CAIIB ABFM Module D Unit 1 : Hybrid Finance

12/10/2023

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CAIIB Paper 3 ABFM Module D Unit 1 : Hybrid Finance (New Syllabus)

IIBF has released the New Syllabus Exam Pattern for CAIIB Exam 2023. Following the format of the current exam, CAIIB 2023 will have now four papers. The CAIIB Paper 3 (ADVANCED CONCEPTS OF FINANCIAL MANAGEMENT) includes an important topic called “Hybrid Finance”. Every candidate who are appearing for the CAIIB Certification Examination 2023 must understand each unit included in the syllabus.

In this article, we are going to cover all the necessary details of CAIIB Paper 3 (ABFM) Module D (EMERGING BUSINESS SOLUTIONS) Unit 1 : Hybrid Finance, Aspirants must go through this article to better understand the topic, Hybrid Finance and practice using our Online Mock Test Series to strengthen their knowledge of Hybrid Finance. Unit 1 : Hybrid Finance

Introduction

The characteristics of debt and equity which are combined into a single instrument is known as a hybrid security.
For many years, Indian companies have been actively participating in the hybrid securities market by issuing preference shares, optionally or compulsorily convertible securities, and foreign currency convertible bonds, among other types of hybrid securities.
The issuance of hybrid securities, which give companies the ability to optimise the proportion of debt to equity in their overall capital structure, has become the preferred method for companies.
The maturity terms of hybrid issuances can vary, several call options can be exercised, and there is some leeway to increase the coupon rate.

Forms of Hybrid

Financing
Preference capital,
Warrants,
Convertible debentures,
Inventive hybrids

Foreign Currency Convertible Bond (FCCB):

A convertible bond that is denominated in a foreign currency is a subtype of a convertible debenture.
This is an instrument issued outside India but denominated in a different currency.
US Dollar is one of the most common currencies used for the Foreign Currency Convertible Bonds.
India’s capital raising efforts, of late the proportion of Foreign Currency Convertible Bonds to External Commercial Borrowings (ECB) and Rupee Denominated Bonds (RDB) has been quite low as is evident from the following table:

Types of Hybrid Securities

Advantages And Disadvantages Of Hybrid Securities

Advantages

Higher yield: Hybrid securities generally offer a higher rate of return than debt

Less volatile market price: Hybrid securities show less volatility in their market price as there is a regular, pre-determined, return.

Risk diversification: Hybrid securities can diversify the overall risk for the issuer as these do not have any strict definition of either equitable securities or debt securities,

Disadvantages

Assessment is difficult: Calculation of return on hybrid securities is not as simple as on equity or bond securities and, therefore, investing through these is more complicated.

Preference Share Capital

Higher priority claim on both the company’s income and assets than the equity shareholders have.
A dividend is guaranteed to preference shareholders, and this dividend must be paid out before any dividends are distributed to regular shareholders.
Cumulative or non-cumulative type of preference shares.
The repercussions of failing to pay the dividend on preference shares are not nearly as severe as those of failing to pay, for example, the interest on a debt obligation:
Preference shareholders, in contrast to creditors, do not have a legal claim to receive the dividend, which means that they are unable to push the company into bankruptcy if they are not paid.
However, in the event that the company is put into liquidation, which involves the sale of all of its assets and the use of the proceeds to settle all of its debts and pay off its owners, the preference shareholders will receive everything that is rightfully theirs before the equity shareholders receive anything.
The same organisations that assign ratings to corporate bond offerings also assign ratings to issues of preference shares.
In India, we have several Credit Rating Agencies like CRISIL, ICRA, CARE, Fitch etc., which are nationally recognised.
The term “perpetual or irredeemable preference shares” refers to preference shares that do not have a maturity date.

Salient Provisions of the Companies Act, 2013

As per Section 43 of the Companies Act, 2013, Preference Share Capital in case of any company limited by shares, means that part of the issued share capital of the company which carries or would carry a preferential right with respect to—

Payment of taxable or tax-free dividend, as a fixed amount or at a fixed rate.
Repayment of paid-up or deemed paid-up share capital, in the case of a winding up or repayment of capital, with or without any fixed premium or premium on any fixed scale, specified in the memorandum or articles of the company.
Capital shall be deemed to be preference capital, notwithstanding that it is entitled to either or both of the following rights, namely:

Right to participate in dividends over and above the preferential right to dividend, with capital not entitled to any preferential right; and/or
right to participate fully or to a limited extent in the surplus left on

winding up after all payments are made, with capital not entitled to that preferential right.

Section 47: Dividend in respect of a class of preference shares has not been paid for a period of 2 years or more, such class of preference shareholders shall have a right to vote on all the resolutions placed before the company.
Section 55: The issue and redemption of preference shares by a company limited by shares, further states that issue of irredeemable shares is prohibited and puts an outer limit of a period not exceeding 20 years from the date of their issue but permits issue of preference shares for a period exceeding 20 years for infrastructure projects, subject to the redemption of such percentage of shares as may be prescribed on an annual basis at the option of such preferential shareholders. Specific terms and conditions need to be fulfilled for such redemption.

Types of Preference Shares

Cumulative Preference Shares:

Holds the right to a definite sum of dividend or dividend at a predetermined rate.
These shares are more valuable than regular preference shares.
Dividend on these shares will continue to accumulate unless they are completely paid out.
Till payment is done, the unpaid dividends are recorded as a contingent liability in the company’s balance sheet.
Dividend is delayed for a period of at least 2 years, the holders of such shares shall be granted the right to participate in and vote on every resolution and every item brought before the general body meeting of the shareholders.

Non-Cumulative Preference Shares:

Grants the holder the right to receive a dividend payment that is predetermined in advance.
If for some reason a dividend is not declared throughout the course of a given year, the right to receive that dividend for that year will be forfeited.
As a consequence of this, the owner of such a share will never be eligible to receive dividends in arrears in the future.

Participating Preference Shares:

Right to a fixed dividend + participate in any surplus profits that remain after equity shareholders have been paid dividends at a predetermined rate.
Additionally, in the event that the company is wound up, the holder of this type of share is entitled to receive a predetermined amount of the surplus as well, but only after the equity shareholders have been compensated in full.

Non-Participating Preference Shares:

A non-participating preference share is a share that only receives a predetermined rate of dividend payment each year and does not get any additional rights in profits or in the surplus when the company is wound up.

Redeemable Preference Shares:

These shares are issued on the condition that the company will redeem them after the specified period or even earlier at the company’s option. A call option may also be incorporated in this type of shares, giving the company the right to redeem at a specified time and rate.

Non-Redeemable Preference Shares:

The preference shares that do not come with an arrangement regarding redemption, are referred to as Non-Redeemable Preference Shares.
Irredeemable preference shares can be redeemed by a company only on liquidation or shutting down of operations.
However, Indian companies are not permitted to issue irredeemable preference shares.

Convertible Preference Shares:

The holders of these shares have the right to have them converted into equity shares, at their discretion, in accordance with the terms and circumstances of the issue of which they are a part.

Non-Convertible Preference Shares:

A non-convertible preference share is one in which the owner of the preference share does not have the right to have his holdings converted into equity shares.
Unless explicitly indicated otherwise, preference shares cannot be converted into common stock.

Adjustable-rate Preference Shares:

Adjustable-rate preference shares do not qualify for a fixed dividend rate. The dividend pay-outs depend on the interest rates prevalent in the market.

Purpose of issuing Preference Shares

The following are some of the reasons why preference shares may be issued:

It is an improved method for acquiring capital in an uninteresting primary market.
If a firm’s shares can’t be bought and sold, it might have trouble obtaining funds, but the possibility of getting one’s money back at some point in the future could entice investors to invest in the company.
In most cases, the preference shares are redeemed when there is a surplus of cash and there are no other successful ventures in which to invest the money.
If there is a loss or a reduction in profit, there will be no dividend paid out, which is not the case with debentures or loans.
The investor interest in preference capital keeps fluctuating with the change in taxation laws.
Preference dividend, which was exempt from taxation in the hands of investors is once again taxable in the hands of the investor.
Therefore, investors’ willingness to accept a lower rate of dividend on preference capital, which was resulting in a lower cost of preference capital for the companies that were issuing it.

Redemption of Preference Shares

Redemption refers to the process of repaying an obligation at predetermined times and amounts over the course of its existence.
It is a contract that gives the holder the right to redeem preference shares at an agreed upon price either at the conclusion of a specific time period or before the end of that time period.
The redemption date, also known as the maturity date, is typically printed on the share certificate, and it indicates the day on which the repayment of the debt is planned to take place.
These shares are issued on the terms and conditions that the shareholders will be refunded the money invested by them in addition to the dividend that they get over the tenure of preference shares.

Methods of Redemption of Fully Paid Up Preference Shares

Section 55 of the Companies Act 2013:

Relating to redemption of preference shares.
It ensures that there is no reduction in shareholder’s funds due to redemption.
Therefore, it either issues fresh shares or distributable profits are retained and transferred to Capital redemption reserve Account.
This is done to safeguard the interest of outsiders who are to be paid before the redemption of preference shares.
The interest is safeguarded if the nominal value of capital redeemed is substituted thus maintaining the same amount of shareholder fund.
In case of redemption through fresh issue, the shareholder fund is kept intact directly while in case of distributable profits being retained and transferred to Capital Redemption Reserve Account, the same is kept intact indirectly.
In this case, the amount which would have gone to shareholders in the form of dividend is retained in the business and is used for settling the claim of preference shareholders.
The transfer of divisible profits to Capital redemption Reserve account makes them Non-divisible profits.

Perpetual Non-Cumulative Preference Shares

This type of Preference Shares is issued by Indian banks as part of Additional Tier 1 Capital, subject to extant legal provisions, only in Indian rupees and should meet the following terms and conditions to qualify for inclusion in Additional Tier 1 Capital for capital adequacy purposes:

The instruments should be issued by the bank (not a bank-created SPV) and fully paid up.
Bank boards may decide how much PNCPS to raise.
Perpetual Non-Cumulative Preference Shares (PNCPS) in Additional Tier 1 Capital cannot exceed 1.5% of risk-weighted assets.
Once this minimum total Tier 1 capital is met, any additional PNCPS issued by the bank can be added.
Excess PNCPS can be considered Tier 2 capital if less than 2% of RWAs, while meeting minimum Total Capital of 9% of RWAs.
The PNCPS have no maturity date, step-ups, or other redemption incentives.
Investor dividends may be fixed or floating, based on a market-determined rupee interest benchmark rate.
PNCPS shouldn’t have a “put option.” However, banks may issue instruments with a call option at a specific date.
The call option on the instrument is acceptable after it has run for at least five years;
To exercise a call option, a bank must have RBI (Department of Regulation) clearance;
A bank must not do anything that generates an expectation that the call will be exercised. The dividend/coupon reset date need not be co-terminus with the call date to avoid such expectations. Banks may, at their discretion, consider a gap between dividend/coupon reset date and call date.
Banks must not exercise a call unless:

i)They replace the called instrument with capital of the same or better quality at conditions sustainable for the bank’s income capacity; or

ii)The bank demonstrates that its capital position is well above the minimum capital requirements after the call. Exercise of calls due to tax event and regulatory event may be permitted.

The bank must have full discretion at all times to cancel distributions/payments. Dividends can neither be cumulative nor have a credit sensitive coupon feature.
PNCPS should absorb principal losses at a pre-specified trigger point either by converting to common shares or by writing down the instrument
Neither the bank nor a related party (as defined by relevant Accounting Standards) should purchase PNCPS, nor should the bank directly or indirectly fund the purchase. Banks should also not grant advances against their PNCPS.
FIIs and NRIs may invest up to 49% and 24% of the issue, respectively, with each investor limited to 10% and 5%.

Redemption of Preference Shares By Fresh Issue Of Shares

A company can use the proceeds from fresh issue of shares to redeem preference shares.
A problem arises when a fresh issue of shares is made at a premium.

For securities premium account, Section 52 of the companies Act, 2013 provides that the securities premium account may be applied by the company:

Towards issue of un-issued shares of the company to be issued to members of the company as fully paid bonus securities.
To write off preliminary expenses of the company
To write off the expenses of, or commission paid, or discount allowed on any of the securities or debentures of the company.
To provide for premium on redemption of preference shares or debentures of the company.
For the purchase of its own shares or securities. However, certain class of companies, as may be prescribed and whose financial statements comply with accounting standards prescribed for such class of companies, undersection 133 of the companies Act 2013, cannot apply the securities premium account for the purposes mentioned against points no. 2 and 4 above.

Features Of Warrants

The holder of a warrant has the right but not the responsibility to purchase a predetermined number of equity shares at a predetermined price during a predetermined time period.
This right is granted by the warrant.
In some cases, warrants are attached to the debt instruments in order to “sweeten” the terms of debt issues.
In many cases, the warrants are issued to the promoters, on a preferential basis, to provide them an option to increase their stake in the company within a specified future period.
For example, pursuant to the receipt of “In-principle Approval” from both the NSE and the BSE, the Allotment Committee of the Board of Directors of Man Industries (India) Ltd. allotted Rs.30 lakhs worth of warrants that are eligible for conversion into equity shares to M/s Man.
Finance Private Limited, a Promoter Group Entity in November 2020, at an issue price of 65 rupees per warrant along with a premium of 60 per warrant on a preferential basis in accordance with the SEBI (Issue of Capital and Disclosure Requirements) Regulations, 2018 [last amended on April 27, 2022].
The Company also received from M/s Man Finance Private Limited 25% of the consideration amount equalling Rs. 4,87,50,000/- that constituted the statutory minimum.
Warrants are also issued to institutional investors and other strategic investors, by the way of preferential allotment, to allow such entities to increase their stake if the company performs well.
As per regulation in India, in the case of preferential allotments, the buyer of the warrants has to pay 25% of the price, upfront.
This amount is adjusted against the final payment that is made in case the warrants are exercised.

In case the warrants are not exercised, the entire upfront payment is forfeited. To protect the interest of the minority shareholders, the pre-determined price of warrant conversion in cases of preferential allotment cannot be less than either:

The average of the weekly high and low of the closing prices of the related shares quoted on the stock exchange during the 6 months preceding the relevant date or,
The average of the weekly highs and lows of the closing prices of the related shares quoted on a stock exchange during the 2 weeks preceding the relevant date
The warrants do not carry any dividend or voting rights. Only after warrants are converted into equity shares, the investor gets these rights.

Features Of Convertible Debentures

The following are the provisions that apply to Fully or Partially Convertible Debentures, also known as FCDs and PCDs, in accordance with SEBI guidelines:

It is required that the conversion premium as well as the timing of the conversion be determined and reported in the prospectus.
If the conversion takes place at or after 18 months but before 36 months from the date of allotment, the holder of the debenture will have the option to convert either partially or fully if the conversion takes place during this time period.
Unless the conversion duration is made optional with “put” and “call” options, a conversion term, that is longer than 36 months, will not be approved.
If the fully convertible debentures have a conversion time that is longer than 18 months, there will be a mandatory requirement for a credit rating. It is obvious from the SEBI guidelines that there are now three different forms of convertible debentures that can be issued in India.
Debentures that are automatically convertible and have a conversion provision that takes effect after 18 months.
Debentures with an optional conversion feature that allow for the conversion to take place within 36 months
Debentures that allow for conversion after 36 months but have “call” and “put” features in addition to that provision.

Differences Between Warrants and Convertible Debentures

Both warrants and convertible debentures share the same core property in their structure. They confer a call option on the equity stock of the corporation upon the holder of the security.

However, there are several key distinctions between the two, which are as follows:

The debenture and the option in a convertible debenture cannot be separated from one another. However, a warrant, if issued as an attachment to debenture, can be removed at any time.
Warrants have the ability to be issued on their own. They do not have to be associated with any other instrument.
Warrants can normally be exercised for monetary compensation.
The conversion of convertible securities results in just an accounting transfer, but the exercise of warrants leads to the injection of additional capital into the company.
The vast majority of convertibles have a call provision, which provides the issuer with the option to either refund the debt or force conversion. This decision is based on whether the conversion value is more than or lower than the call price. Warrants, on the other hand, in usually cannot be cancelled.
Compared to warrants, convertibles often have more time until they expire.
In case of warrants issued on preferential basis, 25% amount is paid upfront and this is forfeited if the holder decides not convert these into equity shares. In case of optionally convertible debentures, no forfeiture is involved.

Valuation Of Warrants

The methods that are used to value options can be used to warrants because a warrant is comparable to a call option on the equity stock of the corporation that is issuing the warrant.
The maximum value that a warrant can have is determined by taking the current stock price and subtracting the exercise price from it.
The stock price itself determines the maximum value that a warrant can have.
The warrant price lies within the parameters established by the lower limit and the upper limit.

The following variables have an effect on the gap that exists between the current market price of the warrant and its minimum acceptable level:

The fluctuation in the prices of the stocks
Remaining time before expiration
Risk Free interest rate
The Value of the Stock
Exercise Price

Applying the Black Scholes Model

If one is willing to disregard the complexities brought about by dividends and/or dilution, it is possible to assess the value of a warrant by following this approach.
Black Scholes model is used for valuation of options.
As warrant is like a call option, this model can be used for its valuation also.
This model takes into consideration five variables viz.,

V(c) [Current Price] = S₀ * N(d1) – (E * e^-rt) * N(d2)

d1 = Log_n (S₀ / E) + [r + (0.5 * σ²/2)] * t / σ √t

d2 = d1 – σ √t

Where,

Ln = Natural log

S0 = Present Market price

E= Exercise Price

t= time remaining for maturity in years

σ = Standard deviation of share price

r = risk free interest rate

N= cumulative area under normal course

Example:

Current stock price = S₀ = Rs. 125

Total Number of warrants issued =1.6 lakh.

Exercise Price = E = Rs. 100

Time to expiration of warrants = 6 months (0.50 year), represented by t

Annual Standard Deviation of Stock Price Changes = 0.40, represented by σ

Risk free Interest Rate = 8%, represented by r

Log_n is a mathematical operation.

N is Cumulative Distribution Function of the standard normal distribution. It represents a standard normal distribution with mean = 0 and standard deviation = 1

V(c) [Current Price]= S₀ * N(d1) – (E * e^-rt) * N(d2)

S₀ = Rs. 125 σ= 0.40

E = Rs. 100 r= 8%

t= 0.50

First Step: Calculate d1 and d2

d1 = Log_n (S₀ / E) + [r + (0.5 * σ²/2)] * t / σ √t

= Log_n(125/ 100) + [0.08 + (0.5* 0.16/2)] * 0.50 / 0.40 √0.50

=0.2231+ [0.08 * 0.4] * 0.5 / 0.4 * 0.707

= (0.2231+0.08)/0.2828

= 1.0718

d2 = d1– σ √t

= 1.0718 – 0.2828 = 0.7890

Second Step: Find N(d1) and N(d2):

N(d1) and N(d2) represent the probabilities that a random variable, that has a standardized normal distribution, will assume values d1 and d2. These values can be obtained from the Probability Tables, readily available on internet. N(d1) =N(1.0718) = 0.8582 [ z= 1.0718 = 0.3585

N(d2) =N(0.7890) = 0.7849 [ z= 0.2849]

Third Step: Estimating the present value of the exercise price, using the continuous discounting principle

E/e^rt = 100/e^0.08*0.50 [ e^0.04 = 1.0408]

= 100/1.0408

= Rs. 96.08

Fourth Step: Plug the numbers, obtained above, in the Black Scholes Formula:

Current price (C0) = S₀N(d1) – E/e^rtN(d2)

= 125 * 0.8582 – 96.08 * 0.7849

= 107.27 – 75.41 = Rs. 31.86

Excel makes it relatively simple to apply each of these formulas for calculating option prices.

The functions NORM.DIST,EXP and LN have been used for computing the values in the above illustration and the dilution effect has not been considered.

Valuation Of Compulsorily Convertible (Partly Or Fully) Debentures

Debentures that can be converted into equity shares at the choice of the holder can be issued internationally under the heading of “Convertible Debentures”.
In India, in addition to such debentures, Companies also issue debentures which are compulsorily convertible partly or entirely into equity shares.
For instance, the Tata Iron and Steel Company made available party convertible debentures with a par value of rupees 1,200 in June 1989.

The most important provisions of these partly convertible debentures were as follows:

A mandatory conversion of Rs. 600 par value into equity shares of Rs. 100 at a premium of Rs. 500 on February 1,1990,
An interest rate of 12% per annum payable twice yearly, and
The redemption of the non-convertible portion at the end of 8 years.

Value of a Partially Convertible Debenture

What kind of value does a partially convertible debenture have, such as the one that TISCO had issued?

The holder of such debentures was entitled to receive

Interest at a predetermined rate throughout the term of the debenture,
Equity shares upon partial conversion, and
Payment pertaining to the portion of the debenture that was not convertible.

The value of such a dimension can therefore be stated in the following manner:

V₀= value of the convertible debentures at the time of issue,

I_t = interest receivable at the end of t,

n = life of the debenture,

a = number of equity shares receivable when part conversion or

conversion occurs at the end of period i,

P_i= expected price for equity share at the end of the period i,

Fj = instalment of principal repayment at the end of period j,

k_d = investor’s required rate of return on the debt component,

Ks = investor’s required rate of return on the equity component.

The time when the repayment of the instalments of principal starts, is shown as m. (the instalments of principal are paid over the period m to n)

Cost of a Partially Convertible Debenture

The discount rate used in the following equation represents the cost of a partly convertible debenture to the issuing company:

NS₀ = net subscription price realized at the time of issue,

I_t = the interest rate payable at the end of period t,

T = tax rate applicable to the firm,

a = number of equity shares to be given when part conversion occurs at

the end of period i,

Pi = price per equity share at the end of period i,

b = proportion of Pi that will be realizable net if the firm were to issue

equity shares to the public,

Fj = instalment of principal repayment at the end of period j,

r_c = discount rate representing the cost of capital,

m = time when the repayment of the instalments of principal starts

Valuation of Optionally Convertible Debentures

The valuation of an optionally convertible debenture is similar to that for a compulsorily convertible debenture.
A premium may be paid by the market for the option, available with the debenture-holder, to decline the conversion.
The amount of such premium will depend on the future prospects of the issuing company.
In case of well established companies, there may not be any such premium, but in case of a company, where the market is not so sure about its future prospects, the premium may be higher.
In any case, the valuation of an optionally convertible debenture will never be less than the valuation of a similar compulsorily convertible debenture.

Conversion Ratio and Conversion Price

CR = number of equity shares that can be obtained in exchange for one debenture upon conversion.
A number that is related to this one is called the conversion price, and it is denoted by the letter P.
The conversion price is the price per share that the holder really pays when the conversion takes place.
These ideas might be better understood with reference to their illustration.
In January 2016, AB Limited issued convertible debentures at a par value of 100 rupees each.
The holder of a debenture has the ability to convert one debenture into 5 equity shares at any time prior to the maturity date of January 1, 2022.
This results in a conversion ratio of 5, denoted by CR.
When the par value of Rs. 100 is divided by 5, the resulting number is the price per share, P, which is Rs. 20.
The conversion price is equal to the par value of the debenture divided by the number of shares received, which is equal to twenty rupees.
At the time of issuance, the conversion price, much like the exercise price of a warrant, is established at a level that is around 20–30% higher than the price that is currently being offered on the market.
In addition, both the conversion ratio and the conversion price will remain unchanged during the duration of the debenture.
There is, as is customary, a clause in place to safeguard the convertible debenture-holders, to provide protection against dilution caused by bonus issuance, stock splits, and the sale of equity shares at prices lower than the conversion price.

Objective Of Issuing Warrants And Convertible Debentures

Conventional explanations, on one hand, and contemporary financial reasons, on the other, make up the two basic categories here.

Conventional Explanations

Two of the most common reasons cited by executives in the financial industry for the issuance of warrants and convertible debentures are as follows:

They make it possible for businesses to inexpensively issue debt;
They give businesses the potential to offer equity shares at some point in the future and put an additional charge on top of the current pricing.

Modern Finance Explanation

The popularity of convertible debentures and debentures with warrants can be better understood with the help of modern financial theory,
Which provides improved explanations for this phenomenon.
These instruments facilitate better matching of cash flows, generate financial synergy, and help alleviate agency issues.

Matching of Cash Flows

Financial instruments that can be easily serviced are typically preferred by businesses.
Because of the low initial interest burden, convertible debentures or debentures with warrants may be tempting to a developing but risky company.
Naturally, if the company is successful, the investors will try to convert their investment.
Although it will result in pricey dilution, the company might not mind if it takes place when it is in a position to pay for it.

Financial Synergy

When it is particularly expensive or impossible to evaluate the risk characteristics of the issuing company, it makes sense to purchase convertible debentures as well as debentures that come with warrants.
Imagine that you are conducting an analysis of a brand-new business that has plans to produce a brand-new product that will be offered for the very first time in India.
You are unsure if the company is high risk (in which case your projected yield on straight debentures will be 20%) or low risk (in which case your expected yield on St debentures will be 15%).
You do not know which category the company falls under.
In a scenario such as this one, convertible debentures and debentures that come with warrants offer some degree of protection against inaccurate risk assessments.

Agency Cost

The agency concerns that are linked with financing can be mitigated with the use of convertible debentures and debentures that come with warrants.
In order to limit the amount of risk that the offer is exposed to, the holders of straight debentures set restrictions on the offer.
They behave in this manner to reduce the potential for incurring default risk.
On the other hand, equity investors want the company to take on high risk initiatives since their claim is analogous to that of holders of call options.
If the competing demands of equity owners and debt holders are not met in an appropriate manner, the company may be forced to forego potentially lucrative investment possibilities.
Debentures that can be converted into equity and debentures that come with warrants could give a solution to this dispute that is acceptable to all parties.
When you invest in these assets, you will likely be less concerned about the potential increase in future risk, and as a result, you will be less likely to apply very stringent debt covenants.
Because you have a stake in the outcome of both wins and losses, it does not bother you if the company takes on unanticipated risk or behaves in a manner that is not in line with the interests of bondholders.

Features Of Foreign Currency Convertible Bond (FCCB)

Foreign currency convertible bond (FCCB) is a bond issued in a currency other than the issuer’s domestic currency, i.e., foreign currency.
A convertible bond is a hybrid of debt and equity instruments.
The holder gets a regular coupon and principal payment, but they also get the option to convert the bond into equity shares.
The conversion rate at which the bonds will be converted to equity is specified in the terms of issue of the bonds.
As the holder has the option, if the stock price is below the conversion price on the relevant date, he will not convert the bond into equity shares.
FCCB investors are usually hedge funds and foreign investors.
These bonds may also have a call option, whereby, the right of early redemption lies with the bond issuer, or put option whereby, the right of early redemption lies with bondholder.
FCCBs are generally issued by corporates in those currencies which are stable and for which, the interest rates are lower.
The coupon payments on such bonds are lower than that on a straight coupon-bearing plain vanilla bond, because of the attraction of conversion option.

Mezzanine Financing

Gives the lender the right to convert the debt in to equity of the company in case of default.
Mezzanine financing is normally for raising funds for specific projects or to finance an acquisition.
Mezzanine financing can provide higher returns to investors compared to normal debt instruments.
However, for the issuing company, its cost is lower than the cost of equity capital
Therefore, it can be considered as very expensive debt or cheaper equity.
Mezzanine debt is often an unsecured debt.
It may be structured with partially fixed and partially variable interest rates.
It typically matures in more than 5 years. depending on the scheduled maturities of existing debt in the books of the issuing company.

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CAIIB Paper 3 Module D UNIT 1- HYBRID FINANCE ( Ambitious_Baba )