Prepared by

Ken Hartviksen

INTRODUCTION TO
CORPORATE FINANCE
Laurence Booth W. Sean Cleary

Chapter 19 Equity and Hybrid
Instruments
CHAPTER 19
Equity and Hybrid
Instruments
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
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 of
shareholders
How preferred shares differ from common shares and the different features
that may be associated with preferred shares
Why combining warrants with debt issues or issuing convertible bonds or
debentures can provide firms with attractive financing options
The wide variety of hybrid financing options available to firms, and how
they are constructed by combining the basic characteristics of debt and
equity to various degrees
CHAPTER 19 Equity and Hybrid Instruments 19 - 5
Important Chapter Terms
Adjustable rate convertible
subordinated securities
Canadian optional interest
notes
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
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

The Nature of Equity Securities
Equity and Hybrid Instruments
CHAPTER 19 Equity and Hybrid Instruments 19 - 8
Equity Securities
Ownership interest in an underlying business, usually a
corporation.
With the 1980 revision of the Canada Business Corporations
Act, the term preferred share was removed from legal
parlance 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 rights
and 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.
CHAPTER 19 Equity and Hybrid Instruments 19 - 9
Preference Versus Common Shares
As previously noted, the term preference share was
stricken from CBCA in 1980.

Nevertheless, the term remains in usage to
describe:
A share class with some preference over the
common share class

However, there can be any number of classes of
shares with different rights and privileges.
CHAPTER 19 Equity and Hybrid Instruments 19 - 10
Preferred Shares
The Common Understanding of a Preferred Share
The term preferred share is now typically used to
describe 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 such
dividends are not a legally enforceable claim)
Has a prior claim to the residual share class to
assets upon dissolution.
Additionally, most preferred shares also offer:
A cumulative feature wherein arrearages in dividends
must be paid before the common share class can
receive dividends
CHAPTER 19 Equity and Hybrid Instruments 19 - 11
Shareholders Equity
Shareholder Rights
When a corporation has only one share class, the
rights 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 corporation
upon dissolution.
Provincially incorporated firms operate under similar
provisions.
CHAPTER 19 Equity and Hybrid Instruments 19 - 12
Shareholders Equity
Voting Rights
At an annual general shareholders meeting (AGM) the
standing 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 special
meeting of shareholders may be called (or typically, the AGM
will 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 of
another firm, etc.
CHAPTER 19 Equity and Hybrid Instruments 19 - 13
Shareholders Equity
Preemptive Right
The preemptive right is the right of shareholders to maintain
proportional ownership in a company when new shares are
issued.
When companies raise new capital under these conditions,
they do so through a rights offering which gives the current
shareholders the first right of refusal on the issue of any new
shares.
The preemptive right, if it exists, usually is contained in the
articles of incorporation and is one of the rights of the share
classes that the firm has.
Removal of the preemptive right from the articles of
incorporation requires approval by the shareholders at a
special meeting of shareholders.
CHAPTER 19 Equity and Hybrid Instruments 19 - 14
Shareholders Equity
Residual Rights
The right to receive a dividend, if declared by the
board of directors, and
The right to receive a pro rata share of any
remaining property upon dissolution of the
corporation after all other claims have been
satisfied.
CHAPTER 19 Equity and Hybrid Instruments 19 - 15
Shareholders Equity
Limited Legal Liability
Implicitly investors in shares in corporations have limited legal
liability.
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 all
assets are liquidated) shareholders are not liable, and cannot be asked
to inject more funds into the firm, or to pay out of their own pockets for
damages.*
Limited legal liability ensures limited downside risk for shareholders
while at the same time, they enjoy unlimited upside potential for
growth in their investment (similar to call options discussed in
Chapter 12)

*NOTE: Even though shareholders have limited legal liability, this is not
true for members of the board of directors or the management team if
they are found responsible (liable) for damages or illegal acts through
decisions and/or errors of omission or commission.
CHAPTER 19 Equity and Hybrid Instruments 19 - 16
Shareholders Equity
Different Classes of Shares
The articles of incorporation spell out the number of share
classes and the rights of each share class.
The CBCA says that the three rights of shareholders do not
have to reside in one share class if there are multiple share
classes each right can be assigned to a different share
class, or shared between share classes.
Under the CBCA the firm will not use the terms common
preferred non-voting instead they will designate different
share classes with different rights:
A Class
B Class
C Class
CHAPTER 19 Equity and Hybrid Instruments 19 - 17
Shareholders Equity
Different 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 common
share class
Latent voting rights in the case of arrearage
Preference to assets upon dissolution over the common share
class.

CHAPTER 19 Equity and Hybrid Instruments 19 - 18
Shareholders Equity
Some Basic Ratios
Your text demonstrates the application of ratios to
the shareholders equity figures for Rothmans Inc.
Table 19 1 presents the equity figures for fiscal
years 2004, 2005, and 2006:
CHAPTER 19 Equity and Hybrid Instruments 19 - 19
Some Basic Ratios
Book 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 168.497 193.708 113.860
Total 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
= =
=
shares of Number
Equity Common
BVPS
CHAPTER 19 Equity and Hybrid Instruments 19 - 20
Some Basic Ratios
Market 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 168.497 193.708 113.860
Total 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
P
B M
= =
=
A stock trading at 12 times
its book value indicates
that the stock is highly
regarding in financial
markets (usually because
of strong profits and growth
potential.)
CHAPTER 19 Equity and Hybrid Instruments 19 - 21
Some Basic Ratios
Dividend 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 168.497 193.708 113.860
Total 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
13.3%
25 . 20 $
70 . 2 $
dividend) special (with = = =
P
DPS
Yield Dividend
In Table 22 2 dividend yields
vary from 0% to a high of
7.22% for Yellow Pages
Income Fund.
Clearly Rothmans is on the
high end of this metric.
What makes this so surprising
is that we already know the
stock price is trading at a
significant multiple above
Book Value.
CHAPTER 19 Equity and Hybrid Instruments 19 - 22
Shareholders Equity
Dividends and Taxes
Dividends are attractive from an income taxation
point of view in Canada:
Dividends received by one corporation from another
corporation are not subject to tax at the corporate
level
Dividend income received by Canadians is subject to
the gross-up / dividend tax credit system that results
in very low rates of taxes on individuals with low to
moderate marginal tax rates (see the following slide)
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: <www.ey.com>.
Table 3-6 Ontario Taxable Income
Marginal Rate on
The dividend
gross-up, tax credit
system makes
dividend income
the lowest taxed
investment income
in the lower tax
brackets.

Dividends are
taxed at a lower
rate than interest
in all tax brackets.
Preferred Shares
Equity and Hybrid Instruments
CHAPTER 19 Equity and Hybrid Instruments 19 - 25
Preferred Share Characteristics
Table 19 2 (on the following slide) reports on
yields on three different types of preferred shares in
Canada as at November, 2005:
Straight preferreds
Retractable preferreds
Floating rate preferreds
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 f rom Nesbitt Burns, Preferred Share Statistics , December 2005.
Table 19-2 Preferred Share Yields, November 2005
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 with
current market interest rates.
In some cases the dividend is connected to the prime lending
rate and changes as the prime rate changes.
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 (preferred
dividends are not)
Bondholders have a secured claim against assets of the
corporation in the event of dissolutionpreferred
shareholders 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 lower
tax rate on dividends than on interest income.
CHAPTER 19 Equity and Hybrid Instruments 19 - 29
Preferred Shares
The Cumulative Provision
A stipulation that no dividends can be paid on
common shares until preferred share dividends,
both current and arrears, are paid in full.
This feature is the reason boards of directors take
the payment of preferred dividends very seriously.
CHAPTER 19 Equity and Hybrid Instruments 19 - 30
Preferred Shares as a Hybrid Instrument
Although preferred shares are equity securities because they are
often seen as a higher yield (and risk) substitute for fixed income
securities.

They are often seen as a hybrid instrument because, while they are
equity from a residual claim point of view, and therefore have
significantly higher default risk, they do promise to offer a steady
stream of dividends (similar to a debt instrument, but treated
preferentially from a taxation perspective)

The higher the quality of the issuer, the more like debt preferred
stock is because of the lower likelihood of default and the greater
the likelihood of an uninterrupted stream of dividends in a high
quality issuer.
CHAPTER 19 Equity and Hybrid Instruments 19 - 31
Preferred Share Dividends
While the preferred dividend is not a legally-
enforceable financial obligations, issuers take the
payment of those dividends very seriously for a
number of reasons:
Failure to pay could jeopardize the firms future ability
to issue securities in the financial markets because of
a damaged reputation
Normally arrears in dividends need to be addressed
before the common share class can receive
dividends, and as arrearages grow, increasingly the
common shareholders will get concerned and voice
those concerns at the AGM.
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 - AA
2. 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
Income Trusts
Equity and Hybrid Instruments
CHAPTER 19 Equity and Hybrid Instruments 19 - 34
Income Trusts
Strong 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 before
tax).
Represents a popular form of equity financing representing
more 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 billion
representing 10% of the quoted market value of the TSX


CHAPTER 19 Equity and Hybrid Instruments 19 - 35
Income Trusts
The Ministers Announced Change in Tax Treatment
Finance Minister Jim Flaherty made an unexpected
announcement 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 2006
federal election.
Existing income trusts (prior to November 1, 2006) will
continue to enjoy the tax benefits of that structure until 2011.
Newly created income trusts will be taxed like normal
corporations.
In the first few days following the announcement almost $30
billion in market capitalization was lost as income trust unit
values fell dramatically.

Warrants
Equity and Hybrid Instruments
CHAPTER 19 Equity and Hybrid Instruments 19 - 37
Warrants
A long-term option to purchase new shares in a corporation at a
specified price.
The corporate finance equivalent of call options that are used to
raise 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 normally
greater 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 the
holder to exercise them to buy new shares in the company, and
thereby 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)
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
Date
Agnico-
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,
2007
Ascendant
Copper
Corp
0.500 ACX.WT TSX 2.500 0.150 0.150 -2.000 0.150 4.3
Nov.21,
2010
Aumega
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 Mining
Corp
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
CHAPTER 19 Equity and Hybrid Instruments 19 - 39
Warrants versus Options
Warrants

Issued by the firm to investors
Issued to raise new capital for the
firm (capital formation purpose)
Traded in the secondary market
between investors
Long-term or perpetual option
At the time of issue the exercise
price is typically greater than the
current stock price (so the warrant
does not have an intrinsic value
immediately)
Exchange-traded Call Options

Created by investors interacting
with the options exchange as the
counterparty
No capital formation, instead used
as an instrument of hedging or
speculating
Short-term option
May be created out-of-the-money,
at-the-money, or in-the-money.

CHAPTER 19 Equity and Hybrid Instruments 19 - 40
Warrant Valuation
Using payoff diagrams normally associated with call
options we can describe visually how warrants are
valued.



(See the diagram on the following slide)
CHAPTER 19 Equity and Hybrid Instruments 19 - 41
Warrants
The Value of a Warrant


$50
exercise
price
Warrant
Value






0
Stock Price
At the time of issue
the warrant will
have a speculative
(time) value only
because the market
value of the stock is
less than the
exercise price.
Over time the stock price
may increase and when it
exceeds the exercise price
of the warrant, the
warrant value will have
both intrinsic value and
speculative (time) value.
CHAPTER 19 Equity and Hybrid Instruments 19 - 42
Payoff to Warrant Holders
Using a Variant of the Standard Options Pricing Model



Where:
n =existing number of shares
m = number of shares issued on exercise of the warrants
X = exercise price of the warrant
V = 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 the
warrants (mX), for a total value of V + mX. (The weighted average of the former stock price
and the warrant exercise price)

The percentage owned by the warrant holders is m/(n+m), whereas the cost to them is
exercise value of mX.

mX)-mX (V
m n
m
holders warrant to Payoff +
+
= [ 19-1]
CHAPTER 19 Equity and Hybrid Instruments 19 - 43
Payoff to Warrant Holders
Equation 19 1 reduces to 19 2 when we multiply the exercise value
mX by (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 the
value of the secondary market call (whether you use the Black-
Scholes or binomial option pricing model)

nX) (V
m n
m
holders warrant to Payoff
+
= [ 19-2]
CHAPTER 19 Equity and Hybrid Instruments 19 - 44
Warrants
As long-term options warrants trade at significant premiums
over 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 a
package together with debt or preferred stock.
If warrants are NOT detachable, issuing bonds plus a warrant
is similar to issuing convertible bonds (the holder holds a
traditional bond, but an option to purchase equity and thereby
participate in the growth of the firm)
Convertible Securities
Equity and Hybrid Instruments
CHAPTER 19 Equity and Hybrid Instruments 19 - 46
Convertible Bonds
Bonds that are convertible into a specified number of common
shares at the option of the convertible holder.
When converted, the bonds are exchanged for common
shares (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 encourage
investors to invest in the convertible and so convertibles tend
to 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.)
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
Energy
AVN.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
Nihon
AN.DB 6.20% 30-Jun-2014 100.80 93.92 6.07% 7.08% 7.33 13.65 AN.UN 12.85
Source: Data f rom Financial Post , August 29, 2006.
Table 19-4 Convertible Bond Listings
CHAPTER 19 Equity and Hybrid Instruments 19 - 48
Conversion Price
The conversion price (CP) is the price at which a
convertible security can be converted into common
shares based on its conversion ratio.





The conversion ratio (CR) is the number of shares that a
convertible security could be exchanged for.


CR
Par
CP =
[ 19-3]
CHAPTER 19 Equity and Hybrid Instruments 19 - 49
Conversion Value (CV)
The Conversion Value (CV) is the value of a convertible
security 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 not
advantageous to the convertible holder.

P CR CV =
[ 19-4]
CHAPTER 19 Equity and Hybrid Instruments 19 - 50
Convertible Premium
The convertible premium is the percentage the
share must increase in order for conversion to make
sense:

Premium e Convertibl
CV
CV P
= [ 19-5]
CHAPTER 19 Equity and Hybrid Instruments 19 - 51
Straight Bond Value (SBV)
Convertible bonds are bonds that have an inherent value in
themselves.
The conversion feature of the bond is considered an option, in
addition to the basic bond value.


) 1 (
1 ) 1 (
1
1
SBV
n
b b
n
b
k
F
k
k
I
+
+
(
(
(
(

+
=
[ 19-6]
CHAPTER 19 Equity and Hybrid Instruments 19 - 52
Floor Value (FV)
The Floor Value (FV) is the lowest price a convertible bond will sell
for, which is equal to the larger of its straight bond value and its
conversion value.





Every convertible will always have a floor value (FV) because it will
always sell for no less than the larger of the straight bond value and
its conversion value.

In practice, convertibles usually sell a higher prices because of the
time value of the conversion option.

) , ( CV SBV Max FV =
[ 19-7]
CHAPTER 19 Equity and Hybrid Instruments 19 - 53
Convertible Bond Valuation
A Graphic Illustration of the Valuation Relationships
Convertible
Bond Value
















0
SBV
Actual
Convertible
value
Conversion
price
Stock Price
Floor
Value
CHAPTER 19 Equity and Hybrid Instruments 19 - 54
Convertible Financing
Convertible financing helps firms obtain capital at a lower
coupon rate at the time of issue.
This is because the buyer is receiving an equity call option
equal to the time premium.
In the event the value of the stock remains below parity, the
firm 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 than
what 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 until
conversion/maturity/call.

(See Figure 19 1 for a graphic depiction of the ACE Holdings situation)
CHAPTER 19 Equity and Hybrid Instruments 19 - 55
Convertible Scenarios
19-1 FIGURE
















ACE Share price
$35
P>$44.88
Conversion:
Cheap Equity
No Conversion:
Cheap Debt
P<$44.88
This what-if scenario indicates that convertibles are rarely the right decision,
but they are never the wrong decision because the firm gets either cheap debt
or cheap equity financing.
Other Hybrid Securities
Equity and Hybrid Instruments
CHAPTER 19 Equity and Hybrid Instruments 19 - 57
Other Hybrids
Warrants, convertible bonds and convertible
preferred shares are the most common hybrid
securities.
Financial innovation takes place in order for
companies to issue securities that meet the needs
of investors in the marketplace.
In this manner, firms that might not be able to raise
capital with traditional financing means are able to
do so, OR, they are able to raise capital in a form
that better suits their cash flow preferences.
CHAPTER 19 Equity and Hybrid Instruments 19 - 58
Other Hybrids
Categorizing Hybrids
DBRS uses four factors help to determine whether a hybrid
instrument is more like debt or more like equity:
1. Permanence factor
Common stock is perpetual, where as CP is very short-term
2. Subordination factor
Place on the prior of claims against income and assets
3. Legal factor
Whether the claim on income is legally enforceable or not
4. Subjective factor
The purpose of the company when it issues the securities.

Following a description of other hybrids we will present a
hierarchy of securities.
CHAPTER 19 Equity and Hybrid Instruments 19 - 59
Other Hybrids
Creative Hybrids: Some Examples
Income bonds
Cash flow bonds
Commodity bonds
Original issue discount bonds (OIDs) or low-yield
notes
Liquid Yield Option Notes (LYONs)
Adjustable Rate Convertible Subordinated Securities
(ARCS)
Preferred securities
Canadian optional interest notes (COINS)
CHAPTER 19 Equity and Hybrid Instruments 19 - 60
Other Hybrids
Creative Hybrids: Income Bonds
Income bonds
Bonds issued after a reorganization with the interest
tied to some cash flow level for the firm and with quite
long maturity dates
Payments are not tax deductible in Canada and as
classified 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 forward
provisions under the Income Tax Act)

CHAPTER 19 Equity and Hybrid Instruments 19 - 61
Other Hybrids
Creative Hybrids: Cash Flow Bonds
Cash flow bonds
Bonds sold in the United States that have the same
objects as do income bonds in Canada.
Maturity dates are long
Interest payments are conditional on the firm meeting
certain thresholds

CHAPTER 19 Equity and Hybrid Instruments 19 - 62
Other Hybrids
Creative Hybrids: Commodity Bonds
Commodity bonds
A bond whose interest or principal is tied to the price
of an underlying commodity such as gold.

CHAPTER 19 Equity and Hybrid Instruments 19 - 63
Other Hybrids
Creative 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 is
held in a taxable account (often, though investors place these
types of investments in tax-deferred (registered plans)
investment accounts and thereby dont have to pay interest until
the 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 the
bonds will equal the ex ante forecast if there is no default on the
issue)

(Table 19 5 illustrates the OID bond interest compared to a normal bond)
CHAPTER 19 Equity and Hybrid Instruments 19 - 64
Creative Hybrids
Principal "Interest"
2 $4.24 $46.65 $4.24
3 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 8.26
10 46.65 100.00 9.09
Table 19-5 OID versus Regular Bond Payments
OID Bond
Regular Bond
CHAPTER 19 Equity and Hybrid Instruments 19 - 65
Other Hybrids
Creative Hybrids: Liquid Yield Option Notes
Liquid Yield Option Notes (LYONs)
Low-yield notes that are combined with a convertible
feature and are accretive convertibles, because the
principal accretes or increases over time.

CHAPTER 19 Equity and Hybrid Instruments 19 - 66
Other Hybrids
Creative Hybrids: Adjustable Rate Convertible Subordinated Securities

Adjustable Rate Convertible Subordinated Securities
(ARCS)
Securities that have fixed principal and maturity, and
interest that normally comprises a fixed interest rate
and some function of the dividend paid in the previous
six months
Typically convertible into common shares
CHAPTER 19 Equity and Hybrid Instruments 19 - 67
Other Hybrids
Creative Hybrids: Preferred Securities
Preferred securities
Not preferred shares
Securities generated by a company by creating a 100
percent owned subsidiary that issues the shares then
loans the proceeds to the parent company, for whom
the interest is tax deductible;
Interest flows to the subsidiary, where it is not taxed,
and is used to make dividend payments.
CHAPTER 19 Equity and Hybrid Instruments 19 - 68
Other Hybrids
Creative 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 the
interest from years 11 to 99 on issue, leaving it with a
net inflow and allowing it to continue to deduct annual
interest payments of $100, even though it has
effectively borrowed less.
CHAPTER 19 Equity and Hybrid Instruments 19 - 69
A Financing Hierarchy
Table 19 6 shows a synopsis of the main securities
discussed in this chapter and shows using a rating system
how 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 risk
to the investor, and the required return investors demand (this
translates into the returns the firm must offer in order to
access that type of capital)

(See the following two slides)
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 preferred shares

-10
Normal convertible debt -50
Accreting convertible bonds (LYONS) -60
Very long term bonds -70
Medium term bonds -80
Auction preferred shares -90
Commercial paper -100
* Pref erred shares f or which conversion into common shares is structured to be automatic.

Pref erred shares that af ter f ive to seven years, are repriced and resold.
Table 19-6 S&P Financing Rankings
CHAPTER 19 Equity and Hybrid Instruments 19 - 71
Other Hybrids
Financing Hierarchy Costs




















19-2 FIGURE
Mortgage
Debt
Straight
Preferred
Shares
Common
Equity
Convertible
Bonds
Convertible
Preferred
Shares
Long-term
Unsecured Debt
Cost






CP
Risk
MTNs
Bank
Loans
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 and
other commitments that is required in order to attract these other, more
risky sources of financing.
Commercial Paper and Bankers Acceptances place the greatest
financial 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 of
interest expense.
Between these two extremes, hybrid financial instruments combine the
characteristics of both debt and equity.
Concept Review Questions
Equity and Hybrid Instruments
CHAPTER 19 Equity and Hybrid Instruments 19 - 74
Concept Review Question 1
Rights Associated with Equity Securities
What are the basic rights associated with equity
securities? How do these differ across different
categories of classes of equities?

CHAPTER 19 Equity and Hybrid Instruments 19 - 75
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