equity and hybrid instruments

7/30/2019 Equity and Hybrid Instruments

1/75

Prepared byKen Hartviksen

INTRODUCTION TO

CORPORATE FINANCELaurence Booth W. Sean Cleary

Chapter 19 Equity and HybridInstruments


2/75

CHAPTER 19

Equity and HybridInstruments


3/75

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


4/75


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


5/75


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


6/75


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


7/75

The Nature of Equity Securities

Equity and Hybrid Instruments


8/75


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.


9/75


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.


10/75


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


11/75


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.


12/75


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.


13/75


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.


14/75


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.


15/75


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.


16/75


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


17/75


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.


18/75


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:


19/75


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


20/75


Some Basic RatiosMarket to Book Value

$ Million 2004 2005 2006


Capital stock 38.869 41.974 45.347









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.)


21/75


Some Basic RatiosDividend Yield

$ Million 2004 2005 2006


Capital stock 38.869 41.974 45.347









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.


22/75


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)


23/75


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.


24/75

Preferred Shares



25/75


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


26/75


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


27/75


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.


28/75


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.


29/75


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.


30/75


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.


31/75


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.


32/75


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


33/75

Income Trusts



34/75


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


35/75


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.


36/75

Warrants



37/75


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)


38/75


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


39/75


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.


40/75


Warrant Valuation

Using payoff diagrams normally associated with calloptions we can describe visually how warrants are

valued.

(See the diagram on the following slide)


41/75


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.


42/75


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]


43/75


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]


44/75


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)


45/75

Convertible Securities



46/75


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.)


47/75


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


48/75


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]


49/75


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]


50/75


Convertible Premium

The convertible premium is the percentage theshare must increase in order for conversion to makesense:

PremiumeConvertiblCV

CVP[ 19-5]


51/75


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]


52/75


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]


53/75


Convertible Bond ValuationA Graphic Illustration of the Valuation Relationships

ConvertibleBond Value

0

SBV

ActualConvertible

value

Conversionprice

Stock Price

FloorValue


54/75


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)


55/75


Convertible Scenarios

19-1FIGURE

ACE Share price$35

P>$44.88

Conversion:Cheap Equity

No Conversion:Cheap Debt

P


56/75

Other Hybrid Securities



57/75


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.


58/75


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.


59/75


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)


60/75


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)


61/75


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


62/75


Other HybridsCreative Hybrids: Commodity Bonds

Commodity bonds

A bond whose interest or principal is tied to the priceof an underlying commodity such as gold.


63/75


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)


64/75


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


65/75


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


66/75


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


67/75


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


68/75


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.


69/75


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)


70/75


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


71/75


Other HybridsFinancing Hierarchy Costs

19-2FIGURE

Mortgage

Debt

StraightPreferred

Shares

CommonEquity

ConvertibleBonds

ConvertiblePreferredShares

Long-termUnsecured Debt

Cost

CP

Risk

MTNs

BankLoans


72/75


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.


73/75

Concept Review Questions


C t R i Q ti 1


74/75


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?


75/75

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.

equity and hybrid instruments

Documents