562 Chapter 14 LEASE FINANCING

6xtensdonsPERCENTAGE COSTANATYSISAnderson's lease-versus-purchase decision could also beanalyzed using the percentage cost approach. Here weknow the after-tax cost of debt, 6.0 percent, so we can findthe aftcrlax cost rate intpliecl in the lease corlract and com-pare it with the cost of the loan. Signing a lease is similarto signing a loan contract- the firm has the use of equip-ment. but it must make a series o[ payments under eithertype of contract. We know the rate built into the loan; it is6.0 percent after taxes for Anderson. There is an equiva-lent cost rate built into the lease. If the equivalent after-taxcost rate in the lease is less than the after-tax interest rateon the debt, then there is ari advantage to leasing.

Table 14E-1 sets forth the cash flows needed to deter-mine the equivalent loan cost. Here is an explanation ofthe table:

1. The net cost to purchase the equipment, which isavoided if Anderson leases, is shown on Line 1 as apositive cash flow (an inflow) at Year 0. lf Ander-

Year 0

l.Avoidednetpurchaseprice $10,000

2. After-tax lease payment (1,650)

3, Lost depreciation tax savings

4. Avoided after-tax maintenance cost 300

5. Lost after-tax residual value

Lee, Wayne Y., ]ohn D, Martin, and nndreir l. Senchack, "The Case for UsinpEvaluate Saivage Values in Financi alLeases," Einancral Managenrort, Autumn".

For a discttssion of the impact of the AMT on lease decisions, sae

"The Effect of the CorporateAltemative Minimum Thx: Amount, Duration, qndLease versus Buy Decision." T[e /ournal of Equipment Lease Eiuanchry,Spring

is also an oPPortunity cost of Ieasing, and it is,n on Line 5 as an outflow in Year 5.

6 is a time line of the annual ne[ cash flows. lfleases, there is an inflow at Year 0 fol-

Exiensions 5b3

Andrrson should nevcr borrow-all "debt" ii-nancing should come from leasing. lf it had a capi-tal budEet of 5100 million, .rnd if its optimal capit.ristructure called for 50 percent tlcbt, thcn i1 5ll1ruklle.rsc assr'ts lvith a cost of $50 nrillion nnd lin,ln(rthe remainder rvith equitl,. All projccts shouid [.cevalu.rted at a WACC bascd on the debt cost inLplicd in the' lcirse contracts, 5.5 percent in our cr-ample. Thus ftlr all average-risk projccts,

WACC for usc in -., -..."pii"r i,.ii.'i,,,i = 0's(s s')') + 0 s( Is"") = 10 25""

Anderson's capital budgeting director should nor'recalculate thc proiec!'s Nl'V using .1 cost of capi-tal of 10.25 percent versus the ave'rage proiect costof capital, ignoring leasing, of 10.5 percr'nt. .\s-sunlL. that thc projcct's NPV is now +$20,000. Thcavailability of lt'ase financing has made the projcctacceptable.

2. The project under consideration is unique-it isthe only one for which favorable lease terms arcavailable. In tllis case, with the furthe'r assunrptirrrrthat tlie cost of the project does not exceed the conr-pany's incrcmental debt capaciiy, the NPV ol thcproject for capital budgeting purposes should [,rcieterminccl as folkrvs:

Adiustcd Nt,v = -Nl'v based on NAL fronr

, regular" WACC * Tobl" U-:

= -$50,000 + $10.1,000 = $5+,00(t.

Flere tlre firm hirs cntrugh dcbt capacity k) financc ilieprolect cntirely by leasing, so the fimr rvill get thc entirrNAL. (lf all prolects were suitable for leasing, they stillcould not all be leasc'd because some ecluity would be ru-quired. Therefore, under the conditions of the precerlingparagraph, this procedure would not be appropriale.) Tireentire NAL should be allocated to this project. All otherprolects should be evaluated on the basis of the Wr\CCwith "regular" debt.

If neither polar position holds, or if different projectscan be leased on diffcrent lease terms with different etltriv-alent loan rates, tlren no simple rule can bc used. Nt,te.though. that as a pr.rrtic.rl mnttof lve raroly neqt{ to gtr irrtothc feedlrack effccts oi le.rsing on capilal bLldgctinE in tir(first place, because fcrv proiects thnt arc not accefrt;ri.rlcunder onc'financinu metlrod lvoulcl be acceptable urrrlcranother. Given all the urcert.rinties about cipital budiict-ing cash florvs, few nran.rgr'rs wotrlcl ch;rngt' their rrrirrrl.about the acceptability of a projcct as a rcsult o[ a fer' [,,r-sis points ch.rnge in thr' IVI\CC. Still, for certain typcs oIbusinesse's the'availability of kase financing could rn.rkrthe diflerence in t[.rr'go/no-go dccision. Thr.refore. it is inr-port.rnt for financial m.tnagers to knolv horv leasing nrightnffcct cnFitdl bu(lgctinE arrrlysis.

Tfte. Cas:s in Financial Management Dryden Reques t series contai,$ the followingileal with lease analysis:

Case 25, "Environmental Sciences, lnc.," Case 25A, "Agro Chemical Corporationi258, "Friendly Food Stores, Inc.," Case 26, "Prudent Solutions, Inc.,i' and ci;'?groGrow, L::rc..," all of which examine the lease decision frorn the perspectives;the lessee and the lessor. ,!

rather than buying, or Line 11 minus7 in-Table 14-2.

the cash flows on Line 6 into the cash flowa cilculator and then pressing the lllll button,

the II{R for the stream; it is 5.5 percent, anduivalent after-tax cost rate implied in the lease

ll rson leases, it is using up $10 million ofand the irnplied cost rate is 5.5 percent.

rite is less than the 6.0 percent after-tax costloan, this IRII analysis confirnrs the NPV

Anderson should lease rather tlran buy thet. The NPV and IRR approaches will alwaysl'same decision. Thus, one method is as good as

from a decision standpoint.r

BACK EFFECT ONAL BUDGETING

we have assumed that the potential lessee hasle a fum decision to acquire the new equip-e a rum qecrsron ro acqulre rne new equlP-the lease analysis was conducted only to de-

the equipment should be leased or pur-{owever, if the cost of leasing is less than the cost

il is possible for projects formerly deenred turac-lo beconre acceptable.

this point, assume that Anclerson's targelcalls for 50 percent debt and 50 percent

y, that Anderson's cost of debt. kd, is 10

C = 0.s(10%)(0.60) + 0.5(1s%)

= 0.5(6.0%) + 0.s(15%) = 10.5%.

that the firm's initial capital budgeting

bv outflows'in Years 1 to 5. Note that then6t cash flows are simply the net cash flows

this equipment, using a 10.5 percent proiectll lor average-risk projccts, resultecl in an NPVAs we saw in the prececling section, the irfter-

leasing for this projlct is 5.5"percent, compareclrson's after-tax cost of debt of 6.0 percent. Thus,

debt component of all projects can be fi-ed by leasing on similar temrs. Iu this case,

son leases, it avoids having to pay the net punprice for the equipmcnt-the lessor pavg

cost-so Anderson saves $10 million.'Tliatpositive cash flow at Year O. ,,Next, we must determine what Andersn'give up (or "pay back") if it leases. As weliet Anderson must make annual leaseoI $?,750,000, which amount to $1ter-tax basis. These amounts are reported ao

outflows on Line 2, Years 0 through 4.

4. If Anderson decides to lease rather thanand buy, it will avoid the maintenance$500,000 per yea! or $3000@ after taxesshown on Line 4 as an inflow, or benefit of

5. Finally. if Anderson leases the uqrrip^enfgive up the net after-tax residual.value of$E

I that its cost of equity. k,, is 1.5 percent. Thus,weighted average cost of capital is

Year 1

($1,650)

(800)

300

w,

Year 2

($1,6s0)

(1,280)

300

rg&!3ol

Year 3 Year 4

(91,6s0) ($1,6s0)

(760) (480)

300 300

6. Net cash flow gz!s, r@r$ 8,650

*n, = i ffi =o whenkL= rRll=s.s%. I he.net cash llowi shorvn on Line 6 are the incremental cash florvs to Andersur if it lcascs r.rthLr th.rn [rorrorvs .rnti Lrrrr:.rvY, ot th(5e flows is the net ad\lrntage to leasing. Whcn discountcd nt r rrtr oi 6.0 perccnt, the NI,V ot thL Linr 6 t'lrr'. ,r

lct can be financed at a lotver cost than other proi-$ involve equipnrent that cannot be leased.

'should we iiu iow? There are lrvo possiblc' rrolrrnould we do now? There are two possible polirr

depending on Ande.rson's opporiunity to'sub-,e lhancing for regular debt financin6:

except for a rounding differenci, is the same as we obtained in thc Tablc .l.l-f, Ni,V iln.tl\.sis

564 Chapter 14 LEASE FINANCING

LEVERAGED LEASEANALYSISWhen leasing began, only two Parties were involved in aleasc transaciion-the lessor, who put up the money, andthe lessee. In recent years, however, a new type of lease, theIneraged lense, has come into widespread use. Under a

leveriged lease, the lessor arranges to bonow part ofthe re-quired funds, generally giving the lender a first mortgageon tlre plant oiequipment being leased. The lessor still re-ceives ihe tax benefiis associated with accelerated deprecia-tion. However, the lessor now has a riskier position, be-cause of the use of financial leverage.

Such leveraged leases, often with syndicates of wealthyindividuals seeking tax shelters acting as owner-lessors,are an important part of the financial scene today. Inci-dentally, whether or not a lease is leveraged is not impor-tant to ihe lessee; from the lessee's standpoint, the methodof analyzing a proposed lease is unaffected by whether ornot thelessor borrows part of the required capital'

The examplc in T.rble l4E-1 is not set uP as a leveragedlease. However, it would be easy enough to modify theanalysis if the lessor borrows all or part of the required$10 million, making the transaction a leveraged lease

First, we would add a set of lines to Table 14E-1 to showthe financing cash flows. The interest component wouldrepresent another tax deduction, while the loan repay-ments would constitute additional cash outlays. The ini-tial cost of the asset would be reduced by the amount ofthe loan. \ryith these changes made, a new NPV and IRRcould be calculated and used to evaluate whether or notthe lease represents a Sood investment.

$25,000 NPV for the unleveraged lease. Note, thiir,the lessor has spent only $3.55 million on t]dTherefore, the lessor could invest in a total of 2^fleveraged leases for the same $8.65 million inveshiquired to finance a single unleveraged lease, prrdritotal net present value of 2.37(526,000) = 5,5,1,Ur0.

-The effect of leverage on the lessor's refum ir rrThe effect of leverage on the lessor's retum isJ

flected in the leveraged lease's IRR. The IRR is [urcount rate which equates the sum of the present vatuthe Line 3 cash flows to zero. We find the IRR of rtr"i

lion of the $10 million net purchase price at a rarcent on a five-year simple interest loan. Table tjtains the lessor's leveraged lease NPV analvsisltjof the leveraged tease ilnvestment U"sea oi-ttsff

has been developed for analyzing them in a rirframework. However, sophisticated lessors are

flows shown on Line 3 is $26,000, which is the

aged lease to be about 8.5 percent, which is

lai of invested capital than unleveraged leases. Hbrnsuch leases are also riskier for the same reason th{leveraged investm€nt is riskier. Since leverageda relaiively new development, no standard

To illustrate, assume that the lessor can

veloping Monte Carlo simulations similar toscribed in Chapter 8. Then, given the aPparentof the lease investment, the lessor can decide wlretums built into the contract are sufficient tofor the risk involved.

higher than the 5.5 percent after-tax retum on tqleveraged lease.' .r,leverageq reabe. :.il

Typically, leveraged leases provide lessors withhiexpected rates of rehrm (IRRs) and higher NPVs pe

2Note two additional points conceming the leveraged lease analysis- First, in this situation, leveraging had no imPact on t!.perlease NpV This is'because the cosiof the loan-to the lessor_(5-4 percent after tax6) equals the__dirount rate, and hmce-u'aging cash flows are netted out on a present value basis. Second, the leveraged lease has multiple IRRs, one at 0.0 percent and

HYBRID FINANCING

6r(-./n earlier chapters, we examined common stock, various types of long-termdebt, and leasing. In this chapter, we examine three other sources of long-termcapital: preferred stock, which is a hybrid security that represents a cross betweendebt and common equity; warrants, which are derivative securities; and convert-ibles, which are hybrids between debt (or preferred stock) and warrants.

RRED STOCKPreferred stock is a hybrid-it is similar to bonds in some respects and to com-mon stock in other ways. Accountants classify preferred stock as equity, henceshow it on the balance sheet as an equity account. However. from a finance per-spective preferred qlq-ck-lies.someruhere-between-deAl anilcommon. eg!4!y-- itimposeT a fi-xe{ q!ra1g9 a1{ t!1us inc.rease5 -!J,rq firmlq,finanqigl !-e_y91ag9,,y.q1-oq-!t-t!19 !!g p1gferlq{.d-i.vr!ead doep_nqt forcs-a qoqp,any_ i$to tl3!*ryptcy.. We firstdescribe the basic features of preferred, after which we describe some recent in-novations in preferred stock financing.

Basic Features

Preferred stock has a par (or liquidating) value, ofien eiiher $25 or $100. Thedividend is stated as-Eithei aaglcsl@{olp-ii, as so,many dollars per !b1le, orSoth- ways. For example, several years ago Klondikc Paper Company sold150,000 shares of $100 par value perpetual preferred stock for a total of $15 mil-lion. This preferred had a stated annual dividend of $12 per share, so the pre-ferred dividend yield was $12l$100 = 0.12, or 12 percent, at the time of issue.The dividend was set when the stock was issued; it will not be changed in thefuture. Therefore, if the required rate of return on preferred, ko., changes from12 percent after the issue date-as it did-then the market price of the pre-ferred stock will go up or down. Currently, ko. for Klondike Paper's preferred is9 percent, and the price of the preferred has risen from $100 to $1210.09 =$133.33.

If the preferred {i_v_!.{qaql is 1q1 earned,. the-company.-dpes not -hove, !o p_ay_ it.However,-most _pre-f

er.red -issues are cu mul ati-ve/ mea n ing tha t the cu mulative to-tal of all nni;aiApieTeiiJa divideniis nrtr+ bd paicl before diviclencis can be pairlon the common stock. Unp_ild ryef1A_gd.divi_de'ndla-rel4!ed affql_rageg. Divi-dends in arrears clo nof eiin in-teresT thiG, ir[iiages do not groru in a com-pound interest sense

-they-o.nl-y gf.; _ftSyl. l:ldjlLQf'.4l"nqnpnymcnts--ol-the.pne-

ferred dividend. Also, many prefc'rred stocks_accrue arreirrages for only a limited

aiap"proximatety 8.5 Percent. Leveraged leases frequently have two IRRs.

Year 0

1. Net cash flow from Tablc 14E-1 ($8,650)

2. Leveragingcash flows" 5,000

3. Net cash florv ($31150)

5 ----NPV =Ztffi= s?5when k =5.4%.

(270) _-Q?9 _Q79)$2,360 $1,840 $1,560

Year 1 Year 2

$2,150 $2,630

(270)

$1,880

Year 3 Year 4

$2,110 $1,830

nThe lessor borrows 55 million at t = 0 and repays it at t = 5. lnterest exPense, Payable at the end of each year, is 0.09($5,000) "sii is tax deductible, so the after-tax interest cish flow is -5450(1 - 'D

= -$'150(0 6) = -$270' .l;

:,1;,.l , t

"lI

t, l,t i-7 ,

(i ..,,, i .,,

iLt. 1,:.t.:hl tr,,lt,t: ) ,t ',', .tj;i

I

! :11

5ob (-traFrL'r l5 IIYBRID FINI\NCINC

Passed.

[]Tl,'.'bTJfl:'ir'i*#;",il:T;il:xlT?"':I"'l'.: :ffi lil n'",*x ff ryare paid.Preferred stock normallylal- lollqli4g. rights. However, most oref.,,^, .Iulate that the preferred stockholderJcai plpct a rrinnr+,, ^r'.il"lltot*,t\ stipulate' that thc preferrei iiock],old"rr".ri ur"., n,"i."'.ii" "rYil'liltd'*"\ s.lv. tlrrce orrt of tpn-if thn n..f.,"-.I ,{i,,;r-^r i^ -^^-^r , I ;. '...':"efloR-\ supul(ltLt flrat thc preferred stockholders can elect a rninoritv.f'rr"- r,"qt

\;3i,1']fi ru';lL1l;l:?:#::":::"*:'i.":'"::ff u:iJ:i:i,:t;,i,ftid/, urrce uur or ren-lr rne preteiled dlvldg,Ild is passed (omtral Power & Light, one of the companies tliii o-neid ilnire;:ij#ffi;,T#:i::ffi :;'ff.';ffiT:T,tXl"".Ti:"i;ff t;Ii,,:$fig.wnich could epq]' ::? :' :!, "i: ":!",:i:::i"i: i.lii:. r:r: :::1

., i:t 1:"9

*o: o;'"a r". i" "' ffii,ll".xiii"j,l;Hillr:;"fi :"\;l'.lilJ.r,'il,on,:1";'.:1,::l*"::i:yffithc dark days following the TMI accidcn*t. Hacl thc pr -- -" "(rr otrt*

to elcct a nrri.r+rr nf rhn rriro.r^"c +1,- .r;.,;r^-i .:. .:.i"1'-:1 ttot,been enbtd

1::,"T, a majority of the directors, the dividend woutd probably-ilffi

l'rclcrrrll >tr)cR 5b/

Some preferred stocks arc sinrilar to pg1p9lqaf !-r1qd9 i1 thirt thcy lrar-c rro ma-turity date, but most new issues norv havc specificd maturities. For cunrplc,manv preferrecl shares Iiave a sinking funci provision which c.rlls for thc rctirc-ment of 2 percent of thc issur: each yeir, rlcarring itr.it ttrc issrre rvill "nraturr." irra maximum of 50 years. Also, nrarry prcferred issuc.s are callatrlc by thc issuingcorporation, which can also linrit the liti of tltc p11.for1cd.'

Nonconvertible prcfgrrelil, stock is virtuallv all ouncrl b)'-corptrratjons, r,vhichcan take advantage of thc 70 percent rlividrnrl exclusion kr obt.riu a hichcr a[tr.r-tax yield on prefcrred stock tlran on L.onds. lnrliridr.rals shoultl nrtt on,n prgfgllqqistocks (except convertihlc prtfcrrecls)-thov c.)lt qet hieher yiclLls-irn s.rfcrbonds, so it is not logical for them to hoLl prcfcrrerls. As a rcsuit of tiris rtu'rrer-ship pattern, the volum_e of preferred stock financirrg is ge.rred to thc sup;rly ofmoney in the hands of corporate invcshrrs. Wlrcn thc supplv of such mrtr.rcy isplentiful. the prices of preferred stocks aic Lritl up, theil yickls fall, aud invest-ment bankers suggest that companios rvhich ncecl financirrg consider issuing pre-ferred stock.

_F-o,q.isqi,rgrs, preferred stock has a tax disadzrrrrrtrrtr relativc to debt-intercst ex-pense is i-leductible,br-ii preferrcil d jvideiirls;rro lrot.-Stiil, fir:rns witlr Iorv Lr\ ntcsmay have an incentive to issue prtfcrrcd stock n'hich can be bor.rght lry corproratt'investors w'ithhigh tax rltes, rvho carr takc advant.tr:e of the 70 pcrccnt clir.iclctrtlexclusion. If a firrn has a lowe'r tax ratc than potcrltial corporatL. brryers, thr finumight bc better off issr"ring preferred stock thirn tiebt. The ke1,, lle1e is that the taradvantage to a high-tax-rate corporition is grt'.ttt'r than thc tax tlisath'.rntate to.rlow-tax-raie issuer. To illtrstrate, assrrnlc that risk rliffererrtials Lrctu'een dr'L.t.rui{piefeired woulcl require an issuer to sct the interest rate on nerv clebt at l0 prsl-cent and the dividend vielcl on nerv preferred at 12 percent in a no-t.rr norkl.Flolvever, when tarxes arc considert,tl, a corporatc br,ryer u'ith a lrigh trx rnto, sa\',40 percerrt, might be willing to buv the preferred strlck if it has an I percent Lrcfore-tax yield. This rvould produce an 8%(1 - Effectivc T) = 8'z;,[1 - 0.30(0.{0)l = 7.012"after-tax return on the preferred verstrs 109/"(1 - 0.10) = 6.094, on thc debt. If tirc is-suer has a low tax rate, say, 10 perccnt, its after-tax costs lvoultl bc 10'1r,,(1 - T) =10%(0.90) = 9% on thc boncls and 8 percent on the preferrerl. Thus, thc sccuritr'rvith lower risk to thc issuer, preferrt'd stock, also has a lon,er cost. Srrch situ.r-tions can make preferred stock a logical financing choice.l

Other Types of Preferrcd Stock

In ac'lclition b the "plain tlanil!{' r,ariety of prcfcrretl strrck-s, ser,cral variationsare also used. Tlvo of thesc', floating ratc antl nr.rrkct auction irrcfcrletl, alr'rlis-crrsstd in the Extelrsions to this ch.rptcr.

2Prior to the late 1970s, virtuallv all preferred skrck rvas pcrpr'luil, arrr.l rlmost no issut's hatl sinlingfunds or c.rll provisions. Tlrcn, insorancc, compnnl, rcgulatr)rs, r\,orriuLl ahcrut tlrr urrrcalizctl loss.s thr,comparries had been incurring on preferred lrolclings as a rcsult (rf risirlc interest rates, put into elfcctsome regulitorv changes u'hich essentialh m.rndnted that insurance conlp-.ini{rs tiuv onl_v Ijnritcd lifrpreferreds. From th.rt tinlc on, virtually no nerv preferred lr.rs been pcrpt'ttr.rl. Tlris t,xamplr illustratcsthe rtny securities change as a result of ch.rngrs in the e(orlonric envir(rnmcnt.rFor a more rigorous treitment of thr'tax hvpothesis ol prcicrre.l stt)ck, sec lraj Frtrladi arrrl GrrrrL,uS. Roberts, "On Preferretl Stock," /ournrtl ttf Firtrntitl Rrscor'/r, lvtiItt'r 1

()S1r, 3 I c)-3:.t. For .rn r,\.1 rn plc ot

an enrpirical test of the hvpothcsis, st'c Aithur L. !lou\ton, lr., rrr.l Car,rl Olsol tloushrn, "l:inricinrwith Preferrcd Stock," Firlrnr:inl r\'ld[tLr)r.ll, r\utunn 1990, {2-a-1.

4ltho:g! rlonplylrg-r1t of prefelregl <liviclends will nrrt bankrupt a comhicorpolations,isstrc_ pre(erred with every intc.ntion of pray;,.,* tt.r" airiia.ni. i,t}pasi4ing the dividcnd does not give the preferred stockriolcl"ers -.,roi o'r-*,.'.Hpan,v., failure.to pay a preferred..dividend precludes payment of .o**niildends. In addition, passing trre dividend makes it diffictrit to raisc capitar iuliing borrds, a.d virtually impossible to sell more preferrecl

". "";;;;,r,ilIlowever, having preferred-itock outstandi.g an"! lir" . fi..'th.-;;;:overconre its difficulties-if bonds had been uscd instcacl of preferred stock_'tsey Central would have been in danger of being forced into trankrupt.y befr.icould straiglrten.out its problems. Thus,from tli aieiopoittt of tt"

"rrig i,1n ;tdpreferretl .stock is less r;isky thnn bonds.

However, for investors plgfgrryd qtock !s iiq!5i91 th,r4 bonds: (1) prefern{stockholders' ctaimi iie suuoiainatea io ttrose of ronarroiJn* in lt,. uu.nt oiEluidation. and (2) bondholderJ are more likely to continre receiving income d,*ing hard_times ihan are preferred stockholders. Accorclingly, iffy_"jtpfr-tSglS_-fhigher after-tax rate of return on "4 giye(r firm's preferred siock ilrin onlii 6c,rriiHowever, since 7O pepcent of preferied dividends is exenrpt from colporaie ta*rpreferred Stock is.attractive to corporate invcstors.. lrr rccent yurrr, high_grr*prelerred.stock/_on average, has sold on a lower pre-tax yield basis thanlurthigh-grade bo.ds. As an example, Du pont,s prefeired stoik recently had a rn'ket yield of about 7.0 percent, wlrereas its boncls provided .r yield oi g.3 p,ertrtor_ 1.3 percentage points nrore than its preferred. The tax trc.rt'menlaccountcd,kthis cliffqre.ntial; the after-tnx yield to corporate investors ivas greater on the Jrferred stock than on the bonds.l

. About half of all preferred stock issued in recent ycars has beelr conl'erflkiuto _common stock. For example, Enion Coiporatitn issued preferred st,r{which stipulated that one share of preferred could bc converted into threeslutrrof contnton, at the opiion of the preierred stockholcler. Convertibles are disnrcrdat length in a later section.

rThr' .titcr-tax yield on an 8.3 percent boncl to a corporate invcstor in t6. J.l pcrccrrt mnrginal-ur ''-hrncket is S.3"i,( I - T) = 8.3rt'o(0.66) = 5.48%. The a fter-ir r v ield on a 7.0 percurr ,;.:,ferrc.l skik is 7f::Elfccti\ e T) = 7.0"i,[l - (0.30)(0.3.1)l = 7.0""(0.8"8) = 6.2Si:;,. A l.o. norr tl]n r ,.r{ 1.1. o^1L;1,;15 firrr-f]irsr rinA riebt rnd lhcr*sing thr pr()ceeds to purch.rsc another firnr's nrcicrre.r or c,inrnrm strrL ! FJi. rrsrd fc'r sh'ck l.urchascs, then the 70 percflrt dir-iricnti orclusit,'n is r.,ri,lerl. fhis p(ilrsiNssiirn('d tn llr('r'rnt i firm from en6aging in "t.r\.rrbitr.r6c," rrsin6 t.rr-,re,rrrttrhrc rretl t,'lut'FlJr8r'l! t.1\-e\r-nrpt preferred skxk.

568 chaPter 15 HYBRID FINANCINC

WARRANTS

Advantages and Disadvantages of Preferred Stock

There are both advantages and disadvaniages to financing with preferred o-Here are the major advantages from the issuers' standpoint: -qL

1. In contrast to bonds, the obligation to pay preferred dividends is not *tractual, and passing a preferred dividend cannot force a firm into b;ruptcy.

2. By issuing preferred stock, the firm avoids the dilution of common eqrrrthat occnrs when comnron stock is sold.

3. Since preferred stock sometimes has no maturity, and since prefenod s.,"ing fund payments, if present, are typically spreatl over a long period, gfferred issues reduce the cash flow drain from rePayment of principal'du

occurs with debt issues.

There are two ma;'or disadvantages:

1. Preferred stock dividends are not deductible to the issuer, hence the al1o.

tax cost of preferred is typically higher than the after-tax cost of debt. g6*.

evet the tax advaniage of preferreds to corPorate purchasers lowers ibpttax cost and thus its effective cosi.

2. Although preferred dividends can be passed, investors expect them to\paid, and firms intend to pay the dividends if conditions permit. Thus,;'rr.

ferred dividends are considered to be a fixed cost. Therefore, theiruse,&that of debt, increases financial risk and thus the cost of common quiS:.

Should preferred stock be considereci as equity or debt? Explain.

Who are the major purchasers of nonconvertible preferred stock? Why?

What are the advantages and disadvantages of preferred stock to the issrs!

than rvoulcl o$erwise be requirt'd. For example, when Infontatics Corponurt'

r.rpitlly growing high-tech .n*pony, wanted to selt $50 million of 2O-yearhttr

W.urants 569

value because trglderC c.lqbgy thg f1;4!qo-n_mg-rl9!$k t!_!bg3x9,r9_ii-S-p!9-e-le--.

sr.q"lJ_iijhoty-h-isb f[a_l3casi.pL.c-c1Gus,.1riffipti;n oiiG; t$l;;;i"6;"stI rate on the bonds and makes the package of low-yield boncls plus rvarrants at-I tractive to investors. (See Chapter 19 for a more complete discussion of options.)

Initial Market Price of a Bond with Warrants

The Infomatics bonds, if they had been issued as straight debt, worrld have car-riecl a 10 percent interest raie. However, with warrants attached, the bonds were.sold to yield B percent. Someone buying the bonds at their $1,000 initial offeringprice would thus be receiving a package consisting of an 8 percent, 20-year bondplus 20 warrants. Since the going interest rate on bonds as risky as those of Info-matics was 10 percent, we can find the straight-debt value of the bonds, assum-ing an annual coupon for ease of illustration, as follows:

0l?320PV 80 80 80 80

1,000

Using a financial calculatot input N =20,1= 10, PMT = tj0, and FV = 1000. Then,press the PV key to obtain the bontl's value, $829.73, or approxinr.ttely $830.Thus, a person buying the boncls in the initial underwriting woulcl pay $1,000and receive in exchange a straight bond worth aborrt $830 plus 20 warrants pre-sumably worth about $1,000 - $830 = $170:

Price paid for _ Straight-debt * Value ofbond with warrants valr.re of bond warrants

$1,000 = $830 + $170.

Since investors receive 20 warrants with each boncl, each warrant has an implierlvalue of $170/20 = $8.50.

Th,e_\ey isque,in setli1glh9-te1m! 9_il !ond;wilh.-wqgasr"ts_.is-yglu.utg'tbs_W.ar:rants. The straight-debt value can be estimated quite accurately, as was doneabove. However, it is more difficult to estimate the value of the warrants. TheBlack-Scholes Option Pricing Mot'te'l (OPM), which we discuss in Chapter 1c), canbe used to find the value of a call option. Therc' is el temptation to use this motlelto fincl the value of a warrant, since call options are similar to warrants in manyrespects: Both give the investor the right to buy a share of stock at a fixed exer-cise price on or before the expiration date. Hcxvever, the19 !9 4 Illqior diffe194q9between call options and warrants. If call options are exercised, the stock pro-viaea-to the optionholde? aomes from the secondaiy-market,'6ut whdn waiiaritsare eieiCiSed, tha st-oak pr<ivicied to the wiiiiinf hioldrlts are newly issuecl'shares.This means that-the exeicise ofwarianis Aiitttes the valtrt of the original-equi.-qy.which could cause tlie i;;iliie-of'the-iriil'irial warrani to cliffei fionr the valtre of a

similar call option. Therefore, inveshrent bankers cannot Lrse the lllack-Scholesmodel to deterrnine the value of warrants.

It is extremely important to assign the correct value to the warranis. lf, whenthe issue is originally priced, the value assignetl to the warrants is greater tharltheir true market valtre, then the coupon rate on the boncls will be set too loir,,and it will be imposiible to sell the bond-rvitlr-rvarrants package at its par value..In this case, lnfomatics rvill not lre able to raise the full $50 million that it needsto fund its grolvth.

in 1998, the company's investmentbankers informecl U't" iinon.int vi5i11{that tl.re boncls wouid be difficult to sell, and that a coupon rate of 10 [tttFrvorrlcl be rer},riretl. However, as an alternative the tralikers suggested d$ 1vestors mighi be willing to buy the bonds with a couPon rate of only B PtlXthe conrpaiy rvor.tlcl off"er 20 warrants with each $1,0-00 boncl, each rvan't1lftling the holder to buy one share of common stock at an glgrctsgi!49:=..!tling the holcler to buy one snare oI comnlon stocK at an exercrse -l]::l::-J,shaie. The stock rvas ielling for $20 per share at tlrO tiine, anct tfiewaffanF-f,Fexp!1e. i5r the year 2008 if they had not been exercised pre'" iously. r -rfitry *o"ti investors Ue witting to buy Infomatics' bontls at a yield ole:pu.."nt i.r a 10 percent market juslbecause warrants were also off;red asiu'

ihe package? Iiis becarse th9 yq.ra!t! ary !o-gg:-teru,r--calt-opflonr{la9I

. i:: ,:. ir' i: ii.i:{'i:,11:.ii::J:,T;i{i1;iiri:-ri'r: :;"+'.

' j .. ., . , :,,r;,: :" ; , I

570 Clui.11'p 15 IIYIllill) IjINANCINC

the projects is )ess than zera.

Conversely, if the value of the warrants is undercstimated. tlrpn +L^rate will be set too high. This means that the truc valuc of tf.," U".i.'li.,Lqp"

;xL': xli1nlis:n"J, IlT":x.',"'ff *f iliii,ilxl,1x"",[:,Ynr:::"i * lil ];the bonds with warrants at the issue price, and Infomatics will ...."#ir'i *,il:'|fl ,iIi J: ;ff*,ll::T';:.1T.',;:.1 iliffi i:l"liHIXli**1!riil:

At the time of the bond offering, Infomatics had 10 milrion .t utu. "i.l]itstock outstanding and no other debt or preferred stock. The,t..[ -i"',].55,11.*i;,xlJ}1,i".:*H"il,1H:j::"il:i'i::fl;i,l:11,1?;:iilTl*:iin projects. Therefore, immediately after the offering the totaI i,.tr"'"if"i'.,"Tis $250 million ($200 million in stock plus $50 million in cash).a If investn^';Ilbonds with warrants pay only $50 million for securities that are *o.tr,*^*'Ilion, then the result i.s; $10 million tiansfer of w-ealth.from tfrg g.iginui;t#

YYnrrJnts 5,/l

-an opportunity !o cxpaprl thc firnr's nrix of sccr.rr.itics ancl thr,rs to apprL,ll 16 ,1tttl*"t,?:n

:j ji';"# iL ", a rc derach ab l e. -rtr us. a f t.r n r,n,.,.r *i tr,' n,t".r.,"awarrants is sold, thc lval'rants can bc dctaclrcri antl trarlcd sepnrntoly frorn thcborrd. Fr.rrthcr eucn ai[cr t'iiJ n'arrants hayc lrcen r,\rrciscLl, tirc tr.,r.t (nith itslow coupon rate) remains outstantlirrg.

Jh.g exercise price ou warrarrts is gcnerally set somc 20 b 3tl pcrccnt .rbove tht'nla-r\-e-!..prige of thg steek_oD tlre date thc'bond is issued. If ihe finn gro*s i".iprospers, and if its stock pricc rises above thc. cxt'rcisc pricc at which illn.", *.-1,bc purchased, warrant holders coulc'l exercisc their warrauts and buy stock at thestated price. However, witho__ut some incenti'e, l\,arrants rvould never be exer-cised prior to maturity-their'aluc in thc open nrarkr.t rvoulcl be greater thantheir r.'aluc if exercised, so holders worrld sell n,arrants ratlrer than ex-ercise them.Therc are three conclition.s which cncouragc holders to exr-rcisc thcir w.rrrants:(1) Warrarrt holcleri will surely exercise o,.,,1 b,-,y stock if the warrants are ab.utto expire and the market price of the stock is above the exercisc pricc. (2) Warrantholders will exercise voluntarilv if the company raises the diviJend on tlrc com-mon stock by a sufficient ahount. No dlvideid is earned on the warrant, so itprovides no current income. However, if thc courmon stock pays a high divi-dend, it provides an .lttractive divirlend yirld trut limits price grorvth. This in-duces warrant holclers to exercise their option to buy thc stoin 1e; Warrantssometimes have stepped-_up-exercise prices, rvhich prod owners into exqrci,singthem. For example, Williamson Scierrtific Company has warrants outstandin[with an exercise price of $25 urrtil Decembc'r 31, 2002, at which time the exerciscprice rises to $30. If the price of the conrnrorr stock is over 925 just bcfore De-cember 31. 2002, many warrant holciers will exercise their options before thestepped-up price takes effect arrd the valut'of tht_. rv.rrrants falls.

Another desirable featurc of warrants is tl1.1t they generally bring in fr.rncls onlyif funds arc nceded. If the company grows, it will protrably neecl nov equiiv cap-ital. At the same time, gro\,vth rvill causc thc pricc of the stock to rise and the rvjr-rants to be exercised, hence the firrn will obt.lin additional cash. If the conrpany isnot successful, ancl it cannot profit,rbly cnrploy addition.rl money, the price of itsstock will probably not rise sufficiently to inducc exercise of the rvarrants.

Wealth Effects and Dilution Due to Warrants

Assume that the value of Infomatics' operatiorrs arrcl irrvcstnrents, tvhich is $250million immediately after issuing thc bontis with rvarrants, is expectt'rl to groi\,,and does grolv, ai 9 percent pcr year. Whtn tlrc !v;lrrrnts arc duc to expire in terryears, the total valuc of Infonratics will bc $250(1.09)1') - $591.841 million. Horv isthis value allocated armong the original stockholrlers, the bondholclcrs, anrl thL'warrant holders?

The bonds will havc ten years remaining until maturity, with a fixed couponpayment of $80. If thc cxpected nlarket irlterL.st rate is still 10 percent. thcrr:

0 1 2 3 10

PV so Eo Eo ,.ol8

Usingafirrarrcial calcr.rlator,inputN=10, I-10,PNIT=E0,arrrlFV=1000.prr.ssthc PV key to obtairr thc bond's valrrr-, SS77.11. Tht krtal valuc of all of thr. bonrlsis 50,000($877.11) = ${3.E56 million.

holders to the investors iir the bonds with warrint!- Therefore, it ir "*?..."i.7poita-nt foi Lifomatiis to iorrectly e.stiiirate thC value of the warrants .iil6[

the bonds with warrants are issued.

Use of Warrants in Financing

!V_qa1ts generally are usgd by sm3!1, rapidly growing f!1-mq as ,,sweererrr.

wlen theyyll debt oi pieferred qtod. Such iirmi frequently are regarded bri+vestors as beinghighty llgky, so their bonds can be sold only at exlremelyirScoupon rates and with very restrictive indenture provisions.-To avoid this;firrlsuch as Infomatics often offer warrants along with the bonds. However, rqyears ago, AT&T raised'$1.57 billionb/ sellin[ 6onds with w*irrants. This nar.t

pany's growth, assuming it does in fact grow and prosper. Therefore, inre+uare willing to accept a lower interest rate and less restrictive indenture pnrisions. A bond with warrants has some characteristics of deb-t-.and qomq durrJ

!9{9t!cs of equ-!!y. It is a hybrid security that provides the financial managerrif

the tirne, the largest financing of any type ever undertaken by a busines ftaand it nrarked the first use ever of warrants by a large, strong corporation.s

Cetting warrants along with bonds enables investors to share in the co

lwe ass,tme that the.lvcrage expected net present vah,e of thesc proiccts is zero. If the Nt{r{tproiccts is trealer than zerol then the total vilue of Infomatics rvill be qicaler than $250 millim b

',case, there will be little chan6e in the price of the bonds, sincc horrdirolders receive a [rt{cSpayment.no matter how well"the company does. Howevcr, thc skrk price ancl thc valueo{dtrriants wjll incrcasc, since tlrc tolal valie of th" comolnu h". in..o.r.,,lt ,lrirtr,r,,r.i .n^*.".rq !crcase in the valrre conrmitted to the brrndholders. il

"'.nr"r..' uoulcl occur if the expxd lF'

ilt is int€resting to note that before the AT&T isue, the Nerv York Skrck Exchange's slated [$fjtllit lvarr.lnts could not be listed because they lvere "speculative" instrumtrrti r.ither ths r

572 Chapter 15 t-lYBRlD I;lNr\NCINC

$75.899 million. With a tax rate of 40 percent, after-tax earnings uru *u,iJfi:::.111 -.

9 i] ; 1*-1??'":":":i ::1 :T''rc' r: :,:Yr" :'- s+s sse 7 1 s i G,Therefore, if Infomatics had no warrants, the stock price would Ue 55.1ii[share, and the eamings per share would be $4.55.

But Infomatics dorr have lvarrants, and with the stock price over $50 ilre r-rant holders surely will choose to exercise their warrants. Infomatics will reri$22 million when the 1 million warrants are exercised at a price of $22p,errrant. This makes the total value $613.841 million (the $591.841 miltion valuoperations plus the $22 million raised by the exercise of the warrants) T}e6ivalue remaining for stockholders is now $569.985 million (9613.841 millionltrthe $43.856 million allocated to bondholders). There are now 11 millionstock (the original 10 million plus the new 1 million due to the exercise ofrants), so the stock price is $569.985/ 11 = $51.82 per share. Notice that this is hrathan the $54.80 price per share that Infomatics would have had if therehadno warrants. In other words, the warrants have dilr,rted the value of thestffL

A similar diiution occurs with earnlngs per s'[iaie. Aftii "idiG;ihetsslrworrld increase from $591.841 million to $613.841 nillion, with the additional

million coming from the purchase of 1 million shares of stock at 922 per shrlthe new funds have the same basic earning power as the existing funds, thsrtnew EBIT would be 0.135($613.841) = $82.869 million. Interest paymentsstill be $4 million. so earnings before taxes would be 682.869 - $4 = $78.869

lion, and after-tax earnings will be 978.869(7 - 0.4) =$47.321 million. Wth 10+

Warrants 573

Note too that investors would recognize the situation, so the actual wealthtransfer would occur gradually over time, not in a fell swoop when 16e-rvarrantswere ex-riiiiieil Flr5t, EPS w-ould [ave been reported on a fully dilutecl basis overthe years, and on that basis, there would be no decline whatever in EPS. Also, in-vestors would know what was happening, so the siock price, over time, would re-flect the likely future dilution, so it too would be stabie when the warrants were ex-ercised. So, whereas our calculations show the effects of the warrants, those_g(ecLswould-actually !g tA"g{11 EP|:$j!,S {qC! p1rSg o{.4€raduaL.ba-s[ over time.

The Component Cost of Bonds with Warrants

lrVhen Infomatics issued its debt with warrants, the firm received 950 million. or$1,000 for each bond. Simultaneously, the company assumed an obligation to pay$80 interest for 20 years plus $1,000 at the end of 20 years. The pre-tax cost of themoney would have been 10 percent if no warrants had been attached, but eachInfomatics bond had 20 warrants, each of which entitles its holder to buy oneshare of Infomatics stock for $22. \alhat is the percentage cost of the $50 million?As we shall see, the cost is well above the 8 perceni coupon rate on the bonds.

As we demonstrated earliet when the warrants expire ten years from now, theexpected stock price is $51.82. The company would then have to issue one shareof stock worth $51.82 for each warrant exercised and, in return, Infornatics wouldreceive the exercise price, $22. Thus, a purchaser of the bonds, if he or she holclsthe complete package, would realize a profit in Year 10 of $51.82 - fi22= $29.82for each common share issued. Since each bond has 20 warrants attached, in-vestors would have a gain of 20($29.82) = $596.40 per bond at the end of Year 10.

Here is a time line of the cash flow stream to an investor:

The vah.re remaining for the original stockholders and the warrant h^rrequal to the remaining value of the firm, after deducting tne ,otuu j,lT.lbondholders. This remaining value is $591.841 - $43.856 = 55a7.g95 j,],.4tthere had been no warrants, then the original stockholders wouta n*.'ff ttitlec'l to all of this remaining value. I{ecall that there ;rre 10 million.-r.-]'e.stock, so the price per share would be $547.895/1.0 = $5a.80. Srpoo..,*l'tdpany has a bisic eirning power of 13.5 percent (recall that BEi,:tB;"^:Assets) and total assets of $591.841 miilion.6 This means that-ilJl0.135($59i.841) = $79.899 million; interest payments are gt miilion (gg0llpayment per bond x 50,000 bonds); and earnings before taxes are g79.g99-_l4l

0191011t_-___--+--_---...#.

-$1,000 +$80 +$80 +$ 80.00 +$80+ 596,40l$OTfr

20

+g 80+ 1,000+T1pm

11 million shares now outstanding, EPS would beg47.32l/71=$4.30,dosnks$,1.55. Therefore, exercising the warrants would dilute EI)S.

Has--thlq lyqal-lh transfer har-me-d.the-ortgtr,alqh"Eii",lclErs? The answerir-raand -no. Yes, because the original sharehoiclers ct;a.ly ;re;;rse off than &q

*oricl ha:i6been if there had been no warrants. However, if there had be$rwarrants attached to ihe bonds, then the boncls would have had a 10 Pdrdcoupon rate instead of the 8 percent colrpon rate. Also. if the value of the conPtl

pectecl, leading to a real transfer of wealth from one .t rt;iiJ";,;ri to r"+l

6ln lhis case, the total marke't value equals the book value of assets, but thc silme caldlJi(r$follorv even if market and book values tvere not equal.

The IRR of this stream is 10.7 percent, rvhich is the investor's overall pre-taxrate of return on the issue. This return is 70 basis points higher than the retum onstraight debt. This reflects the fac!..!hat the issue is riSkigt to investqrq.than a

s_t!aig\!:debt issuebe-iause some of the return is expected to come in the form.ofstock price appreciation, and thai part of the return is qelatively risky.

The expected rate of return to investors is the before-tax cost to the com-pany-this was true of common stocks, straight bonds, and preferrecl stocks, andit is also true of bt'rnds sold with warrants.

Problems with Warrant Issues

Although warrants are bought by investors with the expectation of receiving a to-tal return commensurate with the overall riskiness of the package of securitiesbeing purchased, things do not always work out as expected. For example, in1989 Sony paic'l $3.4 billion for Columbia Pictures, a U.S. movie studio. To help fi-nance the cleal, in 1990 Sony sotd $.170 million of four-year bonds with warrantsat an incredibly low 0.3 percent coupon interest rate. The rate was so low becausethe warrants, which also had a maturity of four years, allowed investors to pur-chase Sony stock at 7,670 yen per share, only 2.5 percent above the share price atthe time the bonds with warrants were issued.

had not increased as expected, then it might not have been profitable for thtr'r'rant holders to exercise their warrants. In other words, the'original shareh{lar^ra.-,^,illi-- r^ +r-l^ ^rr r!.^ -^r^-!:^r f,:r..r:^-.^- !L^ r^-..^- -L:-^^ '"fp tnilwere willing to trade off the potential dilution for the lower coupon rate. ln rexample, th"e original stockholders ancl the investors in ttre boncli with n2tr'ogot what they exfected. Therefore, the answer is no, the wealth trals. f.el at tlt{of ex.'rcise .licl n-ot hlrm the origirral shart'holde!'bec.rtrse'they exp._"cied anachrat transfer nna'**r" f.i.lti;;;;il4*i t y ir-'; i;;; ir.,p".ffi5f*."q,*'1shorv latcr, thcie arc othcr initanit's when t(e wealth trinsfir is clifterent tlusc

)

574 Chapter 15 I-iYBRID FINANCING

CONVERTIBLES

Investors snapped up the issue, and many of thc warrants werp ,,h*, .

1i,1fl ',i"::r"-H"}":l;Hl"*.t,,i[:l;iiil:::* jirT,:Ti;*1,:ffithat Sony's stock would climb well above the exercise price. From Son/r'*}.view, the bond-with-warrants package provided , r".y^,lT::::t "Uiiaffi(the bonds) that would be replaced with equity financing wh"n th"}'S,il:'"::::'i::*,*"::,T::y,i3::rnxi""'^:i:,i,:* j:':::.*:il'Hlow cost capital encouraged Japanese firms to acquire foreign .o*puni"illinvest huge amounts in new plant and equiptnent

However, the willingness of investors to buy Japanese warrants sufferrd r-:vere blow when the Japanese stock market fell by 40 percent. By 199a, wf* fwarrants expirecl, Sony's stock sold for only 5,950 yen versus the 7,670-yenlJrcise price, so the warrants were not exercised. Thus, Sony's planned i^'f,**;equity capital never materialized, and it had to refinance the four-yearbcrdisue at much higher rates.

Both Sony and its investors lost on the deal. Thc investors lost beca6edid not get the return they expected on the issue. Sony lost because it tudbjter its financing plans due to the fact that the warrants were not exercised.

spite of presumably good planning by both the company and investon,6ibond-with-warrants issue, and many like it, did not work out as anticipated

What is a warrant?

Describe how a new bond issue with warrants is valued.

How are warrants used in corporate financing?

The use of warrants lowers the coupon rate on the correspondingdebtiwDoes tl'ris mean that the component cost of a debt-plus-warrants packrgiless than the cost of straight debt? Explain.

rir"ngir.""a ;a"ke'ir easier to riise additionir crpitur. -r1"[ .t.4- i igt]rirqg,a tef'{action.

Conversion Ratio and Conversion Price

Convertible securities are bonds or prefqrred stockq w.hig!, Undel gpeqq

terms and conditions, can be exchanged for (that is, converted into).c9.{stock ai the option of the holder. UnlG the exercise of w.riiants, Yhtqlg

,additional funds to the firm, colver_spn_dge1-not provide-capital: debt (r{f ferred stock) is simply replaced ori the 6"iance itteeiuy iommon stod\1.6,.,rr", ..d*ing ihJ iebt o. preferrqd stqct w!11 i[ptoy! tne ritm! 6ru"'

L OIlvtrtlLrlC| ), l

prior to nt.rtrrrity on JLrly 15,2018, a dcbcnturL. llol(lcr can cxclr.irrqe.r torr.l fol20 shares of contmon stock; thercfore, thc conr.crsi.rr ratirt, CR, is 10. Tlrr. borrrlwould cost a ptrrchascr $1,000, thr. par'",alue, r,.,hon it rvrs issuccl. Dir.irlin,: thc$1,000 par value. by thc 20 sh.rrcs rcct'ir.ct1 gives ..r ctuvorsion prri61 of i5tt ..,

slra re:

_C91y919iqr1price = P. =I'.rr r'.tluc rri borrcl

Slrares rcccivo.l

= $!Tn

= $,:,1,,0

= srr.CR 2I)

Converselv, by solving for CR, rve obtain the convcrsion ratio:

Conversion ratio = Cli = !l i!()

= +P = 2() slrar.os.I" $50

Once CR is set, thc value of P. is establishcrl, arrti vicc vcrsa.L**g_q yaffant'q.qxe-1qisc-p,r!ce, tht'convcrsion [rrice is typical)v stt at fronr

20 to 3O percerrt above thc p.cvailing urarkct prict, o[ the conrr:r.r.t skrck at thetinre the co.vcrtible issrre' is sold. Lra,'rlv h.rv tlrt' c.rr't'rsiorr Pricc is t'st,rlr-iis'hecl cin bJst be r,urde'rstoocl .rftt'r'cranrirrirrq s.r'rL. of the. re.riurs rirrrrs uscconvertibles.

Cenerally, the conversion pliqq a4d conver,sion ratio arc fixerl for the iiic ot'thcbr:nd, although Someiirnei a steppe.l-up conversion price is used. For exanrpic,the 1998 convertibie debenturcs for Brcerltrrr Industries arc convertible ilrk) i2.-5shares until 2008; into 11.76 shares from 2008 trntil 2018; and into 11.11 sh.-rresfrom 2018 until maturity in 2028. Thc convcrsitrrr pricc thus stirrts at $80, rises kr$85, and then goes to 990. Breedon's convt'rtiblc.s, like most, havr'a tcn-voar c.rll-protcction period.

Another factor that may cause a change in thc conversion pr.ice an(-l ratio isa standard feature of almost all convcrtiblcs-the clausc pnrtccting the-con-vertille again-st dilution from stock splits, stock dividends, anr'l the s.rlc ofcommon stock at prices belorv tht' .convcrsion price. The typical provisirtrrstates that if common stock is solJ at ;r pricc belou llrc convrysi(\ll [,iict, thenthe conversion pri-e miist br lox,ertd lancl ihe' conversiorr ratio raiscrl) to thcqlilg_gt which !f9 19w stock u'as issued. Also, if thr' stock is_split, or i! a slgqkdividend is declareid, thb cii.r'crsit'rn Pr:ict must-Lr[ iorveier{ by tlrc pciceritrgcamount of the stock di.",idcrrd or split. For exanrplc, iI Brr.edorr Iurlustries n'err.to have a two-for-one stock split ilr,rring tho firit tcrr years of its conr.crtiblc'slife, the conversion ratio wotrld .rrrtomatica)ly bc.rrljusterl fronr 12.5 to 25, antJthe conversion price lolverecl from 980 to ${0. If tlris protcctiorr !\.erc not con-tainecl in the ccxrtract, a compant' coulcl completelr,' thlvart convorsiLrn br. thcuse of stock sprlits anti skrck divirlencls. lVarrants arr'sinrilarlr'frrotcctt'.1against dilution

The sthndaid protection against diltrtiorr fr:om selling nelv stock .rt pri6g5 lrp-low the cont,ersion pricc catr, lrou'evcr, gct a courpanv irrtrr troulrlc. For cxrnr!rlr,assllmc'th.rt Breetlon's sto('k lr'irs scllins ior 565 pp1 slr.rrr:.tt thc tinrc tlte c()r'l-vertiblc n'as issr"rcd. Furthcr, supposr'tltc rn.rrkct \\'cnt sollr, alttl Brer'rlon's stockprice droppgcl kr $50 pcr sh.ire. If Brr:r'tlorr ncedcd n(.\\'cqr.litv t() support (r[)L,r(r-

tions, a tterl' conlmorl stock s.rlc rvottlrl rctlrrire thc conrp.rrr,, tp lo1.rr t[c crruycr-siorr price on the convertiblc dttrenturos front SS0 to 550. Th.rt rvoukl r.risr' thc

One of the most important provisions of a convertible security is-thecdsion ratio, CR, definecl as th! number of shares of stock a bondholdernu''."iuu l,po,', conversion. ReTaiecl 16"the aonveisiil iltio is ihe,qonygtsLln l:P., wliicliis 0r'e iff6ctive price investors pQy- fqf..-tlte-compron-stock *t:$;;;#::.il.:'fi I;"1.;#ffi J';.'il:;""1;'.;;;;*[ii'l;ii.","Jm;{sion price cin be illustrated by the Silicon Vallev Softrvare Conrpanl's-ct'';ible debentures, issued at their $1,000 par valtie in july of 199.9. At anI

576 Chaptc'r 15 HYBIIID FINANCINCI

valr,re of the convertibles and, in effect, transler wealth from currentto the convertible holders. This transfer would. de facto, amount to un.iil\flotation cost on the new common stock issue. Potential nrllt5rns ,d;X;::.t

0":J"0, in mind by firms considering the use of convertibles or bon4lfi

In the spring of 1998, Silicon Valley Software was evaluating the use of rL -. ,

vertible bond issue described earlier. The issue would consist of 20-year [.I1ible bonds which would sell at a price of $1,000 per bond; this $1,000 woull tbe the bond's par (and maturity) value. The bonds would pay a 10 p.*-Tnual coupon interest rate, or $100 per year. Each bond would b^e.onu.rtibt il

The Component Cost of Convertibles

20 shares of stock, so the conversion price would be $1,000/20 = $50. Ihn,as expected to pay a dividend of $2.80 during the coming year, and it$35 per share, Further, the stock price was expectect to grow at a constant8 percent per year. Therefore, }q = k, = DrlPo + g = $2.80/$35 + 8% =

g|" 1 6l16%. If the bonds were not made convertible, they would have to offer a13 percent, given their riskiness and the general level of interest rates. ILvertible bonds would not be callable for ten years, after which they curld

called at a price of $1,050, with this price declining by $5 per year thereahrafter ten years, the conversion value exceeds the call price by at least 20

management would probably call the bonds.Figtrre 15-1 shows ihe expectations of both an average investor ud

comPany.T

1. The horizontal line at M = $1.000 represents the par (and maAlso, $1,000 is the price at which the bond is initially offered to the

2. The boncl is protected against cali for ten years. It is initially cathb&

price of $1,050, and the call price declines ihereafter by $5 per year

the call price is represented by ihe soiid seciion of the line Vslvl'.

3. Since the convertible iras a 10 percent coupon rate, and since the yidJ r

nonconveriible bond of similir risk was stated io be 13 Percent, lhpected "straight-bond" value of the converiible, B,, must be less tlraAt the time of issue, assnming an annual coupon, Bo is $789:

,.=iffi*ffi=r,r,Note, however, that the bond's siraight-clebt value must be Sl,Ot

prior to maturity, so the straight-debt"value rises over time. B, foll'xl

Pure-BondValue, B,

$ 789

792

795

798

802

806

811

816

9)1

829

837

846

ConversionValue, C,

$ 7oo

756

815

882

952

1,029

1,111

1,200

1 )qA

1 ?OO

1,511

1,632

MaturityValue, M

$1,000

$1,000

$1,000

$1,000

$1,000

$1,000

$1,000

$1,000

$1,000

$1,000

$1,000

$1,000

MarketValue

$1,000

1,,023

1.,077

7,1.47

7,192

L,21L

1 ?O?

1 ll-t

1,398

1.,453

1,511

1,632

FloorValue

$ 789

792

816

882

952

7,029

1.111

1,200

1.,296

7,399

1,51i

1.,632

Premium

$211

231.

,qq

265

240

212

782

144

102

54

0

0

line BgM" in the graph.

4. The boncl's initial conversion value, or the vaiue of the stock the

rvoulcl receive if the boncls lvere convertecl at t = 0, is $700: 8rconversion value is P,(CR), so at t = 0, conversion value = Po(CR);

shirres) - $700. Since ihe stock price is expectecl to grow at an I

i.*. *-,**i,' ,{i<.r'Lqlri ^f

h,rtr thp lonrt rrf 'r 11M\1,.rihl,,.ili,ri., aru d"tcm'irrtl'For a nrorc c()npl(.te discussion o[ horv the ternrs of rr convcrtibL, oifcring .rru ot"''-,!\'lavnc Nlarr anri C. llodncy Ilromlrson, "Thc Pricing trf Nr,rv Convertibl.i Bond Isus,\l,rirrrgrulrrl, Sunrmor l9ti.1, 3l-37.

)

Convertibles 577

Expected Market Value atTime of Conversion,C,o =$1,511

\1,500

vo=1,100M = 1,000

Bo = 789

Co = 700

Market Value

Call Price

I

1

Straight-BondValue, Bl

10

tn

J,ZO5 $1,000 3,263 3.263

578 ChaPter 15 HYBRID FINANCINGConrtrtiLrlt's 579

9. Since n = 10, thc expcctcd nt,lrkct viihrc .rt \t,tr 10 is S35(1.0S)r,'(10) =$1,511. An investor carr fintl thc cxpcctctl r..rto of roturrr orr thc corrvt'rtiblcL.orrd, k., by finding tlrc lRIi of thr. follorving cash florv strcam;

0 1 9 10#'.'---F*_-_.-.]-$1,000 +5100 +5100 +S 100

+ 1,51I

;S1"6x

T'he solution is k. = 111p = 12.8 pcrccrrt.

10. The return on a convertilrle is exptctcd t() cr)n1o Frrtl), fttur iutrrcst incornoarrcl partly fronr capital unins; ii1 this casc, tlrr' tot.rl cxpcctorl rctrrrrr is ll.Spercent, with l0 percent rcprq5o611,1s irrtcrcst incomc anri 2.ti pcrcerrt rcp-resenting the expectr:d capitnl gaitr. Thc irrtcrcst conlfrot.tent is r.cl,rtivcly as-sured, while thc capital g.rin contpttncnt is morc riskt'. Thcrcforc, a con-vertible's expected returrr is morc risky th;rn th.rt of a straight bond. ThisIeads us to concludc that k. shoulcl bc Iarijc'r than tl.rc cost o[ straiglrt ciebt,k.1. Thus, it wor"rld scent that thc expcctcrl riitr. of return orr Silicon's con-vertibles, k., should lic bctrvecn its cost oI straight clcbt, k,, = 13,)i,, arrrl itscost of commorl 51o6lq, k = 1$')i.

Note too that drrc to the fixcrl interost p..rvment, an increasing percent-age of a convertible's yielcl conres fronr crpcctcd capit.rl rains as the- priccof the convertible rises. Thereforc, thc higher the virlue of C,, iire riskitr theconvertible. This factor also motivatcs volunt.rry convorsion.

'11. Investment bankers use the. typc of motlcl rloscrilretl here, plus a krron'l-edge of the market, to sct thc tornls on corrvcrtilrlc.s (thc cortversiorr ratip,coupon interest r;ltc, and vcars of L-all protoction) such that the sccuritv rr.illjust "clear the nrarkct" at its $1,000 offcr.ing price'. In our cxanrplc, thc rc-quired conditions do ltot holtl-tht calculatcd ratc of rctrlrn orr tht'corr-vertible is only 12.8 pclcerrt, whicl-r is less than thc 13 ircrcerrt cost olstraight debt. Therefrrrc, thc ternrs on thL. bonrl must bc madc ntorL. attr.rc-tive to investors. Silicon Valley Softlvare tvor.rlcl havc to increast thc couponinterest rate on the convcrtible abovc 10 percent, raisc the conversion ratioabove 20 (and thereby [o*'er the conversion pricc fronr $50 to a level cltrsr.rto the current $35 market price of thc stock), lenethen the call-protocted pe-riod, or use a combirration of these tlrrec such that the cxpectr-tl r.tte of rc'turn on the convertible ends up betrveerr 13 and 16 prercent.E

Use of Convertibles in Financing

Convertibles have. tu'o important ad\Bntages flonr tllrl !:.ltlr..lj- sllndpoir.!t: (1)Convertibles, Iike bonr{s rvith n,arr.ruts, offer a conrpanv i]rc ili.rirce to scil cltbtwith a low interest.rate in exch.rnge for_a chancc to participilto in ilrc-con,-pany's success if it does rvell. (2) In .r sensc, convL.rtibles provitlo .r l..rv to sellconlmon stock-at prices higher.tharr thosc cur_rlenth, pret-ailing. Sttmc compra-nies actually $.ant to sell common stock, not rlolrt, [.ut fctl that thc plicg 6i

"ln this tlirtrssiorr, rre islrrrt lhr't.r\ nd\ilhl,lAcs h] ill\('st(I.\ rrsocirterl u.ith ailitnl.{lilr: ln s\rnresitu.rtiorrs, tax t'flects could rdsrrlt in k. Lrcing loss th.rrr Lr.

I

:ik,iil?:ci';'=''*#,\H\fi 11tI,!}:!tq:,ffi :"Ili:I"',trI;;;; ,L; is" gi"en by the line C' i. Figure 15-1'

The actual market price of the bond can never fall below tlt ligh"t c t

,i.ri*f.,ua"U, value or its convcrsion valuc. If thc market price droppo:f'#'iii u'rwni-bond v,lue, those who. want* o:,19,:.ry:11'"toq'q i

uorgoin ancl "b

uy. the conve rtible as. a Tll;^t .Tll?lv;, ll, lt'" Tlsn"

and conversion value lines' i

7. At some point, the market value line will lcrt1tl,* t-?1".t'::?""fi:[r:

fi1""ff,I""iJ'J;:J *,''i..,,.ili *o '"n'o"'' First' the stock should

r:,i;h*;;f; ;r.,,-erdividendsa.-lh"I:-i'-F^.?y;,11,1,5"'ll*:,i,,.1'l:f H:';X;:?i;i.",;;;' ro' &n*pi"' siricon's colve'i'!r? .apay $100 in interest. ann" jif lI:, :l:"i#f;lii jilr;HHf#;pay Druu rrt urlsrEo!.qru'--ria

ini,iuffy be 20($2.g0) = 956. Howeverl

;T:,1"TT.:';,1:1':il ff. dividend's arter ten vears wourd be q

$i20.90, while the inte'"st *o]'ii stitt U" gtoo'.rt'"t':t,t:f:IT|Idividends could be expecteJ io push against tl:

-fif1 t"**u

::ffi ;"inJi'"*i,* ^to ai'up p'u",.' I * t

i." "1::'" j:,:":il1;causlng ttrc PrErr'u,r '" - t"it"t-t"il'ble' its market value cannol o

Second, once the bond becr

the higher of the conversi";;;it';;;; the call price without exPosa

vestors to the danger ot ' t"ir' it'-"xaio'",ti-'f:.t^:,::1,t:il'ffI

I{#f:ffi:l*xl[x' ;,"tr *[kl,t : r1ll ; tr'ffiHi;il?$i:I;.'"'H[p1;^-::1r.-#;[*pffi

f#i+i{d+';#d,iil*ffi *'fl til'-iffi f #il:1".1',1'#l'.:T':l:,T"0',"d;"'i';-i,;1:;'J.fl :1#Hket value line hits the conversion valuc linc in Year 10'

comcs callable. . -- ,. *tut d

l:ni:Xffi ::i*LT:,x["'"ffi ::'T::ln:":""]"'"':;tf il*Ililil*iffi ;;;th" " i t! r' a I a n ce. s lr ee' 1l-'."!-'li :]': -,,

8.

couveruL,rE) r\,'rtsr\6!..--' - that n= 10, thc first call date.

In our examPle, we assume

5tl0 chapter 15 HYBRID FINANCINC

,/ their. stock is tr'nrporarily clepressecl. Management may know, for examnl- -', earnings are depresscd becausc of startup costs associated with ^ ^-._.v",q/, earnings are depresscd becausc of startup costs associated with a n6*vlhi but they expect L,arnings to rise sharply during the next year o..^ ^..,,f'hi but they expect L,arnings to rise sharply during the next year o.,o. ",,ulF' price of the stock up with them. Thus, if the cJmpany rria r*o.t ni*I",',Tg A

be giving up rllore shares than necessary to raise a given u*orn, li'l'{Horvcver- if it sct thp conversi,rrr nricp )O tn ?O norronr rk^.,^ rr^ -' *Pqd.

11-,tGf.:::H',ilr',.::i:i'",il':';fi^plii'^::"::,'1..0::li:l'::{&;H$l"lr:i:ft *:::'s;L:li",f"'.T:"Tl'il:J;l,XT,.::,*."111,f;;l::,.il;,:""i:"J:::::lH::l:iT":l::::,::::'::d.E':."y,..;h:'.ffl,T:"T;*:lil"y":::'J.Yi il"::?:T:';::'""::T"s^::-'i: ::."..I. fi .;T*:: :..1n:::: ::'::T r:f :.': ::f j9 o

:lo1 lttlactw e i.' .o"u"."i.,' v*fi

A Final Comparison of Warrants and Convertibles 581

-Test

What is a conversion ratio? A conversion price? A straight-bond value?

What is meant by a convertible's floor value?

What are the advantages and disadvantages of convertibles to issuers? Toinvestors?

How do convertibles reduce agency costs?

AL COMPARISON OF WARRANTS AND CONVERTIBLESConvertible debt can be thought of as straight debt with nondetachable warrants.Thus, at first blush, it might appear that debt with warrants and convertible debtare more or less interchangeable. However, a closer look reveals one major andseveral minor differ-errce_q between these two securities.e Iirst, as we discussedpreviously, the eiercise of warranti brings in new equityGpiial, while the con-version of convertibles results only in an accounting transfer.

A..seconddifference involves flexibility. Most convertible issues contain a callprovision that allows the issuer either to refund the debt or to force conversion,depending on the relationship between the conversion value and call price. How-ever, most warrants are not callabie, so firms generally must wait until expirationfor the warrants to generate new equiiy capital. Generaliy. maturities also differbetween warrants and convertibles. Warrants typically have much shorter matu-rities than convertibles, and warrants typically expire before their accompanyingdebt matures. Further, warrants provide for fewer future common shares than doconvertibles because with convertibles all of the debt is converted to commonwhereas debt remains outstanding when warrants are exercised. Together. thesefacts suggest that debt-plus-warrant issuers are actually more interested in sell-ing debt than in selling equity.

In gengjal, l_rgp1s thai issue debt with warrants are smaller and riskier thanthose that issue convertibles. One possible rationale for the use of option securi-ties, especially the use of debt with warrants by small firms, is the difficulty in-vestors have assessing the risk of small companies. If a startup with a new,untested product seeks debt financing, it is very difficult for potential lenders to

iudge the riskiness of the venture, hence it is difficult to set a fair interest rate.Under these circumstances, many potential investors will be reluctant to invest,making it necessary to set very high interest rates to attract debt capital. By issu-ing debt with warrants, investors obtain a package that offers upside potential tooffset the risks of loss.

Jtglly there is a significant difference in issuance costs between debt withwarrants and convertible debt. Bonds with warrants typically reguire issuancecosts that are about 1.2 percentage points more than the flotation costs for con-vertibles. In general, bond-with-warrant financings have underwriting fees thatclosely reflect the weighted averate of the fees associated with debt and equityissues, while underwriting costs for convertibles are substantially lower.

'For a more detailed comparison of warrants and convertibles, see Michael S. Long and Stepixn E.Sefcik, "Participation Financing: A Comparison of the Characteristics of Convertible Debt andStr.riEht Bonds Issued in Conjunction with Warrants," Finonciil Maragenrrf, Autumn 7990, Z!-34.

ings do not rise and pull the stock price up, hence conversio" ao..."1,3then the company will be saddlecl with debt in the face

"f f.* *ffi)fficor.rlcl be disastror,rs.Fjg.yr. ,can-therompany be-.wr-e.Lhit caqyels!_oq w-rll qqcur if the orice.re-

stock rises above the con'ersio,n pli-ce? Typically, cor,u"itibGs .;ilt,;;tLi'is,ign th;airialilEithe-iisiiiirgTrm to foice hotders to convert. ilril-;con'e'rsion price is $50, the conversion ratio is 20, the market p.i.u ofi,..J.rorr sttlck hirs rist'n kr 960, and ttrc call price on a convertible bond is ltdlf the c.mparry calls the b..r1, bo^rlholt{ers can either convert irrto .or[stock with a market value of 20($60) = $1,200 or allow the co^puny to rcdIthe bond for $1,050. Naiurally, bondholders prefer $1,200 to gt,OSO, so coonision vyould <,rccur" The qlll p-Ig"v-i.q.l-gl--Sj,/99 l\S "cpngany-a-wny-te faJcsE0$;sion, prgvi{qct !!-r9 mar\qt price of the stock is greater than the convemlprice. Note, however, thai inosi-ionvertitiles have=a Tailly ldng'pniiod oidlirofection-ten years is typical. Therefore, if the co^pur,y *urlt, to bu rbLiforce conversion fairly early, then it will have to set ishort call-protctioopriocl. This will, in turn, require that it set a higher coupon rate oi a lowerivL'rsion Pricc.

Fronr the stantlpoint of the issuer, convertibles have three important disrl'vantages: (1) Althongfi the-u-#-b-f a ioiiveifibl'e'bond-mayElvE the compnyeopportunity to sell stock at a price higher than the price at which it couldLsold currently, if the stock greatly increases in price, the firm would probr&ffincl that it would have been better off if it had usecl straight debt in spite6{lhighcr cost and then later sold common stock and refunded the debt. (2)Crvertibles typically have a low cor.rpon interest rate, and the advantageolSiIcxv-c<:rst debt will be lost when cont,ersion occurs. (3) If the company urfwi.utts ttr raise equity capital, ancl if the price'of the stock does not risecy'bcic'ntly after the bond is issued, then the company will be stuck with debt.

Convertibles and Agency Costs

One of the potential agency problems between bondholders and stockhcljdrliscussed in Chapter I is asset sr,rbstitution. Stockholders have an 'dtrelrted" incentive io take on proiects with high Lrpside potential even thrfthcy increase the riskiness of the fi.m. When sJrch ai action is taken, theEirftc.utial for a rve.alth transfer between bondholclers and stockholclers. Hoxs!rvhr'n convertilrlc clebt.is issuecl, actions which increase. t1.," ,irti"*r of tlrA.p,rnv nlay also incrr'ase the value of the convertible clebt. Thus, some of ttrkr shareholdcrs fronr takirrg on high-risk pro.iects have to be sh.rred wiuve'rtible borrrlholders. This sharing of benefits lowers agencv costs. The srllf Icral logic applies to convertible preferred anrl to bondi rviih lvarrants. , li

)

Questions/Problems 583582 (h2p1s1 15 HYBRID FINANCING

What are some differences between debt-with-warrant financing andible debt?

Explain how bonds with warrants might help small, risky firms sell d{curities.

OTHER TOPICS IN HYBRID TINANCINGWhen warrants or convertibles are outstanding, the firm has severalformats for reporting earnings per share. The chapter's Extensions providediscussion of these choices.

Although the exercise of warrants is typically triggered by expiration,sion is generally forced by a call. Thus, firms that issue convertibles aEwith making a call decision. Such decisions are also discussed in the

Finally, in recent years investment bankers have created some unusualhybrid securities which are tax deductible to the issuer. These securities indiscussed in the Extensions.

SUMMARY In this chapter, we discussed preferred stock, warrants, andconcepts are listed below:

I Preferred stock is a hybrid-it is similar to bonds in somecomrnon stock in other ways.

r A warrant is a long-term call option issued along with a bond.generally detadrable from the bond, and they trade separately inWhen warrants are exercised, the firm receives additionaland the orighal bo:rds remain outstanding.

r A convertible security is a bond or preferred stock that can be e

d. Stepped-uP Pricee. Convertiblesecuritvf. Conversion ratio; cbnversion price; convcrsion valucg. "Sweetener"

Is preferred stock more likc bonds or common stock? Explain'

\ /hat effect does the trentl in stock prices (subsequent to issuc) have on a firm's ability to

raise funds through (a) convertibles and (b) warrants?

If a firm expects to have .rdditional financial requiremt'nts in the hrturc' would you rec-

.**""a itt it use convertibles or bonds with iarrants? What f.ectors would inlluence

your decision?

How does a firm's dividend policy affect each of thc following?a. The value of its long-term warrants.b. The likelihood thatits convertiblc bonds will be convcrtc'd'

c. The likelihood that its warrants will be exercised'

Evaluate the following statement: "Issuing convertiblc securities represmts a means by

-t i"fr a fitnt can sell iommon stock at a piice above the cxisting market'"

Why do corporations often sell convertibles on a rights basis?

Suooose a company simultaneously issues $50 million of convcrtible bonds with a coupon

;:t";10-;;";i ""rJsso

mipion 6f straighr bonds with a coupon rarc of l4 perccnr. Both

bonds haie the same maturity. Does thi fact that the convertible issue has lhc lower

"""r". trt" suqqest that it is tJss risky than thc str.light bond? Is the cost of capital lower

on the converti'bfe than on thc strligtrt bond? Explain

Problems

Gress Companv recently issued two types of bonds' Thc first issue consisted of 20-year

,i"ig'tia"6t *th in g'percent o*uli coupon. The second issue consisted of 2.-vear

bond"s with a 6 percent innual coupon and'atta-ched warrants. Both issues sold at their

6i^000 p;;';"ild. Wh"t i" the implild value of the warrants attacled to each bond?

Peterson Securities recently issued convertible bonds with a $1'000 par value'.The bonds

have a conversion price of$40 a share- What is the convertible issuc's conversron raho'

Maesc Industries Inc. has warrants outstanding that Permit the holders to purchase 1

share of stock per warrant at a price of $25'

,."e'ri;ri;i; i{;*"r.i." rrir" Jirf,e firm's warrants if the common sells at each of the fol-- fo*ln* prices: (1) $20, (2) $25, (3) $30, (4) $100' (Hint: A warrant's excrcise valuc is the

;t;.""t":;;;il;!^ tiiJii".l'p:ir'." ntd iltt p"thot" price spccified bv the warrrnt if

the warrant were to be exercised.)

b. At what approximate price ao you think the warrants would actually sell.under each" :;;i;iJffiiiii"J uiio""z w{at premium above exercise value is.implied in your

;;i;;? Y;; iniwer is a guess, but your prices ancl prcmiums should bear reasonablt'

relationshiPs to one another... iio* *orfh each of the following factors affect your estimates of thc rvarrants'prices

and premiums in Part b?(1) The life of the warrant.iZ) Exoected variability (o") in the stock's pricc'

i:i rn! expectea growih rite in the stock's EPS'(4) The company announces a change in dividencl policy: rvhereas it formerly paicl no' -'

iiuia"na'., hinceforth it will pa/out nll earnings as dividends'

d, As.;;; the iirm's stock no,v selis ior $20 per shaie Thc c-omP.aty s'ants to sell some

20-vear,annualinterest,$l,0O0parvalucbonds'Eachbondtvillhaveatt'rched50rvrr-;;^6;*h;;;.itiur"'lntn I ihare of stock at an excrcisc price.of $25 Tht firms

straight bonds yield 12 percent Regardless of your answcr to l'art b' assume tnat eacn

Questions15-1 Define each of the following terms:

a- Preferred stockb. Cumulative dividends; arrearages

c. WarranU detachable warrant

15-2

15-3

15-4

15-5

75-6

15-7

15-8

. 15-1Warrants

75-ZConvertibles

15-3Warrants

for common stock at the option of the holder. When a security is cot

debt or preferred stock is replaced with common stock, and no-

changes hands. i.lill

r Warrant and convertible issues are generally structured so thatconversion price is 20 to 30 Percent above the stock's price at time

r Althoughboth warrants and convertibles are option securities, therc

eral dilferences between the two, including separability, impactcised, call?rbility, maturity, and flotation costs.

r Warrants and convertibles are "sweeteners" which are used to malG!

derlying debt or preferred stock more attractive to investors' Artlqua

couiorirate or dividend yield is lower when options are part oj.Sthe overall cost of the issue is higher than the iost of straight de$

ferred, because option;related securities are riskier.

The Extensions section to this chaptei discusses several new types of

curities. It also discusses how earnings per share are reported when'or warrants are outstanding, as well as information regarding whenbonds should be called to force conversion.

)

584 Chapter 15 HYBRID FINANCINC

l5-4Convertible Premiunrs

15-5Convertible Bond Annlysis

15.6Warra ut,/ Conv e r t ib le'

Dccisions

warrant will have a market value oI $3 when the stock sells at 920. What couu,est rate, and dollar coupon, must the company set on the bonds with warrd;:lare to cle,ar the market?

Thc Tsetsckos Company was planning to finance an expansion in the summer of 1oprincipal executives of the conrpany all agreed that an industrial.ompuny.u.i"Sshould finance growth by means of common stock ratller than by debt. Hciwevei.ilthat the price of the company's common stock did not reflect its true worth, so if,

Total assets

Balance Sheet

Current liabilities

Common stock, par $1

Retained eamings

$550,000 Total claims

Income Statement

Questiors/Problems 585

$400,000

100,000

50,000

$s:1qq9

cictcd to ietl a convertible security. They considered a convertible debenturebutbtrrden of fixetl interest charges if the common stock did not rise in price to mision attractive. They decided on an issue of convertible preferred stock, whicha dividend of $2.10 per share.,lvlclend ol $l.lu Per snare.

The common stock was selling for $.12 a share at the time.The common stock was selling for $.12 a share at the time. Management prings for 1998 at 93 a share and expected a future growth rate of 10 perceniaane{ bevond. It was asreed bv the investment bankers and the manaeement lmon stock would sell at i4 times eamings, the current price/earnings ratio. .:

a. What conversion price should be set by the issuer? The conversion ratio wilthat is, each share of convertible preferred can be converted into 1 share oITherefore, the convertible's par value (and also the issue price) will be equal I

version price, which, in ttrrn, will be determined as a percentage over theket price of the common. Your answer lvill be a Buess, but make it a

b. Shoulcl the preferred stock include a call provision? Why?

In lune 1986, A.A. Steel sold $400 million of convertible bonds. The bonds had amaturity, a 5% percent coupon rate, and were sold at their $1,000 par value. Thesion price was set at $62.75 against a current price of 955 per share of common. Thwere subordinated debentures, and they were given an A rating- Assume shaiconvertible clebentures of the same quality yielded about 8% percent at the time.a. Calculate the premium on the bonds. that is, the percentage excess of the

price over the current stock price.b. What is A.A. Steel's annual interest savings on the convertible isstre versus a

debt issue?qeor l55ue,c. A.A. Steel's current stock price is $37.75. On the basis of this price, do yoil

likely that the bonds would have been converted? (Calculate the value of the si

would receive by converting a bond.)

constant at U7{ percenconvertible bonds?

you tNnk would have happened to the pi

e. Assume that the price of A.A. Steel's common stock had fallen from $55 on

a. Show the new balance sheet under each altemative. For Altematives 2 md 3, show the

balance sheet after conversion of the bonds or exercise of the warrants. Assume thathalf oI the funds raised will be used to pay off the bank loan and half to increase totalassets.

b. Show Mr. Howland's control Position under each altemative, assuming that he doesnot purchase additional shares'

". Whit ir the effect on eamings per share of each altemative, iI it is assumed that Profitsbefore interest and taxes will be 20 Percent of total assets?

d. What will be the debt ratio under each altemative?e. Which of the three altematives would you recommend to Howland, and why?

Nlendorf Incorporated needs to raise $25 million to construct production facilities for a

nerw model disliette drive. The fum's straitht nonconvertible debentures currently yield 14percent. Its stock sells for $30 per share; the last dividend was $2i and the exPected growthiate is a constant 9 percent. lnvestment bmkers have tentatively proposed that the firmraise the $25 million by issuing convertible debentures. These convertibles would have a

91,000 par value, carry a couP6n rate of 10 percent, have a 20-year maturity, and be con-

vertibl6 into 20 share! of stoik. The bonds would be noncallable for 5 years, after whichthey would be callable at a Price of $1,075; tNs call price would decline by $5 per year inVea'r O and each year thereaiter. Management has cailed convertibles in the past (a1d p5'sumably it will iall them again in the future), once they were eligible for call, when thebonds"conversion value wis about 20 percent above the bonds' par value (not their callprice).i. Oi"* an accurate graph similar to Figure 15-1 representing the expectations set forth

above. (Assme an arutual couPon.)b. What is the expected rate of reaum on the proposed convertible issue?

c. Do you think lhat these bonds could be successfully offered to the public at par? Thatis, does $1,000 seem to be an equilibrium price in view of the stated terms? If not, sttg-pest the Wpe of chanqe that would have to be made to cause the bonds to trade ai

$1,OOO in ilie secondar"y market, assurnin8 no change in capital market conditions. --

d. Suppose the proiects outlined here work out on schedule for 2 years, but then the firmUeiins to exi"rience extremely stront comPetition from Japanese fims. As a result,NGndorf's expected growth rate drops from 9 Percent to zero' Assume that the dit'i'dend at the ti-me of the droP is $2.38. The company's credit strength is not imPaired,and its value of k" is also unihanged. What would happen (1) to the stock Price, and (2)

to the convertible bond's Price? Be as precise as you can.

Sales

All costs except interest

EBIT

Interest

EBT

Taxes (40%)

Net income

Shares outstanding

Eamings per share

Price/eamings ratio

Market price of stock

$1,100,000

990,000

$ 110,000

20,000

$ 90,000

36,000

$ s4,000

100,000

$0.54

15.83x

$8.ss

7s-7Bond Analysisbonds were issued to $32.75 at present. Suppose also that the rate of interest

from 8% to 5% percent. Under these conditions, what do you think wouldpened to the price of the bonds?

f. bc* up a graphic model to illustrate how investors valued the A.A. Steel conr

'i'he Howland Carpet Company has grown rapidly during the. past 5 years._Rqcommt'rcial bank urged the company to consider increasing its permanent llnan

bank loan unrler a line of credit has risen to $250,000, carrying an I percent intei

Howland has been 30 to 60 days late in paying trade creditors. IDiscussions with an investment ban(er'have resulted in the decision to raise

1986. How well were these expectations realized? 1;

at this time. Investment bankers have assured the firm that the follolvingfeasible (flotation costs lvill be ignored):

. Altcrilititc i: Sell common stock at SB

t Allernatiua 2: Sell convertible boncls at an 8 percent corrpon, convertible intoof comnron stock for each $1,000 bond (that is, the conversion price is $10

r Altzrrrrtiru 3: Sell tiebentures at an 8 percent coupon, each $1,000 bond car{in$rants kr bttv common stock at $10.

John L. Horr'lancl, the pre'sirlent, owns B0 pcrc!'nt of the comnron stock al9maintain control of the company. One hrrndiecl thousanrl slrtrres itre outstandirmaintain control of the company. res Ire oLrtstandin8'lorv ing arr' cxtr.rcts of H orv l arrtl's l.r test f inincial sta tL'ml'nts:

586 Chapter 15 HYBRID FINANCING

fufrna CasePau) Duncan, Iinancial manager of EduSoft Inc., is facinga dilemma. The firm w.rs founded 5 years ago to provideeducational software for the rapidly expanding primaryanh secondary school markeis'. Aithoigh fdudoft hatdohe well, the firm's fbunder believes that an industryshakeout is iminenl. To suruive, EduSoft must grabmarket share now, and this will require a large infusioin ofnew capital.

Because he expects earnings to continue rising shalplyand looks for the stock price to follow suit, Mr Duncandoes not think it would be wise to issue new commonstock at this time. On the other hand. interest rates arecurrently high by historical standards, and with the firm'sB rating, the interest payments on a new debt issue wouldbe prohibitive. Thus, he has narrowed his choice of fi-nancing alternatives to two securities: (1) bonds with war-rants, or (2) convertible bonds. As Duncan's assistant, youhave been asked to help in the decision process by an-sweriflg the following questions:a. How does preferred stock differ from both cofiunon

equity and debt? Is preferred stock more risky thancommon stock?

b, What is a call option? How can a knowledge of call op-tions help a financial manager to better understandwarrants and convertibles?

c. One of the firm's altematives is to issue a bond withwarrants attached. EduSoft's current stock price is $20,and its investment banker estimates that the cost of a20-year, annual coupon bond without warrants wouldbe 12 percent. The bankers suggest attaching 50 war-rants, each with an exercise price of $25, to each $1.000bond. It is estimated that each warraht, when detachedand traded separately, would have a value of $3.(1) Ufhat coupon rate should be set on the bond with

warrants if the iotal package is to sell for $1,000?(2) Suppose the bonds were issued and the warrants

immediately traded on the open market for $5each. What would this imply about the terms of theissue? Did the company "win" or "lose"?

(3) When would you expect the warrants to be exer-cised? Assume they have a 1O-year life; that is, theyexpire 10 years after issue.

(4) Will the warrants bring in additional capital whenexercised? Ifso, how much,and what type ofcapital?

(5) Since warrants lower the cost of the accompanyingdebt issue, shouldn't all debt be issued with war-rants? What is the expected return to the holders ofthe bond with warrants (or the expected cost to thecompany) if the warranis are expected to be exer-cised in 5 years, when EduSoft's stock price is ex-pected to be $35.75? How would you expect the costof the bond with warrants to cornpare with the costof straight debt? With the cost of common stock?

d.*:T',::"#*I""r :i:f""i't,yH#::,il.-, H

Se'lected Additional References and Cases 587

Selected Additional References and Cases

For additional discussiors on preferred stock, see

Alderson, Michael J., and Donald R. Fraser, "Financial lnnovations and Excesscs Revisited:The Case of Auction Rate Preferred Stock," Financial Mnrngement, Summer 7993,61J5.

Alderson, Michael J., Keith C. Brown, and Scott L. Lummer, "Dutch Auction Ratc Pre-ferred Stock," Financinl Managclrcnf, Summer 1,987, 68-73,

Fooladi, Iraj, and Gordon S. Roberts, "On Preferred Stock," /orrrrlal of FinLtncinl Rescorch,

Winter 1985,319124.Wansley, James W, Ftryez A, Elayan, and Brian A. Maris, "Preferred Stock Rcturns, Ctedit

Watch, and Preferred Stock Rating Changes," Tlre Iirrancial ReoictLr, May 1990,26!-285.

Winger. Bernard J., et al., "Adjustable Rate Preferred Stock," Financial Marrageirerrt, Spring1986,48-57.

Quite d bit of work has been done on warrant pricing. Sotna of thc artigles ittclttdc

Ehrhardt, Michael C., and Ronald E. Shrieves, "The Impact of Warants and ConvertibleSecurities on ihe Systematic Risk of Common Equily," Finnncinl Rezsiew, November1995,843-855.

Galai, Dan, and Mier L Schneller, "The Pricing of Warrants and the Value of the Firm,"lounml of Finance, December 7978,133!-7342.

Lauterbach, Beni, and Paul Schultz, "Pricing Warrants: An Empirical Study of the Black-Scholes Model and lts Alternatives," lourtnl oJ Finance, September 1990, 1181-1209.

Leonard, David C., and Michael E. Solt, "On Using the Black-Scholes Model to Value War-ranls," lornul of Financinl Research, Summer 1990, 81-92.

Phelps, Katherine L., William T. Moore, and Rodney L. Roenfeldt, "Equity Valuation Ef-fects of Warrant-Debt Financing," lournal of Finnncial Researclt, Summer 7997,93-703.

Schwartz, Eduardo S,, "Thc Valuation of Warrants: Implementing a New Approach," /our-nal of Financial Econorrics, January 1977,79-93.

For ntore insights irtto cotnscrtiblc pricitrg and ust, see

Alexander, Gordon J., and Roger D. Stover, "Pricing in the New Issuc Convertible DebtMarket," E inancial Mannganent, Fall 1977, 35-39.

Alexander, Gordon J., Roger D. Stover, and D. B. Kuhnau, "Market Timing Strategies inConvertible Debt Financing," lournal of Fimnce, March 1979, 143-155.

Asquith, Paul, and David W Mullins, Jr., "Convertible Debt: CorPorate Call Poliry andVoluntary Conversion," Iournal of Firrance, September 7991,, 7273-1289.

Billingsley, Randall S., and David M. Smith, "V/hy Do Firms Issue Convertible Debt?" Fi-nnncial Managemerxl, Summer 1996, 93-99.

Brennan, Michael, "The Case fot Convertibles," lssues in Corpomte Finance (New York:Stem Stewart Putnam & Macklis, 1983),102-111.

Emery, Douglas R., Mai E. Iskandor-Datta, and Jong-Chul Rhim, "Capital Structtre Man-agtment as a Motivation for Calling Convertible Debt," /ountni of Filnncial Resenrch,

Spring 1994, 91-104.

Harikumar, T., P. Kadap.rkkam, and Ronald F. Singer, "Convertible Debt and InvestmentIncentives," lountal oJ Finnncial Research, Spring 1994, 15-29.

Ingersoll, Jonathan 8., "A Contingent Claims Valuation of Convertible Sccuritit's," /ournaloJ Financinl Econoltics, May 1977,289-322.

Janiigian, Vahan, "The Leveragc Changing Conscquences of Convertible Debt Financing,"Financial Managcruc,ll, Autunm 1987, 1,5-77.

Krishnan, V. Sivarama, and Ramesh P. Rao, "Financial Distress Costs and Delayed Calls ofConvertible Bonds," Firmrrcrnl Rerrieur, November 1995, 913_925.

The folloioitrg cnse t'ront tlr Cases in Financial Management: Dryden Rcquest st'ric.q cozrer-s

nwiy of the issues presenterl in this chapt$:

Case 27, "Virginia lvlay Chocolate ComPanli" illustrates convertiblc bond valuation.

2o-year, 10.5 percent annual coupon, callabls-i!l-e Ugna for its- $1,000 par value, whereas idebt issue would require a 12 percent corr-iconvertibles would be call protected for Scall price would be $1,100, and the comn

vestment bankers estimate that EduSoft

probably call the bonds as soon asconversion value exceeds $1,200.the cali must occur on an issue date

option.(1) What conversion price is built into the(2) What is the convertible's straight-debt

version value in any year? What is itsvalue at Year 0? At Year 10?

at Year 0? At Year 10?(5) Assume that EduSoft intends to force

by calling the bond as soon as possible

(4) What is meant by the "floor value" of iible? What is the convertible's expected flr

Soft's curent stock price is $20, its last dividl$1.48, and the dividend is expecred to grow iistant 8 percent rate. The convertible ior-rld teverted into 40 shares of EduSoft stock at the.dl

is the implied valtre of the convertibilitv feifr(3) What is the formula for the-.b,ond's exircctd

conversion value exceeds 20 percent abovalue, or 1.2($1,000) = $1,200, When is thepected to be called? (Hint: Recall that thdbe made on an anniversary date of the is

(6) What is the expected cost of capitalvertibie to EduSoft? Does this cost

e. EduSoft's market value capital stnrcture is d

(in millions of dollars): ::

Debt $ 50

Equity 50

$100

If the company raises $20 million in additiotby sellingjl) ionvertibles or (2) bonds with.r.,ihrt *o"uld its WACC bc. and how would

consisient with the riskiness of the

ures compare with its currerrt WACC?

decision based on other factors. What arefactors which he should consider?

rate is 40 percentMr. Duncin believes that the costs of bothwith warrants and the convertible bondenough to one another to call them even, and

sisten"t with the risks involved. Thus, he will

)

588 Chapter 15 HYBRID FINANCING

6xtensionsADJUSTABLE RATE ANDMARKET AUCTIONPREFERRED STOCI(SInstead of paying fixed dividends. adjustable rate Pre-ferred stocks (ARPs) have their dividends tied to the rateon Treasury securities. The ARPs, which are issuedmainly by utilities and large commercial banks, weretouted as nearly pcrfect short-term corporate investmentssince (1) only 3O percent of the dividends are taxable tosince (1) only 30 p€rcent of the dividends are taxable tocorporations, and (2) the floating rate feature was sup-corporations, and (2) the floatingposid to keep the issue trading at near pan The new se-curity proved to be so popular as a short-term investmentcurity proved to be so popular as a short-term investmentfor firms with idle cash that mutual funds designed iustto invest in them sprouted like weeds (shares of thefunds, in trrrn, were purchased by corporations). How-evet the ARPs still had some price volatility due (1) tochanges in the riskiness of the issues (some big bankswhich had issued ARPs, such as Continental Illinois, raninto serious loan default problems) and (2) to the fact thatTreasury yields fluctuated between dividend rate adjust-ments dates. Thus, the ARPs had too much price instabil-ity to be held in the liquid asset portfolios of many cor-porate investors.

To solve tNs problem, investment bankers introducedmoney markct, or market auction, preferred. Here theunderwriter conducts an auction on the issue every sevenweeks (to get the 70 percent exclusion from taxable in-come. buyers must hold the stock at least 46 days). Hold-ers s'ho want to sell their shares can put them up for auc-tion at par value. Buyers then strbmit bids in the form ofthe yields they are willing to accept over the next seven-week period. The yield set on the issue for the coming pe-riod is ihe lowest yield sufficient to sell all the shares be-ing offered at that auction. The buyers pay the sellers thepar value, hence holders are virtually assured that theirshares can be sold at par. The issuer then must pay a div-idend rate over the next seven-week period as deter-mined by the awtion. From the holder's standpoint, mar-ket auction prefe.rrtt is a low-risk, largely tax-exenrpt,seven-week maturity scrcurity which can be sold betweenauction dates at clos€ to par. Flowever, if there are notenough buyers to match the sellers (in spite of the highyield), then the auction can fail, which has occurrecl onoccasion. For example, a few years ago, an auction ofMcorp (a Texas bank holding company) failed to attractenough buyers. Analysts attributed the failure to thedowngrading of lvlCorp's preferred stock from double Ato single B, which causetl potcntial buyers to think (cor-rectly, as it tumed out) that the company rvould go bank-rupt and not pay the tlividencis expecteel.

Atljustable rate and nrarkel auctiorr prcferrerls are alsoissued by industrial and service companies. For example,Texas lnstruments recently issued $2?5 nrillion of marketauction pre{errecl. About the only thing invcstors do notlike about ARPs and auction market preferreds is that, as

stock, they are more vuherable to an issuer,sproblems than debt would be, as evidenced by ftiexample.

REPORTING EARNINGSWHEN WARRANTS ORCONVERTIBLES AREOUTSTANDINGIf warrants or convertibles are outstanding, a fim- 'theoretically report earnings per share in oneways:

1. Bnsic EPS, where eamings available tostockholders are divided by the average rshares actually outstanding during the period.

2. Primary EPS, where eamings available areby the average number of shares that wouldbeen outstandin8 if warrants and"Iikely to be converted in the near future" hadally been exercised or converted. lnmary EPS, earnings are first adjusted byout" the interest on the convertibles, afteradjusted eamings are divided by the adjwtedber of shares. Accountants have a formula'rbasically compares ihe conversion or exercislvith the actual market value of the stck tomine the likelihood of conversion whenon the need to use this arliustment

3. Dililed EPS, which is similar to primarythat rll warrants and convertibles areexercised or converted, regardless of theof exercise or conversion,

Under SEC rules, firms are required to rePortsic and diluted EPS. For firms with large amoulttion securities outstanding, there can be aference between the basic and diluted EPS

financial statement purposes, firms reported

of a company's underlying pe.rform.ince. Also,makes it e.lsier for invcstors to conrpnre theof U,S. firnrs with their foreign courrterparts,to use basic EPS. i

CALLING CONVERTIBL]ISSUES i,,

Most convertiblc issrres hrve provisions thdt allolv ssuer to call the issue Prior to mrtrtrittr tn srrch cas'*

issuing finn must nr.rfe tL" .i*.i;i;'tii .:., if rl{the co-nvertible. lf a convertibtc is calte.l njhen iEl

is less than the stock price, convertible holdersthe call and receive the call price. The firm will

.fav cash to redeem the issue, and no new equityI"l on the balance sheet. If the call is made when

liion pri." exceeds the stock Pdce, holders willtheh securities into common stock. In this case,

ivill not have a cash outlay, and a balance sheet

will be made from debt (or preferred) to common

should a convertible be called? To begin, con-

situation where the conversion value is less thanr tall price. In our Chapter 15 convertibieassume that Silicon Valley's stock pricemple, assume that Silicon valtey's stock Price

rise, and that the conversion value at Year 10 is

Extensions 589

agers "kill" the conversion option, and hence remove theopportunity for convertible holders to share in futurestock price increases,

Interestingly, several studies have shown that firms donot call convertibles when conversion value reaches callprice, but rather tend to wait until th€ conversion value iswell above the call price.' One reason proposd to explainthis observed behavior is that the firm may want to savenear-term cash flow. For example, Silicon Valley's com-mon dividend might be $6 per share when the convertiblebonds become callable. Assuming a ,10 percent tax rate,current after-tax interest on each bond is $100(0.60) = $50per year, while conversion into 20 shares of commonwould require $120 of amual dividend payments. An-other possible explanation involves sitnaling-if a Iirmcalls its convertibles at the earliest posoible time, then in-vestors will be less interested in future convertible issuesit mitht decide to use.

SOME INNOVATIVENEW HYBRIDSOver the past three years, investment bankers have de-vised some new preferred stock hybrids having signifi-cmt appeal to both issuers md investors. For example,RJR Nabisco recently issued trust-oriented preferred secu-rities (TOPTS), which combine features of futh preferredstock and bonds. TOPrS are sold at iust $25 h share, whichmakes them more accessible to small investors than cor-porate bonds with $1,000 or $5,000 par values, althoughmost buyers purchase round lots of 1@ shares. Severalversions of these securities have been isstred by differentcompanies under names such as montNy income pre-ferred securities (MIPS) and quarterly income preferredsecurities (QUIPS). [n fact. in recent years these new hy-brids have accounted for more than half of the total pre-ferred stock issued.

Unlike conventional preferred, these new hybrids offeryields higher than those set on the firm's debt securities,which makes them attractive to individual investors. Forexample, RJR Nabisco's TOPIS were s€t at 8 percent whileits bonds yielded about 7.2 percent at the time. The key tothe higher yield is the securities' tax deductibility for theissuer. The deal works in this way: The parent companycreates a partnership or trust that actually issues the secu-rities. Then the proceeds are loaned to the parent. whichrepays the loan with tax-deductible interest payments.These payments, in tum, are timed to coincide wiih thedividend payments made to the hybrid holders.

The new securities tend to have long maturities-typically 30 to 40 years-so holders are subi€ct to con-siderable price risk, iust as on any long-term fixed-rateinvestment. The hybrids have call provisions, but mostoffer five years of call protection. After that, a sharp dropin interest rates would likely trigger a call. Most of these

= 9700, mtrch less than the $1,050 call price.

assume that interest rates have stayed the same,

the firm has no incentive to call the con-because the convertible couPon rate is less than

required on straight debt. However, if in-iates f;ll, and new straight debt costs less than the

a ne\ry straight-debt issue would cost 13 percent,

ove the convertible's 10 percent coupon rate. In

coupon rate, the convertible should be called.le here is the same as for calling a nonconvert-

non stock, resulting in a wealth transfer of (StockConversion pricel(Number of shares) = ($60 -= $200 per bond. If the call were not made, and

about the situation when the issuer's stock price,nversion value, has riserl? When a convertible is

into common stock, thie difference between theprice and the convertible's conversiona wealth transfer from current stock-

to convertible holders. Since managers are moti-act in the best interest of current stockholders,

to minimize the amount of wealth transfe! the-that the call should be made as soon as the

ion value reaches the call price, assuming the de-eriod has ended. (In reality, because of transac-

the call should be made when the conversionslightly above the call price.) To illustrate, if afterr. Silicon Valley's stock price has risen to $50, thenrersion value is $60(20) = $1,200, and a call at

force holders to convert to get $1,200 worth

trice subsequently rose to $75, the wealth trans-increase to ($75 - $50)(20) = $500 per bond.'this from another perspective, a firm's value isI its securitv holders. As a firm's fortunes rise,of its debt securities are fixed, but the value of

stock rises, and so does the value of its con-which have a call option on the stock. However,

of the convertible issue lowers the value ofstock, and the greater the value of the call

(of the convertible), ihe lower the value of thestock. By calling the convertible as soon as the

value equals the call price, the firm's man-

until 1992 when the Financial AccountinB Stal

Board (FASB) changed to basic EPS. According to

the change was maie to give investors a simPlerl

see Jonathon Ingersolt, "An Examination of Corporate Call Policies on Convertible Securities," lournal o/ Finance. May

)