1、Preferred stockLeasingWarrantsConvertiblesRecent innovationsCHAPTER 20Hybrid Financing: Preferred Stock, Leasing, Warrants, and ConvertiblesLeasingLeasing is sometimes referred to as “off balance sheet” financing if a lease is not “capitalized.” In other words, it is not shown on the balance sheet.

2、Leasing is a substitute for debt financing and, thus, uses up a firms debt capacity.(More.)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.Analysis: Lease vs. Borrow-and-BuyD

3、ata:New machine costs $1,200,000.3-year MACRS class life; 4-year economic life.Tax rate of 40%.kd = 10%.(More.)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

4、 each year.Depreciation ScheduleDepreciable basis = $1,200,000MACRSDepreciationEnd-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 $1,200,000In a lease analysis, what discount rate should cash flows be discounted at?Since

5、 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%.Cost of Owning Analysis(In Thousands)Cost of

6、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%) = -$766,948.01234(More.)Notes:1Depreciation is a tax deductible expense, so it produces a tax savings of T(Deprecia

7、tion). 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 ending book value is $0 so the full $125 salvage (residual) value is taxed.Cost of Leasing Analysis(In Thousands)Lease pmt (AT)1 -204 -204 -204 -204PV cost of

8、 leasing ( 6%) = -$749,294.Note:1Each lease payment of $340 is deductible, so the after-tax cost of the lease is (1 T)($340) = -$204.01234Net 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 shou

9、ld lease.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 incr

10、eased; therefore, the cost of owning would be even higher. Leasing becomes even more attractive.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 the risk to the lessor.Preferred dividends are fi

11、xed, but they may be omitted without placing the firm in default.Most preferred stocks prohibit the firm from paying common dividends when the preferred is in arrears.Usually cumulative up to a limit.How does preferred stock differ fromcommon equity and debt?Dividends are indexed to the rate on trea

12、sury 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.What is floating rate preferred?However, if the issuer is risky, the floating rate preferred stock may have too much pr

13、ice instability for the liquid asset portfolios of many corporate investors.A warrant is a long-term call option.A convertible consists of a fixed rate bond plus a call option.How can a knowledge of call options help one understand warrants and convertibles?P0 = $10.kd of 20-year annual payment bond

14、 without warrants = 12%.50 warrants with an exercise price of $12.50 each are attached to bond.Each 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?Step 1: Calculate VBondVPackage = VBond + VWarra

15、nts = $1,000.VWarrants = 50($1.50) = $75.VBond + $75= $1,000 VBond= $925.Step 2: Find Coupon Payment and RateNI/YRPVPMTFV20 12 -925 1000Solution: 110Therefore, the required coupon rate is $110/$1,000 = 11%.The package would actually have been worthVpackage = $925 + 50($2.50) = $1,050, which is $50 m

16、ore than the actual selling price.If after issue the warrants immediately sell for $2.50 each, what would this imply about the value of the package?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 exercis

17、e price.Current stockholders are giving up value to the warrant holders.Generally, a warrant will sell in the open market at a premium above its theoretical value (it cant sell for less).Therefore, warrants tend not to be exercised until just before they expire.Assume that the warrants expire 10 yea

18、rs after issue. When would you expect them to be exercised?In 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-money warrant holders to exercise

19、just prior to the step-up.Since no dividends are earned on the warrant, holders will tend to exercise voluntarily if a stocks dividend rises enough. When exercised, each warrant will bring in the exercise price, $12.50.This is equity capital and holders will receive one share of common stock per war

20、rant.The 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?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 acco

21、mpanying debt issue, should all debt be issued with warrants?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. Bond has 50 warrants, so on a par bond basis, opportunity cost = 50($5.00) = $250.What is the expected

22、return to the holders of the bond with warrants (or the expected cost to the company) if the warrants are expected to be exercised in 5 years when P = $17.50?Here 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 t

23、o find IRR = 12.93%. This is the pre-tax cost of the bond and warrant 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 e

24、quity because part of the return is fixed by contract.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.Ass

25、ume the following convertible bond data: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 receivedExamples of real convertible bonds issued by Internet companiesIssuerAB

26、CNETDoubleClickMindspringNetBankPSINetSportsLSize of issue$1,250 mil55 mil173 mil250 mil180 mil100 mil400 mil150 milCvt Price$156.0518.3474.8116562.535.6762.3665.12Price at issue$122168413460325552What is (1) the convertibles straight debt value and (2) the implied value of the convertibility featur

27、e?PVFV 20 12 100 1000Solution: -850.61I/YRPMTNStraight debt value:Because 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.The convertibility value corresponds to the warrant value in the previous example.Implied Con

28、vertibility Value$149.3980 sharesConversion 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?The floor value is the higher of the straight debt value and the conversion value.Stra

29、ight debt value0 = $850.61.C0 = $800.Floor value at Year 0 = $850.61.What is meant by the floor value of a convertible?Straight debt value10 = $887.00.C10 = $1,727.14.Floor value10 = $1,727.14.Convertible will generally sell above its floor value prior to maturity because convertibility option has a

30、n additional value.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/YRPMTNWhat 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 calculato