Convertible Securities Research Articles

An empirical analysis of an alternative model of Financial Accounting Standard no. 128

PurposeThis paper aims to investigate the empirical effects of an inconsistency in the calculation of the diluted earnings per share (EPS) number which originated in Accounting Principles Board Opinion No. 15 (APB 15) and continues in Statement of Financial Accounting Standard No. 128 (SFAS 128), EPS. The discrepancy involves the treatment of dilutive warrants and options versus other dilutive convertible securities and is explained in the section of this paper where the authors describe the proposed alternative EPS model. In a sample of 55 publicly traded companies in which they applied their model, it was found that the average increase in diluted EPS to be 5.7 per cent and the median increase to be 3.8 per cent. The authors believe that SFAS 128 should be considered, along with other factors, to be revised to direct that diluted EPS be computed in accordance with their model.Design/methodology/approachThe authors selected a sample of companies from the Compustat Annual Database that had either Convertible Debt or Convertible Stock or both with a year-end between July 1, 2011 and July 1, 2012 which was the most recent data available at the time of the initial study. They then used the model assuming a “repurchase” of common shares as if the “treasury stock method” which applies to options and warrants also applied to these conversions. They then reduced the number of shares initially used to compute diluted EPS by the number of assumed repurchased shares. Using the revised number of shares, the authors recomputed diluted EPS as a percentage of the originally reported diluted EPS.FindingsFor the 55 companies in the sample, the average increase in diluted EPS using the “treasury stock method” was 5.7 per cent. The median increase was 3.8 per cent. The largest increase was 26.6 per cent and the smallest was 0 per cent.Research limitations/implicationsThis is a one-year study of the sampled firms. A multi-year sample is recommended for further research. Also, the sample might be applied to foreign entities under the jurisdiction of IAS 33.Practical implicationsAccording to the Financial Accounting Standards Board (FASB) the price-earnings ratio of an equity is perhaps the most frequently cited statistic in the business of equity investments. As the denominator in the price-earnings ration is the “diluted” EPS figure calculated under generally accepted accounting principles (GAAP) under Statement of Financial Accounting No. 128 (SFAS 128), the results have very significant implications for the recommended study and revision of the diluted EPS statistic.Social implicationsIf the current diluted EPS reported numbers result in lower stock prices than would otherwise be the case under the authors’ model, then it seems likely that these companies with large amounts of debt would have a higher cost of equity capital than would otherwise be the case. The overall result would be a different allocation of equity capital than would be the case if convertible debt and convertible equity were treated the same way as options and warrants. As we are unaware of a rationale for the disparate treatment, it is believed that this a is a misallocation caused by a statement of the Financial Accounting Standards Board (FASB) that seems flawed and recommend that it be considered to be revised.Originality/valueA review of the literature found no other study addressing this issue.

Geographic Concentration of Venture Capital Investors, Corporate Monitoring, and Firm Performance

This paper examines how the coordination of venture capital (VC) investors in their syndicates, as measured by their geographic concentration, affects firm performance and ex ante contractual terms. Using the introduction of new airline routes between the locations of VC investors as a shock to their coordination costs, we find that firms with geographically concentrated VC investors are more likely to exit successfully than other firms. Geographically proximate VC investors are also more likely to form syndicates in follow-up rounds, use less intensive staged financing and fewer convertible securities, and are less likely to send their representatives to firm boards.

Dilutive Securities and Earnings Per Share

The purpose of this article is to discuss the proper accounting for stock-based compensation. In addition, issues related to other types of financial instruments, such as convertible securities, warrants, and contingent shares, including their effects on reporting earnings per share.

Contingent capital with repeated interconversion between debt‐ and equity‐like instruments

AbstractThis paper introduces a new form of contingent capital, contingent convertible securities (CCSs), which might repeatedly convert between debt‐ and equity‐like instruments depending on financial conditions. We derive explicit prices of corporate securities, assuming the cash flow is modeled as a geometric Brownian motion. We present an explicit value of the increased tax shields due to CCSs. We provide an explicit optimal capital structure when CCSs are issued and interestingly, the ratio of the optimal straight bond coupon to CCS coupon is constant and independent of the firm's financial conditions. All the conclusions hold true also for contingent convertibles.

Disagreement and Optimal Security Design

We study optimal security design when the issuer and market participants agree to disagree about the characteristics of the asset to be securitized. We show that pooling assets can be optimal because it mitigates the effects of disagreement between issuer and investors, whereas tranching a cash-flow stream allows the issuer to exploit disagreement between investors. Interestingly, pooling and tranching can be complements. The optimality of debt with or without call provisions can be derived as a special case. In a model with multiple financing rounds, convertible securities naturally emerge to finance highly skewed ventures.

The buyers’ perspective on security design: Hedge funds and convertible bond call provisions

We provide evidence that security design reflects the interplay of capital supplier and security issuer preferences. While call provisions have historically been the default option in convertible security design, only a minority of post-2005 issues are callable. Because hedge funds dominate the market for new convertibles today and because convertible arbitrage is less risky without callability, the recent diminution in the frequency of call provisions in new convertible bond issues illustrates the importance of the preferences of the suppliers of capital in security design.

Insider Investor and Information

After initial investments, relationship financiers typically observe interim about projects before continuing financing them. Meanwhile, entrepreneurs produce endogenously and issue securities to incumbent insider and competitive outsider investors. In such persuasion games with differentially informed receivers and contingent transfers, entrepreneurs' endogenous experimentation reduces insiders' monopoly but impedes relationship formation through an information production hold-up. Insiders' production and interim competition mitigate this hold-up, and jointly explain empirical links between competition and relationship lending. Optimal contracts restore first-best outcomes using convertible securities for insiders and residuals for outsiders. Our findings are robust under various extensions and alternative specifications.

Is There a Link between a Firm's Determinants and Its Decision to Issue Either Debt-Like or Equity-Like Convertibles?

Convertible security misclassification within the Australian market is well documented. Consequently in 2001, the Commonwealth enacted the New Business Tax System (Debt and Equity) Act to mitigate this phenomenon. This paper utilizes the new tax framework to investigate whether there is a link between the firm’s determinants and its decision to issue either debt-like or equity-like convertibles. Our findings reveal that firms with high effective tax rates are more likely to issue debt-like securities, benefiting from the tax shields available. Firms with high levels of franking credits per share are more likely to issue equity-like securities. Finally, unlike in the U.S. markets, agency cost is not a significant determinant in Australia. Overall, the findings on the dissipation of franking credits contribute new evidence to the clientele effect phenomenon for franked dividends. This has significant implications for investors seeking to maximize their demand for higher yields.

Freeport-McMoRan: Financing an Acquisition

Freeport-McMoRan's acquisition of Phelps Dodge created the world's largest publicly traded copper company. JPMorgan and Merrill Lynch advised the acquirer and arranged $17.5 billion in debt financing and $1.5 billion in credit facilities. In addition, these two firms underwrote $5 billion in equity capital through simultaneous offerings of Freeport-McMoRan common shares and mandatory convertible preferred shares. These financings created an optimal capital structure for the company that resulted in stronger credit ratings. The activities of the equity capital markets and sales groups at the underwriting firms are explored and the structure and benefits of mandatory convertible preferred shares is explained.To understand the role of investment banks in advising a large corporation regarding an acquisition and related financings in the capital markets. As part of this, the activities of an investment banking firm's equity capital markets group and their underwriting risks are analyzed. Finally, the structure of a mandatory convertible security is reviewed in terms of benefits to both issuers and investors.

The Buyerss Perspective on Security Design: Hedge Funds and Convertible Bond Call Provisions

Our study provides evidence that security design reflects the interplay of supplier and issuer preferences. While call provisions have historically been the default option in convertible security design, we find that only a minority of post-2005 issues are callable. Because hedge funds dominate the market for new convertibles today and convertible arbitrage is less risky without callability, the diminution in callability emphasizes the importance of the preferences of the suppliers of capital in determining security design. We show that further determinants of callability include rationales for issuing convertibles that emphasize issuer preferences.

The External Financing of Investment

Investment characteristics and the form of external financing are linked. Factor analysis indicates that the principal determinant of the financing choice is whether an investment’s payoffs can be described as a hit or miss. Hit-or-miss investments are more likely to be equity financed. Equity also becomes more common the longer the time until an investment produces positive payoffs. Debt financing is more likely for investments that are both tangible and non-unique. For R&D-like investments, equity and bank debt financing are more likely than non-bank debt financing. Convertible securities link to uncertain investment lives and are therefore useful for sequential financing.

The Role of Contingent Capital Structure in Signaling and Information Disclosure

This paper advocates two novel advantages of contingent convertible securities in capital structure in (1) signaling, and (2) information disclosure. First, in order to signal his type, the good banker should be punished for poor performance and rewarded otherwise. Since the banker knows better about events occurring in the near future (i.e., the interim states) than final cash flows to be realized in the distant future, the former are better performance indicators, thereby providing contingent securities with additional signaling power. Nevertheless, this advantage needs to be supported by a positive cost of misreporting interim states. Second, even if misreporting is costless, contingent capital structure still has an advantage over non-contingent capital in its ability to mitigate ex-post information asymmetries, since it has more degrees of freedom in setting payoffs to fine-tune the issuer's truth-telling incentives. This paper thus sheds some new light on the design of CoCos and the regulation of contingent capital.

Do we need exchange institutions in Ukraine?

The development of economic relations in Ukraine and the transition to a market economy requires fundamental changes in the functioning of market infrastructures. One of its main elements is the stock trading institutions. Exchange as an economic category reflects the totality of economic relations constantly functioning market, which is concentrated about a particular product (supply and demand, quality characteristics, etc.), is its purchase-sale samples are priced and traded securities and foreign currency. With the transition to a market economy was necessary to form a complete wholesale food markets, raw materials for enterprises, convertible securities and money capital. Exchange - is the most convenient operations with securities. Its functions include the organization of trading securities - now almost all electronic exchanges, that an application for auction come back in private electronic communications, and not by exclamation and immediately reflected in the trading system. Attempts to revive the stock market in Ukraine so far can not be called successful. There Exchange, a large number of exchanges registered as legal entities, but really functioning, vibrant stock market there. What would happen if the exchanges would not be? With the elimination of financial exchanges start chaos, as in the real sector will all the money circulating in the secondary securities market. All exchanges now provide what is called free competition, so necessary for the development of all countries.

Announcement Effects of Contingent Convertible Securities: Evidence from the Global Banking Industry

AbstractThis paper investigates the announcement effects of CoCo bonds issued by global banks between January 2009 and June 2014. Using a sample of 34 financial institutions, we examine abnormal stock price reactions and CDS spread changes before and after the announcement dates. We find that the announcement of CoCos correlates with positive abnormal stock returns and negative CDS spread changes in the immediate post‐announcement period. We explain these effects with a set of theories including the lowered probability of costly bankruptcy proceedings, a signaling framework based on pecking order theory and the cost advantage of CoCos over equity (tax shield).

How Accurately Can Convertibles be Classified as Debt or Equity for Tax Purposes? Evidence from Australia

Abstract The New Business Tax System (Debt and Equity) Act established a set of criteria by which convertible securities could be classified as “debt-like” or “equity-like” for tax purposes. Using data on 256 convertible issues made in Australia between 2001 and 2012, we show that there is a strong relation between, on the one hand, a convertible’s ex ante classification determined at issuance using the tax criteria and, on the other hand, its ex post classification based on the conversion premium at maturity. We conclude that the criteria have been an efficient means of classifying convertibles. We also find an industry effect where debt-like convertibles are more likely to be associated with the resources, metals and mining firms, whilst equity-like are mainly issued by the finance sector. This finding is consistent with the solution to a finance-sequencing problem in the former case, and the impact of capital adequacy regulation in the latter.

Disappearing Call Delay and Dividend‐Protected Convertible Bonds

ABSTRACTFirms do not historically call their convertible bonds as soon as conversion can be forced. A number of explanations for the delay rely on the size of the dividends that bondholders forgo so long as they do not convert. We investigate an important change in convertible security design, namely, dividend protection of convertible bond issues. Dividend protection means that the conversion value of the convertible bond is unaffected by dividend payments and thus dividend‐related rationales for call delay become moot. We document that call delay is near zero for dividend‐protected convertible bonds.

Announcement Effects of Contingent Convertible Securities: Evidence from the Global Banking Industry

This paper investigates the announcement effects of contingent convertible securities (CoCo bonds) issued by global banks between January 2009 and June 2014. Using a sample of 34 financial institutions and 87 CoCo bond issues, we examine abnormal stock price reactions and CDS spread changes before and after the announcement dates. We find that the announcement of CoCo bonds correlates with positive abnormal stock returns and negative CDS spread changes in the immediate post-announcement period. The effects are most pronounced for first-time issues. We explain the CDS spread changes by the lower probability of costly bankruptcy proceedings and the abnormal stock returns by a signaling framework that is based on pecking order theory and the cost advantage over equity (tax shield). We also examine the factors that are associated with the post-announcement abnormal stock returns and find that the existence of issuer call provisions reduces the positive abnormal returns.

A Model of Banks' Tier 1 Capital with Contingent Securities

The 2008-2009 financial crisis has brought unprecedented attention to banks' capital ratios. The recent introduction of Contingent Convertible securities (CoCo) allows banks a new way of increasing their Tier 1 capital if they are in danger of becoming insolvent. This paper proposes a parsimonious risk-neutral approach to value these interesting securities. Using Maximum Likelihood Estimation and simulation-based techniques, we evaluate this model with data from the Lloyds September 2009 CoCo issuance. Our model fares reasonably well considering its simple structure.

Valuation and analysis of contingent convertible securities with jump risk

We examine a new type of contingent capital, called contingent convertible security (CCS), when the asset value of the issuing firm follows a jump-diffusion process. The merit of CCS is that it can dynamically adjust capital structure almost without incurring adjustment costs. We obtain closed-form expressions of the equilibrium prices of all corporate securities. Compared with a standard capital structure, CCS can lead to as much as a 9.5% increase in the issuing firm's value but the number declines to 5.7% if classical contingent convertible bond (CCB) is issued instead of CCS. The larger the investment risk, the more pronounced the advantage of CCS over straight bond and CCB. In our model, CCS does not suffer the debt overhang problem and shareholders have no risk-shifting incentive to increase the diffusive volatility of asset value, though they benefit from a higher jump risk.

Signaling with convertible debt in the renewable energy industry?

Purpose – The purpose of this paper is to show how convertible debt is used in the renewable energy industry. The authors argue that there is an investor rationing component to the design and market impact of convertible debt securities. Design/methodology/approach – The authors apply event study methodology, option pricing theory and risk shift analysis to examine capital market reactions following the issuance of convertible debt by exchange-listed companies of the renewable energy sector. Findings – Contrary to prior cross-industry research findings, the authors show that convertible debt in the renewable energy industry tends to have a debt-like structure, and its issue is associated with strongly negative announcement returns. The authors further show that convertible issuers face high business risk and adverse selection costs. Practical implications – The results have important implications for both renewable energy industry companies and investors. For example, one problem is that the risk-mitigating features of convertible debt may not materialize, if issuers fail to credibly signal firm quality to the markets. Furthermore, excessive growth assumptions and mismatches between project risk/return and financing costs may render it more difficult to create credible signals. Originality/value – The paper contributes to three primary strands of literature. One is the research on finance and growth. Here, this paper provides new insights into risk-mitigating securities that should more effectively mirror the risk and return distributions of emerging industry issuers. Additionally, it extends the research on the motives for convertible debt offerings and provides insight on stock returns around such announcements.