Preferred Stock
One advantage and one disadvantage of preferred stock
- Not obliged to pay // Avoid dilution // Reduce cash flow drain
- Not deductible // Investor expectations
Rank according to riskiness (lowest to highest): warrants, debt, common equity, preferred equity
Debt < Preferred Equity < Common Equity < Warrants
Formula of Conversion Price
What are the types of preferred stock? (Apart from plain)
- Adjustable rate
- Market auction
Three conditions that cause holders to exercise their warrants
- Stock price > exercise price*
- Company raises dividend
- Stepped up strike price
What two agency problems can convertible bonds mitigate?
(For 100 extra points classify them in the context of information asymmetry problems)
- Asset Substitution (moral hazard)
- Signalling bad prospects (adverse selection)
Compute the after tax cost of debt, equity and preferred equity:
rd: 8%
re: 10%
rpe: 9%
t: 40%
rd*: 0.08*(1-0.4) = 4.8%
re*: 10%
rpe*: 0.09*(1-(0.3)(0.4)) = 7.92%
Company ABC issued $100 M, $1000 par value, 10 year bonds with an 8% coupon rate + 15 warrants with a strike price of $30. Yield of bonds with similar risk is 10%.
Bond price: $877.11
Calculate the % of the price that corresponds to the bond and the warrant.
Bond price: $877.11
Warrant price: 1000 - 877.11= $122.89
87.7% bond // 12.3% warrant
Company XYZ issues $500 million of convertible bonds.
- 20 year maturity, 7% annual coupon rate, $1000 par.
- Conversion value: $75, Stock price: $60
- Yield of similar risk bonds: 10%
Calculate the value of converting the bond after 15 years, if the stock price has fallen to $43. Is it profitable to convert?
Number of shares: 1000/75 = 13.33
Value of converting: 13.33 * 43 = $573.33
No, share price is lower.