Hybrid Financing: Preferred Stock, Leasing,

Warrants, and Convertibles

Chapter 20

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

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

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 $1,200,00020-4

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, rd, was 10%. Therefore, we should discount cash flows at 6%.

A-T rd = 10%(1 – T) = 10%(1 – 0.4) = 6%.

20-5

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 (A-T)

-15.0 -15.0 -15.0 -15.0

Residual value (A-T)

75.0

Net cash flow -1,215.0

143.4

201.0

57.0 108.6

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

20-6

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 mortgage 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

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

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

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

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 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

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

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

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

N I/YR PMTPV FV

20 12

110

1000-925

20-17

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

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.

0 1 4 5 6 19 20

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

... ...

20-19

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

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

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

N I/YR PMTPV FV

20 12 100 1000

-850.61

20-22

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

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

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

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 PMTPV FV

5.27

8 0 1200-800

20-26

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

Is the cost of the convertible consistent with the riskiness 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

Besides cost, what other factor 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

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