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Agenda
What are Hybrid Securities?
Why Hybrid?
Motivating Example: The Underinvestment Problem
Preferred Shares
Warrants
Convertible Securities
The Moral Hazard Problem
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Kyung Hwan Shim, FINS3625S2Yr2018
What are Hybrid Securities?
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.
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Kyung Hwan Shim, FINS3625S2Yr2018
Motivating Example: The Under
Investment Problem
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Motivating Example: The Underinvestment Problem
Is this project worth pursuing? If so, will the equity holders finance
the project?
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Motivating Example: The Underinvestment Problem
Project’s NPV:
200
= −100 + = 90.4762
1.05
But, the equity holders don’t see any benefit from this project.
× %
= −100 + = 42.8571
.
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Kyung Hwan Shim, FINS3625S2Yr2018
Motivating Example: The Underinvestment Problem
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.
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Preferred Stocks
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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
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Warrants
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Warrants
The market value of equity is = − where is the firm’s market
value and is the firm’s debt market value.
+
′=
# +
where
= #
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Yields on Bonds with Warrants
The yield also represents the cost of capital for the issuer.
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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.
( %) $ ,
= $50 × + = $574.3
% ( %)
$1,000 − $574.32
= = $21.28
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Kyung Hwan Shim, FINS3625S2Yr2018
Yield on Bonds with Warrants: Example
= × (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
# ×
.
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Yield on Bonds with Warrants: Example
( ) , ×( . )
0= −1000 + 50 × + +
( ) ( )
⇒ = 6.2%
The 6.2% yield is significantly lower than ABC’s cost of debt capital.
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Convertible Securities
= ×
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Convertible Securities
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
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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,
, ×
≤ ≤ .
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Convertible Securities: Example
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Convertible Securities: Example
$1,000
= = = $16.6666
60
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Convertible Securities: Example
A) Compute the expected diluted share prie for each year after year 10
(1 + ) 5 (1 + .15)
′= = =
2 1.12 1.12
1 + ×
1
.
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Convertible Securities: Example
yield = 7.9%
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Hybrids and The Moral Hazard
Problem
Also called ‘going for broke’; ‘betting with debt holder’s money’; or
the overinvestment problem.
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Payoff Profiles at Time of Debt Maturity
and
Equity’s Payoff = − ,0
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Straight Debt Payoff at Time of Maturity
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Straight Equity Payoff at Time of Maturity
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Payoff Profiles at Time of Debt Maturity
If debt is convertible :
Conversion Value: CV= ×
#
, =
, ,
and
Equity’s Payoff=
− ,0
= [ − , , , 0]
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Convertible Bond Payoff at Time of Maturity
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Equity Payoff at Time of Maturity if Bonds are Convertible
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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.
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.
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Risk Shifting and Hybrid Securities: Example
b) What are the equity and debt values if the projects are to be financed with
straight debt?
Shareholders Shareholders
Safe Project Risky Project
1 1 1 1 1 99
NPV0 4.4M 02.0M NPV0 274.40M 02.4945M
1.1 2 2 1.1 100 100
1 1
pU pU
2 100
I0 I0
1 99
pD pD
2 100
1 1
pU pU
2 100
I5M I5M
1 99
pD pD
2 100
c) What project would the manager choose? Would the debt holders
finance the project?
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Risk Shifting and Hybrid Securities: Example
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
Kyung Hwan Shim, FINS3625S2Yr2018
Risk Shifting and Hybrid Securities: Example
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
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Risk Shifting and Hybrid Securities: Example
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.
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Kyung Hwan Shim, FINS3625S2Yr2018
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.