Hybrid Financing

Preferred Stock
Leasing
Warrants
Convertibles
 What is a hybrid security?
• Hybrid Securities are tradable securities
possessing characteristics borrowed from both
debt and equity instruments.
• Usually pays a predictable (fixed or float) rate of
return or dividend for a certain period of time,
usually until maturity or conversion date.
• Some hybrid securities are structured in a way
that they behave more like fixed interest
securities and others behave more like the
underlying shares that they convert into.
• In a risk sense, hybrid securities are usually riskier
than debt, but not as risky as equity. They have a
risk profile between debt and ordinary equity.
 Four Hybrids:
• Preferred stock
– A cross between debt and common equity securities.
• Leasing
– An alternative to borrowing to finance fixed assets.
• Warrants
– Derivative securities issued by firms to facilitate the
issuance of some other type of security.
• Convertibles
– Combines the features of debt or preferred stock and
warrants.
 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).
• Cumulative = a protective feature on preferred stock that requires
preferred dividends previously not paid (arrearages) to be paid before
any common dividends can be paid.
• Issuing corporation’s 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.
 Preferred Stocks
• 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.
• However, at times, pre-tax kd > pre-tax kp:
– IF preferred stock is high grade. (Minute chance of default)
– Tax laws of particular countries, making preferred stock more
attractive, for instance:
• US Tax Laws: 70% of preferred dividends is exempt from
corporate taxes.
• Philippine Tax Laws: Preferred dividends from local corporations
is 100% exempt from corporate taxes for corporate investors, but
subject to 10% final tax (passive income) for individual investors.
Advantages of Preferred Stock (Issuer)
• Preferred Stock cannot force company into bankruptcy.
• No dilution impact to existing shareholders.
• Restricted voting rights which is good for the common
shareholders.
• Reduces CF drain from repayment of principal that occurs
with debt issues
– Usually no maturity
– Preferred sinking fund payments are typically spread over
a long period.
Disadvantages of Preferred Stock (Issuer)
• Preferred stock dividends not deductible to the issuer; after-
tax rp > after-tax rd.
• Have to pay fixed dividends to preferred shareholders, thus
increases financial risk and cost of common equity. This also
increases the need for higher levels of operating income to
cover additional fixed expenses.
• Subordination of dividends to be paid on common stock may
put common shareholders’ interest at a disadvantage.
• Limitations on the use of corporate funds to the extent that
pre-established dividend payments must be made.
 Other Types of Preferred Stock
• Adjustable Rate (Floating Rate) Preferred Stock
– Preferred stocks whose dividends are tied to the rate on Treasury
securities (T-bill = benchmark). Their dividend is adjusted at regular
intervals
– Preferred dividend value is set by a predetermined formula to move
with rates. This flexibility provides more stability than the price of fixed
rate preferred stocks. (There is often a limit to the amount of rate of
change on the dividend – adding more security).
– Benefits:
• Only 30% of the dividends are taxable to corporations.
• Floating rate feature supposed to keep the issue trading at near par.
– 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).
 Other Types of Preferred Stock
• Market Auction (Money Market) Preferred Stock
– A.k.a. Auction Market Preferred Stock or Auction Rate Preferred Stock
– Introduced because some ARPs start to trade below par due to the
deterioration of issuing firm’s credit quality.
– A low-risk, largely tax-exempt, seven-week maturity security that can be sold
between auction dates at close to par. (But if there aren’t enough buyers to
match the sellers, in spite of the high yield, then the auction can fail).
– A type of dutch auction (high asking price first, in contrast to English auction, by
an intermediary or underwriter) that involves a process used to reset interest
payments or dividends that are paid on preferred shares or mutual fund shares.
– Dividend paid is reset (more or less) every 49 days by Dutch Auction. Interest
rate is usually subject to a maximum and the issue is puttable at each auction.
(Some AMPs dividend is reset every 28 days)
– 70% exclusion from taxable income = must hold stock at least 46 days).
– Stated Rate Auction Preferred Stocks (STRAPS) – similar to AMPs, but dividend
rate is fixed for the first couple of years.
 Leasing
• Parties in a Lease:
– Lessee – The party that uses the leased property.
– Lessor – The owner of the leased property.
• Different Forms of Leases
– Sale and Leaseback
• An arrangement whereby a firm sells land, buildings, or equipment and
simultaneously leases the property back for a specified period under specific terms.
– Operating Lease or Service Lease (Indirect)
• A lease under which the lessor maintains and finances the property
• Cost of providing maintenance is built into the lease payments.
– Financial or Capital Lease (Direct)
• A lease that does not provide for maintenance services, not cancelable, and is fully
amortized over its life.
• The lessee selects its item requirements and negotiates the price and delivery terms
with the manufacturer or distributor.
• Is identical to a loan as failure to make lease payments can bankrupt a lessee. In
effect is has raised its “true debt ratio” and changed its “true capital structure”.
 Leasing – Financial Statement Effects
• Off Balance Sheet Financing
– Financing in which assets and liabilities involved do not appear on the
firm’s balance sheet.
– Applicable to leases that are not capitalized
BEFORE ASSET INCREASE AFTER ASSET INCREASE
FIRMS Buy & Lease FIRM B, WHICH BORROWS AND BUYS FIRM L, WHICH LEASES (OL)
Current Assets 50 Debt 50 Current Assets 50 Debt 150 Current Assets 50 Debt 50
Fixed Assets 50 Equity 50 Fixed Assets 150 Equity 50 Fixed Assets 50 Equity 50
Total Assets 100 100 Total Assets 200 200 Total Assets 100 100

Debt Ratio 50% 75% 50%

– FASB 13 – Requires firms that enter into capital lease to

• Restate BS to report leased assets as fixed assets.
• Report the PV of future lease payments as a liability.
When a lease must be classified as
a financial or capital lease:
• Ownership of the property is effectively
transferred from the lessor to the lessee.
• BPO (Bargain Purchase Option) – Lessee can
purchase the property or renew the lease at
less than FMV when the lease expires.
• Lease period > or = 75% of the asset’s life.
• PV of lease payments > or = 90% of asset’s
initial value.
 Illustrative Problem (Borrow and
Buy vs. Lease):
Data:
• New computer costs $1,200,000.
• 3-year MACRS class life; 4-year economic life.
• Tax rate = 40%.
• Pre-tax kd = 10%.
• Maintenance of $25,000/year, payable at beginning of
each year.
• Residual value in Year 4 of $125,000.
• 4-year lease includes maintenance.
• Lease payment is $340,000/year, payable at beginning of
each year.
Factors that Affect Leasing Decisions:
• Estimated Residual Value
– Large Residual Value
• Owning may appear to be more beneficial than leasing.
• If high residual value is due to inflation:
– It might be necessary to use a higher discount rate to discount the
residual value, thus leasing may result in becoming more beneficial
than owning.
– Competition among leasing companies will make leasing rates go
down.
– Uncertainty of Residual Value
• Risk of uncertain residual value would require a higher discount
rate to discount the residual value.
• Cost of owning would be higher and leasing would be more
attractive.
Factors that Affect Leasing Decisions:
• Increase Credit Availability
– Financing through lease gives more credit availability for
companies – for those that seek maximum degree of
financial leverage.
– Superficial credit analysis for lease financing gives firm a
strong appearance.
 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
firm’s 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 (Warrants):
• At present, ABC Company’s 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”.
 Illustration of Undervaluation of
Warrants
• ABC Company has 10 million shares of CSO.
Stock price is $20 per share. Thus, market
value of ABC is $200m. Suppose that investors
invest $50m for securities that are worth
$60m.
 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
 Illustrative Problem (Warrants):
Storm Software wants to issue $100 million in new capital to fund
new opportunities. If Storm were to raise the $100 million of new
capital in a straight-debt 20 year bond offering, Storm would have to
offer an annual coupon rate of 12 percent. However, Storm’s
advisors have suggested a 20 year bond offering with warrants.
According to the advisors, Storm could issue 9 percent annual
coupon-bearing debt with 20 warrants per $1000 face value bond.
Storm has 10 million shares of stock outstanding at a current price of
$25. The warrants can be exercised in 10 years at an exercise price of
$30. Each warrant entitles its holders to buy one share of Storm
Software stock. After issuing the bonds with warrants, Storm’s
operations and investments are expected to grow at a constant rate
of 11.4 percent per year.
 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 Storm’s price per share in 10
years?
• With the warrants and assuming the warrants are exercised, what would
Storm’s price per share be in 10 years?
• 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.
 Exercise/Seatwork (Warrants):
• Archie Inc. needs P300 million in funding. If Archie issues 20
year pure bonds, the annual coupon yield would be 10%. To
make the issue more attractive to investors, Archie could
issue 20 year, 7% annual coupon-bearing debt with 30
warrants per P1,000 face value bond. Currently, Archie has
20 million shares of CSO at P55 per share. The warrants can
be exercised in 12 years at an exercise price of P240. Each
warrant entitles the holder to buy 3 shares of Archie stock.
After issuing the bonds with warrants, Archie’s operations
and investments are expected to grow at a constant rate of
8% per year.
 Questions for Exercise:
• Will Archie’s investors exercise the warrants? Why?
• 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 Archie in 10 years?
• If there were no warrants, what would Archie’s price per share
be in 12 years?
• With the warrants, what would Archie’s price per share be in
12 years?
• Assume further that re = 17%. What is the component cost of
these bonds with warrants?
• What is the premium associated with the warrants?
 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 Conversion
Ratio Price
Illustrative Problem (Convertibles):
• Petersen Securities recently issued convertible
bonds with a $1,000 par value. The bonds
have a conversion price of $40 a share. What
is the bond’s conversion ratio?

1000

Conversion
40
Ratio
 Advantages for issuing convertibles:
• Significant source of capital. The option to convert
makes the convertible securities more attractive to
investors.
• They offer a company a chance to sell debt with a low
interest rate in exchange for a chance to participate in
the company’s success if it does well.
• Provide a way to sell common stock at higher prices,
especially when current stock price is temporarily
depressed.
• A study by Billingsley et.al. (1985) confirm empirically an
average interest cost savings of approximately 0.5% of
issuing convertibles than straight debt.
Disadvantages for issuing convertibles:
• If stock price skyrockets, then issuing straight
debt and selling common stock later to refund
the debt would have been a better alternative.
• Upon conversion, the advantage of low cost
debt will be lost.
• If company’s intention is to issue equity
capital, and MP doesn’t rise above CP, then
company will be stuck with debt.
 Illustrative Problem (Convertibles):
• 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%
 If rconv < rdebt
• rd = 13% and re = 16%, so the cost for convertibles have
to be between 13% and 16%.
• But since rconv = 12.8%, it will not be too attractive to
investors considering that hybrids are in general, riskier
than debt.
• Ways to increase rconv:
– Increase 10% coupon interest rate
– Raise conversion ratio above 20 to lower conversion price
– Lengthen the call-protected period to more than 10
years.
 Illustrative Problem (Convertibles):
The Hadaway Company was planning to finance an expansion in the
summer of 2008. the principal executives of the company agreed that an
industrial company like theirs should finance growth by means of common
stock rather than by debt. However, they believed that the price of the
company’s common stock did not reflect its true worth, so they decided to
sell a convertible security. They considered a convertible debenture but
feared the burden of fixed interest charges if the common stock did not rise
enough to make conversion attractive. They decided on an issue of
convertible preferred stock, which would pay a dividend of $1.05 per share.

The common stock was selling for $21 a share at the time.
Management projected earnings for 2008 at $1.50 a share and expected a
future growth rate of 10 percent a year in 2009 and beyond. It was agreed
by the investment bankers and management that the common stock would
continue to sell at 14 times earnings the current price/earnings ratio.
 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?
Illustrative Problem (Convertibles):
• Johnson Beverage’s common stock sells for $27.83, pays a
dividend of $2.10, and has an expected LT Growth of 6%. The
firm’s straight debt bonds pay 10.8%. (With is 10%)
• Johnson is planning a convertible bond issue. The bonds will
have a 20 year maturity, pay $100 interest annually, have a
par value of $1000, and a conversion ratio of 25 shares per
bond. The bonds will sell for $1,000 and will be callable after
10 years.

• Required:
– How much is the conversion price?
– Assuming that the bonds will be converted at Year 10, when they
become callable, what will be the expected return on the convertible
when it is issued?
 Illustrative Problem (Convertibles):
• Insight Incorporated just issued 20 year convertible bonds at a price
of $1,000 each. The bonds pay 9% annual coupon interest rate, have
a par value of $1,000, and are convertible into 40 shares of the firm’s
common stock. Investors would require a return of 12 percent on the
firm’s bonds if they were not convertible. The current market price of
the firm’s stock is $18.75 and the firm just paid a dividend of $0.80.
Earnings and dividends are expected to grow at a rate of 7% into the
foreseeable future.

• Required:
– What is the expected straight debt value?
– What is the conversion value at the end of Y5?
– What is the floor price at Year 5 so that investors would be willing to convert
the convertible security?
 Comparison between Warrants and Convertibles:
Warrants
Impact upon Brings new equity capital
exercise
Flexibility Inflexible as most warrants are not
callable by the issuer.
Maturities Shorter maturities, typically expire
before the underlying debt expires.
Provides fewer shares as debt is still
outstanding
Type of Issuer Small companies, as it is less risky to
issue warrants. Potential losses from
exercising warrants may be offset by
the outstanding debt.
Issuance Costs Higher. Around 1.2% higher than the Lower.
flotation costs for convertibles.
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. It’s more risky to
issue convertibles as there is no
buffer for losses unlike the case for
warrants.
Reporting earnings when warrants
or convertibles are outstanding:
• Basic EPS
– NI to common / WACSO
• Diluted EPS
– NI to common / (WACSO + Other Convertible
Instruments)
The End!!!