Mod-6-Long-termFinancing.pdf

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Hybrid Financing: Preferred
Stock, Leasing, Warrants, and

Convertibles

Leasing
Preferred Stock

Warrants
Convertibles

20-1

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Long-Term Financing

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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 MACRS
Rate

Depreciation
Expense

End-of-Year
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

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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 1 2 3 4
Cost of asset -1,200.0
Deprec. tax savings 158.4 216.0 72.0 33.6
Maintenance (AT) -15.0 -15.0 -15.0 -15.0
Residual value (AT) 75.0
Cash flow -1,215.0 143.4

201.0 57.0 108.6

20-6

PV of the cost of owning (@ 6%) = -$766.948

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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

• 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

0

A-T Lease pmt

1 2 3 4

-204 -204 -204 -204

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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.
• A convertible bond consists of a fixed-rate bond

plus a call option.
• An understanding of options will help financial

managers make decisions regarding warrant
and convertible issues.

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.
• rd 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

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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%.

20-17

INPUTS

OUTPUT
N I/YR PMT PV FV
20 12

110

-925 1000

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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:

• Input the cash flows into a financial calculator
(or spreadsheet) and find IRR = 12.93%. This
is the pre-tax cost.

20-19

0 1 4 5 6 19 20

+1,000 -110 -110 -110 -110 -110 -110
-250 -1,000
-360 -1,110

… …

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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.

20-22

INPUTS

OUTPUT
N I/YR PMT PV FV
20 12 100

-850.61

1000

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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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When is the issue expected to be called?

• The firm intends to force conversion when C
= 1.2($1,000) = $1,200.

• We are solving for the period of time until the
conversion value equals the call price. After
this time, the conversion value is expected to
exceed the call price.

INPUTS

OUTPUT
N I/YR PMT PV FV

5.27

8 0 -800 1200

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What is the convertible’s expected cost of capital
to the firm, if converted in Year 5?

• Input the cash flows from the convertible bond
and solve for IRR = 13.08%.

20-27

0

1,000

1 2 3 4 5

-100 -100 -100 -100 -100

-1,300
-1,200

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Is the cost of the convertible consistent with the
risk of the issue?

• To be consistent, we require that rd < rc < re. • The convertible bond’s risk is a blend of the risk of debt and equity, so rc should be between the cost of debt and equity. – From previous information: rs = $0.74(1.08)/$10 + 0.08 = 16.0%. • rc is between rd and rs, and is consistent. 20-28 INTRO LEASING WARRANTS PREFERRED STOCK CONVERTIBLES © 2016 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. Besides cost, what other factors should be considered when using hybrid securities? • The firm’s future needs for capital: – Exercise of warrants brings in new equity capital without the need to retire low-coupon debt. – Conversion 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. 20-29 INTRO LEASING WARRANTS PREFERRED STOCK CONVERTIBLES © 2016 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. Other Issues Regarding the Use of Hybrid Securities • Does the firm want to commit to 20 years of debt? – Conversion removes debt, while the exercise of warrants does not. – If stock price does not rise over time, then neither warrants nor convertibles would be exercised. Debt would remain outstanding. 20-30 INTRO LEASING WARRANTS PREFERRED STOCK CONVERTIBLES Hybrid Financing: Preferred Stock, Leasing, Warrants, and Convertibles Leasing Lease vs. Borrow-and-Buy Depreciation Schedule In a lease analysis, at what discount rate should cash flows be discounted? Cost of Owning Analysis Notes on Cost of Owning Analysis Cost of Leasing Analysis Net Advantage of Leasing What if there is a lot of uncertainty about the computer’s residual value? What if a cancellation clause were included in the lease? How would this affect the riskiness of the lease? How does preferred stock differ from common equity and debt? What is adjustable-rate preferred? How can a knowledge of call options help one understand warrants and convertibles? A Firm Wants to Issue a Bond with Warrants Package at a Face Value of $1,000 What coupon rate should be set for this bond plus warrants package? Calculating Required Annual Coupon Rate for Bond with Warrants Package What is the expected rate of return to holders of bonds with warrants, if exercised in 5 years at P5 = $17.50? Finding the Opportunity Cost of Capital for the Bond with Warrants Package The Firm is Now Considering a Callable, Convertible Bond Issue What conversion price (Pc) is implied by this bond issue? What is the convertible’s straight-debt value? Implied Convertibility Value What is the formula for the bond’s expected conversion value in any year? What is meant by the floor value of a convertible? When is the issue expected to be called? What is the convertible’s expected cost of capital to the firm, if converted in Year 5? Is the cost of the convertible consistent with the risk of the issue? Besides cost, what other factors should be considered when using hybrid securities? Other Issues Regarding the Use of Hybrid Securities