to buy those securities at lower cost. A detachable warrant is one that can be detached and traded separately from the underlying security. Most warrants are detachable. d. A stepped-up price is a provision in a warrant that increases the striking price over time. This provision is included to prod owners into exercising their warrants. e. Convertible securities are bonds or preferred stocks that can be exchanged for (converted into) common stock, under specific terms, at the option of the holder. Unlike the exercise of warrants, conversion of a convertible security does not provide additional capital to the issuer. f. The conversion ratio is the number of shares of common stock received upon conversion of one convertible security. The conversion price is the effective price per share of stock if conversion occurs. Thus, the conversion price is the par value of the convertible security divided by the conversion ratio. The conversion value is the value of the stock that the investor would receive if conversion occurred. Thus, the conversion value is the market price per share times the conversion ratio. g. A “sweetener” is a feature that makes a security more attractive to some investors, thereby inducing them to accept a lower current yield. Convertible features and warrants are examples of sweeteners. Answers and Solutions: 21 - 1 21-2 Preferred stock is best thought of as being somewhere between debt (bonds) and equity (common stock). Like debt, preferred stock imposes a fixed charge on the firm, affords its holders no voting rights, and has priority over common stock in the event of bankruptcy. However, like equity, its payments are considered dividends from both legal and tax standpoints, it has no maturity date, and it is carried on the firm’s balance sheet in the equity section. From a creditor’s viewpoint, preferred stock is more like common...
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- Spring '10