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Unformatted text preview: Chapter 20 Hybrid Financing: Preferred Stock, Warrants, and Convertibles ANSWERS TO BEGINNING-OF-CHAPTER QUESTIONS 20-1 Both companies and investors have different preferences regarding risks, maturities, and so forth. Companies offer different types of securities in order to get the features they like and also to provide features that investors desire so as to minimize the cost of funds. 20-2 Preferred dividends are not normally deductible by the issuing corporation, so they have a higher after-tax cost than debt. Companies normally plan to pay dividends on preferred stocks, and investors expect to collect them. However, the non-payment of preferred cannot throw a firm into bankruptcy, whereas failure pay interest on debt does lead to bankruptcy. Therefore, preferred is riskier than debt to investors, but less risky to the issuer, and preferred provides only a fixed return (except that some preferred stock has, in effect, a floating dividend rate). Corporate investors can exclude 70% of preferred dividends from taxable income, so for such investors preferred stock provides a relatively high after-tax rate of return. Also, preferred stocks can be made convertible. Today, non-convertible preferred stock is not used very often, and when it is, it is typically has a floating rate and is bought by corporate investors or money market funds. 20-3 A warrant is a long-term option to purchase a share of common stock. Generally, warrants are issued with bonds and serve as “sweeteners” to induce investors to buy the bonds. Because of the possibility of profits from the warrant, investors will buy the bond at a coupon rate that is below the rate on straight debt of comparable risk and maturity. The terms on a bond-with-warrants would be set such that the expected rate of return on the package is somewhat above the straight debt interest rate but below the required return on the common stock. The bond would produce a stream of cash flows from the coupons and eventually the maturity value. The warrants would produce an expected cash flow in Year N equal to: Number of warrants * (P (1+g) N- P exercise ). We could find the IRR of this cash flow stream, and it would be the expected rate of return on the bonds-plus-warrants package. This IRR should be between r d and r s , and the investment bankers could “tinker” with the coupon rate, the number of warrants offered, the exercise price, and the life of the warrants to increase or decrease the IRR and make the offering sufficiently attractive to induce investors to buy the issue. See the tab labeled “Warrants” on the BOC model for an illustration. Answers and Solutions: 20- 1 20-4 A convertible is a bond or preferred stock that can be converted into common stock of the issuing company at the holder’s option. The bond will specify a coupon rate, maturity, call protection period, and number of shares to be received upon conversion. Investors will expect the stock to grow at some rate, and they can use that growth rate to forecast...
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- Summer '12
- Corporate Finance, Dividend