Corporate Finance Theory and Practice, Third Edition

Chapter 25

HYBRID SECURITIES

it's a kind of magic

Before we begin the study of these different products, we caution the reader to bear in mind the following points.

• Some types of securities offer a lower interest rate in exchange for other advantages to the holder, and therefore give the impression of lowering the cost of financing to the company. It is an error to think this way. In markets in equilibrium, all sources of financing have the same cost if one adjusts for the risk borne by the investor.
• To know whether a source of financing is cheap or dear, one must look past the apparent cost to the overall valuation of the financing. Only if securities have been issued at prices higher than market value can one say that the cost of financing is indeed lower.
• With the exception of products that exactly match a particular market demand, these sophisticated hybrid securities are costly to issue and sell. As such, they are a signal to investors that the company, or its majority shareholder, is having trouble attracting investors, perhaps because it is experiencing other difficulties.
• By emphasising the fundamental asymmetry of information between issuer and investor, agency theory and signalling theory are both very useful for explaining the appeal of products of this kind.
• Lastly, it must not be forgotten that corporate finance is not immune to fashion. Investors have a great appetite for novelty, especially if it gives them the feeling of doing high finance!

Hybrid instruments ...