1、20-1CHAPTER 20Hybrid Financing:Preferred Stock,Leasing,Warrants,and ConvertiblesPreferred stockLeasingWarrantsConvertibles20-2LeasingnOften referred to as“off balance sheet”financing if a lease is not“capitalized.”nLeasing is a substitute for debt financing and,thus,uses up a firms debt capacity.nCa
2、pital leases are different from operating leases:nCapital leases do not provide for maintenance service.nCapital leases are not cancelable.nCapital leases are fully amortized.20-3Analysis:Lease vs.Borrow-and-buyData:nNew computer costs$1,200,000.n3-year MACRS class life;4-year economic life.nTax rat
3、e=40%.nkd=10%.nMaintenance of$25,000/year,payable at beginning of each year.nResidual value in Year 4 of$125,000.n4-year lease includes maintenance.nLease payment is$340,000/year,payable at beginning of each year.20-420-520-60 1 2 3 4Cost of Owning AnalysisCost of asset(1,200.0)Dep.tax savings1 158.
4、4 216.0 72.0 33.6Maint.(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 57.0108.6PV cost of owning(6%)=-$766.948.Analysis in thousands:20-7Notes on Cost of Owning Analysis1.Depreciation is a tax deductible expense,so it produces a tax savings of T(Depreciation)
5、.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)=$75.0.20-8Cost of Leasing AnalysisnEach lease payment of$340 is deductible,so the after
6、-tax cost of the lease is(1-T)($340)=-$204.nPV cost of leasing(6%)=-$749.294.0 1 2 3 4A-T Lease pmt -204 -204 -204 -204Analysis in thousands:20-9Net advantage of leasingnNAL=PV cost of owning PV cost of leasingnNAL=$766.948-$749.294=$17.654 nSince the cost of owning outweighs the cost of leasing,the
7、 firm should lease.(Dollars in thousands)20-10Suppose there is a great deal of uncertainty regarding the computers residual valuenResidual value could range from$0 to$250,000 and has an expected value of$125,000.nTo account for the risk introduced by an uncertain residual value,a higher discount rat
8、e should be used to discount the residual value.nTherefore,the cost of owning would be higher and leasing becomes even more attractive.20-11What if a cancellation clause were included in the lease?How would this affect the riskiness of the lease?nA cancellation clause lowers the risk of the lease to
9、 the lessee.nHowever,it increases the risk to the lessor.20-12How does preferred stock differ from common equity and debt?nPreferred dividends are fixed,but they may be omitted without placing the firm in default.nPreferred dividends are cumulative up to a limit.nMost preferred stocks prohibit the f
10、irm from paying common dividends when the preferred is in arrears.20-13What is floating rate preferred?nDividends are indexed to the rate on treasury securities instead of being fixed.nExcellent S-T corporate investment:nOnly 30%of dividends are taxable to corporations.nThe floating rate generally k
11、eeps issue trading near par.nHowever,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.20-14How can a knowledge of call options help one understand warrants and convertibles?nA warrant is a long-te
12、rm call option.nA convertible bond consists of a fixed rate bond plus a call option.20-15A firm wants to issue a bond with warrants package at a face value of$1,000.Here are the details of the issue.nCurrent stock price(P0)=$10.nkd of equivalent 20-year annual payment bonds without warrants=12%.n50
13、warrants attached to each bond with an exercise price of$12.50.nEach warrants value will be$1.50.20-16What coupon rate should be set for this bond plus warrants package?nStep 1 Calculate the value of the bonds in the packageVPackage=VBond+VWarrants=$1,000.VWarrants=50($1.50)=$75.VBond +$75=$1,000 VB
14、ond=$925.20-17Calculating required annual coupon rate for bond with warrants packagenStep 2 Find coupon payment and rate.nSolving for PMT,we have a solution of$110,which corresponds to an annual coupon rate of$110/$1,000=11%.INPUTSOUTPUTNI/YRPMTPVFV20121101000-92520-18If after the issue,the warrants
15、 sell for$2.50 each,what would this imply about the value of the package?nThe package would have been worth$925+50(2.50)=$1,050.This is$50 more than the actual selling price.nThe firm could have set lower interest payments whose PV would be smaller by$50 per bond,or it could have offered fewer warra
16、nts with a higher exercise price.nCurrent stockholders are giving up value to the warrant holders.20-19Assume the warrants expire 10 years after issue.When would you expect them to be exercised?nGenerally,a warrant will sell in the open market at a premium above its theoretical value(it cant sell fo
17、r less).nTherefore,warrants tend not to be exercised until just before they expire.20-20Optimal times to exercise warrantsnIn a stepped-up exercise price,the exercise price increases in steps over the warrants life.Because the value of the warrant falls when the exercise price is increased,step-up p
18、rovisions encourage in-the-money warrant holders to exercise just prior to the step-up.nSince no dividends are earned on the warrant,holders will tend to exercise voluntarily if a stocks dividend rises enough.20-21Will the warrants bring in additional capital when exercised?nWhen exercised,each warr
19、ant will bring in the exercise price,$12.50,per share exercised.nThis is equity capital and holders will receive one share of common stock per warrant.nThe exercise price is typically set at 10%to 30%above the current stock price on the issue date.20-22Because warrants lower the cost of the accompan
20、ying debt issue,should all debt be issued with warrants?nNo,the warrants have a cost that must be added to the coupon interest cost.20-23What is the expected rate of return to holders of bonds with warrants,if exercised in 5 years at P5=$17.50?nThe company will exchange stock worth$17.50 for one war
21、rant plus$12.50.The opportunity cost to the company is$17.50-$12.50=$5.00,for each warrant exercised.nEach bond has 50 warrants,so on a par bond basis,opportunity cost=50($5.00)=$250.20-24Finding the opportunity cost of capital for the bond with warrants packagenHere is the cash flow time line:nInpu
22、t 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 -1,110.20-25Interpreting the opportunity cost of capital for the bond with warrants packagenThe cost of the bond with warrants packa
23、ge 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.nThe cost is lower than the cost of equity because part of the return is fixed by contract.20-26The firm is now considering a callable,convertible bond issu
24、e,described below:n20-year,10%annual coupon,callable convertible bond will sell at its$1,000 par value;straight debt issue would require a 12%coupon.nCall the bonds when conversion value$1,200.nP0=$10;D0=$0.74;g=8%.nConversion ratio=CR=80 shares.20-27What conversion price(Pc)is implied by this bond
25、issue?nThe conversion price can be found by dividing the par value of the bond by the conversion ratio,$1,000/80=$12.50.nThe conversion price is usually set 10%to 30%above the stock price on the issue date.20-28What is the convertibles straight debt value?nRecall that the straight debt coupon rate i
26、s 12%and the bonds have 20 years until maturity.INPUTSOUTPUTNI/YRPMTPVFV20121001000-850.6120-29Implied Convertibility ValuenBecause the convertibles will sell for$1,000,the implied value of the convertibility feature is$1,000$850.61=$149.39.=$1.87 per share.nThe convertibility value corresponds to t
27、he warrant value in the previous example.20-30What is the formula for the bonds expected conversion value in any year?nConversion value=Ct=CR(P0)(1+g)t.nAt t=0,the conversion value is C0=80($10)(1.08)0=$800.nAt t=10,the conversion value is C10=80($10)(1.08)10=$1,727.14.20-31What is meant by the floo
28、r value of a convertible?nThe floor value is the higher of the straight debt value and the conversion value.nAt t=0,the floor value is$850.61.nStraight debt value0=$850.61.C0=$800.nAt t=10,the floor value is$1,727.14.nStraight debt value10=$887.00.C10=$1,727.14.nConvertibles usually sell above floor
29、 value because convertibility has an additional value.20-32The firm intends to force conversion when C=1.2($1,000)=$1,200.When is the issued expected to be called?nWe are solving for the period of time until the conversion value equals the call price.After this time,the conversion value is expected
30、to exceed the call price.INPUTSOUTPUTNI/YRPMTPVFV5.27801200-80020-33What is the convertibles expected cost of capital to the firm,if converted in Year 5?nInput the cash flows from the convertible bond and solve for IRR=13.08%.0 1 2 3 4 51,000 -100 -100-100 -100 -100 -1,200 -1,30020-34Is the cost of
31、the convertible consistent with the riskiness of the issue?nTo be consistent,we require that kd kc ke.nThe convertible bonds risk is a blend of the risk of debt and equity,so kc should be between the cost of debt and equity.nFrom previous information,ks=$0.74(1.08)/$10 +0.08=16.0%.nkc is between kd
32、and ks,and is consistent.20-35Besides cost,what other factor should be considered when using hybrid securities?nThe firms future needs for capital:nExercise of warrants brings in new equity capital without the need to retire low-coupon debt.nConversion brings in no new funds,and low-coupon debt is g
33、one when bonds are converted.However,debt ratio is lowered,so new debt can be issued.20-36Other issues regarding the use of hybrid securitiesnDoes the firm want to commit to 20 years of debt?nConversion removes debt,while the exercise of warrants does not.nIf stock price does not rise over time,then neither warrants nor convertibles would be exercised.Debt would remain outstanding.
