Finance

Chapter 20Hybrid financing: preferred stock, warrants, & convertibles

Additional long term capital types

Preferred stock – a hybrid security that is a cross between debt and common equity

Leasing – an alternative to borrowing to finance fixed assets

Warrants – derivative securities issued by firms to facilitate issuing some other type of security

Convertibles – combine features of debt (or preferred stock) and warrents

Preferred stock

Accountants show preferred stock as equities on the balance sheet

From a financial perspective they’re somewhere in between debt and common equity

It imposes a fixed charge thus increasing a firm’s financial leverage but omitting the preferred dividend does not force a company into bankruptcy

Preferred stock basic features

Preferred stock has a par (or liquidating) value often $25 or $100

Dividend is stated as a percentage of par or as so many dollars per share, e.g.: par value of preferred stock $100 at time of

issue is $12 annual dividend Or 12% annual yield

Preferred stock basic features

Cumulative – a protective feature that requires preferred dividends previously not paid to be paid before any common dividends can be paid

Arrearages – unpaid preferred dividends

Arrearages do not earn interest

Arrearages accumulate for a limited time only (e.g., 3 years) but continue in force until they are paid

Preferred stock basic features

Normally no voting rights unless the dividend is not paid (passes) – PS holders can then elect a minority of directors

Recent trends in issuing PS: About ½ PS are convertible Some PS are similar to perpetual = no maturity

date Some PS issued with a sinking rate (e.g., 2%

must be retired each year) Some have limited life (e.g., 50 years) Some are callable

ARPs

Adjustable Rate Preferred Stocks (ARPs)

Rates tied to Treasuries

Favorable tax rates to corporations

Floating rate designed to keep the issue trading near par

Riskiness became an issue resulting in price instability. This made ARPs unattractive for liquid asset portfolios

Market Auction Preferred

Market Auction (Money Market) Preferred – low-risk, largely tax-exempt, 7-week maturity security that can be sold between auction dates at close to par.

Holders who want to sell their shares auction them at par value. Buyers submit bids in the form of yields.

The yield set on the issue for the coming period is the lowest yield sufficient to to sell all the shares being offered Buyers pay the sellers par value Issuer pays a dividend rate over the next 7-week

period as determined by the auction

Advantages of PS

Unlike bonds, the obligation to preferred dividends is not contractual and passing a preferred dividend does not force bankruptcy

Preferred stock avoids diluting common equity

If no maturity date - reduces cash flow drain from repayment of principal that occurs with bonds

Disadvantages of PS

PS dividends are not deductible to the issuer

Since the intent is to pay dividends, dividends are a fixed cost. Therefore, their use, like that of debt, increases financial risk and thus the cost of common equity

Industry practice, pg. 762

Leasing

An alternative to owning assets since it’s the use of the asset that’s important, not the ownership of it Traditionally associated with real estate (land &

buildings) Since 2002, about 30% of all capital equipment

is leased

Types of leases Sale-and-leaseback Operating leases Straight financial, or capital, leases

Sales & leaseback

An arrangement whereby a form sells land, buildings, or equipment and simultaneously leases the property back for a specified period under specific terms Lessee – the firm selling the property; the party

that uses rather than owns the leased property Lessor – the owner of the leased property

Payments are set-up similar to a mortgage

Operating leases

A lease under which the lessor maintains and finances the property; also called a service lease

Lease payments include cost of providing maintenance

Property is not fully amortized; the full cost of the equipment is not recovered. Recovery can be of 3 types: Renewals Subsequent leases Selling the leased equipment

Operating leases

Cancellation clause – allows the lessee the right to cancel the lease before the term of the lease expires. Useful when: Technology makes the equipment leased

obsolete (computers) Lessee’s business declines

Financial, or Capital, leases

A financial lease does not provide for maintenance services, is not cancelable, and is fully amortized over its life

Similar to sale-and-leaseback lease but Equipment is new Lessor buys from a manufacturer/distributer not

the lessee

Financial statement effects

Deciding to buy or sell

Comparing alternatives and choosing the method with lower PV cost

All cash flows should be discounted at the after-tax cost of debt because the relevant cash flows are relatively certain and are on an after-tax basis

Warrants

A long-term option to buy a stated number of shares of common stock at a specified price A long term call option issued along with the bond Warrants are generally detachable from the bond Warrants are traded separately in the market

When warrants are exercised, the firm receives additional equity capital, and the original bonds remain outstanding

Induces investors to buy long term debt with lower coupon rates Option offsets the bond’s lower interest rate

Warrants

Warrants are used by small, rapidly growing (higher risk) firms as “sweeteners”

Sony-Columbia Pictures case, pg. 776

convertibles

Convertible security – usually a bond or preferred stock that is exchangeable at the option of the holder for the common stock of the issuing firm

Conversion ration (CR) – the number of shares of common stock that are obtained by converting a convertible bond or share of convertible preferred stock

Conversion price, Pc – the effective price paid for common stock obtained by converting a convertible security

Conversion price usually set-up from 20-30% above prevailing market value of the common stock (similar to warrant pricing)

Industry Practice, pg. 778

Warrants cf. convertibles

Both are “sweeteners” but differences include:

Separability – warrants are separated from bonds

Impact when exercised – exercising warrants brings in new equity capital, while conversion of convertibles is only an accounting transfer

Callability – most convertible issues are callable, warrants are not callable

Maturity – warrants have a much shorter maturity

Flotation costs – costs for warrants substantially higher than costs for convertibles