In Practice: Security Innovation and Changing Capital Structure

The changes in leverage discussed so far in this chapter have been accomplished using traditional securities, such as straight debt and equity, but firms that have specific objectives on leverage may find certain products that are designed to meet those objectives. Consider a few examples:

• Hybrid securities (such as convertible bonds) are combinations of debt and equity that change over time as the firm changes. To be more precise, if the firm prospers and its equity value increases, the conversion option in the convertible bond will become more valuable, thus increasing the equity component of the convertible bond and decreasing the debt component (as a percent of the value of the bond). If the firm does badly and its stock price slides, the conversion option (and the equity component) will become less valuable, and the debt ratio of the firm will increase.
• An alternative available to a firm that wants to increase leverage over time is a forward contract to buy a specified number of shares of equity in the future. These contracts lock the firms into reducing their equity over time and may carry a more positive signal to financial markets than would an announcement of plans to repurchase stock, because firms are not obligated to carry  through on these announcements.

A  firm  with  high  leverage,  faced  with  a  resistance  from  financial  markets  to common stock issues, may consider more inventive ways of raising equity, such as using warrants and contingent value rights. Warrants represent call options on the  firm's  equity,  whereas  contingent  value  rights  are  put  options  on  the  firm's stock. The former have appeal to those who are optimistic about the future of the company and the latter make sense for risk averse investors who are concerned about the future.