1、20-1Copyright 2001 by Harcourt,Inc.All rights reserved.nPreferred stocknLeasingnWarrantsnConvertiblesnRecent innovationsCHAPTER 20Hybrid Financing:Preferred Stock,Leasing,Warrants,and Convertibles20-2Copyright 2001 by Harcourt,Inc.All rights reserved.LeasingnLeasing is sometimes referred to as“off b
2、alance sheet”financing if a lease is not“capitalized.”In other words,it is not shown on the balance sheet.nLeasing is a substitute for debt financing and,thus,uses up a firms debt capacity.(More.)20-3Copyright 2001 by Harcourt,Inc.All rights reserved.nCapital leases are different from operating leas
3、es:lCapital leases do not provide for maintenance service.lCapital leases are not cancelable.lCapital leases are fully amortized.20-4Copyright 2001 by Harcourt,Inc.All rights reserved.Analysis:Lease vs.Borrow-and-BuyData:nNew machine costs$1,200,000.n3-year MACRS class life;4-year economic life.nTax
4、 rate of 40%.nkd=10%.(More.)20-5Copyright 2001 by Harcourt,Inc.All rights reserved.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.20-6Copyright 2001
5、 by Harcourt,Inc.All rights reserved.Depreciation ScheduleDepreciable basis=$1,200,000MACRS Depreciation End-of-YearYear Rate ExpenseBook 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$1,200,00020-7Copyright 2001 by Harcourt,Inc.All rights reserved.In
6、a lease analysis,what discount rate should cash flows be discounted at?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
7、 T)=10%(1 0.4)=6%.20-8Copyright 2001 by Harcourt,Inc.All rights reserved.Cost of Owning Analysis(In Thousands)Cost of asset(1,200.0)Dep.tax savings1 158.4 216.0 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%)=-
8、$766,948.01234(More.)20-9Copyright 2001 by Harcourt,Inc.All rights reserved.Notes:1Depreciation is a tax deductible expense,so it produces a tax savings of T(Depreciation).Year 1=0.4($396)=$158.4.2Each maintenance payment of$25 is deductible so the after-tax cost of the lease is(1 T)($25)=$15.3The e
9、nding book value is$0 so the full$125 salvage(residual)value is taxed.20-10Copyright 2001 by Harcourt,Inc.All rights reserved.Cost of Leasing Analysis(In Thousands)Lease pmt(AT)1 -204 -204 -204 -204PV cost of leasing(6%)=-$749,294.Note:1Each lease payment of$340 is deductible,so the after-tax cost o
10、f the lease is(1 T)($340)=-$204.0123420-11Copyright 2001 by Harcourt,Inc.All rights reserved.Net Advantage of LeasingNAL=$766,948$749,294=$17,654.PV cost of owningPV cost of leasingSince the cost of owning outweighs the cost of leasing,the firm should lease.20-12Copyright 2001 by Harcourt,Inc.All ri
11、ghts reserved.Suppose computers residual value could be as low as$0 or as high as$250,000,but expected value is$125,000.How could the riskiness of the SV be incorporated in the analysis?What effect would this have on lease decision?To account for risk,the rate used to discount the SV would be increa
12、sed;therefore,the cost of owning would be even higher.Leasing becomes even more attractive.20-13Copyright 2001 by Harcourt,Inc.All rights reserved.What effect would a cancellation clause have on the riskiness of the lease?A cancellation clause lowers the risk of the lease to the lessee,but increases
13、 the risk to the lessor.20-14Copyright 2001 by Harcourt,Inc.All rights reserved.nPreferred dividends are fixed,but they may be omitted without placing the firm in default.nMost preferred stocks prohibit the firm from paying common dividends when the preferred is in arrears.nUsually cumulative up to
14、a limit.How does preferred stock differ fromcommon equity and debt?20-15Copyright 2001 by Harcourt,Inc.All rights reserved.nDividends are indexed to the rate on treasury securities instead of being fixed.nExcellent S-T corporate investment:lOnly 30%of dividends are taxable to corporations.lThe float
15、ing rate generally keeps issue trading near par.What is floating rate preferred?20-16Copyright 2001 by Harcourt,Inc.All rights reserved.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
16、-17Copyright 2001 by Harcourt,Inc.All rights reserved.nA warrant is a long-term call option.nA convertible consists of a fixed rate bond plus a call option.How can a knowledge of call options help one understand warrants and convertibles?20-18Copyright 2001 by Harcourt,Inc.All rights reserved.nP0=$1
17、0.nkd of 20-year annual payment bond without warrants=12%.n50 warrants with an exercise price of$12.50 each are attached to bond.nEach warrants value will be$1.50.Given the following facts,what coupon rate must be set on a bond with warrants if the total package is to sell for$1,000?20-19Copyright 2
18、001 by Harcourt,Inc.All rights reserved.Step 1:Calculate VBondVPackage=VBond+VWarrants=$1,000.VWarrants=50($1.50)=$75.VBond +$75=$1,000 VBond=$925.20-20Copyright 2001 by Harcourt,Inc.All rights reserved.Step 2:Find Coupon Payment and RateNI/YRPVPMTFV20 12 -925 1000Solution:110Therefore,the required
19、coupon rate is$110/$1,000=11%.20-21Copyright 2001 by Harcourt,Inc.All rights reserved.nThe package would actually have been worthVpackage=$925+50($2.50)=$1,050,which is$50 more than the actual selling price.If after issue the warrants immediately sell for$2.50 each,what would this imply about the va
20、lue of the package?20-22Copyright 2001 by Harcourt,Inc.All rights reserved.nThe 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.nCurrent stockholders are giving up value to the warrant holders.2
21、0-23Copyright 2001 by Harcourt,Inc.All rights reserved.nGenerally,a warrant will sell in the open market at a premium above its theoretical value(it cant sell for less).nTherefore,warrants tend not to be exercised until just before they expire.Assume that the warrants expire 10 years after issue.Whe
22、n would you expect them to be exercised?20-24Copyright 2001 by Harcourt,Inc.All rights reserved.nIn 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 provisions encourage in-the
23、-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.20-25Copyright 2001 by Harcourt,Inc.All rights reserved.nWhen exercised,each warrant will bring in the exercise price
24、,$12.50.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.Will the warrants bring in additional capital when exercised?20-26Copyright 2001 by Harcourt,Inc.All rights
25、reserved.No.As we shall see,the warrants have a cost that must be added to the coupon interest cost.Because warrants lower the cost of the accompanying debt issue,should all debt be issued with warrants?20-27Copyright 2001 by Harcourt,Inc.All rights reserved.nThe company will exchange stock worth$17
26、.50 for one warrant plus$12.50.The opportunity cost to the company is$17.50$12.50=$5.00.nBond has 50 warrants,so on a par bond basis,opportunity cost=50($5.00)=$250.What is the expected return to the holders of the bond with warrants(or the expected cost to the company)if the warrants are expected t
27、o be exercised in 5 years when P=$17.50?20-28Copyright 2001 by Harcourt,Inc.All rights reserved.nHere is the cash flow time line:0 1 4 5 6 19 20+1,000 -110 -110-110-110-110-110-250 -1,000-360 -1,110Input the cash flows in the calculator to find IRR=12.93%.This is the pre-tax cost of the bond and war
28、rant package.20-29Copyright 2001 by Harcourt,Inc.All rights reserved.nThe 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.nThe cost is lower than the cost of equity bec
29、ause part of the return is fixed by contract.20-30Copyright 2001 by Harcourt,Inc.All rights reserved.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%.nC
30、onversion ratio=CR=80 shares.Assume the following convertible bond data:20-31Copyright 2001 by Harcourt,Inc.All rights reserved.What conversion price(Pc)is built into the bond?The conversion price is typically set 10%to 30%above the stock price on the issue date.$1,00080 Pc=$12.50.Par value#Shares r
31、eceived20-32Copyright 2001 by Harcourt,Inc.All rights reserved.Examples of real convertible bonds issued by Internet companiesIssuerABCNETDoubleClickMindspringNetBankPSINetSportsLSize of issue$1,250 mil55 mil173 mil250 mil180 mil100 mil400 mil150 milCvt Price$156.0518.3474.8116562.535.6762.3665.12Pr
32、ice at issue$12216841346032555220-33Copyright 2001 by Harcourt,Inc.All rights reserved.What is(1)the convertibles straight debt value and(2)the implied value of the convertibility feature?PVFV 20 12 100 1000Solution:-850.61I/YRPMTNStraight debt value:20-34Copyright 2001 by Harcourt,Inc.All rights re
33、served.nBecause 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 the warrant value in the previous example.Implied Convertibility Value$149.3980 shares20-35Copyright 2001 by Harcourt
34、,Inc.All rights reserved.Conversion value=Ct=CR(P0)(1+g)t.t=0C0=80($10)(1.08)0=$800.t=10C10=80($10)(1.08)10=$1,727.14.What is the formula for the bonds expected conversion value in any year?20-36Copyright 2001 by Harcourt,Inc.All rights reserved.nThe floor value is the higher of the straight debt va
35、lue and the conversion value.nStraight debt value0=$850.61.nC0=$800.Floor value at Year 0=$850.61.What is meant by the floor value of a convertible?20-37Copyright 2001 by Harcourt,Inc.All rights reserved.nStraight debt value10=$887.00.nC10=$1,727.14.Floor value10=$1,727.14.nConvertible will generall
36、y sell above its floor value prior to maturity because convertibility option has an additional value.20-38Copyright 2001 by Harcourt,Inc.All rights reserved.The firm intends to force conversionwhen C=1.2($1,000)=$1,200.When is the issue expected to be called?PVFV 8 -800 0 1200Solution:N=5.27I/YRPMTN
37、20-39Copyright 2001 by Harcourt,Inc.All rights reserved.What is the convertibles expected cost of capital to the firm?Assume conversion in Year 5 at$1,200.0 1 2 3 4 51,000 -100 -100-100 -100 -100 -1,200 -1,300Input the cash flows in the calculator and solve for IRR=13.08%.20-40Copyright 2001 by Harc
38、ourt,Inc.All rights reserved.nFor consistency,need kd kc ke.nWhy?nThe convertible bonds risk is a blend of the risk of debt and equity,so kc should be in between the cost of debt and equity.Does the cost of the convertible appear to be consistent with the riskiness of the issue?20-41Copyright 2001 b
39、y Harcourt,Inc.All rights reserved.kd=12%and kc=13.08%.ks=+g=+0.08 =16.0%.Since kc is between kd and ks,the consistency requirement is met.nCheck the values:D0(1+g)P0$0.74(1.08)$1020-42Copyright 2001 by Harcourt,Inc.All rights reserved.nThe firms future needs for capital:lExercise of warrants brings
40、 in new equity capital without the need to retire low-coupon debt.lConversion brings in no new funds,and low-coupon debt is gone when bonds are converted.However,debt ratio is lowered,so new debt can be issued.Besides cost,what other factors should be considered?20-43Copyright 2001 by Harcourt,Inc.All rights reserved.nDoes the firm want to commit to 20 years of debt?lConversion removes debt,while the exercise of warrants does not.lIf stock price does not rise over time,then neither warrants nor convertibles would be exercised.Debt would remain outstanding.
