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CHAPTER 21
Hybrid Financing: Preferred Stock,
Warrants, and Convertibles
Types of hybrid securities
Preferred stock
Warrants
Convertibles
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Disadvantages
Preferred dividends not tax deductible,
so typically costs more than debt
Increases financial leverage, and hence
the firms cost of common equity
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12
-850
I/YR
PV
1000
PMT
FV
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What is the expected return to the bondwith-warrant holders (and cost to the
issuer) if the warrants are expected to
be exercised in 5 years when P =
$36.75?
The company will exchange stock worth
$36.75 for one warrant plus $25. The
opportunity cost to the company is $36.75 $25.00 = $11.75 per warrant.
Bond has 50 warrants, so the opportunity
cost per bond = 50($11.75) = $587.50.
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+1,000 -100
19
20
-100
-100
-1,000
-1,100
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Par value
# Shares received
$1,000
=
40
= $25.
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Amazon.com
$1,250 mil
$156.05
$122
Beyond.com
55 mil
18.34
16
CNET
173 mil
74.81
84
DoubleClick
250 mil
165
134
Mindspring
180 mil
62.5
60
NetBank
100 mil
35.67
32
PSINet
400 mil
62.36
55
SportsLine.com
150 mil
65.12
52
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12
I/YR
PV
Solution: -887.96
105
PMT
1000
FV
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8
I/YR
-800
PV
0
PMT
1200
FV
Solution: n = 5.27
Bond would be called at t = 6 since
call must occur on anniversary
date.
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-105
-105
3
-105
-105
-105
6
-105
-1,269.50
-1,374.50
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P0
$1.48(1.08)
+ 0.08
$20
= 16.0%.
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WACC Effects
Assume the firms tax rate is 40% and its
debt ratio is 50%. Now suppose the firm is
considering either:
(1) issuing convertibles, or
(2) issuing bonds with warrants.
Its new target capital structure will have
40% straight debt, 40% common equity and
20% convertibles or bonds with warrants.
What effect will the two financing
alternatives have on the firms WACC?
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1,000
-63
-63
-63
-63
-63
6
-63
-1,269.50
-1,332.50
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= 0.4(7.2%) + 0.2(9.81%)
+ 0.4(16%)
= 11.24%.
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Some notes:
We have assumed that rs is not affected
by the addition of convertible debt.
In practice, most convertibles are
subordinated to the other debt, which
muddies our assumption of rd = 12%
when convertibles are used.
When the convertible is converted, the
debt ratio would decrease and the firms
financial risk would decline.
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+1,000
-60
-60
...
-60
-60
-60
-587.50
-647.50
...
19
20
-60
-1,000
-1,060
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= 0.4(7.2%) + 0.2(10.32%)
+ 0.4(16%) = 11.34%.
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