Hybrid Financing: Preference Shares and Convertibles

Preferred stock is a form of corporate hybrid financing having characteristics of both

debt and common stock. The financial markets view it as a form of debt, but accountants typically place it on the balance sheet as an equity account. Preferred stock units are called shares, with a par value per share and usually no maturity. When preferred stock has a maturity, usually 20 years, it also has a call feature. The shares may have a dividend (fixed) rate or dividend per share specified on a per annum basis but paid prorated quarterly. As preferred stock with a constant dividend per share with no maturity is a perpetuity, the valuation of it is based on the following formula:

where P = the price per share, D = the annual dividend, i = the interest rate in decimal form.

When the dividend rate is different from current market rates, the preferred stock price
per share deviates from its par value. The dividend can change relative to current market interest rates. This preferred stock is called adjustable rate (or variable rate) preferred stock. The mechanism detailing the calculation and frequency of adjustment of the dividend rate would be stated in the indenture (contract). As adjustable rate preferred stock continuously provides a return comparable to prevailing market conditions, the valuation of it is approximately par value. An advantage to the corporation issuing preferred stock is that the dividend is not an obligation as are debt interest payments. If preferred stock dividends are not paid, the consequence to the firm is not insolvency and bankruptcy. When the firm's preferred stock dividend is not paid, it accumulates (cumulative clause) as dividends in arrears. No common stock dividend can be paid until the arrearage has been made up. Most preferred stocks issues provide for voting rights enabling the preferred stockholders as a class to elect at least one director on the board if the preferred stock dividend has been foregone for six consecutive quarters or more. Otherwise, preferred stock has no voting rights. Approximately one-half of the preferred stock in the United States has a convertible put option. This gives convertible preferred stockholders the right to exchange their preferred stock to the company in return for its common stock within a

conversion period of several years. When the preferred stock is convertible, a call feature is usually included giving the firm the right to buy back the convertible preferred stock for cash.

Features of Preference Shares

There are different distinguishing features of preference shares. These shares are
types of securities that are issued by the companies or corporations to their investors with the primary aim of generating funds for the company or corporation. These shares are different from the common stocks and are valued highly. The preference shares are provided with the voting rights but there are exceptions too. At the same time, the dividends that are paid to the preference share holders are generally paid earlier than other forms of shares. Again, at times when the corporation becomes bankrupt, the preference share holders are paid out prior to the other share holders termed as common stock holders. The preferred or preference share holders are provided with several facilities. The prime facility is regarding the payments of dividends. At the same time, if the dividends are not paid by the corporation to the preference share holders, the amount of the dividend is credited to the account of the share holder and is paid to the share holder with the next year's dividend. There are some another features of the preference shares. There are certain types of preferred or preferential shares that provide the shareholders with the rights to play an important role in the process of taking crucial decisions for the company. This voting right is provided to those preferred shares where the dividends are accumulating for a specific period. On the other hand, the preferred shares are designed with some specific planning for the security of the share. These shares are also very useful in forbidding uncongenial takeovers. For the purpose, the preference shares are designed with forced exchange characteristics that can be used at time of hostile takeovers. At the same time, issuing new preference shares is possible but any kind of senior claim for new shares is forbidden.

Apart from these owner-friendly features of preference shares, there are some other features also that may not be in proper harmony with the shareholders. One of such feature is the call provision. According to this provision, the preference share issuing company or corporation may buy-back the shares from the market whenever the situation demands so.

Advantages and Disadvantages of Preference Shares

Preference

shares are hybrid financing instruments having several benefits and

disadvantages for using them as a source of capital. Benefits are in the form of absence of legal obligation to pay dividend, improves borrowing capacity, saves dilution in control of existing shareholders and no charge on assets. Major disadvantage is that it is a costly source of finance and has preferential rights everywhere. Preference shares are used by big corporate as a long term source of funding their projects. They are known as hybrid financing instruments because they share attributes of both equity and debt. It is important to analyze the benefits and disadvantages affixed with using preference shares as a medium of financing. BENEFITS OF PREFERENCE SHARE There are several benefits of a preference share from the point of view of a company which are discussed below: No Legal Obligation for Dividend Payment: There is no compulsion of payment of preference dividend because nonpayment of dividend does not amount to bankruptcy. This dividend is not a fixed liability like the interest on the debt which has to be paid in all circumstances. Improves Borrowing Capacity: Preference shares become a part of net worth and therefore reduces debt to equity ratio. This is how the overall borrowing capacity of the company increases. No dilution in control: Issue of preference share does not lead to dilution in control of existing equity shareholders because the voting rights are not attached to issue of preference share capital. The preference shareholders invest their capital with fixed dividend percentage but they do not get control rights with them. No Charge on Assets: While taking a term loan security needs to be given to the financial institution in the form of primary security and collateral security. There are no such requirements and therefore the company gets the required money and the assets also remain free of any kind of charge on them.

DISADVANTAGES OF PREFERENCE SHARES Costly Source of Finance: Preference shares are considered a very costly source of finance which is apparently seen when they are compared with debt as a source of finance. The interest on debt is a tax deductible expense whereas the dividend of preference shares is paid out of the divisible profits of the company i.e. profit after taxes and all other expenses. For example the dividend on preference share is 9% and interest rate on debt is 10% with prevailing tax rate of 50%. The effective cost of preference is same i.e. 9% but that of the debt is 5% {10% * (150%)}. The tax shield is the main element which makes all the difference. In no tax regime, the preference share would be comparable to debt but such a scenario is just an imagination. Skipping Dividend Disregard Market Image: Skipping of dividend payment may not harm the company legally but it would always create a dent on the image of the company. While applying for some kind of debt or any other kind of finance, the lender would have this as a major concern. Under such a situation, counting skipping of dividend as an advantage is just a fancy. Practically, a company cannot afford to take such a risk. Preference in Claims: Preference shareholders enjoy similar situation like that of an equity shareholders but still gets a preference in both payment of their fixed dividend and claim on assets at the time of liquidation.

Convertible Securities

A "convertible security" is a securityusually a bond or a preferred stockthat can be

converted into a different securitytypically shares of the company's common stock. In most cases, the holder of the convertible determines whether and when to convert. In other cases, the company has the right to determine when the conversion occurs. Companies generally issue convertible securities to raise money. Companies that have access to conventional means of raising capital (such as public offerings and bank financings) might offer convertible securities for particular business reasons. Companies that may be unable to tap conventional sources of funding sometimes offer convertible securities as a way to raise money more quickly. In a conventional convertible security financing, the conversion formula is generally fixed - meaning that the convertible security converts into common stock based on a fixed price. The convertible security financing arrangements might also include caps

or other provisions to limit dilution (the reduction in earnings per share and proportional ownership that occurs when, for example, holders of convertible securities convert those securities into common stock). By contrast, in less conventional convertible security financings, the conversion ratio may be based on fluctuating market prices to determine the number of shares of common stock to be issued on conversion. A market price based conversion formula protects the holders of the convertibles against price declines, while subjecting both the company and the holders of its common stock to certain risks. Because a market price based conversion formula can lead to dramatic stock price reductions and corresponding negative effects on both the company and its shareholders, convertible security financings with market price based conversion ratios have colloquially been called "floorless", "toxic," "death spiral," and "ratchet" convertibles. Both investors and companies should understand that market price based convertible security deals can affect the company and possibly lower the value of its securities. Here's how these deals tend to work and the risks they pose: The company issues convertible securities that allow the holders to convert their securities to common stock at a discount to the market price at the time of conversion. That means that the lower the stock price, the more shares the company must issue on conversion. The more shares the company issues on conversion, the greater the dilution to the company's shareholders will be. The company will have more shares outstanding after the conversion, revenues per share will be lower, and individual investors will own proportionally less of the company. While dilution can occur with either fixed or market price based conversion formulas, the risk of potential adverse effects increases with a market price based conversion formula. The greater the dilution, the greater the potential that the stock price per share will fall. The more the stock price falls, the greater the number of shares the company may have to issue in future conversions and the harder it might be for the company to obtain other financing.