Hybrid Financing

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Chapter 25 HYBRID FINANCING  Centre for Financial Management , Bangalore

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OUTLINE Preference Capital Features of Warrants and Convertible Debentures Valuation of Warrants Valuation of Compulsorily Convertible Debentures Valuation of Optionally Convertible Debentures Motives for Issuing Warrants and Convertible Debentures Innovative Hybrids  Centre for Financial Management , Bangalore

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PREFERENCE CAPITAL The features attached to preference shares may vary along the following dimensions: Cumulation of dividends Callability Convertibility Redeemability Participation in surplus profits and assets Voting rights  Centre for Financial Management , Bangalore

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FEATURES OF WARRANTS AND CONVERTIBLE DEBENTURES A warrant gives its holder the right, but not the obligation, to subscribe to a certain number of equity shares at a stated price during specified period. A convertible debenture is a debenture that is convertible, partially or fully, into equity shares. The conversion may be compulsory or optional. In a convertible debenture, the debenture and the option are inseparable. A warrant, however, is detachable.  Centre for Financial Management , Bangalore

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VALUATION OF WARRANTS Since a warrant is like a call option on the equity stock of the issuing company, the principles of option valuation can be applied to warrants. Value of warrant Upper limit on warrant value Value of the warrant Lower limit on warrant value Stock price Exercise price  Centre for Financial Management , Bangalore

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VALUATION OF WARRANTS The distance between the actual price of the warrant and its lower limit is a function of the following factors: Variance of the stock returns Time to expiration Risk-free interest rate Stock price Exercise price  Centre for Financial Management , Bangalore

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APPLYING THE BLACK-SCHOLES MODEL Ignoring the complications arising from dividends and /or dilution, the value of a warrant may be calculated using the procedure described in Chapter 10. To illustrate the calculation, consider the following data: Number of shares outstanding = N = 20 million Current stock price = S = Rs 60 Ratio of warrants issued to the number of outstanding shares = p = 0.05 Total number of warrants issued = pN = 0.05 x 20 million = 1 million Exercise price =E = Rs 50 Time to expiration of warrants = 3 months Annual standard deviation of stock price changes = σ = 0.40 Risk – free interest rate = 8 percent  Centre for Financial Management , Bangalore

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APPLYING THE BALCK-SCHOLES MODEL Step 1: Calculate d1 and d2 So s 2 ln + r + t E 2 d1 = s  t 60 0.16 ln + 0.08 + 0.25 50 2 d1 = 0.40  0.25 0.1823 + 0.04 = = 1.1115 0.20 d2 = d1 – σ  t = 1.1115 – 0.20 = 0.9115  Centre for Financial Management , Bangalore

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Step 2: Find N(d1) and N (d2). N (d1) and N (d2) represent the probabilities that a random variable that has a standardised normal distribution will assume values less than d1 and d2 N (d1) = N (1.1115) = 0.8668 N (d2) = N (0.9115) = 0.8190 Step 3: Estimate the present value of the exercise price, using the continuous discounting principle E Rs.50 Rs.50 = = = Rs.49.01 ert e 0.08 x 0.25 1.0202 Step 4: Plug the numbers obtained above in the Black-Scholes formula. E C0 = S0N(d1) – N (d2) ert = 60 x 0.8668 – 49.01 x 0.8190 = Rs 11.87  Centre for Financial Management , Bangalore

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EFFECTS OF DILUTION A traded call is a side bet between investors. Hence when an investor exercises a traded call, there is no effect whatsover on the firm. However, when a warrant is exercised the number of outstanding shares goes up and the value of the firm increases by the exercise money. Hence, in valuing warrants, the dilution has to be taken into account.  Centre for Financial Management , Bangalore

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EFFECTS OF DILUTION Let V = value of equity before the exercise of warrants N = number of outstanding shares P = ratio of warrants issued to the number of outstanding shares E = exercise price If the warrants are exercised, the equity value will rise to V + pNE and the number of shares will increase to N + pN. Hence, the share price after the warrants are exercised will be: V + pNE N ( 1 +p)  Centre for Financial Management , Bangalore

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EFFECTS OF DILUTION On maturity, the warrant holder can exercise the warrant or let it lapse. So, the value of warrant, on maturity, will be:   Share – Exercise , 0 price price   V + pNE N(1 + p) V/N – E (1 + p) 1 V 1 + p N Thus, the value of warrant is equal to 1/(1 + p) times the value of call option on the stock of a firm that has the same current value of equity but has no outstanding warrants. Max Max – E, 0 Max , 0 Max – E, 0 =  Centre for Financial Management , Bangalore

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VALUATION OF COMPULSORILY CONVERTIBLE (PARTLY OR FULLY) DEBENTURES n It aPi n Fi V0 =  + +  t = 1 (1+ kd)t (1+ ks)i j=m (1+ kd) j where V0 = value of the convertible debenture at the time of issue It = interest receivable at the end of period t n = life of the debenture a = number of equity shares receivable when part-conversion or full occurs at the end of period i Pi = expected price per equity share at the end of period i Fj = instalment of principal repayment at the end of period j kd = investors’ required rate of return on the debt component ks = investors’ required rate of return on the equity component  Centre for Financial Management , Bangalore

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VALUATION OF OPTIONALLY CONVERTIBLE DEBENTURES Straight debt value Conversion value Firm value Firm value Firm value (a) Straight debt value (b) Conversion value Value of Convertible debentures (c) Value of convertible debentures

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MOTIVES FOR ISSUING WARRANTS AND CONVERTIBLE DEBENTURES Conventional Explanations Cheaper debt Equity at a premium Modern Finance Explanations Cash flow matching Financial synergy Agency costs  Centre for Financial Management , Bangalore

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INNOVATIVE HYBRIDS The payoffs of innovative hybrids are linked to some general economic variable like the interest rate, exchange rate, commodity price, stock market index, and so on.  Centre for Financial Management , Bangalore

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EVALUATION OF HYBRIDS Two primary economic reasons for the popularity of hybrids Make market more complete Provide a tax or regulatory advantage Critics : Hybrids represent a supply driven fad foisted by mercenary investment bankers Votaries : Hybrids represent useful capital market innovations which succeed only if they do a better job than the existing instruments  Centre for Financial Management , Bangalore

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SUMMING UP The important forms of hybrid financing are preference capital, warrants, convertible debentures, and innovative hybrids Preference shares may vary in terms of cumulation of dividends A warrant gives its holder the right, but not the obligation to subscribe to a certain number of equity shares at a stated price during a specified period. A convertible debenture is a debenture that is convertible, partially or fully, into equity shares.  Centre for Financial Management , Bangalore

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A warrant can be valued like a call option. The value of an optionally convertible debenture is a function of three factors: straight debenture value, conversion value, and option value. According to modern finance, convertible debentures improve cash flow matching, generate financial synergy, and mitigate agency problems. An innovative hybrid is a hybrid security whose payoff is linked to some general economic variable like the interest rate, exchange rate, or commodity index.  Centre for Financial Management , Bangalore

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