Slide Financial Management - Chapter 20 pptx

20-1
CHAPTER 20
Hybrid Financing:
Preferred Stock, Leasing, Warrants, and
Convertibles
 Preferred stock
 Leasing
 Warrants
 Convertibles
20-2
Leasing
 Often referred to as “off balance sheet”
financing if a lease is not “capitalized.”
 Leasing is a substitute for debt financing and,
thus, uses up a firm’s debt capacity.
 Capital leases are different from operating
leases:
 Capital leases do not provide for maintenance
service.
 Capital leases are not cancelable.
 Capital leases are fully amortized.
20-3
Analysis: Lease vs. Borrow-
and-buy
Data:
 New computer costs $1,200,000.
 3-year MACRS class life; 4-year economic life.
 Tax rate = 40%.
 k
d
= 10%.

 Maintenance of $25,000/year, payable at
beginning of each year.
 Residual value in Year 4 of $125,000.
 4-year lease includes maintenance.
 Lease payment is $340,000/year, payable at
beginning of each year.
20-4
Depreciation schedule
Depreciable basis = $1,200,000
MACRS Depreciation End-of-Year
Year
Rate Expense Book Value
1 0.33 $ 396,000 $804,000
2 0.45 540,000 264,000
3 0.15 180,000 84,000
40.07
84,000 0
1.00
$1,200,000
20-5
In a lease analysis, at what discount
rate should cash flows be discounted?
 Since cash flows in a lease analysis are
evaluated on an after-tax basis, we should
use the after-tax cost of borrowing.
 Previously, we were told the cost of debt, k
d
,
was 10%. Therefore, we should discount
cash flows at 6%.

A-T kd = 10%(1 – T) = 10%(1 – 0.4) = 6%.
20-6
0 1 2 3 4
Cost of Owning Analysis
Cost of asset (1,200.0)
Dep. tax savings
1
158.4 216.0 72.0 33.6
Maint. (AT)
2
(15.0) (15.0) (15.0) (15.0)
Res. value (AT)
3
______ _____ _____ _____ 75.0
Net cash flow (1,215.0) 143.4 201.0 57.0 108.6
PV cost of owning (@ 6%) = -$766.948.
Analysis in thousands:
20-7
Notes on Cost of Owning Analysis
1. Depreciation is a tax deductible
expense, so it produces a tax savings of
T(Depreciation). Year 1 = 0.4($396) =
$158.4.
2. Each maintenance payment of $25 is
deductible so the after-tax cost of the
lease is (1 – T)($25) = $15.
3. The ending book value is $0 so the full
$125 salvage (residual) value is taxed,
(1 - T)($125) = $75.0.
20-8

Cost of Leasing Analysis
 Each lease payment of $340 is deductible,
so the after-tax cost of the lease is
(1-T)($340) = -$204.
 PV cost of leasing (@6%) = -$749.294.
0 1 2 3 4
A-T Lease pmt -204 -204 -204 -204
Analysis in thousands:
20-9
Net advantage of leasing
 NAL = PV cost of owning – PV cost of leasing
 NAL = $766.948 - $749.294
= $17.654
 Since the cost of owning outweighs the cost
of leasing, the firm should lease.
(Dollars in thousands)
20-10
Suppose there is a great deal of
uncertainty regarding the computer’s
residual value
 Residual value could range from $0 to
$250,000 and has an expected value of
$125,000.
 To account for the risk introduced by an
uncertain residual value, a higher discount
rate should be used to discount the residual
value.
 Therefore, the cost of owning would be
higher and leasing becomes even more
attractive.

20-11
What if a cancellation clause were
included in the lease? How would this
affect the riskiness of the lease?
 A cancellation clause lowers the risk
of the lease to the lessee.
 However, it increases the risk to the
lessor.
20-12
How does preferred stock differ
from common equity and debt?
 Preferred dividends are fixed, but
they may be omitted without placing
the firm in default.
 Preferred dividends are cumulative up
to a limit.
 Most preferred stocks prohibit the
firm from paying common dividends
when the preferred is in arrears.
20-13
What is floating rate preferred?
 Dividends are indexed to the rate on treasury
securities instead of being fixed.
 Excellent S-T corporate investment:
 Only 30% of dividends are taxable to
corporations.
 The floating rate generally keeps issue trading
near par.
 However, if the issuer is risky, the floating
rate preferred stock may have too much price

instability for the liquid asset portfolios of
many corporate investors.
20-14
How can a knowledge of call options
help one understand warrants and
convertibles?
 A warrant is a long-term call option.
 A convertible bond consists of a
fixed rate bond plus a call option.
20-15
A firm wants to issue a bond with
warrants package at a face value of
$1,000. Here are the details of the issue.
 Current stock price (P
0
) = $10.
 k
d
of equivalent 20-year annual
payment bonds without warrants =
12%.
 50 warrants attached to each bond with
an exercise price of $12.50.
 Each warrant’s value will be $1.50.
20-16
What coupon rate should be set for
this bond plus warrants package?
 Step 1 – Calculate the value of the
bonds in the package
V

Package
= V
Bond
+ V
Warrants
= $1,000.
V
Warrants
= 50($1.50) = $75.
V
Bond
+ $75 = $1,000
V
Bond
= $925.
20-17
Calculating required annual coupon
rate for bond with warrants package
 Step 2 – Find coupon payment and rate.
 Solving for PMT, we have a solution of $110,
which corresponds to an annual coupon rate
of $110 / $1,000 = 11%.
INPUTS
OUTPUT
N I/YR PMTPV FV
20 12
110
1000-925
20-18
If after the issue, the warrants sell for

$2.50 each, what would this imply about
the value of the package?
 The package would have been worth $925
+ 50(2.50) = $1,050. This is $50 more
than the actual selling price.
 The firm could have set lower interest
payments whose PV would be smaller by
$50 per bond, or it could have offered
fewer warrants with a higher exercise price.
 Current stockholders are giving up value to
the warrant holders.
20-19
Assume the warrants expire 10 years
after issue. When would you expect
them to be exercised?
 Generally, a warrant will sell in the
open market at a premium above its
theoretical value (it can’t sell for less).
 Therefore, warrants tend not to be
exercised until just before they expire.
20-20
Optimal times to exercise
warrants
 In a stepped-up exercise price, the exercise
price increases in steps over the warrant’s
life. Because the value of the warrant falls
when the exercise price is increased, step-up
provisions encourage in-the-money warrant
holders to exercise just prior to the step-up.
 Since no dividends are earned on the

warrant, holders will tend to exercise
voluntarily if a stock’s dividend rises enough.
20-21
Will the warrants bring in additional
capital when exercised?
 When exercised, each warrant will bring in
the exercise price, $12.50, per share
exercised.
 This is equity capital and holders will receive
one share of common stock per warrant.
 The exercise price is typically set at 10% to
30% above the current stock price on the
issue date.
20-22
Because warrants lower the cost of
the accompanying debt issue, should
all debt be issued with warrants?
 No, the warrants have a cost that
must be added to the coupon
interest cost.
20-23
What is the expected rate of return to
holders of bonds with warrants, if
exercised in 5 years at P
5
= $17.50?
 The company will exchange stock worth
$17.50 for one warrant plus $12.50.
The opportunity cost to the company is
$17.50 - $12.50 = $5.00, for each

warrant exercised.
 Each bond has 50 warrants, so on a par
bond basis, opportunity cost =
50($5.00) = $250.
20-24
Finding the opportunity cost of capital
for the bond with warrants package
 Here is the cash flow time line:
 Input the cash flows into a financial
calculator (or spreadsheet) and find IRR
= 12.93%. This is the pre-tax cost.
0 1 4 5 6 19 20
+1,000 -110 -110 -110 -110 -110 -110
-250 -1,000
-360 -1,110

20-25
Interpreting the opportunity cost of
capital for the bond with warrants
package
 The cost of the bond with warrants
package is higher than the 12% cost of
straight debt because part of the expected
return is from capital gains, which are
riskier than interest income.
 The cost is lower than the cost of equity
because part of the return is fixed by
contract.