Aswath Damodaran 169
Costs of Hybrids
! Preferred stock shares some of the characteristics of debt - the preferred
dividend is pre-specified at the time of the issue and is paid out before
common dividend - - and some of the characteristics of equity - the payments
of preferred dividend are not tax deductible. If preferred stock is viewed as
perpetual, the cost of preferred stock can be written as follows:
- kps = Preferred Dividend per share/ Market Price per preferred share
! Convertible debt is part debt (the bond part) and part equity (the conversion
option). It is best to break it up into its component parts and eliminate it from
the mix altogether.
The easiest way to break down a convertible bond is to value it as a straight
bond and to then assign the remaining market value to the conversion option. In
March 2004, Disney had convertible bonds outstanding with 19 years left to
maturity and a coupon rate of 2.125%, trading at $1,064 a bond. Holders of
this bond have the right to convert the bond into 33.9444 shares of stock
anytime over the bond’s remaining life. To break the convertible bond into
straight bond and conversion option components, we will value the bond using
Disney’s pre-tax cost of debt of 5.25%:
At this conversion ratio, the price that investors would be paying for
Disney shares would be $29.46, much higher than the stock price of
$20.46 prevailing at the time of the analysis.
This rate was based upon a 10-year treasury bond rate. If the 5-year
treasury bond rate had been substantially different, we would have
recomputed a pre-tax cost of debt by adding the default spread to the
5-year rate.
Straight Bond component
= Value of a 2.125% coupon bond due in 19 years with a market interest rate of
5.25%
= PV of $21.25 in coupons each year for 19 years + PV of $ 1000 at end of
year 19
The coupons are assumed to be annual. With semi-annual coupons,
you would divide the coupon by 2 and apply a semi-annual rate to
calculate the present value.
=
Conversion Option = Market value of convertible – Value of straight
bond
= 1064 - $629.91 = $434.09
The straight bond component of $ 630 is treated as debt, while the conversion
option of $434 is treated as equity.
