Chapter 20 Financing with Derivatives

1
Chapter 20Financing with Derivatives
2
Derivatives

• Derivatives are securities whose values is
  derived from another asset.
• Derivatives securities can be classified in
  several classes, such as
• Options
• Forward Type Contracts
• Forward Contracts
• Futures Contracts
• Swaps

3
Financial Engineering

• Financial Engineering involves the design, the
  development, and the implementation of innovative
  financial instruments and processes, and the
  formulation of creative solutions to financial
  problems.
• 35 of securities issued by domestic firms in
  1997 were innovative
• Over 7 trillion in derivatives
• Liquid Yield Option Notes
• Trust-Oriented Preferred Stock (TOPrS)

4
Trust-Oriented Preferred Stock

• The new securities are tax deductible to the
  issuer.
• They are issued by a trust or a partnership which
  then loans the proceeds to the company.
• Thus, the company technically makes interest
  rather than dividend payments.
• The tax deductibility allows yields to be set
  higher than on conventional preferred.
• Corporate investors are not permitted because of
  the Dividends Received Deduction.

5
Options

• Short Term Options
• Written by investors
• Convertible fixed-income securities
• Bonds
• Preferred Stock
• Warrants
• Bond refunding (Previous Chapter)
• Rights offering

6
Call
Option to buy
Option
Put
Option to sell
7
ValuationCall Option

• At expiration Stock price - Exercise price
• Prior to expiration gt Stock price - Exercise
  price
• Maximum value Stock price
• Minimum value 0

8
Exercise price Stock price
Time to expiration date
Variables affecting the value of an
option
Interest rates
Expected stock price volatility
Option Pricing Model
9
Common Stock Viewed as a Call Option

• In a firm with debt outstanding, the stockholders
  can be viewed as having sold the firm to the debt
  holders.
• The stockholders have an option to buy back the
  firm from the debt holders
• If the value of the firm is less than the debt
  claim, the stockholders will let their option
  expire by not repaying the debt...e. g. Savings
  and Loan Associations
• Risk-increasing investments may benefit
  stockholders at the expense of debt holders.

10
Convertible Securities

• Debentures and Preferred Stock
• Terms of conversion represented in conversion
  price (such as 84.50)
• Conversion ratio
• of shares obtained in conversion
• par value of security / Conversion price
• Conversion premium Difference
• Conversion price gt stock price when security is
  issued

11
Reasons for Issuing Convertibles

• Make security more attractive so that lower
  interest rates or dividends may be paid.
• Sell Common Stock in the future at higher price -
  Delayed Equity Financing
• Allow time for investments to pay benefits
• Relatively small, risky companies
• Lessen agency conflict
• Avoids immediate dilution of EPS
• Can force conversion
• Sale of securities to institutional investors

12
Valuation

• Conversion value
• Conversion ratio X Stock price
• Investment value
• the straight bond value
• Market value
• Price the security trades for on the market
• Usually slightly above the higher of the
  conversion value or the investment value
• Difference is the premium
• The premium is typically the largest when the
  conversion value and straight bond value are equal

13
Conversion of Convertible Securities

• Voluntary conversion can occur at any time prior
  to expiration
• Dividends on the common stock are at a high level
• Forced conversion occurs when the issuer uses the
  call privilege on the security
• May occur when conversion value is 15 to 20
  above the call price

14
Disadvantages of Convertibles

• It might have been better to wait and issue
  common at a higher price
• Overhanging convertible issue may depress stock
  prices
• If the stock does not rise, the firm may be stuck
  with debt
• When conversion occurs, the advantage of
  low-cost debt will be lost.

15
Warrants

• Usually issued with other securities
• Might be issued separately
• Characteristics
• Exercise price
• Price at which C/S may be purchased
• Usually 20 to 35 above market price
• Expiration date
• Date when the option to purchase ends
• 5-10 years
• Traded separately
• Why issue warrants ? Sweetener to get
  lower interest rates

16
Advantages and Disadvantages of Warrants

• Advantages
• Sweeten the security with which they are issued
• Sell common stock in the future without
  significant issuing costs
• Can issue to financial institutions such as
  insurance companies
• Equity Kicker
• Reduces agency costs
• Provide leverage to investors
• Disadvantages
• Cant be forced
• Taxed after expiration if not utilized

17
Warrant Valuation

• Formula
  of shares
• value Common stock
  Exercise obtained
• of a Max 0 market price -
  price x with each
• warrant per share
  per share warrant
• Market value of warrant
• Usually exceeds the formula value
• Premium Difference

18
Why buy warrants?
Key

• Warrants provide leverage to investors
• Potential loss is limited to price paid for
  warrant
• Option of holding the warrant instead of
  purchasing the stock

19
Similarities and Differences Between Warrants ( W
) and Convertible Securities ( C )
20
Differences Between Convertibles and Warrants

• Warrants bring in additional capital
• Warrants leave the debt on the books
• Warrants can not be called
• Smaller firms typically issue warrants
• Warrants typically have a shorter maturity
• Warrants typically provide for fewer common
  shares than convertibles
• Bonds with warrants usually have higher flotation
  costs.

21
How can earnings be reported when warrants and
convertibles are used?

• Basic EPS
• Based on the number of common shares actually
  outstanding
• Primary EPS
• Includes shares that would result from
  conversions and exercises likely to occur in the
  near future.

More
22

• Diluted EPS
• Includes shares that would result from exercise
  of all outstanding warrants and conversion of all
  convertibles.
• SEC requires firms to report both basic and
  diluted EPS
• FASB requires firms to report basic EPS

23
Rights Offering

• In a rights offering, the firms existing
  stockholders are given an option to purchase a
  fraction of the new shares equal to the fraction
  they already own.
• Preemptive Right
• A single right attaches to each outstanding share
• The ratio of outstanding shares to be issued
  determines the number of rights to purchase one
  new share.

24
Rights Offering - continued
Richard Klein

• Subscription price
• Subscription price lt current market price
• Can sell rights (DO NOT LET THE RIGHTS JUST
  EXPIRE - USE THEM OR SELL THEM.)
• Issued to shareholders of record date
• Rights on
  Ex-rights
• Rights trade for a price gt the theoretical value
• Investors receive leverage because of the
  potential for stock price to increase.

25
Economic Value

• Theoretical value of a right selling rights-on
• Theoretical value of a right detached

Mo - S
R
N 1
Me - S
R
N
The stocks market value theoretically falls by
the value of the right when it theoretically goes
ex-rights.
26
Interest Rate Swaps

• 5 trillion Outstanding worldwide
• Protects against fluctuations in interest rates
• Used to hedge against interest rate risk
• Longer-term risks some 10 years or more
• Plain vanilla type
• Exchange floating rate interest payments for
  fixed interest payments (net)
• Parties to agreement
• Finance Company Bank Financial
  Institutions
• Tied to LIBOR

27
Conclusion

• Derivatives
• Financial Engineering
• Options
• Convertibles
• Warrants
• Accounting for Convertibles and Warrants
• Rights Offering
• Interest Rate Swaps