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วันพฤหัสบดีที่ 19 กุมภาพันธ์ พ.ศ. 2552


20-14 Preferred Stock, Warrants, and Convertibles Marthas Milon, financial manager of Fish &Chips Inc., is facing a dilemma. The firm was founded 5 years ago to develop a new fast-food concept, and although Fish &Chips has done well, the firm is founder and chairman believes that and industry shake-out is imminent. To survive, the firm must capture market share now, and this requires a large infusion of new capital.
Because the stock price may rise rapidly, Millon does not want to issue new common stock. On the other hand, interest rate are currently very high by historical standards, and, with the firm’s B rating, the interest payments on a new debt issue would be too much to handle if sales took a downturn. Thus, Millon has narrowed her choice to bonds with warrants or convertible bonds. She has asked you to help in the decision process by answering the following questions.
a. How does preferred stock differ from common equity and debt?
 Preferred dividends are fixed, but they may be omitted without placing the firm in default
 Preferred dividends are cumulative up to a limit.
 Most preferred stocks prohibit the firm from paying common dividends when the preferred is in arrears.

b. What is floating rate preferred?
 Dividends are indexed to the rate on treasury securities instead of being fixed.
 Excellent S-T corporate investment :
- Only 30% of dividends are taxable to corporations.
- The floating rate generally keeps issue trading near par.
 However, if the issuer is risky, the floating rate preferred stock may have too much price instability for the liquid asset portfolios of many corporate investors.

c. How can a knowledge of call options help one understand warrants and convertibles?
 A warrant is a long-term call option.
 A convertible bond consists of a fixed rate bond plus a call option.

d. One of Millon’s alternatives is to issue a bond with warrants at attached. Fish &Chips’ current stock price is $10, and its cost of 20-year, annual coupon debt without warrants estimated by its investment bankers to be 12 percent. The bankers suggest attaching 50 warrants to each bond, with each warrant having an exercise price of $12.50. It is estimated that each warrant, when detached and traded separately, will have a value of $1.50.
(1) What coupon rate should be set on the bond with warrants if the total package is to sell for $1,000
 Calculate the value of the bonds in the package
V Package = VBond + VWarrants = $1,000
VWarrants = 50($1.50) = $75
VBond + $75 = $1,000
VBond = $925
 Calculate required annual coupon rate for bond with warrants package (Find coupon payment and rate.)
- Solving for PMT, we have a solution of $110, which corresponds to an annual coupon rate of $110 / $1,000 = 11%

(2) Suppose the bonds are issued and the warrants immediately trade for $2.50 each. What does this imply about the terms of the issue? Did the company “win” or “ lose”?
 The package would have been worth $925 + 50(2.50) = $1,050. This is $50 more than the actual selling price.
 The firm could have set lower interest payments whose PV would be smaller by $50 per bond, or it could have offered fewer warrants with a higher exercise price.
 Current stockholders are giving up value to the warrants holders.

(3) When would you expect the warrants to be exercised?
 Generally, a warrant will sell in the open market at a premium above its theoretical value (it can’t sell for less).
 Therefore, warrants tend not to be exercised until just before they expire.
 In a stepped-up exercise price, the exercise price increases in steps over the warrant’s life. Because the value of the warrant falls when the exercise price is increased, step-up provisions encourage in-the-money warrant holders to exercise just prior to the step-up.
 Since no dividends are earned on the warrant, holders will tend to exercise voluntarily if a stock’s dividend rises enough.

(4) Will the warrants bring in additional capital when exercised? If so, how much and what type of capital?
 When exercised, each warrant will bring in the exercise price, $12.50, per share exercised.
 This is equity capital and holders will receive one share of common stock per warrant.
 The exercise price is typically set at 10% to 30% above the current stock price on the issue date.

(5) Because warrants lower the cost of the accompanying debt, shouldn’t all debt be issued with warrants?
 Yes, the warrants have a cost that must be added to the coupon interest cost.

What is the expected cost of the bond with warrants if the warrants are expected to be exercised in 5 years, when Fish & Chips’ stock price is expected to be $17.50?
 The company will exchange stock worth $17.50 for one warrant plus $ 12.50. The opportunity cost to the company is $17.50 = $12.50 = $5.00, for each warrant excercised.
 Each bond has 50 warrants, so on a par bond basis, opportunity cost = 50($5.00) = $250.
Finding the opportunity cost of capital for the bond with warrants package
 Here is the cash flow time line:

0 1 ....... 4 5 6 ............ 19 20
+1,000 -110 -110 -110 -110 -110 -110
-250 -1,000
-360 -1,100

 Input the cash flows into a financial calculator (or spreadsheet) and find IRR = 12.93%. This is the pre-tax

How would you expect the cost of straight debt? With the cost of common stock?
 The cost of the bond with warrants package is higher than the 12% cost of straight debt because part of the expected return is from capital gains, which are riskier than interest income.
 The cost is lower than the cost of equity because part of the return is fixed by contract.
 20-year, 10% annual coupon. Callable convertible bond will sell at its $1,000 par value; straight debt issue would require a 12% coupon.
 Call the bonds when conversion value > %1,200.
 P0 = $10;, D0 =$0.74; g = 8%.
 Conversion ratio = CR = 80 shares.

e. As an alternative to the bond with warrant, Millon is considering convertible bond. The firm’s investment banker estimate that Fish & Chips could sell a-20-year,10 percent annual coupon,callable convertible bond for its $1,000 par value, whearas a straight-debt issue would required a 12 percent coupon. Fish & Chip current stockprice is $10,its last dividend was $ 0.47,and the dividend is excepted to grow at a constant rate of 8 percent. The convertible could be converted into 80 shares of Fish&Chip stock at the owner’s option.
(1) What conversion price,Pc ,is implied in the convertible terms?
• The conversion price can be found by dividing the par value of the bond by the conversion ratio, $1,000 / 80 = $12.50.
• The conversion price is usually set 10% to 30% above the stock price on the issue date.

(2) What is the straight-debt value of the convertible? What is the implied value of the convertibility feature?
Recall that the straight debt coupon rate is 12% and the bond’s have 20 years until maturity.

Because the convertibles will sell for $1,000, the implied value of the convertibility feature is
$1,000 – $850.61 = $149.39.
= $1.87 per share.
The convertibility value corresponds to the warrant value in the previous example.

(3) What is the formula for the bond’s conversion value in any year? Its value at Year0?At Year 10?
• Conversion value = Ct = CR(P0)(1 + g)t.
• At t = 0, the conversion value is …
C0 = 80($10)(1.08)0 = $800.
• At t = 10, the conversion value is …
C10 = 80($10)(1.08)10 = $1,727.14.

(4) What is the meant by the term “floor value’of a convertible? What is the convertible’s expected floor valuein Year 0? In Year 10?
• The floor value is the higher of the straight debt value and the conversion value.
• At t = 0, the floor value is $850.61.
- Straight debt value0 = $850.61. C0 = $800.
• At t = 10, the floor value is $1,727.14.
-Straight debt value10 = $887.00. C10 = $1,727.14.
• Convertibles usually sell above floor value because convertibility has an additional value.
(5) Assume that Fish & Chip intends to forceconversion by calling the bond when its conversion value is 20 percent above its par value, or at 1.2($ 1,000) = $1,200. When is the issue expected to be called?Answer to the clostestyear?
We are solving for the period of time until the conversion value equals the call price. After this time, the conversion value is expected to exceed the call price.

(6) What is the expected cost of the convertible to Fish & Chip? Does this cost appear consistent with the riskness of the issue? Assume conversion in Year 5 at a conversion value of $1,200.
0 1 2 3 4 5
1,000 -100 -100 -100 -100 -100
Input the cash flows from the convertible bond and solve for IRR = 13.08%.
• To be consistent, we require that kd < kc < ke.
• The convertible bond’s risk is a blend of the risk of debt and equity, so kc should be between the cost of debt and equity.
- From previous information, ks = $0.74(1.08) / $10 + 0.08 = 16.0%.
• kc is between kd and ks, and is consistent.
f. Millon believes that the costs of both the bond with warrant and the convertible bond are essentially equal , so her decision must be based on other factors, What are some of the factors that she should consider in making her decision?
The firm’s future needs for capital:
- Exercise of warrants brings in new equity capital without the need to retire low-coupon debt.
-Conversion brings in no new funds, and low-coupon debt is gone when bonds are converted. However, debt ratio is lowered, so new debt can be issued.

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