Chapter 25
HYBRID FINANCING
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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
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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
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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.
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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 Upper limit on
warrant warrant value
Value of the
warrant
Lower limit on
warrant value
Stock price
Exercise price
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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
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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
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APPLYING THE BALCK-SCHOLES MODEL
Step 1: Calculate d1 and d2
So 2
ln + r+ t
E 2
d1 =
t
60 0.16
ln + 0.08 + 0.25
50 2
d1 =
0.25
0.1823 + 0.04
= = 1.1115
0.20
d2 = d1 – σ t
= 1.1115 – Centre
0.20 for
= Financial
0.9115Management , Bangalore
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
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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.
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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)
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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:
Max Share – Exercise , 0
price price
V + pNE
Max – E, 0
N(1 + p)
V/N – E
Max ,0
(1 + p)
= 1 Max V – E, 0
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.
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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
Centre for Financial rate of return
Management , Bangalore on the equity
VALUATION OF OPTIONALLY
CONVERTIBLE DEBENTURES
Straight
debt value Conversion
value
Firm value Firm value
(a) Straight debt value (b) Conversion value
Value of
Convertible
debentures
Firm value
(c) Value of convertible debentures
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
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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.
Type Example
• Hybrids to manage • Oil-indexed bond
commodity risk
• Hybrids to manage forex • Dual currency bond
risk
• Hybrids to manage interest • Inverse floating rate note
rate risk
• Hybrids to reduce conflicts • Floating rate, rating
between bondholders and sensitive
stockholders note
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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
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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.
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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.
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