GROUP 7

HYBRID FINANCING

Leony Lyn Briones

Christian Gracia
Marven Paolo Pasinos
Lois Marwie Tolentino

Pr e
fer
r ed
Sto
ck

PREFERRED
STOCK

Preferred stocks
hybrid security; having characteristics of
both debt and equity.
Equity or common
stock

Debt

Called stock
and is included
in the equity
section of a
firms balance
sheet

sets a fixed rate

for dividends

Has no maturity
date

Affords its
holders no
voting rights

Has payments
which are
considered
dividends

Has priority over

common
shareholders in
the event of
bankruptcy.

How does preferred stock differ

from common stock and debt?
Preferred dividends are specified by contract,
but they may be omitted without placing the firm
in default.
Most preferred stocks prohibit the firm from
paying common dividends when the preferred is
in arrears.
Usually cumulative up to a limit.

How does preferred stock differ

from common stock and debt?
Preferred dividends are specified
by contract, but they may be omitted
without placing the firm in default.
Most preferred stocks prohibit the
firm from paying common dividends
when the preferred is in arrears.
that is owed and should have been
money
Usually
cumulative up to a limit.
paid earlier.

How does preferred stock differ

from common stock and debt?
Cumulative
Preferreddividends
dividendsis are
a
specified by
contract,
but they
protective
feature
on preferred
may be
omitted
without
stock
that
requires
all pastplacing
the firm in
default. to be paid
preferred
dividends
any common
dividends
before
Most preferred
stocks
prohibit
can
paid.
the be
firm
from paying common
dividends when the preferred is
in arrears.
Usually cumulative up to a
limit.

Advantages of Preferred
stock financing
Dividend obligation not contractual
Avoids dilution of common stock
Avoids large repayment of principal

Disadvantages of Preferred
Stock Financing
Preferred dividends not tax
deductible, so typically costs more
than debt
Increases financial leverage, and
hence the firms cost of common
equity.

Warrants

Introduction For Warrants

TERMS
BONDS
-LONG TERM DEBT INSTRUMENT
-ISSUED BY CORPORATIONS AND LONG TERM AGENCIES THAT ARE
LOOKING FOR LONG TERM DEBT CAPITAL.
COUPON INTEREST RATE
- THE STATED ANNUAL INTEREST RATE ON A BOND

Introduction For Warrants

OPTION
-AN OPTION IS A CONTRACT THAT GIVES ITS HOLDERS THE RIGHT TO
BUY (OR SELL) ASSET AT SOME PREDETERMINED PRICE WITHIN A
SPECIFIED PERIOD OF TIME.
CALL OPTION
-AN OPTION TO BUY OR CALL A SHARE OF STOCK AT A CERTAIN PRICE
WITHIN A SPECIFIED PERIOD.
STRIKE/EXERCISE PRICE
-THE PRICE THAT MUST BE PAID FOR A SHARE OF COMMON STOCK WHEN AN
OPTION IS EXERCISED

WARRANT IS AN OPTION

In simple terms, a warrant is an option issued by a company

that gives the holder the right to buy stock from the company at
a specified price within a certain designated time period.
Generally speaking, warrants are issued by the company
whose stock underlies the warrant and when an investor
exercises a warrant, he or she buys stock from the company
and those proceeds are a source of capital for the firm.

WARRANT IS AN OPTION

Like an option, a warrant does not represent actual

ownership in the stock of the company; it is simply the
right (but not the obligation) to buy shares at a certain
price in the future. Warrants typically have a much
longer life than a call option - it is unusual for a warrant
to be issued with less than a two-year term, and time
periods of five to 10 years are not rare. In fact, some
warrants are perpetual.

WARRANTS
A WARRANT IS A LONG TERM OPTION

Although there are several kinds of warrants, the

most common types are detachable and naked.
Detachable warrants are issued in conjunction
with other securities (like bonds or preferred
stock) and may be traded separately from them.
Thus, after a bond with attached warrant is sold,
the warrants can be detached and traded
separately from the bond.

WARRANTS

WARRANTS ARE GENERALLY DISTRIBUTED

WITH DEBT, AND THEY ARE USED TO
INDUCED INVESTORS TO BUY LONG TERM
DEBT THAT CARRIES A LOWER COUPON
RATE THAN WOULD OTHERWISE BE
REQUIRED.

WARRANTS

For example, when Informatics Corporation, a rapidly

growing high-tech company, wanted to sell a $50 million
of 20-year bonds in 2012, investment bankers informed
management that the bonds would be difficult to sell and
that 10% coupon rate would be required. However, as an
alternative, the bankers suggested that investors would
be willing to buy the bonds with a coupon rate of only 8%
if the company offered 20 warrants with each $1000
bonds, each warrant having a 10-year life and entitling
the holder to buy one share of a common stock at an
exercise price of $22 per share at any time during their

Use of Warrants in
Financing

Small, rapidly growing firms generally use warrants as sweeteners

when they sell debt or preferred stock.
Such firms frequently are regarded by investors as being highly
risky, so their bonds can be sold only with high coupon rates and
very restrictive provisions.
To avoid this, firms such as Informatics offer warrants along with the
bonds.
Receiving warrants along with the bonds enables investors to share

Use of Warrants in Financing

A bond with warrants has some characteristics

of debt and some characteristics of equity.
It is a hybrid security that provides the financial
manager with an opportunity to expand the firms
mix of securities and thus to appeal to a broader
group of investors.

Why Do Companies Issue

Warrants?
Limited Issue
If a company wants to offer options, the possible number of contracts in
each series of options is virtually unlimited. Each series of warrants, on the
other hand, represents a specific number of warrants to be issued, allowing
the company to determine at the outset how many might be sold. Because
of the limits on how many warrants are available, the price for the most
desirable series can be higher, and that is beneficial to the company.
Flexibility
Warrants are exempt from guidelines regarding exercise price and date of
maturity, and they do not have to meet any rules regarding the size of the
contracts. This means that companies may issue a series of warrants
whenever investor demand is sufficient. Each series may have different
conditions and prices, allowing companies to promote a new, more
favorable warrant over a previous series that is no longer appealing to
investors.

Why Do Companies Issue

Warrants?
Potentially Attractive to Small Investor
Investors may purchase warrants for a fraction of the cost of the
stock. During the lifetime of the warrant, if the stock price increases,
the investor may buy the stock at the point that maximizes his profit.
The most the investor stands to lose is the amount paid for the
premium. The low cost and low level of risk make warrants attractive
to investors who are willing to risk only a limited amount of cash.
Warrant Owners Are Not Stockholders
If you purchase warrants, you are purchasing the right to buy stock
at a later date. Until you exercise that right, you do not own stock.
This means that you are not eligible for dividends and you have no
shareholder voting rights. The duration for a warrant series is
typically several years, throughout which the company has the use

CONVERTIBLE
SECURITIES

CONVERTIBLE SECURITIES

A bond or preferred stock that can be exchanged at the

option of the holder for the common stock of the
issuing firm
Gives its owner the right, but not the obligation, to
convert the existing investment into another form.

CONVERTIBLE SECURITIES

McGuire (1991) and Schmidt (2003) have noted that these

securities help align managerial incentives and generate
capital without immediately diluting the equity base of the
acquiring team
Why?
Because it generally lead to a lower initial borrowing cost and
represent a future supply of equity capital.

Conversion Ratio
and Conversion
Price

CONVERSION RATIO
The number of shares of common stock that
are obtained by converting a convertible bond
or share of convertible preferred stock
The number of shares of stock
a bondholder will receive upon
conversion

CONVERSION PRICE
The effective price paid for common stock
obtained by converting a convertible security
Effective price investors pay for
common stock bought through
a convertible

CONVRTIBLE RATIO AND CONVERTIBLE PRICE

Conversion Price (Pc)=

Par Value of Bond Given Up

Shares Received

Conversion Ratio (CR)=

Par Value of Bond Given Up

Conversion Price

CONVERSION RATIO AND CONVERSION PRICE

ILLUSTRATION:

Silicon Valley Software Companys $1,000 par

value convertible debenture s issued in August
2012. At any time prior to maturity on August 15,
2032, a debenture holder can exchange a bond
for 20 shares of common stock;
Therefore:
Conversion Ratio: 20 shares
Bond Cost Purchases: $1,000

CONVERSION PRICE

Conversion
Price (Pc)=

Conversion
Price (Pc)=

$1,000
20
$50

CONVERSION RATIO

Conversion
Ratio(CR)=

Conversion Ratio
(CR)=

$1,000
$50
20

CONVERSION VALUE
ILLUSTRATION:

Continuing this example, suppose the firms

common stock has a market price of $40 per
share; then the Conversion Value:
Conversion Value=
Price per Share multiplied by
Conversion Ratio
CV= $40 x 20
CV= $800

CONVERSION RATIO AND

CONVERSION PRICE

Generally, the conversion price and conversion ratio

are fixed for the life of the bond, although sometimes
a stepped-up conversion price is used.
Another factor that may cause a change in the
conversion price and ratio is a standard feature of
almost all convertiblesthe clause protecting the
convertible against dilution from stock splits, stock
dividends, and the sale of common stock at a price
below the conversion price.

Convertible
Preferred Stock and
Convertible Bonds

CONVERTIBLE
PREFERRED STOCK

Owning a share a share of convertible preferred is

equivalent to holding a portfolio long in a normal share
of preferred stock and long in a call option on the firms
common stock that can be exercised by surrendering
the preferred stock.
There generally is no waiting period before the
conversion can be made, and the conversion privilege
usually never expires.

CONVERTIBLE
PREFERRED STOCK

These means that the minimum value of the

convertible issue must be:
Max[Preferred Stock Value, Conversion Value]
Where the conversion value is the value of the common stock into
which the preferred issue can be exchanged.

CONVERTIBLE
PREFERRED STOCK

Suppose that for $1,000,000 investment, an

institutional investor could purchase 25,000 shares of a
convertible preferred issue with the following terms (per
share)
Current Convertible Price

$40.00

Annual Convertible Dividend

$3.00

Convertible Yield

7.50% ($3 / $40)

Regular Preferred Yield

10.00%

Current Common Stock Price

$20.00

Conversion Ratio

1.75

CONVERTIBLE
PREFERRED STOCK

Share Value of Regular Stock

(3 / 0.10) = $30.00
Conversion Ratio of 1.75 shares of common to each share of
preferred
The Conversion Value of convertibles issue is
(1.75 x 20) = $35
The minimum price of the convertible security would be $35, the
greater of the regular preferred price and the conversion value.
Conversion Premium
[(40-35) / 35] = 14.29%
Meaning that the convertible currently is selling based on its
option value

CONVERTIBLE
BONDS

A convertible bond is a regular corporate bond that has the

added feature of being convertible into a fixed number of
shares of common stock. Convertible bonds are debt
instruments because they pay interest and have a fixed
maturity date.

CONVERTIBLE
BONDS

A Convertible Bond represents a hybrid investments

involving elements of both debt and equity markets.
Although the buyer receives equity-liked returns with a
guaranteed terminal payoff equal to the bonds face
value, he must also pay the option premium, which is
embedded in the price of the security

CONVERTIBLE
BONDS

Silicon Valley Software is evaluating the use of a convertible bond

issue described immediately above. The issue would consist of 20year convertible bonds that sell at a price of $1,000 per bond (also
its par value). Each bond would pay a 10% annual coupon, and
would have a conversion ratio of 20. The stock is expected to pay a
dividend of $2.80 during the coming year, and has a current price of
$35. The dividend is expected to grow at a constant rate of 8%. If
these bonds were not convertible, they would have to offer a yield of
13%. The bonds may be called in ten years at a call price of $1,050.
It can be called any year after that at a call price that declines by
$5 per year thereafter. If after ten years the conversion value
exceeds the call price by at least 20%, management would probably
call the bonds.

1,511

CONVERTIBLE
BONDS

Pure-Debt Value at time of issue

Year

StraightBond
Value, Bt

Conversio
n Value, Ct

Maturity
(Par)
Value

Market
Value

Floor
Value

Premium

$789

$700

$1,000

$1,000

$789

$211

$792

$756

$1,000

$1,023

$792

$231

$795

$816

$1,000

$1,071

$816

$255

$798

$882

$1,000

$1,147

$882

$265

$802

$952

$1,000

$1,192

$952

$240

$806

$1,029

$1,000

$1,241

$1,029

$212

$811

$1,111

$1,000

$1,293

$1,111

$182

$816

$1,200

$1,000

$1,344

$1,200

$144

$822

$1,296

$1,000

$1,398

$1,296

$102

$829

$1,399

$1,000

$1,453

$1,399

$54

10

$837

$1,511

$1,000

$1,511

$1,511

$0

11

$846

$1,632

$1,000

$1,632

$1,632

$0

20

$1,000

$3,263

$1,000

$3,263

$3,263

$0

se of Warrants in Financing
Small, rapidly growing firms use
warrants as sweeteners when they
sell debt or preffered stock.
Receiving warrants along with bonds
enables investors to share in
companys growth, assuming it does in
fact grow and prosper.
Virtually warrants are detachable

Use of Convertibles in
Financing
Two Important Advantages
It offer a company the chance to sell debt
with a low interest rate in exchange for a
chance to participate in the companies
succes if it does well.
It provides a way to sell common stock at a
prices higher than those currently
prevailing

Final comparison of Warrants

and Convertibles
Convertible debt can be thought of as
straight debt with non-detachable
warrants.
The difference between them is flexibility.
Most convertible issues contain a call
provision that allows the issuer to refund
the debt.