Finance management cengage 2013 chapter 020

Chapter 20

Hybrid Financing: Preferred Stock,
Leasing, Warrants, and Convertibles
Preferred Stock
Leasing
Warrants
Convertibles
20-1
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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.
20-2
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Lease vs. Borrow-and-Buy
Data:
• New computer costs $1,200,000.
• 3-year MACRS class life; 4-year economic life.
• Tax rate = 40%.
• rd = 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.
20-3
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Depreciation Schedule
Depreciable basis = $1,200,000
Year
1
2
3
4

MACRS
Rate
0.33
0.45
0.15
0.07
1.00

Depreciation End-of-Year
Expense
Book Value
$ 396,000
$804,000
540,000
264,000
180,000
84,000
84,000
0
$1,200,000
20-4

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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, rd, was
10%. Therefore, we should discount cash flows at
6%.
rd(1 − T) = 10%(1 – T) = 10%(1 – 0.4) = 6%.

20-5
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Cost of Owning Analysis
0
Cost of asset
Deprec. tax savings
Maintenance (AT)

1

2

3

-1,200.0
158.4 216.0 72.0

33.6

-15.0 -15.0 -15.0 -15.0

Residual value (AT)
Cash flow

4

-1,215.0 143.4 201.0

57.0

75.0
108.6

PV of the cost of owning (@ 6%) = -$766.948
20-6
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Notes on Cost of Owning Analysis

•

Depreciation is a tax deductible expense, so it
produces a tax savings of T(Depreciation). Year 1
= 0.4($396) = $158.4.

•

Each maintenance payment of $25 is deductible
so the after-tax cost of the maintenance
payment is (1 – T)($25) = $15.

•

The ending book value is $0 so the full $125
salvage (residual) value is taxed,
(1 – T)($125) = $75.0.

20-7
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Cost of Leasing Analysis

A-T Lease pmt

•

0

1

2

3

-204

-204

-204

-204

4

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.

20-8
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Net Advantage of Leasing

•

NAL = PV cost of owning – PV cost of leasing

•

NAL = $766.948 – $749.294

= $17.654 (Dollars in thousands)

•

Since the cost of owning outweighs the cost of
leasing, the firm should lease.

20-9
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What if there is a lot of uncertainty about 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.

20-10
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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.

20-11
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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.

20-12
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What is adjustable-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 adjustable rate generally keeps issue trading
near par.

•

However, if the issuer is risky, the adjustable-rate
preferred stock may have too much price instability
for the liquid asset portfolios of many corporate

investors.
20-13

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How can a knowledge of call options help one
understand warrants and convertibles?

•
•

A warrant is a long-term call option.

•

An understanding of options will help financial
managers make decisions regarding warrant and
convertible issues.

A convertible bond consists of a fixed-rate bond
plus a call option.

20-14
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A Firm Wants to Issue a Bond with Warrants Package
at a Face Value of $1,000

•
•

Current stock price (P0) = $10.

•

50 warrants attached to each bond with an exercise
price of $12.50.

•

Each warrant’s value will be $1.50.

rd of equivalent 20-year annual payment bonds
without warrants = 12%.

20-15
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What coupon rate should be set for this bond
plus warrants package?

•

Step 1: Calculate the value of the bonds in the
package
VPackage = VBond + VWarrants = $1,000.
VWarrants = 50($1.50) = $75.

VBond + $75 = $1,000
VBond

= $925.
20-16

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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

20

12

-925

N

I/YR

PV

1000
PMT

FV

110

20-17
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What is the expected rate of return to holders of bonds
with warrants, if exercised in 5 years at P5 = $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.

20-18
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Finding the Opportunity Cost of Capital for the Bond
with Warrants Package

•

Here is the cash flow time line:
0

1

+1,000

-110

•

...

4

5

6

-110

-110
-250
-360

-110

...

19
-110

20
-110
-1,000
-1,110

Input the cash flows into a financial calculator (or
spreadsheet) and find IRR = 12.93%. This is the
20-19
pre-tax
cost.
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The Firm is Now Considering a Callable, Convertible
Bond Issue

•

20-year, 10% annual coupon, callable convertible

bond will sell at its $1,000 par value; straight-debt
issue would require a 12% coupon.

•
•
•

Call the bonds when conversion value > $1,200.
P0 = $10; D0 = $0.74; g = 8%.
Conversion ratio = CR = 80 shares.

20-20
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What conversion price (Pc) is implied by this bond
issue?

•

The conversion price can be found by dividing the
par value of the bond by the conversion ratio,
$1,000/80 = $12.50.

•

The conversion price is usually set 10% to 30%
above the stock price on the issue date.

20-21

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What is the convertible’s straight-debt value?

•

Recall that the straight-debt coupon rate is 12%
and the bonds have 20 years until maturity.
INPUTS
OUTPUT

20

12

N

I/YR

PV

100

1000

PMT

FV

-850.61

20-22
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Implied Convertibility Value

•

Because the convertibles will sell for $1,000, the
implied value of the convertibility feature is
$1,000 – $850.61 = $149.39.
$149.39/80 = $1.87 per share.

•

The convertibility value corresponds to the warrant
value in the previous example.

20-23
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What is the formula for the bond’s expected
conversion value in any year?

•

Conversion value = Ct = CR(P0)(1 + g)t.

•

At t = 0, the conversion value is
C0 = 80($10)(1.08)0 = $800.

•

At t = 10, the conversion value is
C10 = 80($10)(1.08)10 = $1,727.14.

20-24
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What is meant by the floor value of a convertible?

•

The floor value is the higher of the straight-debt
value and the conversion value.

•

At t = 0, the floor value is $850.61.
Straight-debt value0 = $850.61. C0 = $800.

•

At t = 10, the floor value is $1,727.14.

Straight-debt value10 = $887.00. C10 = $1,727.14.

•

Convertibles usually sell above floor value because
convertibility has an additional value.

20-25
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