Answers and Solutions: 20 – 1
Chapter 20
Hybrid Financing: Preferred Stock, Warrants, and
Convertibles
ANSWERS TO END-OF-CHAPTER QUESTIONS
20-1 a. Preferred stock is a hybrid security, having characteristics of both debt and equity. It
is similar to equity in that it (1) is called “stock” and is included in the equity section
of a firm’s balance sheet, (2) has no maturity date, and (3) has payments which are
considered dividends—thus, they are not legally required and are not tax deductible.
c. A warrant is an option issued by a company to buy a stated number of shares of stock
at a specified price. Warrants are generally distributed with debt, or preferred stock,
to induce investors to buy those securities at lower cost. A detachable warrant is one
that can be detached and traded separately from the underlying security. Most
additional capital to the issuer.
f. The conversion ratio is the number of shares of common stock received upon
conversion of one convertible security. The conversion price is the effective price per
share of stock if conversion occurs. Thus, the conversion price is the par value of the
g. A “sweetener” is a feature that makes a security more attractive to some investors,
20-2 Preferred stock is best thought of as being somewhere between debt (bonds) and equity
and tax standpoints, it has no maturity date, and it is carried on the firm’s balance sheet in
20-3 The trend in stock prices subsequent to an issue influences whether or not a convertible
In the case of warrants, on the other hand, if the price of the stock goes up sufficiently,
20-4 Either warrants or convertibles could be used by a firm that expects to need additional
have additional funds requirements would not want to use warrants.
20-5 a. The value of a warrant depends primarily on the expected growth of the underlying
stock’s price. This growth, in turn, depends in a major way on the plowback of
b. The same general arguments as in Part a hold for convertibles. If a convertible is
selling above its conversion value, raising the dividend will lower growth prospects,
exceeds its call price raises the probability that it will be converted soon.
c. The same arguments as in Part b apply to warrants.
website, in whole or in part.
20-6 The statement is made often. It is not really true, as a convertible’s issue price reflects the
20-7 The convertible bond has an expected return which consists of an interest yield (10
percent) plus an expected capital gain. We know the expected capital gain must be at
least 4 percent, because the total expected return on the convertible must be at least equal
SOLUTIONS TO END-OF-CHAPTER PROBLEMS
20-1 Bonds with warrants: $1,000 par value 15–year 5% coupon bonds with annual payments,
trading for $1,000.
Bonds with warrants: $1,000 = Bond + Warrants.
This bond should be evaluated at 7% (since we know the straight debt trades at par) to
20-2 Convertible Bond’s Par value = $1,000; Conversion price, Pc = $50;
CR = ?
Answers and Solutions: 20 – 5
warrantsthe
of Value
bond theof Value
debtStraight
VB = $1,000 – $150 = $850.
$850 =
20
1t 20
d
t
d)r1(
000,1$
)r1(
I
=
20
1t 20t)12.1(
000,1$
)12.1(
I
With a financial calculator, N = 20; I/YR = 12; PV = −850; FV = 1000; solve for
PMT = 99.92 $100. Therefore, the company would set a coupon interest rate of 10
percent, producing an annual interest payment I = $100.
20-4 a. A 10 percent premium results in a conversion price of $42(1.10) = $46.20, while a 30
be closer to 10 percent, while a high growth rate firm would command a premium
20-5 a. The premium of the conversion price over the stock price was 14.1 percent:
$62.75/$55 – 1.0 = 0.141 = 14.1%.
b. The before-tax interest savings is calculated as follows:
issue was $331.89 = $1,000 – $669.11.
Answers and Solutions: 20 – 6
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website, in whole or in part.
d. If interest rates had not changed, then the value of the straight bond fifteen years after
issue would have been $699.25, calculated as follows: N = 25, I/YR = 8.75, PV = ?,
PMT = 57.5, FV = 1000. Solving, PV = -699.25.
Assuming that the stock had not gone above $62.75 during the fifteen years after it
was issued, the bond would not have been converted. For example, if a bondholder
converted the bond, the bondholder would receive about 15.9 shares of stock per
bond, calculated as follows:
e. The value of straight bond would have increased from $669.11 at the time of issue to
$699.25 fifteen years later, as calculated above, due to the fact that the bonds are
closer to maturity (because a bond’s value approaches its par value as it gets closer to
maturity). However, the value of the conversion feature would have fallen sharply,
then their straight bond value would be that of a par bond, which is $1,000. This can
also be calculated as follows: N = 25, I/YR = 5.75, PV = ?, PMT = 57.5, FV = 1000.
Solving, PV = -1,000.
probably have a price slightly above their par value of $1,000.
Answers and Solutions: 20 – 7
20-6 a. Balance Sheet
Alternative 1
Total current
liabilities $150,000
Long-term debt —
Alternative 2
Total current
liabilities $ 150,000
Long-term debt —
Common stock, par $1 150,000
Paid-in capital 450,000
Retained earnings 50,000
Total assets $ 800,000 Total claims $ 800,000
Common stock, par $1 150,000
Paid-in capital 450,000
Retained earnings 50,000
Total assets $1,300,000 Total claims $1,300,000
Answers and Solutions: 20 – 8
Net income $ 54,000 $ 96,000 $ 96,000 $ 132,000
Number of shares 100,000 162,500 150,000 150,000
Earnings per share $0.54 $0.59 $0.64 $0.88
Alternative 2 results in maintaining control (53 percent) for the firm. Earnings per
share increase, while a reduction in the debt ratio like that in Alternative 1 occurs.
Under Alternative 3 there is also maintenance of control (53 percent) for the firm.
This plan results in the highest earnings per share (88 cents), which is an increase of
The differences between these two alternatives, which are illustrated in Parts c
and d, are that the increase in earnings per share is substantially greater under
Alternative 3, but so is the debt ratio. With its low debt ratio (19 percent), the firm is
in a good position for future growth under Alternative 2. However, the 50 percent
on its trade credit. Also, the bonds will no doubt be subordinated debentures.
Answers and Solutions: 20 – 9
© 2017 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible
website, in whole or in part.
Both Alternatives 2 and 3 are favorable alternatives. If the principal owner is
willing to assume the risk of higher leverage, then 3 is slightly more attractive than 2.
The actual attractiveness of Alternative 3 depends, of course, on the assumption that
funds can be invested to yield 20 percent before interest and taxes. It is this fact that
makes the additional leverage favorable and raises the earnings per share.
20-7 a.
Stock data and stock required return:
rd = 9%.
Convertible bond data:
Par = $1,000, 20-year.
Coupon = 8%.
Find N (number of years) to anticipated call/conversion:
We need to find the number of years that it takes $805 to grow to $1,200 at a 6% interest
N ln(1.06) = ln(1.49)
Straight-debt value of the convertible at t = 0:
At t = 0 (N = 20): N = 20, I/YR = 9, PMT = 80, FV = 1,000; solving, PV = -908.715.
Alternatively,
20
000,1$
80$