chapter 20 hybrid financing: preferred stock, leasing, warrants, and convertibles

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Copyright © 2001 by Harcourt, Inc. All rights reserved.

Preferred stock

Leasing

Warrants

Convertibles

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CHAPTER 20Hybrid Financing: Preferred Stock, Leasing, Warrants, and Convertibles

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Leasing

Leasing 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.

Leasing is a substitute for debt financing and, thus, uses up a firm’s debt capacity.

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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.

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Analysis: Lease vs. Borrow-and-Buy

Data:New machine costs $1,200,000.3-year MACRS class life; 4-year

economic life.Tax rate of 40%.kd = 10%.

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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.

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Depreciation Schedule

Depreciable basis = $1,200,000

MACRS Depreciation End-of-YearYear Rate Expense 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

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In 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 – T) = 10%(1 – 0.4) = 6%.

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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 57.0 108.6

PV cost of owning (@ 6%) = -$766,948.

0 1 2 3 4

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Notes:1 Depreciation is a tax deductible

expense, so it produces a tax savings of T(Depreciation). 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.

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Cost of Leasing Analysis(In Thousands)

Lease pmt (AT)1 -204 -204 -204 -204

PV cost of 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.

0 1 2 3 4

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Net Advantage of Leasing

NAL = –

= $766,948 – $749,294

= $17,654.

PV cost of owning

PV cost of leasing

Since the cost of owning outweighs the cost of leasing, the firm should lease.

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Suppose computer’s 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 increased; therefore, the cost of owning would be even higher. Leasing becomes even more attractive.

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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.

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Preferred dividends are fixed, 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?

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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 floating rate generally keeps

issue trading near par.

What is floating rate preferred?

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However, 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.

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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?

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P0 = $10.

kd of 20-year annual payment bond without warrants = 12%.

50 warrants with an exercise price of $12.50 each are attached to bond.

Each warrant’s 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?

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Step 1: Calculate VBond

VPackage = VBond + VWarrants = $1,000.

VWarrants = 50($1.50) = $75.

VBond + $75 = $1,000

VBond = $925.

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Step 2: Find Coupon Payment and Rate

N I/YR PV PMT FV20 12 -925 1000

Solution: 110

Therefore, the required coupon rate is $110/$1,000 = 11%.

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The package would actually have been worth

Vpackage = $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 value of the package?

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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 exercise price.

Current stockholders are giving up value to the warrant holders.

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Generally, a warrant will sell in the open market at a premium above its theoretical value (it can’t sell for less).

Therefore, warrants tend not to be exercised until just before they expire.

Assume that the warrants expire 10 years after issue. When would you

expect them to be exercised?

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In a stepped-up exercise price, the exercise price increases in steps over the warrant’s 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 just prior to the step-up.

Since no dividends are earned on the warrant, holders will tend to exercise voluntarily if a stock’s dividend rises enough.

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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 warrant.

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?

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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?

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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 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?

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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 -1,110

Input the cash flows in the calculator to find IRR = 12.93%. This is the pre-tax cost of the bond and warrant package.

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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 equity because part of the return is fixed by contract.

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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.

Assume the following convertible bond data:

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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 received

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Examples of real convertible bonds issued by Internet companies

Issuer

Amazon.com

Beyond.com

CNET

DoubleClick

Mindspring

NetBank

PSINet

SportsLine.com

Size of issue

$1,250 mil

55 mil

173 mil

250 mil

180 mil

100 mil

400 mil

150 mil

Cvt Price

$156.05

18.34

74.81

165

62.5

35.67

62.36

65.12

Price at issue

$122

16

84

134

60

32

55

52

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What is (1) the convertible’s straight debt value and (2) the implied value of

the convertibility feature?

PV FV

20 12 100 1000

Solution: -850.61

I/YR PMTN

Straight debt value:

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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 Convertibility Value

$149.3980 shares

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Conversion value = Ct = CR(P0)(1 + g)t.

t = 0

C0 = 80($10)(1.08)0 = $800.

t = 10

C10 = 80($10)(1.08)10

= $1,727.14.

What is the formula for the bond’s expected conversion value in any

year?

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The floor value is the higher of the straight debt value and the conversion value.

Straight debt value0 = $850.61.

C0 = $800.

Floor value at Year 0 = $850.61.

What is meant by the floor value of a convertible?

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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 an additional value.

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The firm intends to force conversionwhen C = 1.2($1,000) = $1,200. When

is the issue expected to be called?

PV FV

8 -800 0 1200

Solution: N = 5.27

I/YR PMTN

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What is the convertible’s expected cost of capital to the firm? Assume

conversion in Year 5 at $1,200.

0 1 2 3 4 5

1,000 -100 -100 -100 -100 -100 -1,200 -1,300

Input the cash flows in the calculator and solve for IRR = 13.08%.

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For consistency, need kd < kc < ke.

Why?

The convertible bond’s 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?

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kd = 12% and kc = 13.08%.

ks = + g = + 0.08

= 16.0%.

Since kc is between kd and ks, the consistency requirement is met.

Check the values:

D0(1+g)

P0

$0.74(1.08)$10

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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.

Besides cost, what other factors should be considered?

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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.

chapter 20 hybrid financing: preferred stock, leasing, warrants, and convertibles

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