Finance Chapter 20 Hybrid 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
