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Preferred Stocks
A special equity instrument that has properties of both an equity and a debt instrument. Like bonds, they are ranked by credit rating agencies. Par value is often $25 or $100 (in the US) Senior to common stock but subordinate to bonds. (If bankruptcy occurs, company has to pay bondholders 1st, preferred shareholders 2nd, and common shareholders last.) Usually cumulative but nonparticipating (no voting rights). Issuing corporations viewpoint: bonds riskier than preferred stock Investors viewpoint: preferred stock (cannot really force the company to pay) riskier than bonds (can force the company to pay). Thus, investors require higher after-tax rate of return for preferred stock than for bonds. Pre and After-tax kd is usually less than pre and after-tax kp After-tax kd < After-tax kp because:
Riskiness of preferred stock compels investors to require higher returns. Interest expense is tax deductible thus resulting to tax savings. Dividends are not tax deductible.
Drawbacks:
Some price volatility due to changes in riskiness of the issues (Default problems of big banks that issue ARPs). T-yields that fluctuate between dividend rate adjustments dates. (Though usually it is limited).
Parties in a Lease:
Leasing
Lessee The party that uses the leased property. Lessor The owner of the leased property.
Debt Ratio
50%
75%
50%
Warrants
A long-term option to buy a stated number of shares of common stock at a specified price. Are long-term call options that have value because holders can buy the firms common stock at the exercise price regardless of how high the market price climbs. Makes the underlying debt more valuable, hence, with the warrants, the debt would require a lower discount rate or interest rate. The higher the value of the warrant, the lower the discount rate required. The lower the value of the warrant, the higher the discount rate required. Detachable Warrant a warrant that can be detached from a bond and traded independently of it. (Virtually all warrants are detachable). Stepped-Up Exercise Price an exercise price that is specified to rise if a warrant is exercised at a designated date. Exercise price typically is 20% to 30% above the price at issuance.
Warrants
When will investors exercise warrants?
When the market price > exercise price, especially when the warrants are about to expire. If issuing company raises dividends on common stock. With warrants having stepped-up exercise price, before the stepped up price takes effect.
Illustrative Problem
At present, ABC Companys value is $200 million. It currently has 10 million shares of common stock outstanding. It wants to raise additional capital worth $50,000,000 and it decided to issue bonds. To make the issue more attractive, warrants are attached to the bonds. The offer price for 20 year bonds + 20 warrants is $1,000. Without the warrants, the bonds has a yield of 10%. With the warrants, the yield is 8%. Price of 1 common stock today is $20. Exercise price is $22. The warrant will expire in 10 years. Assume annual payments. Compute the Value of the Warrants.
Warrants
Question: Since Warrants are Long Term Call Options, can we use the Black-Scholes OPM to estimate the value of the warrants? Answer: No.
Warrants differ from Call Options. Shares involved when warrants are exercised are newly issued shares. Shares involved when Call Options are exercised are from the secondary market. Failure to meet the Liquidity assumptions of the BS OPM Trading in all securities takes place continuously, and stock price moves randomly.
Warrants
Dangers when warrants are mispriced:
Overpriced = Bond coupon rate would be set too low. (Pay 50m for bonds worth 40m) Cannot sell bonds with package at par Cannot raise its intended funds Underpriced = Bond coupon rate would be set too high. (Pay 50m for bonds worth 60m) Existing shareholders will experience dilution of their stocks
Questions:
If investors pay $1,000 for each bond, what is the value of each warrant attached to the bond issue? What is the expected total value of Storm Software in 10 years? If there were no warrants, what would be Storms price per share in 10 years? What would the price be with the warrants? What is the component cost of these bonds with warrants? What is the premium associated with the warrants?
A) 10.5%, - 150 BP B) 12.7%, 70 BP C) 13.4%, 140 BP D) 15%, 300 BP E) 16.3%, 430 BP
Interpreting the opportunity cost of capital for the bond with warrants package
The cost of the bond with warrants package is higher than the cost of straight debt because part of the expected return is from capital gains, which are riskier than interest income. The cost is lower than the cost of equity because part of the return is fixed by contract.
Convertibles
Convertible Security a security (bond or preferred stock) that is exchangeable at the option of the holder for the common stock of the issuing firm. Nature of Convertible Bonds:
Leverage: Leverage rises upon issuance, but falls upon conversion. Dilutive Impact: No dilutive impact upon issuance, dilutive impact upon conversion.
Conversion ratio (CR) # of shares of CS obtained by converting a convertible security. Conversion price (Pc) effective price paid for CS obtained by converting a convertible security. Usually set at 20% to 30% above the market price of the common stock at issuance. Call Protection protects the investors. It prohibits the issuer from calling back the security for a period early in its life. Typically for 2 to 5 years.
Convertibles
PAR
Conversion Ratio Conversion Price
1000
Conversion Ratio 40
Illustrative Problem:
ABC Company decides to issue 20 year convertible bonds, selling at $1,000 per bond at a 10% annual coupon rate. 1 Bond is convertible to 20 shares of common stock. Yield for straight bonds is 13%. The stock will pay a dividend of $2.80/share, and it is sold at $35/share. Growth is expected to remain constant at 8%. The convertible bonds are callable at 10 years and can be sold at P1,050 with price declining at $5/year.
Questions:
How much is the conversion price? How much is the value of the straight debt? How much is the conversion value in 10 years? What is the component cost of the convertible?
A) 10% B) 11.5% C) 12.8% D) 13.4% E) 15.3%
Required:
What conversion price should be set by the issuer? The conversion rate will be 1.0 Should the preferred stock include a call provision? Why or why not? At which year (at the earliest) would investors be willing to exercise the convertible securities?
Convertibles
Involves only an accounting transfer More flexible as most convertibles are callable by the issuer. Longer maturities. Provides more shares as all the debt are converted to common stock
Big companies. Its more risky to issue convertibles as there is no buffer for losses unlike the case for warrants.
Issuance Costs
Higher. Around 1.2% higher than the Lower. flotation costs for convertibles.