HYBRID SECURITIES Preferred Stock dividends have been paid.

Typically, preferred stock dividends are cumulative so that all dividends Preferred stock is a hybrid instrument; it is like debt but it is also like equity. The dividends on preferred stock are generally set at a specific dollar amount per share, often expressed as a percentage of par value. There is also dividend preference the company cannot pay any common stock dividends until the preferred stock in arrears on preferred stock must be paid before common stockholders can be paid anything. It is not uncommon that dividends in arrears also carry an interest rate that accumulates. In the event of liquidation, preferred shareholders will be repaid the par value of the preferred stock. While the standard type of preferred stock pays a constant dividend and never matures, there is a wide variety of provisions that may be included in a preferred stock issue: Sometimes the preferred stockholder get to vote. There may be a maturity date and sinking fund provision. Sometimes there is a call provision. On rare occasion, there is what is known as participating preferred stock that participates in the profits up to a limit during unusually good years. Very often the preferred stock is convertible into common shares. Many times the ability to vote is linked to the conversion feature and the preferred stockholders can vote as if they had converted into common stock.

You will often see preferred stock used in small companies that need to raise additional capital. The investors, typically venture capitalists, will invest money in the form of convertible preferred stock. Thus, if the company prospers and the common stock becomes worth a significant amount, the investor can convert to common stock and cash in on the companys good fortunes. On the other hand, if the company ultimately founders or fails, the investor is first in line to get paid dividends or to be repaid from any proceeds that remain after liquidation. Advantages of Preferred Stock to the Investor Relatively steady income (relative to common stock). Preference over common stock in liquidation. Dividends paid to corporations owning the preferred stock are excluded from income to as much as a 70% extent.

Disadvantages of Preferred Stock to the Investor Returns are limited. There is no enforceable right to dividends (unlike interest payments that must be paid annually).

There is high risk due to price fluctuations. Recall from our discussion of valuation of securities that preferred stock is a perpetuity and perpetuities are the most sensitive to changes in interest rates.

Advantages of Preferred Stock to the Company There is no fixed charge that must be paid each year. There is no maturity. No dilution of control (unless convertible). The cost is less than the cost of common equity. While the first two advantages are the same as the advantage of using common stock, the cost is less. Why? Because the risk to the investor is less than that of common stockholders.

Disadvantages of Preferred Stock to the Company Cost is higher than debt. Dividends are not tax-deductible.

From the perspective of a bondholder, preferred stock is like common equity. It provides for more assets that generate income that is used to pay lenders their interest first and provides more asset that can be liquidated to pay lenders their principal first if the firm goes bankrupt. From the perspective of a common stockholder, on the other hand, preferred stock is like debt. The preferred stock dividends must be paid first (and also act as leverage in terms of magnifying the variability of income) and the preferred stockholders are ahead of the common shareholders in the event of liquidation (just like lenders). Preferred Stock Valuation The classic version of preferred stock is a share that pays a fixed dollar amount of dividend and never matures. It is, therefore, a perpetuity. The formula for the value of a share of preferred stock is
Value of Preferred Stock = Dividend rp

Since the plain vanilla type of preferred stock is a perpetuity, its value is very sensitive to changes in interest rates. Options Typically, when people talk about options on stocks, they are referring to the standardized options that are traded on exchanges. These standardized options are for 100 shares of stock and have maturity dates that go up to nine months in three-month intervals. Also, the exercise price (or strike price) is always in specified intervals of two and one-half or

five dollar increments. A call option gives the holder of the option the right to buy 100 shares of stock at a set price (strike price, or exercise price) during a set period of time (until expiration). A put option gives the holder (owner) of the option the right to sell 100 shares of stock at a set price during a set period of time. Options are part of a set of securities referred to as derivatives due to the fact that their value is derived from some underlying asset. An options value is a function of five factors: 1. 2. 3. 4. 5. Market price of the stock Strike price of the option Time to maturity of the option Volatility of the underlying stock Risk-free rate of interest

The following graph illustrates the value of a call option at different market prices of the underlying stock given a set strike price, maturity date, etc.

Value of Option Market Value 0

Intrinsic Value

Stock Price

The intrinsic value (blue line) is the value of the option if it were to be exercised at that point in time. Intrinsic Value = Max(M-S,0) Note, however, that the market value is always higher than the intrinsic value due to the speculative appeal of an option (except on expiration date when the two should converge). For example, if the exercise price is higher than the market price, the intrinsic value is zero since it is irrational that one would pay a higher price to buy the stock through an option exercise than what it would cost to purchase on the open market. As long as there is some time before the expiration of the option, there is a chance that the market price will move above the strike price, thereby making the option in the money and worth exercising. Warrants and Convertibles A firm must often add features to make its debt more attractive. In times of high interest rates, it is undesirable to raise money in general because the rate of interest paid on debt will be

high and stock prices will be low. In order to help offset the high interest rates that prevail, a firm may add a sweetener to its debt in order to make it more attractive to investors. Warrants A warrant is an option to buy stock at a set price. In this sense, it is an option. The difference is that a warrant typically does not expire for many years. A warrant will often be issued in conjunction with a bond issue. If you buy a bond, you receive a warrant that entitles you to purchase a fixed number of shares at a fixed price during a fixed period of time. Sometimes, the exercise price will increase over time in order to encourage the warrant holders to exercise the option sooner. The intrinsic value of the warrant is W = Max{0,N*(M-S)} Where N = the number of shares the warrant entitles you to buy M = the market price of the stock S = the subscription price of the warrant to buy the stock A warrant is generally issued at the same time as a fixed income security (bond or preferred stock) in order to make the security more attractive to investors. At the time of the issue, the subscription price is generally set anywhere from 15%-20% above the market price. Consequently, it does not make sense to exercise the warrant at the time of issuance. However, the warrants speculative appeal lies in the fact that the stock price may increase substantially in the future, making the warrant valuable. If an investor had to choose between two identical bonds with identical maturities and paying and identical rate of interest, but with one bond offering a warrant that, although not worth exercising at the time of issuance, the bond with the warrant would be perceived as more valuable since the stock may appreciate substantially. Since investors would prefer the bond with the warrant, what can we do to make investors indifferent between the two bonds? The easiest way to make the bond with the warrant less attractive (i.e., equivalent to the straight bond without a warrant) is to lower the coupon rate of interest that it pays. A warrant is detachable from the bond. That is, a separate market exists for the warrant. If you buy a bond with a warrant attached, you can keep the bond and sell the warrant or keep the warrant and sell the bond. Also, just like an option, a warrant will sell for more than its intrinsic value (as in the above equation) since it has speculative appeal. Just as you can buy the price movement of a share of stock using a call option, you can buy the right to N shares of stock simply by purchasing the warrant. The risk on the downside of purchasing a warrant is limited to the amount that is paid for the warrant which is less than if you purchased the stock. On the other hand, the upside potential is unlimited. The effect of purchasing a warrant is the leverage that is provided both gains and losses are magnified. Convertible Bonds Just as warrants make a bond more attractive to investors, adding a conversion feature makes a bond more attractive. A convertible bond gives the bondholder the right to convert the

bond into a specified number of shares of common stock. The number of shares that a convertible bond is convertible into is referred to as the conversion ratio. Typically, the number of shares that a bond is convertible into is specified through what is known as the conversion price. In this sense, a convertible bond is said to have an embedded option; i.e., the bond comes with a non-separable option to purchase stock at the strike price of surrendering the bond.

Conversion Price =

Par Value Conversion Ratio

Thus, if a $1,000 par value bond is convertible into 20 shares of common stock, the conversion price will be $50 per share. The reason for expressing the conversion ratio as a conversion price arises from the fact that most convertible bonds are protected against dilution. If a firm were to declare a two-for one stock split, for instance, the conversion price would be cut in half (i.e., the number of shares that the bond is convertible into would be doubled). As in the case of warrants, convertible bonds are generally issued when interest rates are high (a bad time to sell debt) and stock prices are low (a bad time to sell equity). Also, the conversion price is generally set at 15%-20% above the current market price of the stock at the time of issuance, so the appeal is strictly speculative. Consider the following graph: $ Conversion Value Call Price Par Value Bond Value Market Price

Time There are two ways of looking at the convertible bond: first, it can always be held as a straight bond. Since the conversion feature will allow the bond to pay a slightly lower rate of interest than if it were non-convertible (a straight bond), its bond value is at a discount. This is referred to as the floor of the convertible bonds value since it can never be worth less than its value as a straight bond. (See the red line.) On the other hand, it can be viewed as if it were converted into common stock. Its conversion value is equal to the number of shares that it is convertible into times the market price per share of stock.
Conversion Value = Conversion Ratio * Market Price per Share

Since stock prices are generally expected to increase over time, the conversion value of the convertible bond is portrayed as increasing over time as well. A company typically includes a call provision on a convertible bond. If an investor had total discretion as to when they wanted to convert, what would motivate the investor to convert from a bond to stock? An investor would voluntarily convert (prior to maturity) only if there was more income being paid to shareholders than to bondholders. In particular, assume that the convertible bond pays an 8% coupon rate of interest. Since the typical stock today pays only about a 2% dividend yield, then dividends would have to quadruple before an investor would voluntarily convert the bond. The company, on the other hand can force conversion by exercising the call provision. If, for example, the conversion value of the bond was $1,150 while the call price was $1,050 what do you think an investor would do when the company sends a letter saying send us your bond within the next two months and well send you $1,050? The investor would send the bond and say heres the bond, send me the stock (worth $1,150). Why would a company want to force conversion? In order to stop paying interest at the high rate. It will also make the debt/equity ratio look a lot better. The advantage to the company of selling a convertible bond is that it can sell the bond at a lower rate of interest than if it were a straight bond. In addition, it is contingently selling stock at a higher price than the current market price of the stock. Both warrants and convertibles act as sweeteners to make a bond issue more attractive. The difference is that when warrants are issued, new money (the exercise price) comes into the firm while the debt remains outstanding and must be retired. When a convertible bond is exercised, on the other hand, the debt is converted into equity.