Thursday, March 19, 2009

Dealing with Hybrids

One of my favorite devices to introduce concepts in valuation and corporate finance is a financial balance sheet. Unlike an accounting balance sheet, a financial balance sheet is a forward looking instrument. On the asset side of this balance sheet, there are only two categories for assets: assets in place, i.e., the value of investments that have already been made by the firm and growth assets, i.e., the value added by investments that I expect the firm to make in the future. On the liability side of the balance sheet, there are only two items as well: Borrowed money (debt) or owners' funds (equity).

While I hold fast to the belief that all financing has to come from debt or equity, and that the cost of capital is a weighted average of the costs of these two funding sources, hybrid securities pose both a conceptual and a practical challenge. Hybrids, of course, are financing choices that are part debt and part equity. A classic is convertible debt, where the lender (bondholder) has the option to convert to equity at a fixed price. Convertible debt has a debt component (the traditional bond or loan, with a finite maturity and interest payments) and an equity component (the conversion option).

While I see companies and analysts treating convertible debt as a source of funding, separated from debt and equity, it is a bad idea for two reasons. First, it makes any attempt to optimize capital structure much more difficult - it is easier to find the optimal mix when you have two elements to work with, rather than three. Second, and this is my real problem with this approach, is that it can lead firms to make bad choices and here is why. Analysts who treat convertible debt as a financing choice often use the coupon rate on the convertible debt as the cost of convertible debt. This coupon rate will be low, because of the presence of the conversion option. A corporate treasurer who compares the cost of convertible debt to straight debt will then jump to the unsurprising conclusion that convertible debt is cheaper than straight debt and will lower the cost of capital... And analysts feed the illusion!

So, what should we do with hybrids? I would attempt to break the hybrid security down into its debt and equity components. With convertible debt, this is simple to do. Ignore the conversion option and value the convertible debt as if it were straight debt, i.e, take the present value of coupon payments and the face value using the pre-tax cost of debt for the firm's straight debt. With its low coupon rate, you will arrive at an estimate of value that is well below both face value and market value. That is the debt portion. Subtracting this from the market value of the convertible bond will yield the conversion option value: this is the equity portion. If the convertible debt is not traded, the conversion option will have to be valued using an option pricing model. Add the debt portion to the rest of the debt, the conversion option value to equity and presto: there is no hybrid left.

Almost debt hybrids can be dealt with using this technique. The one exception is preferred stock, a hybrid that is tough to categorize. More about what to do with that source of financing in my next post.


Mahesh Sethuraman said...

Could you give your views on the convertible bond arbitrage?Is it a really an arbitrage or is it just an illusion?

If the call option in the convertible bond is cheaper than say a call option on the same stock in the market, then isn't it just factoring in the dilution effect of additional equity or is there a real arbitrage possible?

not-so-erudite said...

I worked as a banker in Europe during the mid-80s and came across a lot of Treasurers and even CFOs who took the view that equity was cheaper than debt or that the cost of a hybrid was the coupon. But I would have thought that breed went the way of the dinosaur and that there isn't an analyst or company finance person who would subscribe to those archaic and quite frankly ludicrous assumptions. Please tell me we have made some progress from the Dark Ages!

Aswath Damodaran said...

Is arbitrage possible when you have convertibles, debt, equity and options traded on the same company? Sure. Is it likely? I don't think so...