HYBRID FINANCING: Preferred Stocks, Warrants and Convertibles securities

Preferred Stocks

• Classified as equity

• Has a par value

• Dividends is stated either in percentage or in money value

• Dividends is set when the stock is issued

• Most preferred stocks are cumulative and so accumulates dividends in arrears

• Arrearages- unpaid preferred dividends.

• Less risky than bonds-Issuing corporation

• Riskier than bonds- Investors

Preferred Stock- Tax effect

Recipeint

Individuals Corporations

Domestic Corporation 10% final tax Exempt

Foreign Corporation Regular Tax Regular Tax

1. Nonresident alien engaged in business-= 20%

Nonresident alien not engaged in

business- 25%

2. Nonresident Foreign Corporation- 30%

WARRANTS

• Certificate issued by a company that gives the holder the right to buy a stated number of shares
of the company’s stock at a specified price for some specified length of time.

• Generally issued along with debt

• Used to induce investors to buy long term debt with lower interest

• A long term call options that have value

• Exercise of warrants dilutes the value of original equity

WARRANTS- VALUATION

WARRANTS IN FINANCING

• Sweeteners when selling debt of preferred stock

• Enables the investors to share in the company’s growth assuming it does fact grow and prosper

• Virtually detachable
THREE CAUSES TO EXERCISE WARRANTS

• When warrants is about to expire and the market price of the stock price is above the exercise
price.

• Company raises the dividend on common stock

• When warrants has a stepped-up strike price

COMPONENT COST OF BONDS WITH WARRANTS

• 1. Get the breakdown of bonds with warrants

Percentage

BONDS $830.00 83%

WARRANTS $170.00 17%

TOTAL $1,000.00 100%

• 2. Estimate the value of the firm

Assume $250 million is the worth immediately after issuing bond with warrants and expected to
grow at 9% per year.

Computation: $250 million X (1.09)^10

Answer: $591.841 million

• 3. Estimate the value of debt

PV bonds ($1000 x (1+10%)^-10) $385.54

PV of annuity of interest payment

($80 X ([1-(1+10%)^-10)]/10%)) $491.57

$877.11

50000 WARRANTS X $877.11 $43.856 million

• 4. Estimate the intrinsic value of entity

Total value of the firm $591.841 million

Income from exercising warrants

(50000 Warrants X $1000 X $22 ) $22 million

Total intrinsic of value of entity

 Less bonds ( 50000 Warrants X $877.11) $43.856 million

Total intrinsic value of entity $569.985 million

• 5. Compute shares issued

(50000 warrants X 20) 1000000 new shares

• 6. Compute common stock intrinsic value after conversion of warrants into share

Total intrinsic value of entity $569.985 million

Divided by shares outstanding 11.11 million shares

* the company has 10 million shares

before the buying shares

through warrants

Value per share $51.82

• 7. Compute the Pre-tax cost of bonds with warrants

CONVERTIBLE SECURITIES

• Bonds or preferred stocks that, under specified terms and conditions can be exchanged for
common stock at the option of the holder.

• Does not provide new capital; debt is simply replaced on the balance sheet by common stock

Convertible Securities

• Conversion Ratio – number of shares of stock a bondholder will receive upon conversion

• Conversion Price- effective price investors pay for common stock when conversion occurs
Use of Convertibles in Financing

• Offer the company chance to sell debt with low interest rate in exchange forgiving holders a
chance to participate in company’s success if it does well

• A way to sell common stock at a prices higher than those currently prevailing

Convertibles and Agency cost

Bait and Switch- a conflict between bondholders and stockholders due to asset substitution.

“Heads I win, tails you lose”

Agency cost – debt holders charge a higher interest rate to compensate for the bait and switch
instances.

Convertibles and Agency cost

• Bait and Switch- a conflict between bondholders and stockholders due to asset substitution.

“Heads I win, tails you lose”

• Agency cost – debt holders charge a higher interest rate to compensate for the bait and switch
instances.
When is best to issue Convertible securities?

• If the company would want to finance with straight debt but lenders are afraid the funds will be
invested in manner that increases the firm’s risk profile

• If the company wants to issue stocks but thinks such move would cause the investors to
interpret stock offering signals of tough times ahead.

Convertible VS Warrants

• Warrants bring new capital; Convertible securities results only in an accounting transfer

• Warrants are not callable; Convertible securities contains a call provision

• Warrants expire before the debts maturity; Convertibles expire with debt maturity

• Warrants provide fewer future common shares; Convertibles convert all debt into common
stocks

• Warrants suggests interest to sell a debt; Convertibles suggests interest in selling common
stocks

• Warrants has issuance cost, underwriting fees; underwriting for convertibles are most like those
associated with the straight debt.

Reporting Earnings When Warrants or Convertibles are Outstanding

• Basic Earning per share- earnings available to common stockholders divided by the average
number of shares actually outstanding during the period>

• Diluted earnings per share- earnings that would have been available to common stockholders
divided by the average number of shares that would have been outstanding if “dilutive
securities” had been converted.