3. Chapter Hybrid Capital

• Hybrid - similar to bonds in some respects and to common stock in other ways.

• Accountants classify perpetual preferred stock as equity

• the typically pay out a fixed dividend

• preffered stock holders have a higher standing in case of liquidation

• Have no reduced voting rights

—> it providing investors with a steady income stream and a higher priority claim in case of liquidation

• Preferred stockholders’ claims are subordinated to those of bondholders in the event of liquidation

• bondholders are more likely to continue receiving income during hard times than are preferred stockholders.

• Investors require a higher after-tax rate of return on a given firm’s preferred stock than on its bonds.

• The obligation to pay preferred dividends is not contractual

• passing a preferred dividend cannot force a firm into bankruptcy.

• By issuing preferred stock, the firm avoids the dilution of common equity that occurs when common stock is sold.

• reduced repayments of principals that would occure while going for debt

• Preferred stock dividends are not deductible to the issuer,

• the after-tax cost of preferred stocks is higher than the after-tax cost of debt.

• Although preferred dividends can be passed, investors expect them to be paid,

• , preferred dividends are like debt, which increases financial risk and thus the cost of common equity.

• A security, usually a bond or preferred stock, that is exchangeable into common stock of the issuing firm.

• Like a warrant’s exercise price, the conversion price is typically set at from 20 to 30 percent above the prevailing market price

  
  

• Conversion Ratio, CR, is the number of shares of common stock that are obtained by converting a convertible bond or share of convertible preferred stock.

Conversion Price, Pc is the effective price paid for common stock obtained by converting a convertible security.

• Generally, the conversion price and conversion ratio are fixed for the life of the bond,

• although sometimes a stepped-up conversion price is used.

• A change may also result from a clause protecting the convertible against dilution from stock splits,

• stock dividends, and the sale of common stock below the conversion price.

• Convertibles, like bonds with warrants, offer a company the chance to sell debt with a low interest rate

• chance to participate in the company’s success if it does well.

• the advantage of this low-cost debt will be lost when conversion occurs.

• In a sense, convertibles provide a way to sell common stock at prices higher than those currently prevailing. —> Speculation in rising Stocks

  • ((But if the stock greatly increases in price, the firm would probably find that it would have been better off, if it had used straight debt in spite of its higher cost and then later sold common stock and refunded the debt.))

• If the company truly wants to raise equity capital, and if the price of the stock does not rise sufficiently after the bond is issued, then the company will be stuck with debt.

• A potential conflict of interest between bondholders and stockholders lies in an “option-related” incentive to take on projects with high upside potential and high risk. However, when convertible debt is issued some of the gains to shareholders have to be shared with convertible bondholders which reduces conflicts of interest.

• A warrant (Optionsschein) is a certificate issued by a company that gives the holder the right to buy a stated number of shares of the company’s stock

• at a specified price for some specified length of time.

• Generally, warrants are distributed with debt, and they are used to induce investors to buy long-term debt with a lower coupon rate than would otherwise be required.

• When call options are exercised, the stock provided to the option holder comes from the secondary market,

• when warrants are exercised, the stock provided to the warrant holders are newly issued shares.

• the exercise of warrants dilutes the value of the original equity,

• Therefore, investment bankers cannot use the Black-Scholes model to determine the value of warrants.

• A second difference involves flexibility.

• Most convertible issues contain a call provision that allows the issuer either to refund the debt or to force conversion

• However, most warrants are not callable, so firms generally must wait until maturity for the warrants to generate new equity capital.

• Generally, maturities also differ between warrants and convertibles.

• Warrants typically have much shorter maturities than convertibles

• warrants typically expire before their accompanying debt matures.

• With convertibles, all of the debt is converted to common stock,

• whereas debt remains outstanding when warrants are exercised.

• We can suggest that debt-plus-warrant issuers are actually more interested in selling debt than in selling equity

• In general, firms that issue debt with warrants are smaller and riskier than those that issue convertibles.

• One possible rationale is the difficulty investors have assessing the risk of small companies.

• Mezzanine financing is a hybrid of debt and equity financing

• gives the lender the rights to convert to an ownership or equity interest in the company in case of default.

• It usually is completed with little due diligence on the part of the lender

• little or no collateral on the part of the borrower

• treated like equity on a company's balance sheet.

• A typical interest rate for mezzanine financing is 12 to 20%, making it a high-risk, potentially high-return debt form.

• Mezzanine financing typically replaces part of the capital that equity investors would otherwise have to provide a company.

• Mezzanine financing may result in lenders gaining equity in a business

• or warrants for purchasing equity at a later date.

• This may significantly increase an investor's rate of return.

• In addition, mezzanine financing providers receive contractually obligated interest payments.

• Borrowers prefer mezzanine debt because the interest is tax-deductible.

• It is more manageable than other debt structures because some or all of the interest may be deferred.

• However, owners sacrifice control and upside potential and also pay more in interest the longer mezzanine financing is in effect.

• Leasing is a form of asset based lending,

• substitute for medium to long term credit.

• The owner of an asset provides the right to use of the asset for a specified period in exchange for payments

• The lessors retain ownership of the assets they lease

• Leasing separates the legal ownership of an asset from its economic use.

• Ownership of the asset may or may not pass to the customer at the end of the lease contract.

• In “finance leases”, typically substantially all the risks and rewards of ownership of the asset are transferred to the lessee (while the lessor remains owner)

• “Operating leases” essentially are rental contracts for the temporary use of an asset by the lessee.

• Typically, the risks associated with the ownership of the asset (e.g. maintenance and insurance responsibilities) remain with the lessor

• “Hire purchase” involves the transfer of ownership of the asset at the end of the contract,

• automatically or through the exercise of a purchase option.

• These types of hire purchase contracts are therefore leases (i.e. in the UK, Germany, Poland and the Netherlands).

• Leasing is a very important source of financing for SMEs.

• The overall leasing market (new lease totals, all enterprise sizes) showed a continuous increase in recent years.

• Factoring is a financial transaction and a type of debtor finance in which a business sells its accounts receivable to a third party (called a factor) at a discount.

• It is commonly referred to as accounts receivable factoring, invoice factoring, and sometimes accounts receivable financing.

• From a user’s perspective the main advantages of factoring is that users do not need to have other assets or be in business for a long time to access credit.

• The relative ease of attracting funding from factors and the “lightness” of their contracts has attracted more users in the aftermath of the financial crisis

• Factoring allows for a partial diversification of a company´s funding sources.

• The factoring facility naturally grows with sales

• it is revolving and renewable without renegotiations.

• The factor can also provide ledger management, collection services and credit advice (and insurance, if required)

• The vast majority of global users of factoring are small and medium sized enterprises

• SMEs usually display diverse customer bases.

• Since the factor advances funds against the security of debts from them and not the SME itself, factoring therefore takes advantage of a better distributed spread of risk than loans.

• In case of default, recovery is made from the debtors, not the SME, so the factor is well placed to advance (and recover) securely.

• Factoring includes a value added service beyond the provision of funding.

• It therefore attracts a premium price over traditional lending and consequently has higher potential returns on equity and assets.