7 - FINS3625S2Yr2018Wk7HybridSecuritiesSlides

Topic: Hybrid Securities
Agenda
What are Hybrid Securities?
Why Hybrid?
Motivating Example: The Underinvestment Problem
Preferred Shares
Warrants
Convertible Securities
The Moral Hazard Problem
1
Kyung Hwan Shim, FINS3625S2Yr2018
What are Hybrid Securities?
Kyung Hwan Shim, FINS3625S2Yr2018 2

Hybrid Securities
Hybrid securities are financial securities that border between

common equity and/or corporate bonds and/or financial
derivatives.
Examples of hybrids are: preferred shares, convertible bonds, and

warrants.
Hybrid securities generally incorporate more complex features

than ordinary shares or straight bonds.
These features can make hybrids attractive alternatives to

straight bonds or common shares for the manager or investors.
3
Why Hybrids?

Why Hybrid Securities?
A common way to raise external capital is by issuing common

equity and/or corporate bonds.
Selling hybrid securities provides an alternative way to raise capital.
Hybrids :
(1) are most useful when a company has difficulty raising
external capital with straight bonds or common shares;
(2) can be effective resolving conflicts of interest between
stakeholders of the firm.
5
Motivating Example: The Under
Investment Problem

The Underinvestment Problem
Heavily indebted firms are exposed to a problem commonly

referred to as the Debt Overhand Problem or the
Underinvestment Problem.
Debt Overhand Problem: the incentive to forego positive NPV

projects if the shareholders of an indebted firm don’t see a benefit.
Debt overhand problem leads to suboptimal firm value and

sometimes even failure.
7
Gloomy Corp. is in financial trouble because it is unable to pay the

creditors. The firm’s current asset value is $100M which is below
the $600M owed to the creditors. The creditors intend to take
immediate action to liquidate the firm for payments.
Gloomy has no immediate cash and it is investigating a project that

costs $100M and will generate a risk-neutral expected payoff of
$200M next year. The risk free rate is 5%. The creditors perceive
Gloomy to be so gloomy with its prospects; therefore are unwilling
to extend any more loans to Gloomy.
Is this project worth pursuing? If so, will the equity holders finance
the project?
8
Project’s NPV:
200
= −100 + = 90.4762
1.05
NPV in the eyes of the equity holders:

(100 + 200 − 600 , 0)
= −100 +
1.05
= −100
The project creates value. It has a + NPV.
But, the equity holders don’t see any benefit from this project.
Gloomy will face immediate liquidation.

9
Now, what if Gloomy’s CEO negotiates with the creditors to make

their debt convertible into 50% of the company’s shares?
If Gloomy’s debt becomes convertible:
× %
= −100 + = 42.8571
.
The equity holders will finance the project.
They see a gain of $42.8571 against a gain of $0 from immediate

liquidation.
10
What about the creditors? Are they better off with debt
renegotiation?
× %
The debt holders see a benefit of $ = $142.8571
.
which is higher than the $100M liquidating value.
The debt holders are also better off.
Making the debt convertible averts the Debt Overhand Problem,
and relieves Gloomy from facing immediate liquidation.
11
Preferred Stocks

Preferred Stocks
Preferred shares are a cross between common shares and bonds
Features similar to Bonds:

• issued at par value (usually $10, $25, $50 or $100);
• periodic dividends as a % of par value paid before any common
dividends are paid. Increases ‘financial’ leverage;
• perceived to be less risky than common equity;
• usually non-voting, but may be voting and/or give rights to elect
minority directors on the Board;
• may be subject to sinking fund provisions and/or be called by the
issuer.
Feature similar to Equity:
• subordinated to debt holders. Missed preferred dividends do not
force firm into liquidation or bankruptcy. 13
Preferred Stocks
Value of Preferred Stocks:
=
Preferred dividends tend to be fixed and are rarely unpaid.
Pros:
- preferred dividends are not legal obligations unlike unpaid debt;
- avoids dilution unlike common shares;
- avoids cash drain from principal payments on corporate bonds.
Cons:
- preferred dividends must be treated as hard obligations;
- preferred dividends are not tax deductible unlike debt payments;
- like debt, increases financial leverage and constrains the manager.
14
Warrants

Warrants
A warrant gives the holder the right to buy a specified number of stocks
from the company at a strike price by a certain date. Warrants are
examples of financial derivatives (similar to call options)
Generally issued with debt to ‘sweeten the deal’. Can:
• lower coupons on bonds; and/or
• lower yield on long-term debt
Most of the warrants are detachable from the debt and are tradable.
Warrants tend to be exercised if:
• expiration date is fast approaching;
• common dividends grow rapidly;
• the strike price rises rapidly (only in cases of ‘stepped up’ strike
prices).
Otherwise, it is better to hold them or to sell them (not to exercise
them). 16
Warrants
Valuation of Bonds with Warrants:

Bond Value with Warrants = Straight Bond Value + Value of Warrants
Pros: - can lower the cost of debt capital;

- if the firm is fast-growing, then exercising warrants brings in
much needed financing;
- if warrants are not exercised, then the issuer gains at the
expense of the lenders
Cons: - warrants can lead to dilution
(i) if the warrants are in-the-money, the new shares are sold
below market price;
(ii) voting power is diluted post-exercise of warrants
17
Warrants
The market value of equity is = − where is the firm’s market
value and is the firm’s debt market value.
Pre-exercise price of a common share:

=
#
Post-exercise price of a common share:
+
′=
# +
where
= #
18
Yields on Bonds with Warrants
Computing the yield on bonds with warrants entails computing the

yield on a portfolio of both securities:
(1) determine the cash flows from the straight bond;

(2) determine when the warrants are expected to be exercised;
(3) determine the pay off from exercising the warrants;
(4) compute the yield, given the current market values and the cash
flows of the bond and warrants.
The yield is the return priced by the market.
The yield also represents the cost of capital for the issuer.
19
Yield on Bonds with Warrants: Example
Example: ABC's total firm value is $5M with 1M shares outstanding.
The firm's value is expected to grow at 15% per year for at least the next
20 years. ABC has recently raised $2M in capital by issuing 20-yr, 5%
coupon, $1,000 par value bonds with warrants. Each bond carries 20
warrants with a strike price of $6 which expire in 10 years. Each
warrant, if exercised, grants the holder one share. The yield on
compatible investments is 10% and likely to remain constant.
a) What is the price of each warrant at the time of issuance?
( %) $ ,
= $50 × + = $574.3
% ( %)
$1,000 − $574.32
= = $21.28
20
20
b) What is ABC’s expected share price post-exercise of the warrants?
= × (1 + ) = 5 × (1 + 15%) = $20.227789
=
2 1 − 1 + 10% 1,000 2
− × 50 × + + × 20 × 6
1 10% 1 + 10% 1
.

= 20.227789 − 1.385543 + 0.24 = 19.082245
.
′= = =18.35
# ×
.
21
c) What is the cost of capital?
( ) , ×( . )
0= −1000 + 50 × + +
( ) ( )

⇒ = 6.2%
The 6.2% yield is significantly lower than ABC’s cost of debt capital.
The warrants were overvalued at the start.
22

Convertible securities are bonds or preferred shares that are
exchangeable for common shares.
Conversion happens at the discretion of the holder.
Conversion does not provide the firm any additional capital.
Usually issued at par value.
The conversion ratio CR is the number of shares the holder receives

when conversion occurs
=
where dentoes the conversion price. 24

is the price the holder ‘pays’ for the stock when the conversion
occurs.
The value that investors receives by converting is referred to as

the Conversion Value CV.
= ×
is usually set at 20 to 30% above the pre-issuance share price

and some convertibles are ‘stepped up’.
25
Some convertibles have a call protection period.
Most have protection against dilution from stock splits, stock

dividends and sale of common shares at prices below .
If is revised downwards, there is transfer of wealth from

existing shareholders to convertible holders.
Hence, convertibles can disadvantage common shareholders of

poorly performing firms.
26
Pros:
• can help issuer borrow with attractive terms;
• averts the problem of selling undervalued stocks in bad times;
• issuer can control conversion by making the security callable;
• alleviates the cash drain if conversion occurs
Cons:
• straight bonds are a better alternative if the share price rises more
rapidly than expected;
• lower coupons terminate with conversion or redemption;
• issuer can be burdened with too much debt if left unconverted
27
Value of Convertible Securities
The value of a convertible security is constrained from below:
≥ ,
≥ , ×
If callable, then the call value serves as the upper bound for the value of the
convertible security:
≤ .
Hence,
, ×
≤ ≤ .
28
Convertible Securities: Example
Now assume that ABC had issued convertible debt instead of

bonds with warrants. Again, ABC's total company value is $5M
with 1M shares outstanding. The firm's value is expected to grow
at 15% per year for at least the next 20 years. ABC has recently
raised $2M in capital by issuing 20-yr, 5% coupon, 1,000 par value
convertible bonds. The Conversion Ratio is set at 60 and it is
callable in 10 years for $1,250. The yield on bonds with compatible
investment grade is 10% and likely to remain constant.
29
Q) What is the conversion price? What does it mean?
$1,000
= = = $16.6666
60
A) The conversion price is break-even price.
It measures the minimum stock price level at which investors’

recoup the initial investment of $1,000.
30
Q) When are the bonds expected to be converted?
A) Compute the expected diluted share prie for each year after year 10
(1 + ) 5 (1 + .15)
′= = =
2 1.12 1.12
1 + ×
1
.
⇒ ′ = 18.06 and ′ = 20.77
⇒ = 18.06 × 60 = 1,083.63 = 20.77 × 60 = 1,246.18
If CV>Call Value=$1,250, then ABC will force conversion.

Conversion expected to take place just after year 11.
31
32
Q) What is the yield on the convertible debt?

A) Assuming that bonds are called only at year end, conversion is
expected to happen in year 12, CV12 =20.77 × 60=1,433.18. Since
the conversion value is greater than the call value in year 12,
conversion will take place just before they are called.
The yield is given

1 − (1 + yield )−12 1, 433.18
0 = −  + 50 ×
, 000
1 +
yield (1 + yield )12
Initial Investment 

 
PV of Coupon from Bond PV of Conversion Value in year 12
 yield = 7.9%
33
Hybrids and The Moral Hazard
Problem

Hybrids to Solve Conflicts of Interest Between
Debt Holders and Shareholders
Indebted firms are susceptible to conflicts of interests between debt

holders and shareholders.
The Risk-Shifting Problem: Shareholders favor investments in

excessively risky projects, even if the project has - NPV.
Also called ‘going for broke’; ‘betting with debt holder’s money’; or
the overinvestment problem.
Hybrids can alleviate the risk-shifting problem.
35
Payoff Profiles at Time of Debt Maturity
If straight debt and equity only:
Straight Debt’s Payoff = ,
and
Equity’s Payoff = − ,0
where denotes firm value and denote the amount of debt

owed.
36
Straight Debt Payoff at Time of Maturity
37
Straight Equity Payoff at Time of Maturity
38
Payoff Profiles at Time of Debt Maturity
If debt is convertible :
Conversion Value: CV= ×
#
Convertible Debt Payoff=
, =
, ,
and
Equity’s Payoff=
− ,0
= [ − , , , 0]
39
Convertible Bond Payoff at Time of Maturity
40
Equity Payoff at Time of Maturity if Bonds are Convertible
41
Risk Shifting Problem and Hybrid Securities: Example
XYZ is in financial distress and will face liquidation next year unless XYZ can
significantly improve its conditions. XYZ's current firm value is $100M;
owes creditors $200M; and has 1M shares outstanding. XYZ has two
projects under evaluation.
Project Safe has equal risk-neutral probabilities of realizing cash flows of

$110M and $105M one year later.
Project Risky has a 1/100 risk-neutral probability of $380M and a 99/100

risk-neutral probability of -$100M.
Both projects require an investment of $5M to be financed by the debt

holders, if agreeable, and the risk-neutral required rate of return on both
projects is 10%.
Assume an interest rate of 12% on borrowed funds.

42
Risk Shifting and Hybrid Securities: Example
a) What is the NPV of the projects?
Safe Project Risky Project
1 1 1
NPV5M 110M 105M92.7273M NPV5M
1

1
380M
99
100M91.5455M
1.1 2 2
1.1 100 100
X U 110M X U 380M
1 1
pU pU
2 100
I5M I5M
1 99
pD pD
2 100
X D 105M X D 100M
Since Project Safe has a positive NPV and Project Risky has a negative
NPV. Project Safe should be adopted.
43
b) What are the equity and debt values if the projects are to be financed with
straight debt?
Shareholders Shareholders
1 1 1 1 1 99
NPV0 4.4M 02.0M NPV0 274.40M 02.4945M
1.1 2 2 1.1 100 100
MaxVX U I1cF,04.4M MaxVX U I1cF,0274.40M
1 1
pU pU
2 100
I0 I0
1 99
pD pD
2 100
MaxVX D I1cF,00 MaxVX D I1cF,00
Shareholders would prefer the risky project.

44
b)
Debtholders Debtholders
1 1 99
205.60M 205M181.6364M NPV5M 1.1 100 205.6MM 100 03.1309M
1 1 1
NPV5M
1.1 2 2
MinI1cF,VX U 205.60M MinI1cF,VX U 205.60
1 1
pU pU
2 100
I5M I5M
1 99
pD pD
2 100
MinI1cF,VX D 205M MinI1cF,VX D 0
Debt holders would prefer the safe project.

45
c) What project would the manager choose? Would the debt holders
finance the project?
ABC will invest in the risky project in spite of a - NPV.
The debt holders, knowing ABC’s lack of commitment to invest in the

safe project, will not finance the project.
As a consequence, the firm will face liquidation.
46
d) What if the debt is convertible into 20M shares after the cash flows are
realized. What is your conclusion?
Shareholders
Safe Project
1 1 1
NPV0 4.4M 02.0M
1.1 2 2
CR
MaxV X D MaxMinI1cF,V X D ,V X D ,04.40M
1 CR
1
pU
2
I0
1
pD
2
CR
MaxV X D MaxMinI1cF,V X D ,V X D ,00
1 CR 47
Shareholders
Risky Project
1 1 99
NPV0 22.8571M 00.2078M
1.1 100 100
CR
MaxVX U MaxMinI1cF,VX U ,VX U ,022.8571M
1 CR
1
pU
100
I0
99
pD
100
CR
MaxVX D MaxMinI1cF,VX D ,VX D ,00
1 CR
48
If the debt is convertible, the equity holders will prefer the safe project
over the risky project.
With convertible debt, the risky - NPV project becomes less desirable to
the equity holders because the debt holders share the gains.
This creates an incentive to pursue the safer + NPV project over the
riskier – NPV project.
Conclusion: Hybrids can be effective tools to mitigate conflicts of

interest between debt holders and shareholders.
49
Conclusion
Hybrids have benefits.
Particularly useful for younger and smaller firms facing difficulties raising
capital with straight bonds or common shares or during bad market
conditions.
The pros and cons of a particular hybrid must be considered against

conventional ways of raising capital.
Hybrids, with their option-like features, can be effective in resolving

conflicts of interest that may lead to destruction in firm value or even
failure.
Hybrids can also mitigate problems related to asymmetric information in

financial markets (not discussed in these notes).
Questions: 20-2 to 20-7; Problems: 20-1 to 20-5, 20-7

50

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Topic: Hybrid Securities

Kyung Hwan Shim, FINS3625S2Yr2018 2

Hybrid securities are financial securities that border between

Examples of hybrids are: preferred shares, convertible bonds, and

Hybrid securities generally incorporate more complex features

These features can make hybrids attractive alternatives to

Kyung Hwan Shim, FINS3625S2Yr2018 4

A common way to raise external capital is by issuing common

Selling hybrid securities provides an alternative way to raise capital.

Kyung Hwan Shim, FINS3625S2Yr2018 6

Heavily indebted firms are exposed to a problem commonly

Debt Overhand Problem: the incentive to forego positive NPV

Debt overhand problem leads to suboptimal firm value and

Gloomy Corp. is in financial trouble because it is unable to pay the

Gloomy has no immediate cash and it is investigating a project that

NPV in the eyes of the equity holders:

The project creates value. It has a + NPV.

Gloomy will face immediate liquidation.

Now, what if Gloomy’s CEO negotiates with the creditors to make

If Gloomy’s debt becomes convertible:

The equity holders will finance the project.

They see a gain of $42.8571 against a gain of $0 from immediate

The debt holders are also better off.

Making the debt convertible averts the Debt Overhand Problem,

and relieves Gloomy from facing immediate liquidation.

Kyung Hwan Shim, FINS3625S2Yr2018 12

Features similar to Bonds:

Kyung Hwan Shim, FINS3625S2Yr2018 15

Valuation of Bonds with Warrants:

Pros: - can lower the cost of debt capital;

Pre-exercise price of a common share:

Post-exercise price of a common share:

Computing the yield on bonds with warrants entails computing the

(1) determine the cash flows from the straight bond;

The yield is the return priced by the market.

a) What is the price of each warrant at the time of issuance?

b) What is ABC’s expected share price post-exercise of the warrants?

c) What is the cost of capital?

The warrants were overvalued at the start.

Kyung Hwan Shim, FINS3625S2Yr2018 23

Conversion happens at the discretion of the holder.

Conversion does not provide the firm any additional capital.

Usually issued at par value.

The conversion ratio CR is the number of shares the holder receives

where dentoes the conversion price. 24

The value that investors receives by converting is referred to as

is usually set at 20 to 30% above the pre-issuance share price

Some convertibles have a call protection period.

Most have protection against dilution from stock splits, stock

If is revised downwards, there is transfer of wealth from

Hence, convertibles can disadvantage common shareholders of

Now assume that ABC had issued convertible debt instead of

Q) What is the conversion price? What does it mean?

A) The conversion price is break-even price.

It measures the minimum stock price level at which investors’

Q) When are the bonds expected to be converted?

⇒ ′ = 18.06 and ′ = 20.77

⇒ = 18.06 × 60 = 1,083.63 = 20.77 × 60 = 1,246.18

If CV>Call Value=$1,250, then ABC will force conversion.

Q) What is the yield on the convertible debt?

The yield is given

Kyung Hwan Shim, FINS3625S2Yr2018 34

Indebted firms are susceptible to conflicts of interests between debt

The Risk-Shifting Problem: Shareholders favor investments in

MaxVX U I1cF,04.4M MaxVX U I1cF,0274.40M

MaxVX D I1cF,00 MaxVX D I1cF,00

MinI1cF,VX U 205.60M MinI1cF,VX U 205.60

MinI1cF,VX D 205M MinI1cF,VX D 0