Business finance ch 20 hybrid financing

CHAPTER 20
Hybrid Financing:
Preferred Stock, Leasing, Warrants,
and Convertibles





Preferred stock
Leasing
Warrants
Convertibles
20-1


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


Analysis: Lease vs. Borrowand-buy
Data:
 New computer costs $1,200,000.
 3-year MACRS class life; 4-year economic
life.
 Tax rate = 40%.
 k = 10%.
d
 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
20-3
at beginning of each year.


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
4
0.07
84,000
0
1.00
$1,200,000
20-4


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, kd, was 10%. Therefore, we should
discount cash flows at 6%.
A-T kd = 10%(1 – T) = 10%(1 – 0.4) =
6%.
20-5


Cost of Owning Analysis
Analysis in thousands:

0

1

2

3

4

Cost of asset
(1,200.0)
Dep. tax savings1

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.
20-6


Notes on Cost of Owning
Analysis
1.

2.

3.

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 lease 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


Cost of Leasing Analysis
Analysis in thousands:

A-T Lease pmt

0

1

2

3

-204

-204

-204

-204



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.

4

20-8


Net advantage of leasing


NAL = PV cost of owning – PV cost of
leasing



in thousands)
NAL = $766.948(Dollars
- $749.294
= $17.654



Since the cost of owning outweighs the
cost of leasing, the firm should lease.
20-9

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.
20-10


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


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


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.
20-13


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.

20-14


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 (P0) = $10.



kd 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.





20-15


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


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


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.
20-18


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.
20-19


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.

20-20


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.
20-21


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.

20-22

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.
20-23


Finding the opportunity cost of
capital for the bond with warrants
package


0

Here is the cash flow time line:
1

+1,000 -110



...

4

5

-110 -110
-250
-360

6
-110

...

19

20

-110

-110
-1,000
-1,110

Input the cash flows into a financial

calculator (or spreadsheet) and find
IRR = 12.93%. This is the pre-tax cost.
20-24


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.
20-25