ISBN: 0-03-028931-9
Chapter 20 Hybrid Financing: Preferred Stock, Leasing, Warrants and Convertibles
In this chapter, we discussed preferred stock, leasing, warrants, and convertibles. The key concepts are listed below:
Preferred stock is a hybrid – it is similar to bonds in some respects and to common stock in other ways. Most preferred stock issues are cumulative, which means that the cumulative total of all unpaid preferred dividends must be paid before dividends can be paid on the common stock. Unpaid preferred dividends are called arrearages.
Preferred stock generally has no voting rights, and is less risky than bonds, from the corporation's standpoint.
The 1980's spawned two innovations in preferred stock financing: (1) floating or adjustable rate, preferred, and (2) money market, or market auction, preferred.
Leasing is a means of obtaining the use of an asset without purchasing that asset. The three most important forms of leasing are (1) sale-and-leaseback arrangements, under which a firm sells an asset to another party and leases it back for a specified period under specific terms; (2) operating leases, under which the lessor both maintains and finances the asset; and (3) financial leases under which the asset is fully amortized over the life of the lease, the lessor does not normally provide maintenance, and the lease is not cancelable.
The decision to lease or to buy an asset is made by comparing the financing costs of the two alternatives and choosing the method with the lower PV cost. All cash flows should be discounted at the after-tax cost of debt, because the relevant cash flows are relatively certain and are on an after-tax basis.
A warrant is a long-term call option issued along with a bond. Warrants are generally detachable from the bond, and they trade separately in the market. When warrants are exercised, the firm receives additional equity capital, and the original bonds remain understanding.
A convertible security is a bond or preferred stock that can be exchanged for common stock at the option of the holder. When a security is converted, debt or preferred stock is replaced with common stock, but no money changes hands.
Warrants and convertibles are "sweeteners" which are used to make the underlying debt or preferred stock issue more attractive to investors. Although the coupon rate on the debt is lower when options are involved, the overall cost of the issue is higher than the cost of straight debt because option-related securities are riskier.
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