Laurence Booth Sean Cleary. LEARNING OBJECTIVES Equity and Hybrid Instruments 1919 19.1 Explain the...

Laurence Booth

Sean Cleary

LEARNING OBJECTIVESLEARNING OBJECTIVES

Equity and Hybrid Instruments1919.1 Explain the basic rights associated with share ownership.19.2 Identify and describe the various classes of shares and the

shareholders’ rights associated with each.19.3 Explain how preferred shares differ from common shares and

outline the various features associated with preferred shares.19.4 Explain how combining warrants with debt issues or issuing

convertible bonds or debentures can provide firms with attractive financing options.

19.5 Identify and describe the various hybrid financing options available to firms, and explain how they are constructed.

19.1 SHAREHOLDERS’ EQUITY• Equity securities represent an ownership interest in an underlying

business, usually a corporation• We often call common shares those shares with both voting and

residual rights to earnings and assets, but all of those rights do not technically have to vest in a single share class

• The 1980 revision of the Canada Business Corporations Act (CBCA) removed “preferred share” from Canadian legal terminology

• “Par value” was also removed in 1975• The 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– One share class with residual rights to assets upon dissolution

3© John Wiley & Sons Canada, Ltd.Booth • Cleary – 3rd Edition

© John Wiley & Sons Canada, Ltd.

Shareholder Rights• When a corporation has only one share class, the rights are

equal in all respects and include:– To vote at any meeting of the shareholders of the

corporation– To receive any dividend declared by the corporation– To receive the corporations’ remaining property upon

dissolution• Firms incorporated under provincial legislation instead of the

CBCA operate under similar provisions.

Booth • Cleary – 3rd Edition 4

19.1 SHAREHOLDERS’ EQUITY


Shareholder Rights• At an annual general meeting (AGM) the standing agenda

includes a shareholders vote to:– Elect members of the board of directors– Appoint the firm’s external auditors– Receive the audited financial statements

• If major changes are proposed, a special shareholders’ meeting may be called and the shareholders may be asked to vote on the proposals. The proposals could include: changes to the articles of incorporation, bylaws, operations, financial structure, acquisition of another firm, etc.




Shareholder Rights• The Pre-emptive Right– The pre-emptive 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

– If pre-emptive right exists, it is usually contained in the articles of incorporation

– Removal of the pre-emptive right from the articles of incorporation requires approval by the shareholders at a special meeting




Shareholder Rights• Residual Rights– Residual rights are the rights 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 corporati0n after all other claims have been satisfied




Shareholder Rights• Investors in the shares of 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• If the firm’s activities exhaust its financial resources (i.e., not even

the liquidation of the firm can pay off its liabilities), then shareholders are not liable for the unpaid amount and cannot be asked to inject more funds into the firm

• Limited legal liability ensures limited “downside” risk for shareholders while, at the same time, they enjoy unlimited “upside” potential for growth in their investment

• Members of the Board of Directors and the management team, however, can be found liable for damages or illegal acts through decisions and/or errors of omission or commission even if they are shareholders




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 classes

• Under the CBCA, the firm will not use the terms “common,” “preferred,” or “non-voting,” but instead will designate different share classes with different rights.– Example: Class A, Class B, Class C




Different Classes of Shares• Non-voting or restricted shares participate in dividends with

the common share class and usually do not have voting rights• Common shareholders have full voting rights, receive

dividends and are the residual share class after other creditors and share classes

• Preferred shareholders receive a stated dividend with a preference to dividends over the common share class, have latent voting rights in the case of arrearage, and have preference to assets upon dissolution over the common share class




• Table 19-2 presents shareholders’ equity for Tim Horton’s, including book value per share, diluted earnings per common share, and common dividend per share




• In Canada, dividends are attractive from an income taxation point of view, because:– 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 results in very low rates of tax on individuals with low to moderate marginal tax rates




• Although no longer described in the CBCA, preferred shares are those which have some preference or priority over the common share class

• There can be any number of share classes with different rights and voting privileges

• Preferred shares refer to 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 be “residual” share class to assets upon

dissolution• Additionally, most preferred shares also offer a cumulative

feature where dividends in arrears must be paid before the common share class can receive dividends


19.2 PREFERRED SHARE CHARACTERISTICS


• Table 19-3 shows yields on three different types of preferred shares in Canada:– Straight preferreds– Retractable preferreds– Floating rate preferreds




• Straight preferred shares have no maturity date and pay a fixed dividend at regular intervals (quarterly)

• Retractable preferred shares give the investor the right to sell the shares back to the issuer, usually after five years

• Floating rate preferred shares reset their dividends periodically (usually every three to six months) 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




• The Cumulative Provision– A stipulation that no dividends can be paid on common

shares until preferred share dividends, both current and in arrears, are paid

– This feature is the reason that boards of directors take the payment of preferred share dividends seriously




• Preferred Share Dividends– Although preferred share dividends are not legally-

enforceable financial obligations, issuers take the payment of dividends seriously because:• Failure to pay could jeopardize the firm’s 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




• Although preferred shares are equity securities, they are often seen as a higher yield (and risk) substitute for fixed income securities

• Preferred shares can be regarded as a hybrid security 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




19.3 WARRANTS AND CONVERTIBLE SECURITIES

Warrants• Warrants are long-term options to purchase new shares in a

corporation at a specified price, and are therefore the corporate finance equivalent of call options used to raise new capital for a firm

• As long-term options, warrants trade at significant premiums over their intrinsic value

• Warrants usually have long maturities and can even be perpetual (with no maturity date) and are issued by the firm




Warrants• The warrant’s exercise price at the time of issue is normally

greater than the current share price• Warrants are often packaged with the sale of other new

securities as “equity sweeteners,” allowing the holder to exercise them to buy new shares in the company and thereby participate in the growth of the firm

• If warrants are not detachable, issuing bonds plus a warrant is similar to issuing convertible bonds, where the holder has a traditional bond and an option to purchase equity



Warrants• 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’s value will have both intrinsic and speculative value


$50 exercise price

Warrant Value

0 Stock Price



• Equation 19-1:

where:n = the existing number of sharesm = number of shares issued on exercise of the warrantsX = exercise price of the warrantV = stock price of the firm without the warrants

• 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

• This is a weighted average of the former stock price and the warrant’s exercise price


mX)mXV(mn

mholders warrant toPayoff



• Equation 19-1 reduced to Equation 19-2 when we multiple the exercise value by (n + m) / (n + m):

• The term m / (n + m) is the dilution factor.• Therefore, the value of the warrant is the dilution factor multiplied

by the value of the secondary market call (whether you use the Black-Scholes model or the binomial option pricing model


mn

mnXV )(holders warrant toPayoff



Convertible Securities • Convertible bonds are bonds that are convertible into a specified

number of common shares at the option of the holder• When converted, the bonds are exchanged for common shares and

the bonds are no longer outstanding• The firm does not obtain any additional financing through conversion,

although conversion reduces its debt level.• The convertibility feature is a “sweetener” used to encourage

investors to invest in the convertible bond and so convertibles tend to be issued by higher risk firms

• Convertible bonds are issued with a maturity date, however they are also usually callable to ensure conversion does eventually occur




Convertible Securities • The conversion price (CP) is the price at which

the bond can be converted into common shares based on its conversion ratio

• The conversion ratio (CR) is the number of shares for which the convertible bond can be exchanged

• The conversion value (CV) is the value of a convertible bond if it is immediately converted into common shares

• Conversion value is denoted as “parity” in convertible bond listings

• If CV < Bond Price, conversion is not advantageous to the convertible bondholder


PCRCV

CR

ParCP



Convertible Securities • The conversion premium is the percentage the share price

must increase in order for conversion to be advantageous

• Straight bond value (SBV) is the price that a convertible bond would sell for if it could not be converted into common stock. The conversion feature is considered an option, in addition to the basic bond value.


CV

CVeMarketvaluPremium Conversion



Convertible Securities • The floor value (FV) is the lowest price for which a convertible

bond will sell, and is equal to the larger of its straight bond value (SBV) and its conversion value (CV)

• Every convertible bond 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 for higher prices because of the time value of the conversion option


),max( CVSBVFV



Convertible Securities • Convertible bond financing helps firms obtain capital at a lower

coupon rate at the time of issue, because the buyer is receiving an “equity call option” equal to the time premium in addition to the bond

• If the value of the stock remains below parity, the firm has obtained cheap debt

• If the value of the stock exceeds parity, the firm receives cheap equity since they sold equity at a price greater than what they could have sold it for at the time of issue

• The outcome, whether in the firm’s favour or not, depends on the subsequent movement of the stock price until conversion/maturity/call




19.4 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 means of financing are able to, or they are able to raise capital in a form that better suits their cash flow preferences

• Categorizing Hybrids– DBRS uses four factors to determine whether a hybrid instrument is

more like debt or like equity:1. Permanence – common stock is perpetual, debt is finite2. Subordination – priority of claims against income and assets3. Legal – enforceability of any claim on income and assets4. Subjective – company’s purpose when it issues the securities



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)


19.4 OTHER HYBRIDS


Creative Hybrids: Some Examples• Income bonds are bonds issued after a reorganization where

interest payments are tied to some cash flow level for the firm• Income bonds generally have long maturities• Payments are not tax deductible in Canada, and are instead

treated as dividends by CRA• Seen as a “desperation play” because the issuer may not have

much tax incentive to issue real bonds, because it may have little taxable income because of losses carried forward under the provisions of the Income Tax Act


19.4 OTHER HYBRIDS


Creative Hybrids: Some Examples• Cash Flow Bonds– Cash flow bonds are bonds sold in the United States that

have the same objects as income bonds do in Canada– Like income bonds, cash flow bonds usually have long

maturities– Interest payments are conditional on the firm meeting

certain thresholds• Commodity Bonds– Commodity bonds have their interest or principal tied to

the price of an underlying commodity, such as gold


19.4 OTHER HYBRIDS


Creative Hybrids: Some Examples• Original issue discount bonds (OIDs) or

low-yield notes are bonds that sell at a discount from par value when issued

• Interest is not paid regularly, but instead as a bullet payment on maturity

• Investors must report “accrued” interest income if the bond is held in a taxable account

• Some investors like non-coupon bearing bonds because there is no reinvestment rate problem since the ex post yield on the bonds will equal the ex ante forecast if there is no default on the issue


19.4 OTHER HYBRIDS


Creative Hybrids: Some Examples• Liquid yield option notes (LYONs)– LYONs are low-yield notes that are combined with a

convertibility feature.– LYONs are accretive convertibles, because the principal

accretes, or increases, over time• Adjustable rate convertible subordinated securities (ARCS)– ARCS are securities that are typically convertible into

common shares– Principal and maturity are fixed, and interest normally

comprises a fixed interest rate plus some function of the dividend paid in the previous six months


19.4 OTHER HYBRIDS


Creative Hybrids: Some Examples• Preferred securities

– Preferred securities are not preferred shares, but rather securities generated by a company creating a 100% owned subsidiary that issues the shares and then loans the proceeds of the share issue to the parent company for whom the interest is then tax deductible

– Interest flows to the subsidiary, where it is not taxed and used to make dividend payments

• Canadian optional interest notes (COINs)– COINs are 99-year bonds sold at par values of $100 on which the

firm immediately pre-pays the interest from years 11 to 99 on the 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


19.4 OTHER HYBRIDS


• Table 19-7 uses a rating system to show how equity-like the securities discussed in this chapter are. Equities are rated as 100% because they are equity, and commercial paper is rated -100% because it is the most debt-like


19.4 OTHER HYBRIDS


• Figure 19-4 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 (i.e., the returns the firm must offer in order to access that type of capital)


19.4 OTHER HYBRIDS


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Textbook Companion Website (resources for students and instructors): www.wiley.com/go/boothcanada


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COPYRIGHTCopyright © 2013 John Wiley & Sons Canada, Ltd. All rights reserved. Reproduction or translation of this work beyond that permitted by Access Copyright (the Canadian copyright licensing agency) is unlawful. Requests for further information should be addressed to the Permissions Department, John Wiley & Sons Canada, Ltd. The purchaser may make back-up copies for his or her own use only and not for distribution or resale. The author and the publisher assume no responsibility for errors, omissions, or damages caused by the use of these files or programs or from the use of the information contained herein.

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