Assessing Project Risk

Finding the appropriate discount rate, or cost of capital, for evaluating investment projects requires an accurate estimate of project risk. This can be challenging because project risk cannot be estimated directly using the CAPM, but must instead be inferred from a set of traded securities, typically the equity betas of comparable firms in the same industry. These equity betas are then unlevered to undo the effect of comparable companies' financial leverage and obtain estimates of “asset” betas, which are then used to estimate project risk. The authors show that asset betas estimated in this way are likely to overestimate project risk. The equity returns of companies are risky not only because of their existing projects but also because of their growth opportunities. Such growth opportunities often include embedded “real options,” such as the option to delay, expand, or abandon a project. Because such real options are similar to leveraged positions in the underlying project, a company's growth opportunities are typically riskier than its existing projects. Therefore, to properly assess project risk, analysts must also unlever the asset betas derived from comparable company stock returns for the leverage contributed by their growth options. The authors derive a simple method for unlevering asset betas for growth options leverage in order to properly assess project risk. They then show that standard methods for assessing project risk significantly overestimate project costs of capital—by as much as 2–3% in industries such as healthcare, pharmaceuticals, communications, medical equipment, and entertainment. Their method should also be applied to stock return volatility to derive project volatility, an important input for determining the value of a firm's growth opportunities and the appropriate time for investing in these opportunities.     

Hedge Fund Involvement in Convertible Securities

Convertible arbitrage hedge funds combine long positions in convertible securities with short positions in the underlying stock. In effect, hedge funds use their knowledge of the borrowing and short‐sale market to hedge themselves while distributing equity exposure to a large number of well‐diversified investors through their short positions. The authors argue that many “would‐be” equity issuers that would otherwise pay high costs in a secondary equity issue choose instead to issue convertible debt to hedge funds that in turn distribute equity exposure to institutional investors. This allows companies to receive “equity‐like” financing today at lower cost than a secondary equity offering. The authors' findings also suggest that more convertibles will be privately placed with hedge funds when issuer and market conditions suggest that shorting costs will be lower.     

Convertible Debt Issuance and Market Completeness

Recent empirical evidence on option listings supports the notion that equity options help to span the market. This paper investigates the role of convertible debt in market completion. To the extent that the warrant portion of convertible instruments is similar to a call option, the securities can provide payoffs in states of nature that were previously unspanned. Stockholders of firms without listed options or pre-existing warrant-related securities suffer less severe wealth declines around convertible offerings than do owners of firms with contingent claims on their stock. The results suggest that, particularly before the rise of options on index futures, convertible debt played a market-spanning role similar to that of equity options.     

CONVERTIBLE BONDS: MATCHING FINANCIAL AND REAL OPTIONS

For companies whose value consists in large part of “real options”‐ growth opportunities that may (or may not) materialize‐convertible bonds may offer the ideal financing vehicle because of the matching financial options built into the securities. This paper proposes that convertible debt can be a key element in a financing strategy that aims not only to fund current activities, but to give companies access to low‐cost capital if and when their real investment options turn out to be valuable. In this sense, convertibles can be seen as the most cost‐effective solution to a sequential financing problem‐how to fund not only today's activities, but also tomorrow's growth opportunities (some of them not yet even foreseeable). For companies with real options, the ability of convertibles to match capital inflows with corporate outlays adds value by minimizing two sets of costs: those associated with having too much (particularly equity) capital (known as “agency costs of free cash flow”) and those associated with having too little (“new issue” costs). The key to the cost‐effectiveness of convertibles in funding real options is the call provision. Provided the stock price is “in the money” (and the call protection period is over), the call gives managers the option to force conversion of the bonds into equity. If and when the company's investment opportunity materializes, exercise of the call feature gives the firm an infusion of new equity (while eliminating the debt service burden associated with the convertible) that enables it to carry out its new investment plan. Consistent with this argument, the author's recent study of the investment and financing activities of 289 companies around the time of convertible calls reports significant increases in capital expenditures starting in the year of the call and extending three years after. The companies also showed increased financing activity following the call, mainly new long‐term debt issues (many of them also convertibles) in the year of the call.     

Convertible Securities,Employee Stock Options and the Cost of Equity

We provide a method for calculating the cost of equity and the cost of capital in the presence of convertible securities and employee stock options. We demonstrate how this approach can be applied if a company already has issued convertible claims or if it is considering doing so for the first time. We provide several numerical examples illustrating the significance of errors in estimating the cost of capital that can result when (1) employee stock options are ignored or (2) the observable stock price is used as a proxy for the unobservable underlying asset.     

The Impact of Warrants and Convertible Securities on the Systematic Risk of Common Equity

This paper addresses the relationship between the capital structure and the systematic risk of common equity for a firm whose capital structure includes convertible securities. Adding warrants to the capital structure reduces the systematic risk of equity, which is consistent with the fact that warrants dampen the volatility of equity by reducing the upside potential gains of existing stockholders. Expressions showing the impact of conversion features in debt and preferred stock on the systematic risk of equity are derived, and contrasted with the systematic risk effects of non-convertible debt or non-convertible preferred stock financing. Failure to incorporate conversion features may lead to serious errors in assessing the impact of financing alternatives on the risk of equity.     

Fair Terms and Fair Pricing for Multiple Warrant Issues

Abstract

Some firms utilize one or more tranches of warrant issues to supplement their capital base. Unlike exchange-traded options, the exercise of warrants requires the issuance of stock by the company, resulting in a form of dilution. Some previous studies of warrant valuation relied on “the value of the firm,” which is nonobservable, making it difficult to apply the corresponding valuation formula. This paper derives closed-form formulas to value single and multiple tranches of warrants based on the underlying stock price, its volatility, and other known parameter values. The paper first establishes the equivalence of the Black-Scholes formula for both call options and warrants in the case of a single tranche. Thereafter, it considers the impact on the value of previously issued warrants that results when a new tranche of warrants is subsequently issued, showing in each case that fair treatment of the first-issued warrant holders requires an adjustment (due to dilution) in the terms of those warrants and a corresponding modification in the warrants’ value once a second tranche of warrants is issued. To promote such fair treatment, terms of a warrant indenture would specify the nature of the adjustment required when future warrants are issued or exercised, analogous to the antidilution terms related, for example, to stock dividends. Unlike multiple issues of traded options, which are valued independently of one another, multiple warrant issues will be shown to have prices dependent on other warrants outstanding. Also examined is the sensitivity of the fair-value adjustment to changes in the underlying variables, and the theoretical fair-value prices are compared with Black-Scholes prices and with market prices of warrants in the case of two publicly traded companies, each with two warrant issues outstanding. As warrant issues modify the equity structure of a firm, the methodology of valuing warrants presented here will be useful to investment actuaries in situations in which a comprehensive market value for all of a firm’s securities is called for. In addition, risk management practices may sometimes include the use of warrant transactions to hedge stock positions similar to the way that call options are used for that purpose. This may include hedging the risk in equity-linked insurance contracts when the equity position includes stock in companies that have one or more warrant issues that are traded. The methods developed here are also applicable to multiple issues of executive stock options (ESOs) or to combinations of warrant issues and ESOs.     

SOME NEW EVIDENCE ON WHY COMPANIES USE CONVERTIBLE BONDS

The popular argument for convertibles holds that they provide issuers with "cheap" debt and allow them to sell equity at a premium over current value. Objecting to the "free lunch" implied by such an argument, financial economists have offered other explanations that show how the combination of debt and equity built into convertibles can serve to reduce information and agency costs faced by companies and their investors.
In this article, the authors use the results of their recent study to reconcile the two positions. Following Jeremy Stein's view of convertibles as "backdoor equity," the authors argue that convertible bond financing is an attractive alternative for companies that have large growth potential but find both conventional debt and equity financing very costly. Such companies are often deterred from funding their capital investments with straight public bonds by their high risk, relatively short track records, and high expected costs of financial distress. At the same time, the information "asymmetry" between management and outside investors can make equity very expensive in such cases. In layman's terms, management may feel that the company's share price does not accurately reflect its growth prospects, or be concerned that the mere announcement of a new equity offering will cause the share price to fall sharply.
To the extent the stock market is persuaded that management's choice of convertibles is based on this combination of promising growth prospects with limited financing options, it is likely to respond more favorably to the announcement of a new convertible offering. The authors furnish evidence in support of this argument by reporting that the market reacts less negatively to those convertible issuers with higher post-issue capital expenditures and higher market-to-book ratios, but with lower credit ratings and higher (post-offering) debt-equity ratios.     

The long-run performance of firms that issue convertible debt: an empirical analysis of operating characteristics and analyst forecasts

Many firms issue hybrid securities, such as convertible debt, instead of standard securities like straight debt or common equity. Theoretical arguments suggest that convertible debt minimizes costs for firms facing high debt- and equity-related external financing costs. Theory also suggests that an appropriately designed convertible security provides efficient investment incentives. We show, however, that firms on average perform poorly following the issuance of convertible debt. The empirical evidence suggests that the efficient investment decisions predicted by theory are not in fact achieved by the actual design and issuance of convertible debt securities. An alternative interpretation of convertible debt offers is that investors ration the participation of some issuers in the seasoned equity market.     

A SEQUENTIAL SIGNALING MODEL OF CONVERTIBLE DEBT ISSUE AND CALL POLICIES

This paper offers a new explanation for why some risk‐averse firms may prefer to issue callable convertible debt. Here, the convertible debt issue and call policies are integrated into a unified financing policy. It is then shown that for firms with relatively low unsystematic risk, convertible debt issuance followed by an appropriate in‐the‐money signaling call policy reduces more unsystematic equity risk than equity, callable straight debt, or their combination. The model is modified to incorporate asymmetric information at the issue stage to explain the stock price behavior at announcements of convertible debt sales.     

Re‐equitizing Corporate Balance Sheets: Choosing Among the Alternatives

Companies are generally reluctant to issue new equity because it can be expensive capital. Among the largest costs of an equity offering are so‐called “market‐impact” costs. To the extent the typically negative market reaction to a stock offering causes an issue to be underpriced, such underpricing dilutes the value of current shareholders. Despite such costs, many companies—particularly financial institutions—are raising equity capital to “delever” balance sheets that have been squeezed by the credit crunch and economic slowdown. And far from transferring value from existing shareholders, these offerings can preserve and even increase the value of highly leveraged companies by shoring up their capital bases and providing the flexibility to get through a difficult period. According to recent studies, announcements of equity offerings by distressed companies have been accompanied by positive stock returns in excess of 5 %. The challenge for CFOs is to determine why and when issuing equity is the value‐maximizing strategy. The kinds of companies that are most likely to benefit from equity offerings are those that score low on credit metrics, have experienced cyclical declines in operating performance, and have growth opportunities as part of their recovery. There are a number of options for raising equity capital, but no set rules for identifying the optimal one. Nevertheless, the author offers a number of suggestions designed to help CFOs make smarter decisions: Communicate clearly to investors the intended uses of the proceeds from the equity offering and how they are expected to create value; Consider judicious cuts to the dividend to preserve capital; Involve current shareholders to minimize dilution, perhaps by considering a rights offering, and strengthen their commitment; Seek out “smart money” such as private equity or SWFs as long‐term investors; Get the offer size right the first time so a second offering can be avoided; and Monetize volatility in uncertain markets by issuing convertible securities.     

Liquidity,the Value of the Firm,and Corporate Finance

The theory of corporate finance has been based on the idea that a company's market value is determined mainly by just two variables: the company's expected after‐tax operating cash flows or earnings, and the risk associated with producing them. The authors argue that there is another important factor affecting a company's value: the liquidity of its own securities, debt as well as equity. The paper supports this argument by reviewing the large and growing body of evidence showing that differences—and changes—in liquidity can have major effects on the pricing of corporate stocks and bonds or, equivalently, on investors' required returns for holding them. The authors also suggest that the liquidity of a company's securities can be managed by corporate policies and actions. For those companies whose value is likely to be increased by having more liquid securities—which is by no means true of all companies (mature firms that don't need outside capital may well benefit from having more concentrated ownership and hence less liquidity)—management should consider actions such as reducing leverage and substituting dividends for stock repurchases as well as measures designed to increase the effectiveness of their disclosure and investor relations program and the size of their investor base.     

The Information Content Of Calls Of Debt: Evidence From Long-Run Stock Returns

We examine the long‐run performance of the common stock of firms following calls of both straight and convertible debt from 1945 to 1995. Using a sample of 718 calls of straight debt, we find an average abnormal return in the five years following the call of between 0.16% and 0.34% per month, which compounds to an economically and statistically significant 11% to 22% over the five‐year period. This evidence of overperformance following calls shows a distinct symmetry between the straight debt and equity markets. Issues of debt and equity are both followed by long‐term underperformance, whereas stock repurchases and debt calls are both followed by long‐run overperformance. For our sample of 713 calls of convertible debt, we find little systematic evidence of abnormal performance following the call. Some researchers suggest that calls of convertible debt provide negative signals to the market. Our results provide no support for this claim. In contrast, our evidence of marginal positive long‐run returns provides weak support for the model that calls of convertible debt signal the realization of profitable investment options, and for the price pressure hypothesis.     

Liquidity,the Value of the Firm,and Corporate Finance*

The theory of corporate finance has been based on the idea that a company's market value is determined mainly by just two variables: the company's expected aftertax operating cash flows or earnings, and the risk associated with producing them. The authors argue that there is another important factor affecting a company's value: the liquidity of its own securities, debt as well as equity. The paper supports this argument by reviewing the large and growing body of evidence showing that differences—and, perhaps even more important, sudden changes—in liquidity can have major effects on the pricing of corporate stocks and bonds or, equivalently, on investors' required returns for holding them. The authors also suggest that the liquidity of a company's securities can be managed by corporate policies and actions. For those companies whose value is likely to be increased by having more liquid securities—which is by no means true of all companies (for example, mature firms with little need for outside equity are likely to benefit from having more concentrated ownership and hence less liquidity)—management should consider actions such as reducing leverage and substituting dividends for stock repurchases as well as measures designed to increase the effectiveness of their disclosure and investor relations program and the size of their retail investor base.     

Stock Returns and Operating Performance of Securities Issuers

We examine long‐run stock returns and operating performance around firms’ offerings of common stock, convertible debt, and straight debt from 1985 to 1990. We find that pre‐issue abnormal returns are positive and significant for stock issuers, but not for convertible and straight debt issuers. The post‐issue mean returns show that common stock and convertible debt issuers experience underperformance during the post‐issue periods, but straight debt issuers do not. Consistent with these results, common stock issuers experience the best pre‐issue operating performance among all three types of issuers, and operating performance declines during the post‐issue periods for common stock and convertible debt issuers. Using a new approach in linear model estimations to correct heteroskedasticity and to adjust for finite sample, we find a positive relation between post‐issue operating performance and issue‐period stock price reactions. The results suggest that future operating performance is anticipated at the issue and that securities issues provide information on issuers’ future performance.     

Why Do Western European Firms Issue Convertibles Instead of Straight Debt or Equity?

Unlike their US counterparts, European convertible debt issuers tend to be large companies with small debt‐ and equity‐related financing costs. Therefore, it is puzzling why these firms issue convertibles instead of standard financing instruments. This paper examines European convertible debt issuer motivations by estimating a security choice model that incorporates convertibles, straight debt, and equity. We find that European convertibles are used as sweetened debt, not as delayed equity. This motivation is reflected in the debt‐like design of most European convertible issues.     

The impact of rights issues of convertible debt in Australian markets

Australian convertible debt issues are rights issues of non-callable securities and are issued in a market characterised by thin trading, significant institutional investor participation rates and a high number of resource firms. However, this study documents a significant negative announcement effect for rights issues of convertible debt, similar to international evidence. An analysis of the determinants of the announcement effect supports variants of the information asymmetry and agency cost hypotheses. The results do not support the convertible debt models of Kim [Kim, Y., 1990. Informative conversion ratios, a signalling approach. Journal of Financial and Quantitative Analysis 25, 229–243], Brennan and Kraus [Brennan, M., Kraus, A., 1987. Efficient financing under asymmetric information. Journal of Finance 42, 1225–1243], Green [Green, R.C., 1984. Investment incentives, debt and warrants. Journal of Financial Economics 13, 115–136] but some support is found for Stein's [Stein, J., 1992. Convertible bonds as backdoor equity financing. Journal of Financial Economics 32, 3–22], convertible debt model and Mayers [Mayers, D., 1998. Why firms issue convertible bonds: the matching of financial and real investment options. Journal of Financial Economics 47, 83–102], sequential financing model. However, support is found for Brous and Kini [Brous, P.A., Kini, O., 1994. The valuation effects of equity issues and the level of institutional ownership: evidence from analysts’ earnings forecasts. Financial Management 23, 33–46], equity issue based external monitoring model and Eckbo and Masulis [Eckbo, B., Masulis, R., 1992. Adverse selection and the rights offer paradox. Journal of Financial Economics 32, 292–332], rights issue adverse selection model.     

Convertible calls and corporate taxes under asymmetric information

This paper develops a signalling model of call of convertible securities (bonds or preferred stock) in the presence of corporate taxes and asymmetric information about future earnings. In equilibrium, managers with relatively unfavorable information call to force convertible holders to convert to common stock (in spite of the loss of corporate tax benefits if the convertibles are bonds), while those with relatively favorable information do not call. The model predicts that the announcement period common stock returns are more negative at the call of convertible bond than at the call of convertible preferred stock. Furthermore, we predict that when the importance of the tax deductibility of interest differs among firms, so does the stock price reaction to the announcement of convertible debt call. Specifically, the loss of equity value at the announcement decreases with the amount of non-debt tax shield that the calling firm owns, decreases with the book value of convertible debt called, and increases with corporate taxes.     

CONVERTIBLE SECURITIES: A TOLLBOX OF FLEXIBLE FINANCIAL INSTRUMENTS FOR CORPORATE ISSUERS

During the 1990s, convertible and equity-linked securities emerged as a major source of financing for U.S. corporate issuers. Issuance volume grew steadily throughout the decade and the secondary market value of U.S. convertible securities now exceeds $200 billion. In this overview of the market, the authors discuss the following: (1) the growth of issuance volume in the U.S. equity-linked market; (2) the basic characteristics of convertible securities; (3) convertible debt alternatives; and (4) convertible preferred alternatives.
As a result of the proliferation of new convertible structures, corporate issuers are now able to adjust coupon/dividend, conversion premium, and call protection in order to meet their tax, accounting, rating agency, and cost-of-capital objectives. Historically, the convertible new issue market has had a broad variety of issuers, spanning all industry sectors as well as both investment grade and high yield credits. But in the last two years, the most aggressive issuers have been technology-oriented companies, including telecommunications, Internet, hardware, software, and biotechnology concerns. Such technology-related issuers, which are often rated below investment grade and unable to secure straight debt capital, are generally in heavy-spending phases and view convertible bonds as a source of inexpensive financing. At the same time, investment-grade, "old-economy" issuers have continued to use convertible securities selectively, in most cases as cheap "quasi-equity" in the context of mergers and acquisitions, or as a tax-deferred strategy for selling cross-holdings of stock.     

Top management incentives and financial flexibility: The case of make‐whole call provisions

Consistent with the premise that make‐whole call provisions enhance value‐creating financial flexibility, we find that higher sensitivity of managerial wealth to stock price (delta) increases the likelihood that corporate bonds contain make‐whole provisions. Building on the results of related research, post‐issue financial performance of make‐whole callable bond issuers increases in delta. In line with prior findings that demonstrate financial flexibility can be costly to bondholders, we find that managerial equity incentives impact the incremental effect of make‐whole provisions on the pricing of corporate debt securities. Consistent with the flexibility explanation, we also find that the market response as measured by abnormal trading volume to the issuance of make‐whole callable debt varies in equity incentives. Overall, our results suggest that managerial incentives play a role in the choice, pricing, and market response to make‐whole options in corporate debt securities.