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A Ch 19 Mini Case

I 3/11/2003

Chapter 19. Mini Case for Hybrid Financing: Preferred Stock, Warrants, and Convertibles
Paul Duncan, financial manager of Edusoft Inc., is facing a dilemma. The firm was founded five years ago to provide educational software for the rapidly expanding primary and secondary school markets. Although Edusoft has done well, the firm's founder believes that an industry shakeout is imminent. To survive, Edusoft must grab market share now, and this will require a large infusion of new capital. Because he expects earnings to continue rising sharply and looks for the stock price to follow suit, Mr. Duncan does not think it would be wise to issue new common stock at this time. On the other hand, interest rates are currently high by historical standards, and with the firm's B rating, the interest payments on a new debt issue would be prohibitive. Thus, he has narrowed his choice of financing alternatives to two securities: (1) bonds with warrants or (2) convertible bonds. As Duncan's assistant, you have been asked to help in the decision process by answering the following questions: a. How does preferred stock differ from both common equity and debt? Is preferred stock more risky than common stock? What is floating rate preferred stock? Answer: See Chapter 19 Mini Case Show b. What is a call option? How can a knowledge of call options help a financial manager to better understand warrants and convertibles? Answer: See Chapter 19 Mini Case Show c. One of the firm's alternatives is to issue a bond with warrants attached. EduSoft's current stock price is $20, and its investment banker estimates that the cost of a 20-year, annual coupon bond without warrants would be 12 percent. The bankers suggest attaching 50 warrants, each with an exercise price of $25, to each $1,000 bond. It is estimated that each warrant, when detached and traded separately, would have a value of $3. Value Package Value Package Value Package Value Bonds Value Bonds N I PV FV Payment = = = = = 20 12% $850 $1,000 $100 Value Bonds Value Bonds Value Bonds $1,000 $850 + + + Value Warrents 50($3) $150 $150 = = = $1,000 $1,000 $1,000

(1) What coupon rate should be set on the bond with warrants if the total package is to sell for $1,000? Coupon Rate 10%

(2) Suppose the bonds were issued and the warrants immediately traded on the open market for $5 each. What would this imply about the terms of the issue? Did the company "win" or "lose"? Value Package Value Package Value Package Value Package = = = = Value Bonds $850 $850 $1,100 + + + Value Warrents 50($5) $250

At issue, the package was actually worth $1,100 which is $100 more than the selling price. So, the company lost. (3) When would you expect the warrants to be exercised? Assume they have a 10-year life; that is, they expire 10 years after issue. Generally, a warrant will sell in the open market at a premium above its value if exercised (it cant sell for less). Therefore, warrants tend not to be exercised until just before expiration.

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A B C D E F G H (4) Will the warrants bring in additional capital when exercised? If so, how much, and what type of capital?

When exercised, each warrant will bring in the exercise price, $25. This is equity capital and holders will receive one share of common stock per warrant. The exercise price is typically set some 20% to 30% above the current stock price when the warrants are issued. (5) Since warrants lower the cost of the accompanying debt issue, shouldn't all debt be issued with warrants? What is the expected return to the holders of the bond with warrants (or the expected cost to the company) if the warrants are expected to be exercised in five years, when EduSoft's stock price is expected to be $36.75? How would you expect the cost of the bond with warrants to compare with the cost of straight debt? With the cost of common stock? No. As we shall see, the warrants have a cost which must be added to the coupon interest cost. Answer: See Chapter 19 Mini Case Show d. As an alternative to the bond with warrants, Mr. Duncan is considering convertible bonds. The firm's investment bankers estimate that EduSoft could sell a 20-year, 10.5 percent annual coupon, callable convertible bond for its $1,000 par value, whereas a straight-debt issue would require a 12 percent coupon. The convertibles would be call protected for 5 years, the call price would be $1,100, and the company would probably call the bonds as soon as possible after their conversion value exceeds $1,200. Note, though, that the call must occur on an issue date anniversary. EduSoft's current stock price is $20, its last dividend was $1.48, and the dividend is expected to grow at a constant 8 percent rate. The convertible could be converted into 40 shares of EduSoft stock at the owner's option. (1) What conversion price is built into the bond? Pc = Par Value Pc = $ 1,000 Pc = $ 25.00

/ /

# Shares 40

(2) What is the convertible's straight-debt value? What is the implied value of the convertibility feature? N= I= PMT = $ FV = $ 20 12% 105 1,000 Straight-debt value = $ 887.96

Implied convertible value = $1000 - $887.96 112.04 Implied convertible value = $

(3) What is the formula for the bond's expected conversion value in any year? What is its conversion value at Year 0? At Year 10? Conversion value = CVt = CR(P0)(1 + g)t. Conversion value = $ 800.00 CR = Po = $ g= t= 40 20 8% 0 Note: Change value of "t" to see effect on conversion value.

(4) What is meant by the "floor value" of a convertible? What is the convertible's expected floor value at Year 0? At Year 10? The floor value is the higher of the straight debt value and the conversion value. Straight-debt value = $ Conversion value = $ Floor value at t = $ 887.96 800.00 887.96 N= I= PMT = $ FV = $ t= 20 12% 105 1,000 0 Note: Change value of "t" to see effect on floor value.

A convertible will generally sell above its floor value prior to maturity because convertibility constitutes a call option that has value.

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A B C D E F G H I (5) Assume that EduSoft intends to force conversion by calling the bond as soon as possible after its conversion value exceeds 20 percent above its par value, or 1.2($1,000) = $1,200. When is the issue expected to be called? (Hint: Recall that the call must be made on an anniversary date of the issue.) N= I= PMT = PV = $ FV = $ 5.268 8% $0 (800) 1,200

Since bond must be called on anniversary date the bond would be called at t = 6. (6) What is the expected cost of capital for the convertible to EduSoft? Does this cost appear to be consistent with the riskiness of the issue? 0 $1,000 IRR = 13.7% For consistency, need rd < rc < rs. rd = 12% and rc = 13.7%. rs = [Do ( 1+g) / Po] + g rs = 16.0% Do = Po = g= $1.48 20 8% 1 -$105 2 -$105 3 -$105 4 -$105 5 -$105 6 -$1,375 -$105 -$1,269.50 -$1,374.50

Since rc is between rd and rs, the costs are consistent with the risks. e. EduSoft's market value capital structure is as follows (in millions of dollars): Debt Equity $50 50 $100

If the company raises $20 million in additional capital by selling (1) convertibles or (2) bonds with warrants, what would its WACC be, and how would those figures compare with its current WACC? EduSoft's tax rate is 40 percent. WACC Step 1. Find the after tax cost of convertibles INT(1 - T) = $105(0.6) = $63. 0 $1,000 rc (after tax) = 9.81% WACC Step 2. Find the after tax cost of straight debt. rd (after tax) = rd (after tax) = 12% 7.2% X 0.6 1 -$63 2 -$63 3 -$63 4 -$63 5 -$63 6 -$1,333 -$63.00 -$1,269.50

WACC Step 3. Calculate the WACC WACC with convertibles = [w(sd)] x [ i(sd)] + [w(co)] x [i(co] + [w(eq)] x [i(eq)] WACC with convertibles = 11.24% WACC without convertibles = [w(sd)] x [ i(sd)] + [w(eq)] x [i(eq)] WACC without convertibles = 11.60% Warrents Step 1. Find the after-tax cost of the bond with warrents Time Cash Flow

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A B C D E INT(1 - T) = $100(0.60) = $60. # Warrants (Opportunity loss per warrant) = 50($11.75) = $587.50. rw (after tax) = 10.32%

Warrents Step 2. Calculate WACC if the firm uses warrents WACC with warrents = [w(sd)] x [ i(sd)] + [w(co)] x [i(co] + [w(eq)] x [i(eq)] WACC with warrents = 11.34%

WACC without warrents = [w(sd)] x [ i(sd)] + [w(eq)] x [i(eq)] WACC without warrents = 11.60%

F 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20

G H $1,000.00 -$60.00 -$60.00 -$60.00 -$60.00 -$647.50 = -$60 -$587.50 -$60.00 -$60.00 -$60.00 -$60.00 -$60.00 -$60.00 -$60.00 -$60.00 -$60.00 -$60.00 -$60.00 -$60.00 -$60.00 -$60.00 -$1,060.00 = -$60 -$1000

f. Mr. Duncan believes that the costs of both the bond with warrants and the convertible bond are close enough to one another to call them even, and also consistent with the risks involved. Thus, he will make his decision based on other factors. What are some of the factors which he should consider? The firms future needs for equity capital: 1. Exercise of warrants brings in new equity capital. 2. Convertible conversion brings in no new funds. 3. In either case, new lower debt ratio can support more financial leverage. Does the firm want to commit to 20 years of debt? 1. Convertible conversion removes debt, while the exercise of warrants does not. 2. If stock price does not rise over time, then neither warrants nor convertibles would be exercised. Debt would remain outstanding. g. How do convertible bonds help reduce agency costs? Agency costs can arise due to conflicts between shareholders and bondholders, in the form of asset substitution (or baitand-switch. This happens when the firm issues low cost straight debt, then invests in risky projects. Bondholders suspect this, so they charge high interest rates. Convertible debt allows bondholders to share in upside potential, so it has low rate. Thus, convertible debt helps reduce this agency cost. Information asymmetry occurs when a company knows its future prospects better than outside investors. Otside investors think the company will issue new stock only if future prospects are not as good as market anticipates, so issuing new stock send negative signal to market, causing the stock price to fall. A company with good future prospects can issue stock "through the back door" by issuing convertible bonds. This avoids the negative signal of issuing stock directly. Since prospects are good, bonds will likely be converted into equity, which is what the company wants to issue.

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