Online Case Studies accompanying Business Finance, 8th Edition

Chapter 19 — Timbercorp Limited’s issue of converting preference shares (Options and Contingent Claims)

Timbercorp Limited is a leading company in the agribusiness investment industry and listed on the Australian Stock Exchange (ASX) in 1996. Timbercorp’s primary business activity is the management of a range of horticultural and agricultural investment projects, aimed at providing tax-effective investment opportunities to wealthy individual investors. The company initially focused its activities on forestry plantation projects, but has recently diversified into olive grove and almond orchard investments due to the growing demand for these commodities and the longer-life nature of these crop plantations.

To fund further expansion into these new investment activities, Timbercorp announced on 16 October 2001 an issue of converting preference shares with the aim of raising $30 million. The proceeds from this issue would be used for a number of applications, namely:

  • the establishment of an olive processing facility as part of the expansion into olive grove investment;
  • a reduction in the degree of leverage (debt) of the company; and
  • the provision of ongoing working capital to support these expansion activities and new investment projects.

The details relating to this issue of converting preference shares are as follows:

Timbercorp Limited — Issue of Converting Preference Shares

Security nature: / Converting preference shares with a face value or issue value of $1.00.
Term of the security: / Five years to maturity. Final conversion date, if not converted earlier, is December 2006.
Dividend rate: / 9 per cent fully franked, payable half-yearly based on the $1.00 face value.
Conversion details: / Convertible into Timbercorp Limited ordinary shares at a 10 per cent discount to the market price in December 2004, 2005 or 2006, subject to a:
  • minimum conversion price of $0.25; and
  • a maximum conversion price of $0.75 per ordinary share

At the time of the announcement of the converting preference share issue (16 October 2001), Timbercorp ordinary shares were trading at $0.53.

As these converting preference shares are non-redeemable and will mature and convert into Timbercorp ordinary shares in 2006, and potentially earlier at the discretion of holders of the convertible preference shares, they represent equity securities with an attached option component. The option feature is represented by the convertibility of these securities into ordinary shares of the company in December 2004 or 2005. This option component, however, differs from normal stand-alone option or warrant securities in that it has the ability to take on the characteristic of either a long call option or a short put option dependent on the prevailing price of the underlying Timbercorp Limited shares. Although this feature is slightly different from standard option securities, the option component associated with these converting preference shares can be valued in a similar fashion to traditional option securities using the Black-Scholes option-pricing model.

The return being offered by these securities comprises both a stable income return (represented by the 9 per cent fully-franked annual dividend) plus the potential for capital appreciation in both the price of the converting preference shares and through the option component (with unlimited upside gain at a share price for Timbercorp Limited above $0.825). As such, they are potentially attractive to investors looking for a stable income cash flow, as well as investors requiring capital growth and option-related attributes.

Questions:

1)Consider the option component associated with these converting preference shares. Explain how these shares can represent either a long (purchased) call option or a short (written) put option, and outline what factors will determine the total return earned from investing in these securities.

2)Using both graphs and figures, outline the potential pay-offs to investors associated with the option component of these converting preference shares. Under what conditions would an investor choose to convert these preference shares into Timbercorp ordinary shares prior to the final conversion date of December 2006?

3)Assuming that investors choose to hold these converting preference shares until December 2006, what is the minimum price of Timbercorp ordinary shares required for investors to receive a pay-off from the call option? How important is the option component associated with these securities to the potential attractiveness of these securities to investors?

Online Case Studies t/a Business Finance 8e by Peirson et al.1