equity and hybrid instruments
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Prepared byKen Hartviksen
INTRODUCTION TO
CORPORATE FINANCELaurence Booth W. Sean Cleary
Chapter 19 Equity and HybridInstruments
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CHAPTER 19
Equity and HybridInstruments
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CHAPTER 19 Equity and Hybrid Instruments 19 - 3
Lecture Agenda
Learning Objectives
Important Terms
Shareholders Equity
Preferred Share Characteristics Income Trusts
Warrants and Convertible Securities
Other Hybrids Summary and Conclusions
Concept Review Questions
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CHAPTER 19 Equity and Hybrid Instruments 19 - 4
Learning Objectives
You should understand the following:
The basic rights associated with share ownership
How these rights are distributed differently across different classes ofshareholders
How preferred shares differ from common shares and the different featuresthat may be associated with preferred shares
Why combining warrants with debt issues or issuing convertible bonds ordebentures can provide firms with attractive financing options
The wide variety of hybrid financing options available to firms, and howthey are constructed by combining the basic characteristics of debt andequity to various degrees
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CHAPTER 19 Equity and Hybrid Instruments 19 - 5
Important Chapter Terms
Adjustable rate convertiblesubordinated securities
Canadian optional interestnotes
Cash flow bonds Commodity bond Conversion price Conversion ratio Conversion value Cumulative provision Dilution factor Family trust Floating rate preferred share
Floor value Hard retraction Hybrid security Income bonds
Legal factor Liquid Yield Option Notes Low-yield notes Non-voting shares Original issue discount notes
Permanence factor Pre-emptive right Preferred securities Prepaid bonds
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CHAPTER 19 Equity and Hybrid Instruments 19 - 6
Important Chapter Terms
Residual owners
Restricted shares
Retractable preferred share
Soft retraction
Straight bond value (SBV)
Straight preferred share
Subjective factor Subordination factor Tax value of money
Warrants
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The Nature of Equity Securities
Equity and Hybrid Instruments
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CHAPTER 19 Equity and Hybrid Instruments 19 - 8
Equity Securities
Ownership interest in an underlying business, usually acorporation.
With the 1980 revision of the Canada Business CorporationsAct, the term preferred share was removed from legalparlance in Canada.
Par values were also removed since 1975 under the CBCA. CBCA now allows corporations to issue any number of
classes of shares however, there must be: One share class with voting rights One share class with residual rights to dividends and One share class with residual rights to assets upon dissolution.
NOTE: We often call common shares those shares with both voting rightsand residual rights to earnings and assets, but you will note that
technically, all those rights do not have to vest in a single share class.
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CHAPTER 19 Equity and Hybrid Instruments 19 - 9
Preference Versus Common Shares
As previously noted, the term preference share wasstricken from CBCA in 1980.
Nevertheless, the term remains in usage todescribe: A share class with some preference over the
common share class
However, there can be any number of classes ofshares with different rights and privileges.
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CHAPTER 19 Equity and Hybrid Instruments 19 - 10
Preferred SharesThe Common Understanding of a Preferred Share
The term preferred share is now typically used todescribe a share class that: Has no voting rights (unless the fixed dividend is in
arrears for a given period of time)
Offers to pay a fixed dividend (although suchdividends are not a legally enforceable claim)
Has a prior claim to the residual share class toassets upon dissolution.
Additionally, most preferred shares also offer: A cumulative feature wherein arrearages in dividends
must be paid before the common share class canreceive dividends
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CHAPTER 19 Equity and Hybrid Instruments 19 - 11
Shareholders EquityShareholder Rights
When a corporation has only one share class, therights are equal in all respects and include:
The right to vote at any meeting of the shareholders
of the corporation; To receive any dividend declared by the corporation;
To receive the remaining property of the corporationupon dissolution.
Provincially incorporated firms operate under similarprovisions.
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CHAPTER 19 Equity and Hybrid Instruments 19 - 12
Shareholders EquityVoting Rights
At an annual general shareholders meeting (AGM) thestanding agenda includes a shareholders vote to: Elect members of the board of directors Appoint the external auditors of the firm Receive the audited financial statements
If fundamental/major changes are proposed, a specialmeeting of shareholders may be called (or typically, the AGMwill be called a AGM and Special meeting of shareholders)and the shareholders may be asked to vote on: Changes to the articles of incorporation
Changes to the bylaws of the corporation Major changes in operations, financial structure, acquisition ofanother firm, etc.
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CHAPTER 19 Equity and Hybrid Instruments 19 - 13
Shareholders EquityPreemptive Right
The preemptive right is the right of shareholders to maintainproportional ownership in a company when new shares areissued.
When companies raise new capital under these conditions,they do so through a rights offering which gives the currentshareholders the first right of refusal on the issue of any newshares.
The preemptive right, if it exists, usually is contained in thearticles of incorporation and is one of the rights of the shareclasses that the firm has.
Removal of the preemptive right from the articles ofincorporation requires approval by the shareholders at aspecial meeting of shareholders.
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CHAPTER 19 Equity and Hybrid Instruments 19 - 14
Shareholders EquityResidual Rights
The right to receive a dividend, if declared by theboard of directors, and
The right to receive a pro rata share of anyremaining property upon dissolution of thecorporation after all other claims have beensatisfied.
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CHAPTER 19 Equity and Hybrid Instruments 19 - 15
Shareholders EquityLimited Legal Liability
Implicitly investors in shares in corporations have limited legalliability. In practice, this means that if the corporation fails, the worst-case
scenario for shareholders is that their shares will become worthless(they lose what they paid for those shares).
If the firms activities outstrip its financial resources (for example, it is
found guilty of polluting and faces fines that it cannot pay, even when allassets are liquidated) shareholders are not liable, and cannot be askedto inject more funds into the firm, or to pay out of their own pockets fordamages.*
Limited legal liability ensures limited downside risk for shareholderswhile at the same time, they enjoy unlimited upside potential forgrowth in their investment (similar to call options discussed in
Chapter 12)
*NOTE: Even though shareholders have limited legal liability, this is nottrue for members of the board of directors or the management team ifthey are found responsible (liable) for damages or illegal acts through
decisions and/or errors of omission or commission.
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CHAPTER 19 Equity and Hybrid Instruments 19 - 16
Shareholders EquityDifferent Classes of Shares
The articles of incorporation spell out the number of shareclasses and the rights of each share class.
The CBCA says that the three rights of shareholders do nothave to reside in one share class if there are multiple share
classes each right can be assigned to a different shareclass, or shared between share classes.
Under the CBCA the firm will not use the terms common
preferred non-voting instead they will designate differentshare classes with different rights:
A Class
B Class
C Class
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CHAPTER 19 Equity and Hybrid Instruments 19 - 17
Shareholders EquityDifferent Types of Shares
Non-voting / Restricted Shares Participate in dividends with the common share class Typically no voting rights or perhaps latent voting rights (the right
to vote in the case of arrears in dividends)
Common shares
Full voting rights Participates in receipt of dividends Is the residual share class after other creditors and share
classes.
Preferred shares
Stated dividend with a preference to dividends over the commonshare class Latent voting rights in the case of arrearage Preference to assets upon dissolution over the common share
class.
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CHAPTER 19 Equity and Hybrid Instruments 19 - 18
Shareholders EquitySome Basic Ratios
Your text demonstrates the application of ratios tothe shareholders equity figures for Rothmans Inc.
Table 19 1 presents the equity figures for fiscalyears 2004, 2005, and 2006:
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CHAPTER 19 Equity and Hybrid Instruments 19 - 19
Some Basic RatiosBook Value per Share
$ Million 2004 2005 2006
Preferred stock 0 0 0
Capital stock 38.869 41.974 45.347
Retained earnings 129.628 151.734 68.513
Total shareholders' equity 168.497 193.708 113.860Total liabilities and equity 496.757 528.528 449.075
Total common equity 168.497 193.708 113.860
Shares outstanding year end (million) 67.351 67.572 67.856
Book value per share ($) 2.5018 2.8667 1.6780
Diluted earnings per common share ($) 1.34 1.37 1.45
Common dividend per share ($) 0.8125 1.05 2.70*
*Includes a special dividend of $1.50
Table 19-1 Rothmans Inc. Shareholders' Equity
678.1$856.67
860.113$
2006
sharesofNumber
EquityCommonBVPS
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CHAPTER 19 Equity and Hybrid Instruments 19 - 20
Some Basic RatiosMarket to Book Value
$ Million 2004 2005 2006
Preferred stock 0 0 0
Capital stock 38.869 41.974 45.347
Retained earnings 129.628 151.734 68.513
Total shareholders' equity 168.497 193.708 113.860Total liabilities and equity 496.757 528.528 449.075
Total common equity 168.497 193.708 113.860
Shares outstanding year end (million) 67.351 67.572 67.856
Book value per share ($) 2.5018 2.8667 1.6780
Diluted earnings per common share ($) 1.34 1.37 1.45
Common dividend per share ($) 0.8125 1.05 2.70*
*Includes a special dividend of $1.50
Table 19-1 Rothmans Inc. Shareholders' Equity
07.12
678.1$
25.20$
/ 2006
times
BVPS
PBM
A stock trading at 12 timesits book value indicatesthat the stock is highlyregarding in financialmarkets (usually becauseof strong profits and growthpotential.)
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CHAPTER 19 Equity and Hybrid Instruments 19 - 21
Some Basic RatiosDividend Yield
$ Million 2004 2005 2006
Preferred stock 0 0 0
Capital stock 38.869 41.974 45.347
Retained earnings 129.628 151.734 68.513
Total shareholders' equity 168.497 193.708 113.860Total liabilities and equity 496.757 528.528 449.075
Total common equity 168.497 193.708 113.860
Shares outstanding year end (million) 67.351 67.572 67.856
Book value per share ($) 2.5018 2.8667 1.6780
Diluted earnings per common share ($) 1.34 1.37 1.45
Common dividend per share ($) 0.8125 1.05 2.70*
*Includes a special dividend of $1.50
Table 19-1 Rothmans Inc. Shareholders' Equity13.3%
25.20$
70.2$dividend)special(with
P
DPSYieldDividend
In Table 22 2 dividend yields
vary from 0% to a high of7.22% for Yellow PagesIncome Fund.
Clearly Rothmans is on thehigh end of this metric.
What makes this so surprising
is that we already know thestock price is trading at asignificant multiple above
Book Value.
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CHAPTER 19 Equity and Hybrid Instruments 19 - 22
Shareholders EquityDividends and Taxes
Dividends are attractive from an income taxationpoint of view in Canada:
Dividends received by one corporation from another
corporation are not subject to tax at the corporatelevel
Dividend income received by Canadians is subject tothe gross-up / dividend tax credit system that results
in very low rates of taxes on individuals with low tomoderate marginal tax rates (see the following slide)
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CHAPTER 19 Equity and Hybrid Instruments 19 - 23
Taxation of Dividend Income
Lower Limit Upper
Limit
Basic Tax Rate on
Excess
Dividend
Income
Capital
Gains
$ - to $8,148 $ - 0.00% 0.00% 0.00%$8,149 to 11,336 $ - 16.00 3.33 8.00
$11,337 to 14,477 510 28.10 5.63 14.05
$14,478 to 34,010 1,393 22.05 4.48 11.03
$34,011 to 35,595 5,700 25.15 8.36 12.58
$35,596 to 59,882 6,098 31.15 15.86 15.58
$59,883 to 68,020 13,664 32.98 16.86 16.49
$68,021 to 70,559 16,348 35.39 19.88 17.70
$70,560 to 71,190 17,246 39.41 22.59 19.70$71,191 to 115,739 17,495 43.41 27.59 21.70
$115,740 and up 36,833 46.41 31.34 23.20
Source: Ernst & Young website: .
Table 3-6 Ontario Taxable Income
Marginal Rate on
The dividendgross-up, tax credit
system makesdividend incomethe lowest taxed
investment incomein the lower tax
brackets.
Dividends aretaxed at a lower
rate than interestin all tax brackets.
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Preferred Shares
Equity and Hybrid Instruments
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CHAPTER 19 Equity and Hybrid Instruments 19 - 25
Preferred Share Characteristics
Table 19 2 (on the following slide) reports onyields on three different types of preferred shares inCanada as at November, 2005:
Straight preferreds Retractable preferreds
Floating rate preferreds
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CHAPTER 19 Equity and Hybrid Instruments 19 - 26
Preferred Share Yields
Straight Preferreds (%)
Dividend yield 5.22
Long Canada yield 4.19
After tax spread (corp.) 2.50
After tax spread (indiv.) 1.34
Retractable Preferreds (%)
Dividend yield 3.33
Mid Canada yield 3.90
After tax spread (corp.) 0.80
After tax spread (indiv.) 0.20
Floating Rate Preferreds (%)
Dividend yield 3.24
BA (3 month) 3.40
After-tax spread (corp.) 1.03
After-tax spread (indiv.) 0.40
Source: Data from Nesbitt Burns, Preferred Share Statistics , December 2005.
Table 19-2 Preferred Share Yields, November 2005
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CHAPTER 19 Equity and Hybrid Instruments 19 - 27
Types of Preferred Shares
Straight preferred
No maturity date
Pay a fixed dividend at regular intervals (quarterly)
Retractable preferred
Gives the investor the right to sell it back to the issuer
Typical retraction feature is 5 years
Floating rate preferred
Periodically (every 3 to 6 months) the dividend is reset by an
auction mechanism so that the yield will remain consistent withcurrent market interest rates.
In some cases the dividend is connected to the prime lendingrate and changes as the prime rate changes.
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CHAPTER 19 Equity and Hybrid Instruments 19 - 28
Yield Spreads
Preferred shares offer higher yields than bonds Greater default risk associated with an equity security
Bonds obligations are a legally enforceable claim (preferreddividends are not)
Bondholders have a secured claim against assets of thecorporation in the event of dissolutionpreferredshareholders are second to last in residual claims.
Tax Value of Money
Actual yield spreads are greater than the observable
spread on an after-tax basis because of the lowertax rate on dividends than on interest income.
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CHAPTER 19 Equity and Hybrid Instruments 19 - 29
Preferred SharesThe Cumulative Provision
A stipulation that no dividends can be paid oncommon shares until preferred share dividends,both current and arrears, are paid in full.
This feature is the reason boards of directors takethe payment of preferred dividends very seriously.
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CHAPTER 19 Equity and Hybrid Instruments 19 - 30
Preferred Shares as a Hybrid Instrument
Although preferred shares are equity securities because they areoften seen as a higher yield (and risk) substitute for fixed incomesecurities.
They are often seen as a hybrid instrument because, while they areequity from a residual claim point of view, and therefore have
significantly higher default risk, they do promise to offer a steadystream of dividends (similar to a debt instrument, but treatedpreferentially from a taxation perspective)
The higher the quality of the issuer, the more like debt preferredstock is because of the lower likelihood of default and the greater
the likelihood of an uninterrupted stream of dividends in a highquality issuer.
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CHAPTER 19 Equity and Hybrid Instruments 19 - 31
Preferred Share Dividends
While the preferred dividend is not a legally-enforceable financial obligations, issuers take thepayment of those dividends very seriously for anumber of reasons:
Failure to pay could jeopardize the firms future abilityto issue securities in the financial markets because ofa damaged reputation
Normally arrears in dividends need to be addressedbefore the common share class can receivedividends, and as arrearages grow, increasingly thecommon shareholders will get concerned and voicethose concerns at the AGM.
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CHAPTER 19 Equity and Hybrid Instruments 19 - 32
Preferred Share Ratings
Dominion Bond Rating Service (DBRS)
Preferred Rating Bond Equivalent Rating
1. PFD 1 AAA - AA2. PFD 2 A
3. PFD 3 highly rated BBB
4. PFD 4 lower rated BBB and BB
5. PFD 5 B or lower rated bonds
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Income Trusts
Equity and Hybrid Instruments
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CHAPTER 19 Equity and Hybrid Instruments 19 - 34
Income TrustsStrong Popularity Driven by Tax Considerations
A tax efficient financial structure allowing distribution of pre-tax corporate cash flows to trust investors resulting in: Greater cash distributions to unitholders than the same firm
using a traditional capital structure involving debt and equity Elimination of double taxation (which is the reason for the
greater cash distributions because they are being made beforetax).
Represents a popular form of equity financing representingmore than half the IPOs in Canada in the 2000s
As of March 2006: 238 income trusts listed on the TSX
Total market capitalization of income trusts $192 billionrepresenting 10% of the quoted market value of the TSX
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CHAPTER 19 Equity and Hybrid Instruments 19 - 35
Income TrustsThe Ministers Announced Change in Tax Treatment
Finance Minister Jim Flaherty made an unexpectedannouncement regarding income trusts on October 31, 2006 It was unexpected because the Conservative Party had
campaigned on a promise not to tax income trusts in the 2006federal election.
Existing income trusts (prior to November 1, 2006) willcontinue to enjoy the tax benefits of that structure until 2011.
Newly created income trusts will be taxed like normalcorporations.
In the first few days following the announcement almost $30billion in market capitalization was lost as income trust unitvalues fell dramatically.
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Warrants
Equity and Hybrid Instruments
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CHAPTER 19 Equity and Hybrid Instruments 19 - 37
Warrants
A long-term option to purchase new shares in a corporation at aspecified price.
The corporate finance equivalent of call options that are used toraise new capital for a firm.
Have long maturities and may be perpetual (no maturity date)
Warrants are issued by the firm. The exercise price of the warrant at the time of issue is normallygreater than the current stock price of the firm.
Warrants are often packaged with the sale of other new securities(preferred stock or bonds) and are equity sweetners allowing theholder to exercise them to buy new shares in the company, andthereby participate in the growth of the firm along with shareholders.
(Table 19 3 illustrates the first five warrants outstanding on Canadian exchanges in August,2006)
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CHAPTER 19 Equity and Hybrid Instruments 19 - 38
Warrant Listings
Company Stock
Close
Symbol Stock
Exchange
Exercise
Price
Recent
Close
Bid/
Ask
Intrinsic
Value
Time
Value
Years
Left
Expiry
DateAgnico-
Eagles
Mines Ltd 40.420 AEM.WT.U TSX US$19.000 US$19.500 US$19.5 18.920 3.147 1.3
Nov. 14,
2007Ascendant
Copper
Cor 0.500 ACX.WT TSX 2.500 0.150 0.150 -2.000 0.150 4.3
Nov.21,
2010Aumega
Discoveries
Ltd 0.090 AUM.WT TSX-VEN 0.400 0.010 0.010 -0.310 0.010 0.5
Feb. 16,
2007
Avnel Gold
Mining Ltd 1.100 AVK.WT TSX 1.060 0.550 0.550 0.040 0.510 3.9
June 30,
2010
Baja MiningCorp
1.500 BAJ.WT TSX-VEN 1.150 1.270 1.270 0.350 0.920 2.7
Apr. 19,
2009
Source: Data f rom Financial Post, August 29, 2006.
Table 19-3 Warrant Listings
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CHAPTER 19 Equity and Hybrid Instruments 19 - 39
Warrants versus Options
Warrants
Issued by the firm to investors
Issued to raise new capital for thefirm (capital formation purpose)
Traded in the secondary marketbetween investors
Long-term or perpetual option
At the time of issue the exerciseprice is typically greater than thecurrent stock price (so the warrant
does not have an intrinsic valueimmediately)
Exchange-traded Call Options
Created by investors interactingwith the options exchange as thecounterparty
No capital formation, instead usedas an instrument of hedging orspeculating
Short-term option
May be created out-of-the-money,at-the-money, or in-the-money.
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CHAPTER 19 Equity and Hybrid Instruments 19 - 40
Warrant Valuation
Using payoff diagrams normally associated with calloptions we can describe visually how warrants are
valued.
(See the diagram on the following slide)
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CHAPTER 19 Equity and Hybrid Instruments 19 - 41
WarrantsThe Value of a Warrant
$50exercise
price
WarrantValue
0Stock Price
At the time of issuethe warrant will
have a speculative(time) value only
because the marketvalue of the stock is
less than theexercise price.
Over time the stock pricemay increase and when it
exceeds the exercise priceof the warrant, the
warrant value will haveboth intrinsic value andspeculative (time) value.
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CHAPTER 19 Equity and Hybrid Instruments 19 - 42
Payoff to Warrant HoldersUsing a Variant of the Standard Options Pricing Model
Where:n =existing number of sharesm = number of shares issued on exercise of the warrants
X= exercise price of the warrantV= stock price of the firm without the warrant
This equation says that after the warrants are exercised, the value of the firm must be the
value without the warrants (V) plus the proceeds to the firm from the exercise of thewarrants (mX), for a total value of V + mX. (The weighted average of the former stock priceand the warrant exercise price)
The percentage owned by the warrant holders is m/(n+m), whereas the cost to them isexercise value of mX.
mX)-mX(Vmn
mholderswarranttoPayoff
[ 19-1]
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CHAPTER 19 Equity and Hybrid Instruments 19 - 43
Payoff to Warrant Holders
Equation 19 1 reduces to 19 2 when we multiply the exercise valuemXby (n+m)/(n+m):
The first term m / (n+m) is the dilution factor.
Therefore the value of the warrant is the dilution factor times thevalue of the secondary market call (whether you use the Black-Scholes or binomial option pricing model)
nX)(Vmn
mholderswarranttoPayoff
[ 19-2]
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CHAPTER 19 Equity and Hybrid Instruments 19 - 44
Warrants
As long-term options warrants trade at significant premiumsover their intrinsic value.
This is known as a time (speculative) premium
They are often used as sweetners to make other financial
securities more attractive to investors by being issued as apackage together with debt or preferred stock.
If warrants are NOT detachable, issuing bonds plus a warrantis similar to issuing convertible bonds (the holder holds atraditional bond, but an option to purchase equity and thereby
participate in the growth of the firm)
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Convertible Securities
Equity and Hybrid Instruments
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CHAPTER 19 Equity and Hybrid Instruments 19 - 46
Convertible Bonds
Bonds that are convertible into a specified number of commonshares at the option of the convertible holder.
When converted, the bonds are exchanged for commonshares (bonds are no longer outstanding)
The firm does not obtain additional financing through conversion. The debt level of the firm is reduced through conversion.
The convertible feature is a sweetner used to encourageinvestors to invest in the convertible and so convertibles tendto be issued by higher risk firms.
Convertibles are issued with a maturity date, however, they
are also usually callable to ensure conversion does occur.
(See Table 19 4 for some examples.)
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CHAPTER 19 Equity and Hybrid Instruments 19 - 47
Convertible Bond Listings
Issuer Symbol Coupon Maturity Last
Price
Parity Yield to
Maturity
Premium Conver
sion
Ratio
Conver
sion
Price
Symbol Share
Price
Tuesday
August
28, 2006
ACE
Aviation ACE.NT.A 4.25% 1-Jun-2035 94.50 67.19 4.60% 40.66% 2.23 44.88 ACE.A 30.15
Advantage
EnergyAVN.DB 10.00% 1-Nov-2007 134.62 132.78 -15.82% 1.33% 7.52 13.30 AVN.UN 17.67
Agricore
AU.DB 9.00% 30-Nov-2007 106.25 102.13 3.81% 4.03% 13.33 7.50 AU 7.66
Alamos
Gold AGI.DB 5.50% 15-Feb-2010 172.00 154.91 -11.05% 9.83% 18.87 5.30 AGI 8.30
Alexis
NihonAN.DB 6.20% 30-Jun-2014 100.80 93.92 6.07% 7.08% 7.33 13.65 AN.UN 12.85
Source: Data from Financial Post, August 29, 2006.
Table 19-4 Convertible Bond Listings
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CHAPTER 19 Equity and Hybrid Instruments 19 - 48
Conversion Price
The conversion price (CP) is the price at which aconvertible security can be converted into commonshares based on its conversion ratio.
The conversion ratio (CR) is the number of shares that aconvertible security could be exchanged for.
CR
ParCP[ 19-3]
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CHAPTER 19 Equity and Hybrid Instruments 19 - 49
Conversion Value (CV)
The Conversion Value (CV) is the value of a convertiblesecurity if it is immediately converted into common shares.
This value is denoted as parity in the Convertible Bond
listings.Obviously, if CV < Bond Price, conversion is notadvantageous to the convertible holder.
PCRCV [ 19-4]
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CHAPTER 19 Equity and Hybrid Instruments 19 - 50
Convertible Premium
The convertible premium is the percentage theshare must increase in order for conversion to makesense:
PremiumeConvertiblCV
CVP[ 19-5]
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CHAPTER 19 Equity and Hybrid Instruments 19 - 51
Straight Bond Value (SBV)
Convertible bonds are bonds that have an inherent value inthemselves.
The conversion feature of the bond is considered an option, inaddition to the basic bond value.
)1(
1)1(
11
SBVn
bb
n
b
k
F
k
kI
[ 19-6]
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CHAPTER 19 Equity and Hybrid Instruments 19 - 52
Floor Value (FV)
The Floor Value (FV) is the lowest price a convertible bond will sellfor, which is equal to the larger of its straight bond value and itsconversion value.
Every convertible will always have a floor value (FV) because it willalways sell for no less than the larger of the straight bond value andits conversion value.
In practice, convertibles usually sell a higher prices because of thetime value of the conversion option.
),( CVSBVMaxFV[ 19-7]
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CHAPTER 19 Equity and Hybrid Instruments 19 - 53
Convertible Bond ValuationA Graphic Illustration of the Valuation Relationships
ConvertibleBond Value
0
SBV
ActualConvertible
value
Conversionprice
Stock Price
FloorValue
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CHAPTER 19 Equity and Hybrid Instruments 19 - 54
Convertible Financing
Convertible financing helps firms obtain capital at a lowercoupon rate at the time of issue.
This is because the buyer is receiving an equity call optionequal to the time premium.
In the event the value of the stock remains below parity, thefirm has obtained cheap debt In the event the value of the stock exceeds parity, the firm
receives cheap equity (they sold equity at a price greater thanwhat they could have sold it at the time of issue)
The outcome, whether in the firms favour or not depends on
the subsequent movement of the stock price untilconversion/maturity/call.
(See Figure 19 1 for a graphic depiction of the ACE Holdings situation)
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CHAPTER 19 Equity and Hybrid Instruments 19 - 55
Convertible Scenarios
19-1FIGURE
ACE Share price$35
P>$44.88
Conversion:Cheap Equity
No Conversion:Cheap Debt
P
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Other Hybrid Securities
Equity and Hybrid Instruments
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CHAPTER 19 Equity and Hybrid Instruments 19 - 57
Other Hybrids
Warrants, convertible bonds and convertiblepreferred shares are the most common hybridsecurities.
Financial innovation takes place in order for
companies to issue securities that meet the needsof investors in the marketplace.
In this manner, firms that might not be able to raisecapital with traditional financing means are able to
do so, OR, they are able to raise capital in a formthat better suits their cash flow preferences.
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CHAPTER 19 Equity and Hybrid Instruments 19 - 58
Other HybridsCategorizing Hybrids
DBRS uses four factors help to determine whether a hybridinstrument is more like debt or more like equity:
1. Permanence factorCommon stock is perpetual, where as CP is very short-term
2. Subordination factorPlace on the prior of claims against income and assets
3. Legal factorWhether the claim on income is legally enforceable or not
4. Subjective factorThe purpose of the company when it issues the securities.
Following a description of other hybrids we will present ahierarchy of securities.
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CHAPTER 19 Equity and Hybrid Instruments 19 - 59
Other HybridsCreative Hybrids: Some Examples
Income bonds Cash flow bonds
Commodity bonds
Original issue discount bonds (OIDs) or low-yieldnotes
Liquid Yield Option Notes (LYONs)
Adjustable Rate Convertible Subordinated Securities(ARCS)
Preferred securities
Canadian optional interest notes (COINS)
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CHAPTER 19 Equity and Hybrid Instruments 19 - 60
Other HybridsCreative Hybrids: Income Bonds
Income bonds
Bonds issued after a reorganization with the interesttied to some cash flow level for the firm and with quitelong maturity dates
Payments are not tax deductible in Canada and asclassified by CRA as dividends.
Seen as a desperation play as the issuer may not
have much tax incentive to issue real bonds (little
taxable income because of loss carried forwardprovisions under the Income Tax Act)
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CHAPTER 19 Equity and Hybrid Instruments 19 - 61
Other HybridsCreative Hybrids: Cash Flow Bonds
Cash flow bonds
Bonds sold in the United States that have the sameobjects as do income bonds in Canada.
Maturity dates are long
Interest payments are conditional on the firm meetingcertain thresholds
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CHAPTER 19 Equity and Hybrid Instruments 19 - 62
Other HybridsCreative Hybrids: Commodity Bonds
Commodity bonds
A bond whose interest or principal is tied to the priceof an underlying commodity such as gold.
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CHAPTER 19 Equity and Hybrid Instruments 19 - 63
Other HybridsCreative Hybrids: Original Issue Discount Bonds
Original issue discount bonds (OIDs) or low-yield notes Bonds that sell at a discount from par value when issued by
firms. The company doesnt pay coupon interest annually, simply a
bullet payment on maturity.
Investors must report accrued interest income if the bond isheld in a taxable account (often, though investors place thesetypes of investments in tax-deferred (registered plans)investment accounts and thereby dont have to pay interest untilthe funds are with drawn) RESPs and RRSPs.
Investors have grown to like non-coupon bearing bonds because
there is no reinvestment rate problem (the ex post yield on thebonds will equal the ex ante forecast if there is no default on theissue)
(Table 19 5 illustrates the OID bond interest compared to a normal bond)
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CHAPTER 19 Equity and Hybrid Instruments 19 - 64
Creative Hybrids
Principal "Interest"
2 $4.24 $46.65 $4.243 4.24 51.32 4.67
4 4.24 56.45 5.13
5 4.24 62.09 5.64
6 4.24 68.30 6.21
7 4.24 75.13 6.83
8 4.24 82.64 7.551
9 4.24 90.91 8.2610 46.65 100.00 9.09
Table 19-5 OID versus Regular Bond Payments
OID BondRegular Bond
Oth H b id
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CHAPTER 19 Equity and Hybrid Instruments 19 - 65
Other HybridsCreative Hybrids: Liquid Yield Option Notes
Liquid Yield Option Notes (LYONs)
Low-yield notes that are combined with a convertiblefeature and are accretive convertibles, because the
principal accretes or increases over time.
Oth H b id
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CHAPTER 19 Equity and Hybrid Instruments 19 - 66
Other HybridsCreative Hybrids: Adjustable Rate Convertible Subordinated Securities
Adjustable Rate Convertible Subordinated Securities(ARCS)
Securities that have fixed principal and maturity, andinterest that normally comprises a fixed interest rateand some function of the dividend paid in the previoussix months
Typically convertible into common shares
Oth H b id
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CHAPTER 19 Equity and Hybrid Instruments 19 - 67
Other HybridsCreative Hybrids: Preferred Securities
Preferred securities
Not preferred shares
Securities generated by a company by creating a 100percent owned subsidiary that issues the shares thenloans the proceeds to the parent company, for whomthe interest is tax deductible;
Interest flows to the subsidiary, where it is not taxed,and is used to make dividend payments.
Oth H b id
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CHAPTER 19 Equity and Hybrid Instruments 19 - 68
Other HybridsCreative Hybrids: Canadian Optional Interest Notes
Canadian optional interest notes (COINS)
99-year bonds that are sold at their par values of
$100, on which the firm immediately prepays theinterest from years 11 to 99 on issue, leaving it with anet inflow and allowing it to continue to deduct annualinterest payments of $100, even though it haseffectively borrowed less.
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CHAPTER 19 Equity and Hybrid Instruments 19 - 69
A Financing Hierarchy
Table 19 6 shows a synopsis of the main securitiesdiscussed in this chapter and shows using a rating systemhow like equity they are. Equities are rated as 100% because they are equity
Commercial papers are rated -100% because they are the most
debt-like. Figure 19 2 shows the spectrum of financing options
available to corporations and expresses them in terms of riskto the investor, and the required return investors demand (thistranslates into the returns the firm must offer in order to
access that type of capital)
(See the following two slides)
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CHAPTER 19 Equity and Hybrid Instruments 19 - 70
A Financing Hierarchy
Equity Share (%)
Common shares 100
Mandatory convertible preferred shares* 90
Straight preferred shares 50
Trust preferred shares 40
Convertible preferred shares 20
Re-marketed referred shares -10
Normal convertible debt -50
Accreting convertible bonds (LYONS) -60
Very long term bonds -70
Medium term bonds -80Auction preferred shares -90
Commercial paper -100
* Preferred shares for w hich convers ion into common shares is s tructured to be automatic. Preferred shares that after five to seven years, are repriced and resold.
Table 19-6 S&P Financing Rankings
Oth H b id
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CHAPTER 19 Equity and Hybrid Instruments 19 - 71
Other HybridsFinancing Hierarchy Costs
19-2FIGURE
Mortgage
Debt
StraightPreferred
Shares
CommonEquity
ConvertibleBonds
ConvertiblePreferredShares
Long-termUnsecured Debt
Cost
CP
Risk
MTNs
BankLoans
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CHAPTER 19 Equity and Hybrid Instruments 19 - 72
Summary and Conclusions
In this chapter you have learned: That securities are financial contracts and their risk depends on the
structure of the contract Basic issues are tax treatment and equity weight Common stock imposes the least risk on a firm because it imposes no
legally binding cash flow commitments and never matures,consequently, common stock provides a cushion to senior debt andother commitments that is required in order to attract these other, morerisky sources of financing.
Commercial Paper and Bankers Acceptances place the greatestfinancial risk on the firm because they place a fixed, time-delimited(short-term) financial and contractual obligation on the firm, including
repayment of principal. An offsetting advantage of CPs and BAs is the tax-deductibility ofinterest expense.
Between these two extremes, hybrid financial instruments combine thecharacteristics of both debt and equity.
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Concept Review Questions
Equity and Hybrid Instruments
C t R i Q ti 1
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CHAPTER 19 Equity and Hybrid Instruments 19 - 74
Concept Review Question 1Rights Associated with Equity Securities
What are the basic rights associated with equitysecurities? How do these differ across differentcategories of classes of equities?
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Copyright
Copyright 2007 John Wiley & SonsCanada, Ltd. All rights reserved.Reproduction or translation of this workbeyond that permitted by AccessCopyright (the Canadian copyrightlicensing agency) is unlawful. Requestsfor further information should be
addressed to the PermissionsDepartment, John Wiley & Sons Canada,Ltd. The purchaser may make back-upcopies for his or her own use only andnot for distribution or resale. The authorand the publisher assume noresponsibility for errors, omissions, or
damages caused by the use of these filesor programs or from the use of theinformation contained herein.
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