Lecture notes, lectures 6 - hybrid securities PDF

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Topic:HybridSecurities LectureAgenda WhyHybrid? Prosandconsofissuing – PreferredShares, – Warrantsand – ConvertibleSecurities overstraightsecuritiessuchascommonsharesand/orbonds. Valuationanddeterminationoftheyieldonhybridsecurities Hybridsecuritiestoeliminate/reducethecostofconflictofinterest betweenthecompany’sdebtholdersandshareholders. FINS3625 1

WhyHybridSecurities? Common ways to raise external capital is to issue common equity or corporate bonds. Selling hybrid securities provide alternative ways to raise capital. • Hybrid securities can be viewed as a cross between common equity or corporate bond and financial derivatives. • Hybrids are most useful when a company has difficulty raising external capital by issuing straight bonds or common equity. • Hybrids may be effective tools to resolve conflicts of interest between debt holder and equity holders. Each hybrid has pros and cons, which are based on the features of FINS3625 the security. 2

MotivatingExample,Gloomy:Conflictsofinterestbetween ManagerandDebtholders GloomyCorp.isinfinancialtroublebecauseitcannotaffordtopay itscreditors.Asaresult,thefirm’sassetvalueis$1Mwhichis belowthe$600MthatGloomyowesitscreditors.Thecreditors intendtotakeimmediateactionstoliquidatethefirm. Gloomyhasnoimmediatecashanditisinvestigatingasafeproject thatcosts$40Mandwillgenerateacertainpayoffof$630Mnext year.Theriskfreerateis5%.ThecreditorsperceiveGloomytobe sogloomywithitsprospectsthattheyarenotwillingtolendto Gloomyanymore. Isthisprojectworththeinvestment?Ifso,willtheequityholders financetheproject? FINS3625

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MotivatingExample,Gloomy:Conflictsofinterestbetween ManagerandDebtholders Project’sNPV:   40 

630  560 1.05

NPVforequityholders:   40 

631  600  0  10 1.05

TheprojecthasapositiveNPV,soitisagoodinvestment. However,theequityholderswillnotfinancetheprojectbecause mostofthegainswillgotowardpayingthedebtholders. Gloomywillfaceimmediateliquidatingbythedebtholders. FINS3625

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MotivatingExample,Gloomy:Conflictsofinterestbetween ManagerandDebtholders Now,whatifGloomy’s shareholdersnegotiatedwiththecreditorstoallow theirdebttobeconvertibleto90%ofthecompany’sstock? IfGloomy’s debtbecameconvertible:   40 

%  .

20.095

Theequityholderswouldbewillingtofinancetheprojectbecausethey wouldget$20,095Mwhichisgreaterthan$0fromimmediateliquidation. Moreover,thedebtholderswouldalsobebetteroffbecausethedebtvalue % wouldriseto$  $540.857 whichisgreaterthanthe$1M . currentassetvalue. Makingthedebtconvertibleresolvestheunderinvestmentproblem. FINS3625

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MotivatingExample,Gloomy:Conflictsofinterestbetween ManagerandDebtholders Makingthedebtconvertibleto90%ofequityresolvesthe underinvestmentproblemforGloomyandinsuresthatGloomydoesn’t fail. Asamatteroffact,thereisarangeofpossiblevaluesofconversionthat canalsoresolvetheunderinvestmentproblemandinsurethatGloomy doesn’tfail. Q)Solvefortherangeofconversionrateasapercentoftotalfirmvalue thatwouldresolvetheunderinvestmentproblem.Yoursolutionmust insure(a)totalfirmvaluecreation,(b)thatequityholdersarewillingto financetheproject,(c)andthatdebtholdersarebetteroffasaresultof projectadoptions. A)Tryitonyourown.Theanswershouldbebetween0.1664%and FINS3625 6 93.34%.

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PreferredStocks Preferredsharesareacrossbetweencommon sharesandbonds FeaturessimilartoBonds: • Issuedatparvalue(usually$25or$100). • Periodicfixedchargeasa%ofparvaluepaidbeforeanycommon dividendsarepaid.Increasesfinancialleverage. • Perceivedtobelessriskythancommonequity. • Novotingrights,butmaygiverightstoelectminoritydirectors. • Maybesubjecttosinkingfundprovisionsand/orbecalledbythe issuer. FeaturesimilartoEquity: • Subordinatedtodebtholders.Missedpreferreddividendpayments doesnotforcebankruptcy. FINS3625 7

PreferredStocks 

ValueofPreferredStocks:   Mostpreferreddividendsdonotgrowanddividendsarefairlystable. Pros: ‐PreferredDividendsarenotfirmobligationslikeinterestpaymentson corporatebonds. ‐ Avoidsdilutionassociatedwithissuingcommonshares. ‐ Reducescashdrainfromprincipalpaymentsoncorporatebonds. Cons: ‐ PreferredDividendsarenottaxdeductible.Theyarepaidafter corporatetaxesandtaxedagaininthehandsoftheinvestors(likelyto beanissueintheclassicaltaxsystem). ‐ PreferredDividendsarenotfirmobligations,butmustbetreatedas firmobligationsbythemanager.Increasesfinancialleverage. FINS3625

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Warrants Awarrantgivestheholdertherighttobuyaspecifiednumberofstocks fromthecompanybypayingthestrikepricebyacertaindate.Warrants areexamplesoffinancialderivatives(similartocalloptions) Generallyissuedwithdebtto‘sweetenthedeal’ • Tolowercouponrateondebtand/or • Togethigherbondprice(andloweryield)onlongtermdebt Mostofthewarrantsaredetachablefromthedebtandaretradableonthe exchanges. Warrantscanbeexercisedbytheholderif • Expirationdateisfastapproaching • ifcommondividendsgrowrapidly • ifstrikepricerisesrapidly(onlyincasesofsteppedupstrikeprices). Otherwise,likeAmericanoptions,itisbettertoholdthemortosellthem (nottoexercisethem). FINS3625

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Warrants ValuationofBondswithWarrants: BondValuewithWarrants=StraightBondValue+ValueofWarrants Pros:‐ canlowerthecostofraisingdebtcapital ‐ iffirmisafastgrowingcompany,thentheexerciseofthe warrantscanbringinginmuchneededexternalcapitaltothefirm. ‐ ifwarrantsarenotexercised,thentheissuergainsattheexpense ofthelenderssincetheissuerreceivedpaymentforthewarrantsat theoutset(presumably). Cons:‐ equitydilutionifwarrantsareexercised. (i)Valuedilutionsincethestrikepriceonthewarrantsislower thanmarketprice. (ii)Dilutionofpowerduetotheincreasednumberofshares aftertheexercise ofthewarrants. FINS3625

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ValueDilutionfromExercisingWarrants ThemarketvalueofequityisE=V‐D whereV isthefirm’smarketvalue andD isthefirm’sdebtmarketvalue. Pre‐exercisemarketpriceofcommonsharesis 

 #

Post‐exercisemarketpriceofcommonshare,ordilutedshareprice,is 

   #  

where   # FINS3625

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YieldsonBondswithWarrants Computingtheyieldoncorporatebondswithwarrantsattheoutset (oranytime): • Determinethecashflowsfromstraightdebt • Determinewhen thewarrantisexpectedtobeexercised • Determinetheexpectedcashflowsattributedtotheexerciseof thewarrants • ComputetheIRRusingthecashflowsofaportfoliocomposedof thestraightbondandthewarrants,andthecurrentmarketvalues ofthebondandwarrants. • TheIRRistheyieldonthesecurity.It’sthemarketdetermined requiredrateofreturnonthehybridsecurity. TheIRRisalsothecostofcapitalfortheissueriftheissuerdoesnot FINS3625 12 retirethesecurities.

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YieldonBondswithWarrants:Example Example:ABC'stotalcompanyvalueis$5Mwith1Mshares outstanding.Thefirm'svalueisexpectedtogrowat15%peryearforat leastthenext20years.ABChasrecentlyraised$2Mincapitalbyissuing 20year,5%couponand$1,000parvaluebondswithwarrants.Each bondcarries20warrantswithastrikepriceof$6andexpirein10years. Eachwarrantifexercisedgrantstheholderonestock.Thecurrentyield onbondsofcompatibleinvestmentgradeis10%andlikelytoremain constant. a) Whatisthepriceofeachwarrantatthetimeofissue? Ans:   $50 

󰇛%󰇜



%



$, 󰇛%󰇜

$1,000  $574.32 20

 $574.3

 $21.28

FINS3625

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YieldonBondswithWarrants:ExampleCont’d b)WhatisABC’sexpectedsharepricepostexerciseofwarrants?     󰇛1  󰇜  5  󰇛1  15%󰇜 $20.227789    1  1  10%  2 2 1,000  50      20  6 1  10%  1 1  10%   

. 



 20.227789  1.385543  0.24  19.082245

 

 #



.

FINS3625

=18.35

     . 



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YieldonBondswithWarrants:ExampleCont’d c)WhatistheyieldontheABC’sbondswithwarrants? 0=1000  50   

→   6.2%

󰇛󰇜 

,

 󰇛󰇜 

 

󰇛.󰇜 󰇛󰇜  

Theyieldcanbefoundbytrialanderror. Theyieldof6.2%issignificantlylowerthan10%,whichisABC’scostof debtcapital. Thewarrantswereovervaluedattheoutset.ABCreceived$21.28for eachwarrant,butthewarrant holdersareexpectedtoreceiveatotal valueof$18.35‐$6=$12.35whenexercised. FINS3625

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ConvertibleSecurities Convertiblesecuritiesarebondsorpreferredsharesthatcanbeexchanged forcommonshares.Conversionhappensatthediscretionoftheholder. Unlikewarrants,conversionofconvertibles doesnotprovidenewcapitalto thefirm. Debtorpreferredequityisreplacedbycommonequityinthebalance sheet. Usuallyissuedatparvalue Theconversionratio isthenumberofsharesofstocktheholderreceives whenconversion takesplace ConversionRatio CR 

Par PC

Where istheconversionprice. isthepricetheholderpaysforthe stockwhentheconversionoccurs.

ConversionPrice  PC 

ParValueofBondorPreferred CR FINS3625

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ConvertibleSecurities • ConversionValue,ortheexercisevalue,isthevalueinvestorreceives byconvertingintoequity        • Conversionpriceisusuallysetat20to30%abovecurrentstockprice andsomeconvertiblescanbeallowedtobe‘steppedup’. • Somehavecallprotectionperiod. • Mosthaveprotectionagainstdilutionfromstocksplits,stock dividendsandsaleofcommonsharesatpricesbelowconversion price. • Transferofwealthfromexistingshareholderstoconvertibleholders tendtoresultiftheconversionpriceisreviseddownwardsifthe companysellscommonsharesforapricebelowtheconversionprice. Thisislikelytobethecaseforpoorlyperformingfirms. FINS3625

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ConvertibleSecurities Pros: • Giveschancefortheissuertoselldebtwithattractiveterms • Overcomestheissueofsellingundervaluedstockswhenissuing equity. • Issuercancontroltheconversionfeaturebymaking theconvertible securitycallable. • Alleviatescashdrainproblemassociatedwithprincipalpaymentsif convertiblesareexpectedtobeconverted. Cons: • Debtisabetteralternativeifthefirmisveryprofitableandstock priceisexpectedtoriserapidly • Lowcouponpaymentsterminateswithconversionorredemption • Issuercanbeburdenedwithalotofdebtifthestockpricedrops FINS3625

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ValueofConvertibleSecurities Atanypointintime,thevalueoftheconvertiblesecuritymustbegreateror equaltothemaximumbetween thevalueofstraightdebtandtheconversion value    ,    ,    Thevalueoftheconvertible securityriseswiththestockpricesincethelatter increasestheconversionvalue. Often,callableconvertiblesecuritiesarecalledifthepriceofstockhas,oris expected,toappreciateinvaluesubstantially Iftheconvertiblesecurityiscallable,thenthesecurity’svaluecannotexceed thevaluetheholderreceivesifthesecurityiscalledbythecompany    FINS3625

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ConvertibleSecurities:Example

NowassumethatABChadissuedconvertibledebtinsteadof bondswithwarrants.Again,ABC'stotalcompanyvalueis$5M with1Msharesoutstanding.Thefirm'svalueisexpectedtogrow at15%peryearforatleastthenext20years.ABChasrecently raised$2Mincapitalbyissuing20year,5%couponand1,000par valueconvertiblebonds.TheConversionRatioissetat60anditis callablein10yearsfor$1,250.Thecurrentyieldonbondswith compatibleinvestmentgradeis10%andlikelytoremainconstant.

FINS3625

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ConvertibleSecurities:Example Q)Whatistheconversionprice?Whatdoesitmean?  

 $1,000   $16.6666 60 

A)Theconversionpricemeasurestheminimumstockpricelevel soconversioncanatleastcoverinvestors’initialinvestmentof $1,000intheconvertiblebond.It’sthebreak‐evenprice.

FINS3625

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ConvertibleSecurities:Example Q)Inwhatyearisitexpectedthatthebondswillbeconverted? A)Computetheexpecteddilutedpriceofstockforeachyearafteryear10   󰇛1  󰇜 5󰇛1  .15󰇜      2 1.12 1.12 1     1 .  . 

→   18.06 and  20.77 →   18.06  60  1,083.63  20.77  60  1,246.18 Ifconversionvalue>callableprice=$1,250,thenABCwillforceconversion. Conversionexpectedtotakeplacejustafteryear11. FINS3625

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ConvertibleSecurities:Example A BC Convertible Bond Model 1 500

1 400

Value

1 300

1 200 1 100

1 000 9 00

8 00

8

9

10

11

12

t FINS3625

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ConvertibleSecurities:Example Q)Whatistheyieldontheconvertibledebt?

A)Assumingthatbondsarecalledonlyatyearend,conversionis expectedtohappeninyear12,CV 12=20.77  60=1,433.18.Since theconversionvalueisgreaterthanthecallvalueinyear12, convers ionwilltakeplacejustbeforetheyarecalled. TheyieldisgivenbytheIRR 1 (1 yield )  12   0   1, 000  50   yield Initial  Investment   PVofCouponfromBond

1, 433. 18 (1  yield )12  PV of  ConversionValueinyear12

  yield  7.9% FINS3625

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Hybridstosolveconflictsofinterestbetween DebtholdersandShareholders Ifacompanyhasdebt,thereisthepotentialforconflictsofinterests betweenthecompany’sdebtholdersandshareholders Thecostsfromtheseconflictscanbeverylargeandsignificantlyreduce firmvaluation. Hybridscanbeusedtoalleviateconflictsofinterestsbetweenbondand equityholders. Weinvestigatetherisk‐shiftingproblem(alsocalledthe‘goingforbroke’, or‘bettingwithdebtholder’smoney’,ortheoverinvestmentproblem). ConflictofinterestinRiskShiftingProblem: Stockholdersfavor investmentsinexcessivelyriskyprojects,eveniftheprojecthasanegative NPV. FINS3625

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PayoffProfilesatTimeofDebtMaturity Ifstraightdebtandequityonly: StraightDebt’sPayoff: ,  Equity’sPayoff:   , 0 Ifdebtisconvertible: 

ConversionValue:CV= #   ConvertibleDebt’sPayoff:  ,     ,  ,  Equity’sPayoff:     󰆒, 0  󰇟  FINS3625   ,  ,  , 0󰇠

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StraightDebtPayoffatTimeofMaturity

FINS3625

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StraightEquityPayoffatTimeofMaturity

FINS3625

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ConvertibleBondPayoffatTimeofMaturity

FINS3625

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EquityPayoffatTimeofMaturityifBondsareConvertible

FINS3625

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RiskShiftingProblemandHybridSecurities:Example XYZisinfinancialdistressanditsassetswillbeseizedbythedebtholders nextyearunlessXYZcansignificantlyimproveitsoperations.XYZ'scurrent firmvalueis$100Manditowesthecreditors$200M.XYZhas1Mshares outstanding.XYZhastwoprojectsunderevaluation. ProjectSafehasequalprobabilitiesofrealizingcashflowsof$110Mand $105Moneyearlater. ProjectRiskyhas1/100probabilityof$380Mand99/100probabilityof‐ $100M. Bothprojectsrequireaninvestmentof$5Mtobefinancedbythedebt holders,ifagreeable,andtheriskneutralrequiredrateofreturn onboth projectsis10%. AssumeXYZhas1Msharesoutstandingandthecouponrateis12%. FINS3625

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RiskShiftingandHybridSecurities:Example a)Whataretheprojects’NPV? NPV5M

1

Safe Project 1 1  110M 105M92.7273M

1.1 2

Risky Project NPV5M

2

1



1

1.1 100

99

380M 100 100M91.5455M

X U 110M

X U 380M

1

1

pU 

p

2

U

100

I5M

I5M

pD 

99

1 p

2

D

100

X D 105M

X D 100M

SinceProjectSafehasapositiveNPVandProjectRiskyhasanegative NPV,projectSafeshouldbeadopted. FINS3625

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RiskShiftingandHybridSecurities:Example b)Whataretheequityanddebtvaluesiftheprojectsaretobefinancedwith straightdebt? Shareholders Safe Project NPV0

1

 1.1

1 2

Shareholders Risky Project

1

4.4M 02.0M

NPV0

2

MaxVX

1  1 1.1 100

99

274.40M 100 0 2.4945M

U I1 cF,04.4M

MaxVX

1 p

U

I1cF,0274.40M

1 pU

U

2

100

I0

I0

99

1 p

D

pD 2

100

D

MaxVX I1 cF,00

MaxVX

D

I1cF,00

TheshareholderspreferXYZ’smanagementtoinvestintheriskyproject. FINS3625

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RiskShiftingandHybridSecurities:Example b)

Debtholders Risky Project

Debtholders Safe Project NPV5M

1 1 1  1.1 2 205.60M 2

205M181.6364M NPV5M

1 1.1



1 99 205.6MM 100 03.1309M 100