Hybrid Financing: Preferred Stock,

Warrants, and Convertibles

Ch 19
 How does preferred stock differ from
common stock and debt?
• Preferred dividends are specified by contract

• Most preferred stocks prohibit the firm from paying

common dividends when the preferred is in arrears.

• Usually cumulative up to a limit.

• Preferred stock has no voting rights

• Is preferred stock closer to debt or common stock?

What is its risk to investors
What are the advantages and disadvantages
of preferred stock financing?
• Advantages
– Dividend obligation contractual
– Avoids dilution of common stock

• Disadvantages
– Preferred dividends not tax deductible, so
typically costs more than debt
 How can a knowledge of call options
help one understand warrants and
convertibles?

• A warrant is a long-term call option.

• A convertible consists of a fixed rate bond

(or preferred stock)plus a long-term call
option.
Recap the differences between warrants
and convertibles.

• Warrants bring in new capital, while

convertibles do not.
• Most convertibles are callable, while
warrants are not.
• Warrants typically have shorter maturities
than convertibles, and expire before the
accompanying debt.
• Warrants usually provide for fewer
common shares than do convertibles.
• Bonds with warrants typically have much
higher flotation costs than do convertible
issues.
• Bonds with warrants are often used by
small start-up firms. Why?
 How do convertibles help minimize
agency costs?
• Agency costs due to conflicts between
shareholders and bondholders

– Asset substitution. Firm issues low cost straight

debt, then invests in risky projects

– Bondholders suspect this, so they charge high

interest rates

– Convertible debt allows bondholders to share in

upside potential, so it has low rate.
 Agency Costs Between Current
Shareholders and New Shareholders
• Information asymmetry: company knows its
future prospects better than outside investors

– Outside investors think company will issue new

stock only if future prospects are not as good as
market anticipates

– Issuing new stock send negative signal to market,

causing stock price to fall
• Company with good future prospects can
issue stock “through the back door” by
issuing convertible bonds

– Avoids negative signal of issuing stock

directly

– Since prospects are good, bonds will

likely be converted into equity,