Chapter20-IFM10 - CHAPTER 20 Hybrid Financing: Preferred...

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1 CHAPTER 20 Hybrid Financing:  Preferred  Stock, Warrants, and Convertibles
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2 Topics in Chapter Types of hybrid securities Preferred stock Warrants Convertibles Features and risk Cost of capital to issuers
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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. ..)
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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?
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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
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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.
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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.
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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.
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9 What coupon rate must be set on the  following bond with warrants if the total  package is to sell for $1,000? P 0  = $20. r d  of 20-year annual payment bond  without warrants = 10%. 45 warrants with a strike price (also  called an exercise price) of $25 each  are attached to bond. Each warrant’s value is estimated to be  $3.
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10 Step 1:  Calculate V Bond V Package  = V Bond  + V Warrants  = $1,000.               V
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Chapter20-IFM10 - CHAPTER 20 Hybrid Financing: Preferred...

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