special topics in managerial finance -...

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P A R T6SPECIAL TOPICSIN MANAGERIAL

FINANCE

CHAPTERS IN THIS PART

16 Hybrid and Derivative Securities

17 Mergers, LBOs, Divestitures, and Business Failure

18 International Managerial Finance

Integrative Case 6: Organic Solutions

L E A R N I N G G O A L S

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HYBRIDAND DERIVATIVESECURITIES

C H A P T E R

Across the Disciplines W H Y T H I S C H A P T E R M AT T E R S TO YO U

Accounting: You need to understand the types of leasingarrangements and the general features of convertible securi-ties, stock purchase warrants, and options, which you will berequired to record and report.

Information systems: You need to understand types of leasingarrangements and of convertible securities in order to designsystems that will track data used to make lease-or-purchaseand conversion decisions.

Management: You need to understand when and why it maymake better sense to lease assets than to purchase them. Youneed to understand how convertible securities and stock pur-chase warrants work in order to decide when using such

financing tools is a good decision for the firm. You also need tounderstand the impact of call and put options on the firm.

Marketing: You need to understand leasing because you maywant to propose that the firm lease equipment as part of anew project proposal. You also should understand the use ofderivative securities as a cost-effective way to add to themarketability of securities and thus provide more funds fornew projects.

Operations: You need to understand leasing, and what mainte-nance obligations the firm will have for a leased asset, becausethe firm may choose to obtain operating equipment by thismeans.

Demonstrate the procedures for determining thestraight bond value, the conversion (or stock)value, and the market value of a convertible bond.

Explain the basic characteristics of stock pur-chase warrants, the implied price of an attachedwarrant, and the values of warrants.

Define options and discuss calls and puts,options markets, options trading, the role of calland put options in fund-raising, and hedgingforeign-currency exposures with options.

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LG4Differentiate between hybrid and derivative secu-rities and their roles in the corporation.

Review the basic types of leases, leasingarrangements, the lease-versus-purchase deci-sion, the effects of leasing on future financing,and the advantages and disadvantages ofleasing.

Describe the basic types of convertible securities,their general features, and financing withconvertibles.

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16

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When restaurateurs Kai Adams, BradMonarch, and Timothy Haines

opened their Sebago Brewing Companyrestaurant and brewery in South Portland,Maine, they chose to lease several big-ticket items. After leasing a $30,000 point-of-sale computersystem and a $4,000 dishwasher for their first restaurant, they continued to lease equipment asthey expanded to other locations.

“Now is a good time to be doing that,” Adams says. “We don’t have to buy all this equip-ment, so it frees up some cash for us.” In addition to preserving cash, Adams and his partners likebeing able to leave maintenance to the lessor that owns the equipment.

Many other businesses, both large and small, are joining Sebago Brewing in opting to leaserather than purchase and finance equipment. In recent years, leasing has accounted for about 30percent of all business investment in new equipment. Manufacturing companies are among thelargest users of equipment lease financing, although service firms such as Sebago Brewingclearly find it attractive as well. Leasing is particularly attractive to small companies, becausetheir bankers may be tightening credit standards on more traditional financing alternatives.

According to an Equipment Leasing Association survey, the top reasons why small- andmedium-size businesses choose to lease rather than buy equipment are to preserve cash flow(cited by 35 percent), to lock in financing costs (17 percent), convenience and flexibility of leasing(13 percent), tax advantages (13 percent), inclusion of maintenance costs (13 percent), and abilityto afford state-of-the-art technology (9 percent). With a lease, the company’s payments are set atthe beginning of the lease term for the life of the lease, so the company is not affected by changesin interest rates. Companies may be able to structure variable payment terms as well, to accom-modate seasonal cash flow patterns, and they may also be able to upgrade equipment during thelease term.

Before jumping into lease financing, however, companies such as Sebago Brewing mustcarefully analyze the whole lease package—down payment if required, monthly payments, andresidual (remaining) value of the equipment at the end of the lease. They must determine theafter-tax cash flows for both leasing and purchasing, taking into account depreciation, mainte-nance costs, purchase options, and related items. They should then calculate the present value(PV) of these outflows and choose the one with the lower PV.

In this chapter, we’ll demonstrate how to approach this analysis for lease financing, ahybrid financing technique that incorporates elements of debt and equity. Other hybrids that we’lldescribe include convertible securities and stock purchase warrants. Then we’ll look at deriva-tive securities such as stock options.

SEBAGO BREWINGCOMPANY“I’LL HAVE A LEASE, PLEASE”

lessorThe owner of assets that arebeing leased.

operating leaseA cancelable contractualarrangement whereby the lesseeagrees to make periodic pay-ments to the lessor, often for 5 orfewer years, to obtain an asset’sservices; generally, the totalpayments over the term of thelease are less than the lessor’sinitial cost of the leased asset.

674 PART 6 Special Topics in Managerial Finance

hybrid securityA form of debt or equity financingthat possesses characteristics ofboth debt and equity financing.

derivative securityA security that is neither debt norequity but derives its value froman underlying asset that is oftenanother security; called ”deriva-tives,” for short.

leasingThe process by which a firm canobtain the use of certain fixedassets for which it must make aseries of contractual, periodic,tax-deductible payments.

lesseeThe receiver of the services ofthe assets under a leasecontract.

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16.1 An Overview of Hybrids and DerivativesChapters 6 and 7 described the characteristics of the key securities—corporatebonds, common stock, and preferred stock—used by corporations to raise long-term funds. In their simplest form, bonds are pure debt and common stock is pureequity. Preferred stock, on the other hand, is a form of equity that promises to payfixed periodic dividends that are similar to the fixed contractual interest paymentson bonds. Because it blends the characteristics of both debt (a fixed dividend pay-ment) and equity (ownership), preferred stock is considered a hybrid security.Other popular hybrid securities include financial leases, convertible securities,and stock purchase warrants. Each of these hybrid securities is described in thefollowing pages.

The final section of this chapter focuses on options, a popular derivativesecurity—a security that is neither debt nor equity but derives its value from anunderlying asset that is often another security. As you’ll learn, derivatives are notused by corporations to raise funds but, rather, serve as a useful tool for manag-ing certain aspects of the firm’s risk.

R e v i e w Q u e s t i o n

16–1 Differentiate between a hybrid security and a derivative security. How dotheir uses by the corporation differ?

16.2 LeasingLeasing enables the firm to obtain the use of certain fixed assets for which it mustmake a series of contractual, periodic, tax-deductible payments. The lessee is thereceiver of the services of the assets under the lease contract; the lessor is theowner of the assets. Leasing can take a number of forms.

Basic Types of LeasesThe two basic types of leases that are available to a business are operating leasesand financial leases (often called capital leases by accountants).

Operating Leases

An operating lease is normally a contractual arrangement whereby the lesseeagrees to make periodic payments to the lessor, often for 5 or fewer years, to obtainan asset’s services. Such leases are generally cancelable at the option of the lessee,who may be required to pay a penalty for cancellation. Assets that are leased underoperating leases have a usable life that is longer than the term of the lease. Usually,however, they would become less efficient and technologically obsolete if leasedfor a longer period. Computer systems are prime examples of assets whose relativeefficiency is expected to diminish as the technology changes. The operating lease istherefore a common arrangement for obtaining such systems, as well as for otherrelatively short-lived assets such as automobiles.

CHAPTER 16 Hybrid and Derivative Securities 675

financial (or capital) leaseA longer-term lease than anoperating lease that isnoncancelable and obligates thelessee to make payments for theuse of an asset over a predefinedperiod of time; the total paymentsover the term of the lease aregreater than the lessor’s initialcost of the leased asset.

direct leaseA lease under which a lessorowns or acquires the assets thatare leased to a given lessee.

sale–leaseback arrangementA lease under which the lesseesells an asset for cash to aprospective lessor and thenleases back the same asset,making fixed periodic paymentsfor its use.

If an operating lease is held to maturity, the lessee at that time returns theleased asset to the lessor, who may lease it again or sell the asset. Normally, theasset still has a positive market value at the termination of the lease. In someinstances, the lease contract gives the lessee the opportunity to purchase theleased asset. Generally, the total payments made by the lessee to the lessor are lessthan the lessor’s initial cost of the leased asset.

Financial (or Capital) Leases

A financial (or capital) lease is a longer-term lease than an operating lease. Finan-cial leases are noncancelable and obligate the lessee to make payments for the useof an asset over a predefined period of time. Financial leases are commonly usedfor leasing land, buildings, and large pieces of equipment. The noncancelable fea-ture of the financial lease makes it similar to certain types of long-term debt. Thelease payment becomes a fixed, tax-deductible expenditure that must be paid atpredefined dates. Like debt, failure to make the contractual lease payments canresult in bankruptcy for the lessee.

With a financial lease, the total payments over the lease period are greaterthan the lessor’s initial cost of the leased asset. In other words, the lessor mustreceive more than the asset’s purchase price to earn its required return on theinvestment. Technically, under Financial Accounting Standards Board (FASB)Standard No. 13, “Accounting for Leases,” a financial (or capital) lease is definedas one that has any of the following elements:

1. The lease transfers ownership of the property to the lessee by the end of thelease term.

2. The lease contains an option to purchase the property at a “bargain price.”Such an option must be exercisable at a “fair market value.”

3. The lease term is equal to 75 percent or more of the estimated economic lifeof the property (exceptions exist for property leased toward the end of itsusable economic life).

4. At the beginning of the lease, the present value of the lease payments is equalto 90 percent or more of the fair market value of the leased property.

The emphasis in this chapter is on financial leases, because they result in ines-capable long-term financial commitments by the firm.

Leasing ArrangementsLessors use three primary techniques for obtaining assets to be leased. Themethod depends largely on the desires of the prospective lessee.

1. A direct lease results when a lessor owns or acquires the assets that are leasedto a given lessee. In other words, the lessee did not previously own the assetsthat it is leasing.

2. In a sale–leaseback arrangement, lessors acquire leased assets by purchasingassets already owned by the lessee and leasing them back. This technique isnormally initiated by a firm that needs funds for operations. By selling anexisting asset to a lessor and then leasing it back, the lessee receives cash forthe asset immediately, while obligating itself to make fixed periodic pay-ments for use of the leased asset.

lease-versus-purchase (lease-versus-buy) decisionThe decision facing firmsneeding to acquire new fixedassets: whether to lease theassets or to purchase them, usingborrowed funds or availableliquid resources.


leveraged leaseA lease under which the lessoracts as an equity participant,supplying only about 20 percentof the cost of the asset, while alender supplies the balance.

maintenance clausesProvisions normally included inan operating lease that requirethe lessor to maintain the assetsand to make insurance and taxpayments.

renewal optionsProvisions especially common inoperating leases that grant thelessee the right to re-leaseassets at the expiration of thelease.

purchase optionsProvisions frequently included inboth operating and financialleases that allow the lessee topurchase the leased asset atmaturity, typically for a prespeci-fied price.

1. Including the cost of exercising a purchase option in the cash flows for the lease alternative ensures that underboth lease and purchase alternatives the firm owns the asset at the end of the relevant time horizon. The otherapproach would be to include the cash flows from sale of the asset in the cash flows for the purchase alternative atthe end of the lease term. These strategies guarantee avoidance of unequal lives, which were discussed in Chapter 10.In addition, they make any subsequent cash flows irrelevant because these would be either identical or nonexistent,respectively, under each alternative.

Hint Although, for clarity,the approach demonstratedhere compares the presentvalues of the cash flows for thelease and the purchase, a moredirect approach would calculatethe NPV of the incrementalcash flows.

3. Leasing arrangements that include one or more third-party lenders are lever-aged leases. Under a leveraged lease, the lessor acts as an equity participant,supplying only about 20 percent of the cost of the asset, and a lender suppliesthe balance. Leveraged leases have become especially popular in structuringleases of very expensive assets.

A lease agreement normally specifies whether the lessee is responsible formaintenance of the leased assets. Operating leases normally include maintenanceclauses requiring the lessor to maintain the assets and to make insurance and taxpayments. Financial leases nearly always require the lessee to pay maintenanceand other costs.

The lessee is usually given the option to renew a lease at its expiration.Renewal options, which grant lessees the right to re-lease assets at expiration, areespecially common in operating leases, because their term is generally shorterthan the usable life of the leased assets. Purchase options allowing the lessee topurchase the leased asset at maturity, typically for a prespecified price, are fre-quently included in both operating and financial leases.

The lessor can be one of a number of parties. In operating leases, the lessor islikely to be the manufacturer’s leasing subsidiary or an independent leasing com-pany. Financial leases are frequently handled by independent leasing companiesor by the leasing subsidiaries of large financial institutions such as commercialbanks and life insurance companies. Life insurance companies are especiallyactive in real estate leasing. Pension funds, like commercial banks, have also beenincreasing their leasing activities.

The Lease-versus-Purchase DecisionFirms that are contemplating the acquisition of new fixed assets commonly con-front the lease-versus-purchase (or lease-versus-buy) decision. The alternativesavailable are (1) lease the assets, (2) borrow funds to purchase the assets, or (3)purchase the assets using available liquid resources. Alternatives 2 and 3,although they differ, are analyzed in a similar fashion; even if the firm has the liq-uid resources with which to purchase the assets, the use of these funds is viewedas equivalent to borrowing. Therefore, we need to compare only the leasing andpurchasing alternatives.

The lease-versus-purchase decision involves application of the capital budget-ing methods presented in Chapters 8 through 10. First, we determine the relevantcash flows and then apply present value techniques. The following steps areinvolved in the analysis:

Step 1 Find the after-tax cash outflows for each year under the lease alternative.This step generally involves a fairly simple tax adjustment of the annuallease payments. In addition, the cost of exercising a purchase option inthe final year of the lease term must frequently be included.1


2. Lease payments are generally made at the beginning of the year. To simplify the following discussions, end-of-year lease payments are assumed.3. The annual loan payment on the 9%, 5-year loan of $24,000 is calculated by using the loan amortization tech-nique described in Chapter 4. Dividing the present value interest factor for an annuity, PVIFA, from Table A–4 at9% for 5 years (3.890) into the loan principal of $24,000 results in the annual loan payment of $6,170. (Note: If afinancial calculator were used, the annual loan payment would be $6,170.22.) For a more detailed discussion ofloan amortization, see Chapter 4.

Step 2 Find the after-tax cash outflows for each year under the purchase alter-native. This step involves adjusting the sum of the scheduled loanpayment and maintenance cost outlay for the tax shields resulting fromthe tax deductions attributable to maintenance, depreciation, andinterest.

Step 3 Calculate the present value of the cash outflows associated with the lease(from Step 1) and purchase (from Step 2) alternatives using the after-taxcost of debt as the discount rate. The after-tax cost of debt is used toevaluate the lease-versus-purchase decision because the decision itselfinvolves the choice between two financing techniques—leasing and bor-rowing—that have very low risk.

Step 4 Choose the alternative with the lower present value of cash outflowsfrom Step 3. This will be the least-cost financing alternative.

The application of each of these steps is demonstrated in the following example.

E X A M P L E Roberts Company, a small machine shop, is contemplating acquiring a newmachine that costs $24,000. Arrangements can be made to lease or purchase themachine. The firm is in the 40% tax bracket.

Lease The firm would obtain a 5-year lease requiring annual end-of-year leasepayments of $6,000.2 All maintenance costs would be paid by the lessor, andinsurance and other costs would be borne by the lessee. The lessee would exerciseits option to purchase the machine for $4,000 at termination of the lease.

Purchase The firm would finance the purchase of the machine with a 9%, 5-yearloan requiring end-of-year installment payments of $6,170.3 The machine wouldbe depreciated under MACRS using a 5-year recovery period. The firm wouldpay $1,500 per year for a service contract that covers all maintenance costs;insurance and other costs would be borne by the firm. The firm plans to keep themachine and use it beyond its 5-year recovery period.

Using these data, we can apply the steps presented earlier.

Step 1 The after-tax cash outflow from the lease payments can be found bymultiplying the before-tax payment of $6,000 by 1 minus the tax rate, T,of 40%.

After-tax cash outflow from lease�$6,000� (1�T)�$6,000� (1�0.40)�$3,600


T A B L E 1 6 . 1 Determining the Interest and PrincipalComponents of the Roberts Company LoanPayments

Payments End-of-yearLoan Beginning-of- Interest Principal principal

End of payments year principal [0.09� (2)] [(1)� (3)] [(2)� (4)]year (1) (2) (3) (4) (5)

1 $6,170 $24,000 $2,160 $4,010 $19,990

2 6,170 19,990 1,799 4,371 15,619

3 6,170 15,619 1,406 4,764 10,855

4 6,170 10,855 977 5,193 5,662

5 6,170 5,662 510 5,660 —a

aThe values in this table have been rounded to the nearest dollar, which results in a slight difference ($2)between the beginning-of-year-5 principal (in column 2) and the year-5 principal payment (in column 4).

4. When the rate of interest on the loan used to finance the purchase just equals the cost of debt, the present value ofthe after-tax loan payments (annual loan payments � interest tax shields) discounted at the after-tax cost of debtjust equals the initial loan principal. In such a case, it is unnecessary to amortize the loan to determine the paymentamount and the amounts of interest when finding after-tax cash outflows. The loan payments and interest payments(columns 1 and 4 in Table 16.2) can be ignored, and in their place, the initial loan principal ($24,000) is shown as anoutflow occurring at time zero. To allow for a loan interest rate that is different from the firm’s cost of debt and foreasier understanding, here we isolate the loan payments and interest payments rather than use this computationallymore efficient approach.5. The year-6 depreciation is ignored, because we are considering the cash flows solely over a 5-year time horizon.Similarly, depreciation on the leased asset, when it is purchased at the end of the lease for $4,000, is ignored. The taxbenefits resulting from this depreciation would make the lease alternative even more attractive. Clearly, the analysiswould become both more precise and more complex if we chose to look beyond the 5-year time horizon.

Step 2 Therefore, the lease alternative results in annual cash outflows over the5-year lease of $3,600. In the final year, the $4,000 cost of the purchaseoption would be added to the $3,600 lease outflow to get a total cashoutflow in year 5 of $7,600 ($3,600�$4,000).

Step 2 The after-tax cash outflow from the purchase alternative is a bit moredifficult to find. First, the interest component of each annual loan pay-ment must be determined, because the Internal Revenue Service allowsthe deduction of interest only—not principal—from income for tax pur-poses.4 Table 16.1 presents the calculations necessary to split the loanpayments into their interest and principal components. Columns 3 and 4show the annual interest and principal paid.

In Table 16.2, the annual loan payment is shown in column 1, andthe annual maintenance cost, which is a tax-deductible expense, isshown in column 2. Next, we find the annual depreciation write-offresulting from the $24,000 machine. Using the applicable MACRS 5-year recovery period depreciation percentages—20% in year 1, 32% inyear 2, 19% in year 3, and 12% in years 4 and 5—given in Table 3.2 onpage 100 results in the annual depreciation for years 1 through 5 givenin column 3 of Table 16.2.5


T A B L E 1 6 . 2 After-Tax Cash Outflows Associated with Purchasing for Roberts Company

Total After-taxLoan Maintenance deductions Tax shields cash outflows

payments costs Depreciation Interesta [(2)� (3)� (4)] [(0.40� (5)] [(1)� (2)� (6)]End of year (1) (2) (3) (4) (5) (6) (7)

1 $6,170 $1,500 $4,800 $2,160 $ 8,460 $3,384 $4,286

2 6,170 1,500 7,680 1,799 10,979 4,392 3,278

3 6,170 1,500 4,560 1,406 7,466 2,986 4,684

4 6,170 1,500 2,880 977 5,357 2,143 5,527

5 6,170 1,500 2,880 510 4,890 1,956 5,714

aFrom Table 16.1, column 3.

6. Although other cash outflows such as insurance and operating expenses may be relevant here, they would be thesame under the lease and purchase alternatives and therefore would cancel out in the final analysis.7. If we ignore any flotation costs, the firm’s after-tax cost of debt would be 5.4% [9% debt cost� (1�0.40 taxrate)]. To reflect both the flotation costs associated with selling new debt and the possible need to sell the debt at adiscount, we use an after-tax debt cost of 6% as the applicable discount rate. A more detailed discussion of tech-niques for calculating the after-tax cost of debt is found in Chapter 11.8. Using a financial calculator would reveal the present value of the cash outflows for the lease to be $18,154, andthat for the purchase to be $19,541, resulting in an incremental savings of $1,387.

Table 16.2 presents the calculations required to determine the cashoutflows6 associated with borrowing to purchase the new machine. Col-umn 7 of the table presents the after-tax cash outflows associated withthe purchase alternative. A few points should be clarified with respect tothe calculations in Table 16.2. The major cash outflows are the total loanpayment for each year given in column 1 and the annual maintenancecost in column 2. The sum of these two outflows is reduced by the taxsavings from writing off the maintenance, depreciation, and interestexpenses associated with the new machine and its financing. The result-ing cash outflows are the after-tax cash outflows associated with the pur-chase alternative.

Step 3 The present values of the cash outflows associated with the lease (fromStep 1) and purchase (from Step 2) alternatives are calculated in Table16.3 using the firm’s 6% after-tax cost of debt.7 Applying the appropri-ate present value interest factors given in columns 2 and 5 to the after-tax cash outflows in columns 1 and 4 results in the present values oflease and purchase cash outflows in columns 3 and 6, respectively. Thesum of the present values of the cash outflows for the leasing alternativeis given in column 3 of Table 16.3, and the sum of those for the purchas-ing alternative is given in column 6.

Step 4 Because the present value of cash outflows for leasing ($18,151) is lowerthan that for purchasing ($19,539), the leasing alternative is preferred.Leasing results in an incremental savings of $1,388 ($19,539�$18,151)and is therefore the less costly alternative.8


T A B L E 1 6 . 3 A Comparison of the Cash Outflows Associated with Leasing versusPurchasing for Roberts Company

Leasing Purchasing

Present value Present value After-tax Present value of outflows After-tax Present value of outflows

cash outflows factorsa [(1)� (2)] cash outflowsb factorsa [(4)� (5)]End of year (1) (2) (3) (4) (5) (6)

1 $3,600 .943 $ 3,395 $4,286 .943 $ 4,042

2 3,600 .890 3,204 3,278 .890 2,917

3 3,600 .840 3,024 4,684 .840 3,935

4 3,600 .792 2,851 5,527 .792 4,377

5 7,600c .747��

5�,�6�7�7�

5,714 .747��

4�,�2�6�8�

PV of cash outflows $��1��8��,��1��5��1��

PV of cash outflows $��1��9��,��5��3��9��

aFrom Table A–2, PVIF, for 6% and the corresponding year.bFrom column 7 of Table 16.2.cAfter-tax lease payment outflow of $3,600 plus the $4,000 cost of exercising the purchase option.

capitalized leaseA financial (capital) lease thathas the present value of all itspayments included as an assetand corresponding liability onthe firm’s balance sheet, asrequired by Financial AccountingStandards Board (FASB)Standard No. 13.

The techniques described here for comparing lease and purchase alternativesmay be applied in different ways. The approach illustrated by the Roberts Com-pany data is one of the most straightforward. It is important to recognize that thelower cost of one alternative over the other results from factors such as the differ-ing tax brackets of the lessor and lessee, different tax treatments of leases versuspurchases, and differing risks and borrowing costs for lessor and lessee. There-fore, when making a lease-versus-purchase decision, the firm will find that inex-pensive borrowing opportunities, high required lessor returns, and a low risk ofobsolescence increase the attractiveness of purchasing. Subjective factors mustalso be included in the decision-making process. Like most financial decisions,the lease-versus-purchase decision requires some judgment or intuition.

Effects of Leasing on Future FinancingBecause leasing is considered a type of financing, it affects the firm’s futurefinancing. Lease payments are shown as a tax-deductible expense on the firm’sincome statement. Anyone analyzing the firm’s income statement would proba-bly recognize that an asset is being leased, although the amount and term of thelease would be unclear.

The Financial Accounting Standards Board (FASB), in Standard No. 13,“Accounting for Leases,” requires explicit disclosure of financial (capital) leaseobligations on the firm’s balance sheet. Such a lease must be shown as a capital-ized lease, meaning that the present value of all its payments is included as anasset and corresponding liability on the firm’s balance sheet. An operating lease,on the other hand, need not be capitalized, but its basic features must be dis-closed in a footnote to the financial statements. Standard No. 13, of course,establishes detailed guidelines to be used in capitalizing leases. Subsequent stan-dards have further refined lease capitalization and disclosure procedures.


In Practice

Moving their lease applicationprocesses online has provided asolid advantage for computerequipment vendors. Customers ofAuspex Systems, Inc., a manufac-turer of computer file servers fornetworks, can apply for leasefinancing directly from Auspex’sWeb site. Instead of filing a paperapplication and waiting about30 days to learn whether they haveobtained financing, they can file inabout 10 minutes, receive real-time credit scoring and creditdecisions, and gain access to anetwork of potential fundingsources. The software, developedby Ampent Inc., automaticallyanalyzes and processes the appli-cations, sending to lessors onlythose applicants that meet itscredit standards. This new service

also enables customers to calcu-late monthly payments instantly,customize payment plans, gener-ate finance documentation, andview their account status online atany time.

“Leasing our file servers canoffer significant advantages, rang-ing from lower-cost financing toconservation of working capital,better cash flow management, andtax benefits involving accelerateddepreciation,” said Peter Simpson,CFO of Auspex Systems. The speedand simplicity of online applicationand loan processing have provedattractive to the firm’s customers,who like having an alternative tocash purchases.

Likewise, using online leaseapplications has proved beneficialto Computer Connection of New

York (CCNY) for its small-ticketleases. “It’s a win–win solution,”said Scott Fluty, CEO of CCNY. “Ourcustomers get approvals at thepoint-of-sale, an easy online appli-cation, and low monthly payments;we get an automated process thathelps to generate income andimprove our cash flow.” In addi-tion, the funding network associ-ated with the applicationincreases the chances that cus-tomers will secure lease approvalat competitive, risk-adjustedprices. For the vendor, the systemalso speeds payment.

Sources: “Auspex Adds Online LeaseFinancing Option for Its Enterprise FileServers,” PRNewswire (August 2, 2001); and“Key Equipment Vendors Accelerate Cus-tomers’ Lease Transactions with AmpentPlatform,” Business Wire (July 11, 2001),downloaded from findarticles.com.

FOCUS ON e-FINANCE Logging-On for Leases

9. The Financial Accounting Standards Board in Standard No. 13 established certain guidelines for the appropriatediscount rate to use when capitalizing leases. Most commonly, the rate that the lessee would have incurred to bor-row the funds to buy the asset with a secured loan under terms similar to the lease repayment schedule is used. Thissimply represents the before-tax cost of a secured debt.

E X A M P L E Jeffrey Company, a manufacturer of water purifiers, is leasing an asset under a10-year lease requiring annual end-of-year payments of $15,000. The lease canbe capitalized merely by calculating the present value of the lease payments overthe life of the lease. However, the rate at which the payments should be dis-counted is difficult to determine.9 If 10% were used, the present, or capitalized,value of the lease would be $92,175 ($15,000�6.145). (The value calculated byusing a financial calculator is $92,169.) This value would be shown as an assetand corresponding liability on the firm’s balance sheet, which should result in anaccurate reflection of the firm’s true financial position.

Because the consequences of missing a financial lease payment are the same asthose of missing an interest or principal payment on debt, a financial analyst mustview the lease as a long-term financial commitment of the lessee. With FASB No.13, the inclusion of each financial (capital) lease as an asset and correspondingliability (i.e., long-term debt) provides for a balance sheet that more accuratelyreflects the firm’s financial status. It thereby permits various types of financialratio analyses to be performed directly on the statement by any interested party.


Advantages and Disadvantages of LeasingLeasing has a number of commonly cited advantages and disadvantages thatmanagers should consider when making a lease-versus-purchase decision. It isnot unusual for a number of them to apply in a given situation.

Advantages

The commonly cited advantages of leasing are as follows:

1. In a lease arrangement, the firm may avoid the cost of obsolescence if thelessor fails to anticipate accurately the obsolescence of assets and sets thelease payment too low. This is especially true in the case of operating leases,which generally have relatively short lives.

2. A lessee avoids many of the restrictive covenants that are normally includedas part of a long-term loan. Requirements with respect to minimum liquidity,subsequent borrowing, cash dividend payments, and so on are not normallyfound in a lease agreement.

3. In the case of low-cost assets that are infrequently acquired, leasing—espe-cially operating leases—may provide the firm with needed financing flexibil-ity. That is, the firm does not have to arrange other financing for these assets.

4. Sale–leaseback arrangements may permit the firm to increase its liquidity byconverting an existing asset into cash, which can then be used as workingcapital. This can be advantageous for a firm that is short of working capitalor in a liquidity bind.

5. Leasing allows the lessee, in effect, to depreciate land, which is prohibited ifthe land were purchased. Because the lessee who leases land is permitted todeduct the total lease payment as an expense for tax purposes, the effect isthe same as though the firm had purchased the land and then depreciated it.

6. Because it results in the receipt of service from an asset possibly withoutincreasing the assets or liabilities on the firm’s balance sheet, leasing mayresult in misleading financial ratios. Understating assets and liabilities cancause certain ratios, such as the total asset turnover, to look better than theymight be. With the passage of FASB No. 13, this advantage no longer appliesto financial leases, although in the case of operating leases, it remains apotential advantage.

7. Leasing provides 100 percent financing. Most loan agreements for the pur-chase of fixed assets require the borrower to pay a portion of the purchaseprice as a down payment. As a result, the borrower is able to borrow only 90to 95 percent of the purchase price of the asset.

8. When a firm becomes bankrupt or is reorganized, the maximum claim oflessors against the corporation is 3 years of lease payments, and the lessor ofcourse gets the asset back. If debt is used to purchase an asset, the creditorshave a claim that is equal to the total outstanding loan balance.

Disadvantages

The commonly cited disadvantages of leasing are as follows:

1. A lease does not have a stated interest cost. Thus, in many leases the return tothe lessor is quite high, so the firm might be better off borrowing to purchasethe asset.


convertible bondA bond that can be changed intoa specified number of shares ofcommon stock.

straight bondA bond that is nonconvertible,having no conversion feature.

LG3 LG4

conversion featureAn option that is included as partof a bond or a preferred stockissue and allows its holder tochange the security into a statednumber of shares of commonstock.

2. At the end of the term of the lease agreement, the salvage value of an asset, ifany, is realized by the lessor. If the lessee had purchased the asset, it couldhave claimed its salvage value. Of course, an expected salvage value whenrecognized by the lessor results in lower lease payments.

3. Under a lease, the lessee is generally prohibited from making improvements onthe leased property or asset without the approval of the lessor. If the propertywere owned outright, this difficulty would not arise. Of course, lessors gener-ally encourage leasehold improvements when these are expected to enhancethe asset’s salvage value.

4. If a lessee leases an asset that subsequently becomes obsolete, it still mustmake lease payments over the remaining term of the lease. This is true even ifthe asset is unusable.

R e v i e w Q u e s t i o n s

16–2 What is leasing? Define, compare, and contrast operating leases and finan-cial (or capital) leases. How does the Financial Accounting StandardsBoard (FASB) Standard No. 13 define a financial (or capital) lease?Describe three methods used by lessors to acquire assets to be leased.

16–3 Describe the four basic steps involved in the lease-versus-purchase deci-sion process. How are capital budgeting methods applied in this process?

16–4 What type of lease must be treated as a capitalized lease on the balancesheet? How does the financial manager capitalize a lease?

16–5 List and discuss the commonly cited advantages and disadvantages thatshould be considered when deciding whether to lease or purchase.

16.3 Convertible SecuritiesA conversion feature is an option that is included as part of a bond or a preferredstock issue and allows its holder to change the security into a stated number ofshares of common stock. The conversion feature typically enhances the mar-ketability of an issue.

Types of Convertible SecuritiesCorporate bonds and preferred stocks may be convertible into common stock.The most common type of convertible security is the bond. Convertibles nor-mally have an accompanying call feature. This feature permits the issuer to retireor encourage conversion of outstanding convertibles when appropriate.

Convertible Bonds

A convertible bond can be changed into a specified number of shares of commonstock. It is nearly always a debenture—an unsecured bond—with a call feature.Because the conversion feature provides the purchaser with the possibility ofbecoming a stockholder on favorable terms, convertible bonds are generally a lessexpensive form of financing than similar-risk nonconvertible or straight bonds.


straight preferred stockPreferred stock that is noncon-vertible, having no conversionfeature.

conversion ratioThe ratio at which a convertiblesecurity can be exchanged forcommon stock.

conversion priceThe per-share price that iseffectively paid for commonstock as the result of conversionof a convertible security.

convertible preferred stockPreferred stock that can bechanged into a specified numberof shares of common stock.

The conversion feature adds a degree of speculation to a bond issue, although theissue still maintains its value as a bond.

Convertible Preferred Stock

Convertible preferred stock is preferred stock that can be changed into a specifiednumber of shares of common stock. It can normally be sold with a lower stateddividend than a similar-risk nonconvertible or straight preferred stock. The rea-son is that the convertible preferred holder is assured of the fixed dividend pay-ment associated with a preferred stock and also may receive the appreciationresulting from increases in the market price of the underlying common stock.Convertible preferred stock behaves much like convertible bonds. The followingdiscussions will concentrate on the more popular convertible bonds.

General Features of ConvertiblesConvertible securities are nearly always convertible at any time during the life ofthe security. Occasionally, conversion is permitted only for a limited number ofyears—say, for 5 or 10 years after issuance of the convertible.

Conversion Ratio

The conversion ratio is the ratio at which a convertible security can be exchangedfor common stock. The conversion ratio can be stated in two ways.

1. Sometimes the conversion ratio is stated in terms of a given number of sharesof common stock. To find the conversion price, which is the per-share pricethat is effectively paid for common stock as the result of conversion, dividethe par value (not the market value) of the convertible security by the conver-sion ratio.

E X A M P L E Western Wear Company, a manufacturer of denim products, has outstanding abond that has a $1,000 par value and is convertible into 25 shares of commonstock. The bond’s conversion ratio is 25. The conversion price for the bond is$40 per share ($1,000�25).

2. Sometimes, instead of the conversion ratio, the conversion price is given. Theconversion ratio can be obtained by dividing the par value of the convertibleby the conversion price.

E X A M P L E Mosher Company, a franchiser of seafood restaurants, has outstanding a con-vertible 20-year bond with a par value of $1,000. The bond is convertible at $50per share into common stock. The conversion ratio is 20 ($1,000�$50).

The issuer of a convertible security normally establishes a conversion ratio orconversion price that sets the conversion price per share at the time of issuanceabove the current market price of the firm’s stock. If the prospective purchasersdo not expect conversion ever to be feasible, they will purchase a straight securityor some other convertible issue.


contingent securitiesConvertibles, warrants, andstock options. Their presenceaffects the reporting of a firm’searnings per share (EPS).

basic EPSEarnings per share (EPS)calculated without regard to anycontingent securities.

diluted EPSEarnings per share (EPS)calculated under the assumptionthat all contingent securities thatwould have dilutive effects areconverted and exercised and aretherefore common stock.

conversion (or stock) valueThe value of a convertiblesecurity measured in terms of themarket price of the commonstock into which it can beconverted.

10. For excellent discussions and demonstrations of the two methods of reporting EPS, see Donald A. Kieso, Jerry J.Weygandt, and Terry Warfield, Intermediate Accounting, 10th ed. (New York: John Wiley, 2001), pp. 147–149,893–897.

Conversion (or Stock) Value

The conversion (or stock) value is the value of the convertible measured in termsof the market price of the common stock into which it can be converted. The con-version value can be found simply by multiplying the conversion ratio by the cur-rent market price of the firm’s common stock.

E X A M P L E McNamara Industries, a petroleum processor, has outstanding a $1,000 bondthat is convertible into common stock at $62.50 a share. The conversion ratio istherefore 16 ($1,000 ÷ $62.50). Because the current market price of the commonstock is $65 per share, the conversion value is $1,040 (16 � $65). Because theconversion value is above the bond value of $1,000, conversion is a viable optionfor the owner of the convertible security.

Effect on Earnings

The presence of contingent securities, which include convertibles as well as war-rants (described later in this chapter) and stock options (described in Chapter 1and later in this chapter), affects the reporting of the firm’s earnings per share(EPS). Firms with contingent securities that if converted or exercised would dilute(that is, lower) earnings per share are required to report earnings in two ways—basic EPS and diluted EPS.

Basic EPS are calculated without regard to any contingent securities. Theyare found by dividing earnings available for common stockholders by the numberof shares of common stock outstanding. This is the standard method of calculat-ing EPS that has been used throughout this textbook.

Diluted EPS are calculated under the assumption that all contingent securitiesthat would have dilutive effects are converted and exercised and are thereforecommon stock. They are found by adjusting basic EPS for the impact of convertingall convertibles and exercising all warrants and options that would have dilutiveeffects on the firm’s earnings. This approach treats as common stock all contingentsecurities. It is calculated by dividing earnings available for common stockholders(adjusted for interest and preferred stock dividends that would not be paid, givenassumed conversion of all outstanding contingent securities that would have dilu-tive effects) by the number of shares of common stock that would be outstanding ifall contingent securities that would have dilutive effects were converted and exer-cised. Rather than demonstrate these accounting calculations,10 suffice it to saythat firms with outstanding convertibles, warrants, and/or stock options mustreport basic and diluted EPS on their income statements.

Financing with ConvertiblesUsing convertible securities to raise long-term funds can help the firm achieve itscost-of-capital and capital structure goals. There also are a number of more spe-cific motives and considerations involved in evaluating convertible financing.


Hint Convertible securitiesare advantageous to both theissuer and the holder. Theissuer does not have to give upimmediate control as it wouldhave to if it were issuingcommon stock. The holder of aconvertible security has thepossibility of a futurespeculative gain.

Motives for Convertible Financing

Convertibles can be used for a variety of reasons. One popular motive is their useas a form of deferred common stock financing. When a convertible security isissued, both issuer and purchaser expect the security to be converted into com-mon stock at some future point. Because the security is first sold with a conversionprice above the current market price of the firm’s stock, conversion is initially notattractive. The issuer of a convertible could alternatively sell common stock, butonly at or below its current market price. By selling the convertible, the issuer ineffect makes a deferred sale of common stock. As the market price of the firm’scommon stock rises to a higher level, conversion may occur. Deferring theissuance of new common stock until the market price of the stock has increasedmeans that fewer shares will have to be issued, thereby decreasing the dilution ofboth ownership and earnings.

Another motive for convertible financing is its use as a “sweetener” forfinancing. Because the purchaser of the convertible is given the opportunity tobecome a common stockholder and share in the firm’s future success, convert-ibles can be normally sold with lower interest rates than nonconvertibles. There-fore, from the firm’s viewpoint, including a conversion feature reduces theinterest cost of debt. The purchaser of the issue sacrifices a portion of interestreturn for the potential opportunity to become a common stockholder. Anotherimportant motive for issuing convertibles is that, generally speaking, convertiblesecurities can be issued with far fewer restrictive covenants than nonconvertibles.Because many investors view convertibles as equity, the covenant issue is notimportant to them.

A final motive for using convertibles is to raise cheap funds temporarily. Byusing convertible bonds, the firm can temporarily raise debt, which is typicallyless expensive than common stock, to finance projects. Once such projects areunder way, the firm may wish to shift its capital structure to a less highly leveredposition. A conversion feature gives the issuer the opportunity, through actionsof convertible holders, to shift its capital structure at a future time.

Other Considerations

When the price of the firm’s common stock rises above the conversion price, themarket price of the convertible security will normally rise to a level close to itsconversion value. When this happens, many convertible holders will not convert,because they already have the market price benefit obtainable from conversionand can still receive fixed periodic interest payments. Because of this behavior,virtually all convertible securities have a call feature that enables the issuer toencourage or “force” conversion. The call price of the security generally exceedsthe security’s par value by an amount equal to 1 year’s stated interest on the secu-rity. Although the issuer must pay a premium for calling a security, the call privi-lege is generally not exercised until the conversion value of the security is 10 to 15percent above the call price. This type of premium above the call price helps toassure the issuer that the holders of the convertible will convert it when the call ismade, instead of accepting the call price.

Unfortunately, there are instances when the market price of a security doesnot reach a level sufficient to stimulate the conversion of associated convertibles.


In Practice

Once used mostly by non-invest-ment-grade, high-tech companies,convertible financings reachedrecord volume in 2001 as high-quality companies issued convert-ible bonds. Finance executiveswere attracted to convertibles bytheir generally lower interest ratesthan on nonconvertible debt andby the opportunity to issue futureequity at higher prices than themarkets currently offered.

“The debt markets are closednow to a lot of companies, andwho wants to issue stock at priceswe have seen recently?” observedGeorge Chacko, assistant profes-sor at the Harvard GraduateSchool of Business. “Convertiblesoffer the best opportunity a lot ofcompanies have to raise capital inthese jittery markets.”

Information technology ser-vices company EDS, rated A1 by

Moody’s Investor Services, sold$1.6 billion of 20-year, zero-couponconvertible bonds in June 2001 andanother $780 million in October2001. The October issue was con-vertible into EDS common shares atan initial conversion price of $80.11,representing a premium of about 30percent, and it carried a 1.25 per-cent yield to maturity. EDS cannotcall the bonds for 3 years. Bond-holders can sell the bonds back toEDS after 2, 3, 5, 10, and 15 years.

Duke Energy Corp. chose adifferent structure and soldmandatory convertible debt inMarch 2001. Investors must con-vert the 3-year, 8.25 percent secu-rities to common shares at matu-rity, regardless of the current stockprice and based on a 22 percentconversion premium. Until conver-sion, the securities are treated asdebt for tax and accounting pur-

poses and mostly as equity bycredit rating agencies. “It helps usmaintain our strong credit rating,”explains Myron Caldwell, Duke’svice president of corporatefinance. Compared with traditionalconvertible debt, which typicallycarries a lower rate than straightdebt, Duke had to offer investors ayield that was about 2 percenthigher. The strategy worked, how-ever, and investor demand pushedthe size of the offering from $500million to $875 million.

Sources: Adapted from “EDS CompletesPublic Offering of 20-Year, Senior ConvertibleNotes,” PR Newswire (October 4, 2001),downloaded from findarticles.com; RichardH. Gamble, “Convertibles Roll Out in Fleets,”Business Finance (July 2001), downloadedfrom businessfinance.com; and Ian Spring-steel, “Who Needs Equity?” CFO (July 1,2001), downloaded from cfo.com.

FOCUS ON PRACTICE Convertibles Speed Down Financing Highway

overhanging issueA convertible security thatcannot be forced into conversionby using the call feature.

A convertible security that cannot be forced into conversion by using the call fea-ture is called an overhanging issue. An overhanging issue can be quite detrimentalto a firm. If the firm were to call the issue, the bondholders would accept the callprice rather than convert the bonds. In this case, the firm not only would have topay the call premium but would also require additional financing to pay off thebonds at their par value. If the firm raised these funds through the sale of equity,a large number of shares would have to be issued because of their low marketprice. This, in turn, could result in the dilution of existing ownership. Anothermeans of financing the call would be the use of debt or preferred stock, but thisuse would leave the firm’s capital structure no less levered than before the call.

Determining the Value of a Convertible BondThe key characteristic of convertible securities that enhances their marketabilityis their ability to minimize the possibility of a loss while providing a possibility ofcapital gains. Here we discuss the three values of a convertible bond: (1) thestraight bond value, (2) the conversion value, and (3) the market value.


11. Just as we did in Chapter 6, we continue to assume the payment of annual rather than semiannual bond interest.This assumption simplifies the calculations involved, while maintaining the conceptual accuracy of the procedurespresented.

straight bond valueThe price at which a convertiblebond would sell in the marketwithout the conversion feature.

Straight Bond Value

The straight bond value of a convertible bond is the price at which it would sell inthe market without the conversion feature. This value is found by determiningthe value of a nonconvertible bond with similar payments issued by a firm withthe same risk. The straight bond value is typically the floor, or minimum, price atwhich the convertible bond would be traded. The straight bond value equals thepresent value of the bond’s interest and principal payments discounted at theinterest rate the firm would have to pay on a nonconvertible bond.

E X A M P L E Duncan Company, a southeastern discount store chain, has just sold a $1,000-par-value, 20-year convertible bond with a 12% coupon interest rate. The bondinterest will be paid at the end of each year, and the principal will be repaid atmaturity.11 A straight bond could have been sold with a 14% coupon interestrate, but the conversion feature compensates for the lower rate on the convert-ible. The straight bond value of the convertible is calculated as shown:

This value, $867.76, is the minimum price at which the convertible bond isexpected to sell. (The value calculated using a financial calculator is $867.54.)Generally, only in certain instances in which the stock’s market price is below theconversion price will the bond be expected to sell at this level.

Conversion (or Stock) Value

Recall that the conversion (or stock) value of a convertible security is the value ofthe convertible measured in terms of the market price of the common stock intowhich the security can be converted. When the market price of the common stockexceeds the conversion price, the conversion (or stock) value exceeds the parvalue. An example will clarify the point.

E X A M P L E Duncan Company’s convertible bond described earlier is convertible at $50 pershare. Each bond can be converted into 20 shares, because each bond has a

Present value interest Present valuePayments factor at 14% [(1)� (2)]

Year(s) (1) (2) (3)

1–20 $ 120a 6.623b $794.76

20 1,000 0.073c��

7�3�.�0�0�

Straight bond value $��8��6��7��.��7��6��

a$1,000 at 12%�$120 interest per year.bPresent value interest factor for an annuity, PVIFA, discounted at 14% for20 years, from Table A–4.cPresent value interest factor for $1, PVIF, discounted at 14% for year 20,from Table A–2.


market premiumThe amount by which the marketvalue exceeds the straight orconversion value of a convertiblesecurity.

$1,000 par value. The conversion values of the bond when the stock is sellingat $30, $40, $50, $60, $70, and $80 per share are shown in the followingtable.

When the market price of the common stock exceeds the $50 conversionprice, the conversion value exceeds the $1,000 par value. Because the straightbond value (calculated in the preceding example) is $867.76, the bond will, in astable environment, never sell for less than this amount, regardless of how low itsconversion value is. If the market price per share were $30, the bond would stillsell for $867.76—not $600—because its value as a bond would dominate.

Market Value

The market value of a convertible is likely to be greater than its straight value orits conversion value. The amount by which the market value exceeds its straightor conversion value is called the market premium. The general relationshipsamong the straight bond value, conversion value, market value, and market pre-mium for Duncan Company’s convertible bond are shown in Figure 16.1. Thestraight bond value acts as a floor for the security’s value up to the point X,where the stock price is high enough to cause the conversion value to exceed thestraight bond value. The market premium is attributed to the fact that the con-vertible gives investors a chance to experience attractive capital gains fromincreases in the stock price, while taking less risk. The floor (straight bond value)provides protection against losses resulting from a decline in the stock pricecaused by falling profits or other factors. The market premium tends to be great-est when the straight bond value and conversion (or stock) value are nearlyequal. Investors perceive the benefits of these two sources of value to be greatestat this point.


16–6 What is the conversion feature? What is a conversion ratio? How do con-vertibles and other contingent securities affect EPS? Briefly describe themotives for convertible financing.

16–7 When the market price of the stock rises above the conversion price, whymay a convertible security not be converted? How can the call feature beused to force conversion in this situation? What is an overhanging issue?

Market price of stock Conversion value

$30 $ 600

40 800

50 (conversion price) 1,000 (par value)

60 1,200

70 1,400

80 1,600


LG5

stock purchase warrantAn instrument that gives itsholder the right to purchase acertain number of shares ofcommon stock at a specifiedprice over a certain period oftime.

Hint One of the majorreasons for attaching a warrantor offering a security as aconvertible is that with either ofthese features, investors do notrequire the issuing firm to payan interest rate that is as highas on a security without thesefeatures.

Market Value

Conversion Value

Straight Bond Value

MarketPremium

X

100 20 30 40 50 60 70 80 90

200

400

600

800

1,000

1,200

1,400

1,600

Valu

e of

Conve

rtib

le B

ond (

$)

Price per Share of Common Stock ($)

FIGURE 16 .1

Values and Market

Premium

The values and marketpremium for DuncanCompany’s convertible bond

16–8 Define the straight bond value, conversion (or stock) value, market value,and market premium associated with a convertible bond, and describe thegeneral relationships among them.

16.4 Stock Purchase WarrantsStock purchase warrants are similar to stock rights, which were briefly describedin Chapter 7. A stock purchase warrant gives the holder the right to purchase acertain number of shares of common stock at a specified price over a certainperiod of time. (Of course, holders of warrants earn no income from them untilthe warrants are exercised or sold.) Warrants also bear some similarity to con-vertibles in that they provide for the injection of additional equity capital into thefirm at some future date.

Basic CharacteristicsWarrants are often attached to debt issues as “sweeteners.” When a firm makes alarge bond issue, the attachment of stock purchase warrants may add to the mar-ketability of the issue and lower the required interest rate. As sweeteners, war-rants are similar to conversion features. Often, when a new firm is raising its ini-tial capital, suppliers of debt will require warrants to permit them to share inwhatever success the firm achieves. In addition, established companies sometimesoffer warrants with debt to compensate for risk and thereby lower the interestrate and/or provide for fewer restrictive covenants.


implied price of a warrantThe price effectively paid foreach warrant attached to a bond.

exercise (or option) priceThe price at which holders ofwarrants can purchase aspecified number of shares ofcommon stock.

Exercise Prices

The price at which holders of warrants can purchase a specified number of sharesof common stock is normally referred to as the exercise (or option) price. Thisprice is usually set at 10 to 20 percent above the market price of the firm’s stockat the time of issuance. Until the market price of the stock exceeds the exerciseprice, holders of warrants will not exercise them, because they can purchase thestock more inexpensively in the marketplace.

Warrants normally have a life of no more than 10 years, although some haveinfinite lives. Although, unlike convertible securities, warrants cannot be called,their limited life stimulates holders to exercise them when the exercise price isbelow the market price of the firm’s stock.

Warrant Trading

A warrant is usually detachable, which means that the bondholder may sell thewarrant without selling the security to which it is attached. Many detachable war-rants are listed and actively traded on organized securities exchanges and on theover-the-counter exchange. The majority of actively traded warrants are listed onthe American Stock Exchange. Warrants often provide investors with betteropportunities for gain (with increased risk) than the underlying common stock.

Comparison of Warrants to Rights and Convertibles

The similarity between a warrant and a right should be clear. Both result in newequity capital, although the warrant provides for deferred equity financing. Thelife of a right is typically not more than a few months; a warrant is generally exer-cisable for a period of years. Rights are issued at a subscription price below theprevailing market price of the stock; warrants are generally issued at an exerciseprice 10 to 20 percent above the prevailing market price.

Warrants and convertibles also have similarities. The exercise of a warrantshifts the firm’s capital structure to a less highly levered position because newcommon stock is issued without any change in debt. If a convertible bond wereconverted, the reduction in leverage would be even more pronounced, becausecommon stock would be issued in exchange for a reduction in debt. In addition,the exercise of a warrant provides an influx of new capital; with convertibles, thenew capital is raised when the securities are originally issued rather than whenthey are converted. The influx of new equity capital resulting from the exercise ofa warrant does not occur until the firm has achieved a certain degree of successthat is reflected in an increased price for its stock. In this case, the firm conve-niently obtains needed funds.

The Implied Price of an Attached WarrantWhen warrants are attached to a bond, the implied price of a warrant—the pricethat is effectively paid for each attached warrant—can be found by first usingEquation 16.1:

Implied price of �

Price of bond withall warrants warrants attached

� Straight bond value (16.1)


The straight bond value is found in a fashion similar to that used in valuing con-vertible bonds. Dividing the implied price of all warrants by the number of war-rants attached to each bond results in the implied price of each warrant.

E X A M P L E Martin Marine Products, a manufacturer of marine drive shafts and propellers,just issued a 10.5%-coupon-interest-rate, $1,000-par, 20-year bond payingannual interest and having 20 warrants attached for the purchase of the firm’sstock. The bonds were initially sold for their $1,000 par value. When issued,similar-risk straight bonds were selling to yield a 12% rate of return. The straightvalue of the bond would be the present value of its payments discounted at the12% yield on similar-risk straight bonds.

Substituting the $1,000 price of the bond with warrants attached and the$888 straight bond value into Equation 16.1, we get an implied price of all war-rants of $112:

Implied price of all warrants�$1,000�$888�$��1��1��2��

Dividing the implied price of all warrants by the number of warrants attached toeach bond—20 in this case—we find the implied price of each warrant:

Implied price of each warrant� �$��5��.��6��0��

Therefore, by purchasing Martin Marine Products’ bond with warrants attachedfor $1,000, one is effectively paying $5.60 for each warrant.

The implied price of each warrant is meaningful only when compared to thespecific features of the warrant—the number of shares that can be purchased andthe specified exercise price. These features can be analyzed in light of the prevail-ing common stock price to estimate the true market value of each warrant.Clearly, if the implied price is above the estimated market value, the price of thebond with warrants attached may be too high. If the implied price is below theestimated market value, the bond may be quite attractive. Firms must therefore

$112�

20

Present value interest Present valuea

Payments factor at 12% [(1)� (2)]Year(s) (1) (2) (3)

1–20 $ 105b 7.469c $784

20 1,000 0.104d�1�0�4�

Straight bond valuee $��8��8��8��

aFor convenience, these values have been rounded to the nearest $1.b$1,000 at 10.5%�$105 interest per year.cPresent value interest factor for an annuity, PVIFA, discounted at 12% for20 years, from Table A–4.dPresent value interest factor for $1, PVIF, discounted at 12% for year 20,from Table A–2.eThe value calculated by using a financial calculator and rounding to thenearest $1 is also $888.


warrant premiumThe difference between themarket value and the theoreticalvalue of a warrant.

price their bonds with warrants attached in a way that causes the implied price ofits warrants to fall slightly below their estimated market value. Such an approachallows the firm to sell the bonds more easily at a lower coupon interest rate thanwould apply to straight debt, thereby reducing its debt service costs.

The Value of WarrantsLike a convertible security, a warrant has both a market value and a theoreticalvalue. The difference between these values, or the warrant premium, dependslargely on investor expectations and on the ability of investors to get more lever-age from the warrants than from the underlying stock.

Theoretical Value of a Warrant

The theoretical value of a stock purchase warrant is the amount one wouldexpect the warrant to sell for in the marketplace. Equation 16.2 gives the theoret-ical value of a warrant:

TVW� (P0 �E)�N (16.2)

where

TVW� theoretical value of a warrantP0 �current market price of a share of common stockE�exercise price of the warrantN�number of shares of common stock obtainable with one warrant

The use of Equation 16.2 can be illustrated by the following example.

E X A M P L E Dustin Electronics, a major producer of transistors, has outstanding warrantsthat are exercisable at $40 per share and entitle holders to purchase three sharesof common stock. The warrants were initially attached to a bond issue to sweetenthe bond. The common stock of the firm is currently selling for $45 per share.Substituting P0 �$45, E�$40, and N�3 into Equation 16.2 yields a theoreticalwarrant value of $15 [($45�$40)�3]. Therefore, Dustin’s warrants should sellfor $15 in the marketplace.

Market Value of a Warrant

The market value of a stock purchase warrant is generally above the theoreticalvalue of the warrant. Only when the theoretical value of the warrant is very highor the warrant is near its expiration date are the market and theoretical valuesclose. The general relationship between the theoretical and market values ofDustin Electronics’ warrants is presented graphically in Figure 16.2. The marketvalue of warrants generally exceeds the theoretical value by the greatest amountwhen the stock’s market price is close to the warrant exercise price per share. Theamount of time until expiration also affects the market value of the warrant.Generally speaking, the closer the warrant is to its expiration date, the morelikely that its market value will equal its theoretical value.


100 20 30 40 50 60 70

10

20

30

40

50

60

Valu

e of

Warr

ant

($)

Price per Share of Common Stock ($)

TheoreticalValue

MarketValue

WarrantPremium

FIGURE 16 .2

Values and Warrant

Premium

The values and warrantpremium for DustinElectronics’ stock purchasewarrants

Warrant Premium

The warrant premium, or the amount by which the market value of Dustin Elec-tronics’ warrants exceeds the theoretical value of these warrants, is also shown inFigure 16.2. This premium results from a combination of positive investor expec-tations and the ability of the investor with a fixed sum to invest to obtain muchlarger potential returns (and risk) by trading in warrants rather than the underly-ing stock.

E X A M P L E Stan Buyer has $2,430, which he is interested in investing in Dustin Electronics.The firm’s stock is currently selling for $45 per share, and its warrants are sellingfor $18 per warrant. Each warrant entitles the holder to purchase three shares ofDustin’s common stock at $40 per share. Because the stock is selling for $45 pershare, the theoretical warrant value, calculated in the preceding example, is $15[($45�$40)�3].

The warrant premium results from positive investor expectations and lever-age opportunities. Stan Buyer could spend his $2,430 in either of two ways: Hecould purchase 54 shares of common stock at $45 per share, or 135 warrants at$18 per warrant, ignoring brokerage fees. If Mr. Buyer purchases the stock andits price rises to $48, he will gain $162 ($3 per share�54 shares) by selling thestock. If instead he purchases the 135 warrants and the stock price increases by$3 per share, Mr. Buyer will gain approximately $1,215. Because the price of ashare of stock rises by $3, the price of each warrant can be expected to rise by $9(because each warrant can be used to purchase three shares of common stock). Again of $9 per warrant on 135 warrants means a total goal gain of $1,215 on thewarrants.


striking priceThe price at which the holder ofa call option can buy (or theholder of a put option can sell) aspecified amount of stock at anytime prior to the option’s expira-tion date.

12. Real options, opportunities embedded in capital projects that enable management to alter their cash flows andrisk, were discussed in Chapter 10. The options described here differ from real options; they are a type of derivativesecurity that derives its value from an underlying financial asset, typically common stock. Although some of the ana-lytical tools used to value both of these types of options are similar, the focus here is merely on the definitionalaspects of options. The models used to value these options are typically discussed in more advanced financial man-agement textbooks.

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optionAn instrument that provides itsholder with an opportunity topurchase or sell a specifiedasset at a stated price on orbefore a set expiration date.

call optionAn option to purchase a specifiednumber of shares of a stock(typically 100) on or before aspecified future date at a statedprice.

The greater leverage associated with trading warrants should be clear fromthe example. Of course, because leverage works both ways, it results in greaterrisk. If the market price fell by $3, the loss on the stock would be $162, whereasthe loss on the warrants would be close to $1,215. Clearly, investing in warrantsis more risky than investing in the underlying stock.


16–9 What are stock purchase warrants? What are the similarities and key dif-ferences between the effects of warrants and those of convertibles on thefirm’s capital structure and its ability to raise new capital?

16–10 What is the implied price of a warrant? How is it estimated? To be effec-tive, how should it be related to the estimated market value of a warrant?

16–11 What is the general relationship between the theoretical and market val-ues of a warrant? In what circumstances are these values quite close?What is a warrant premium?

16.5 OptionsIn the most general sense, an option can be viewed as an instrument that providesits holder with an opportunity to purchase or sell a specified asset at a statedprice on or before a set expiration date. Options are probably the most populartype of derivative security. Today, the interest in options centers on options oncommon stock.12 The development of organized options exchanges has createdmarkets in which to trade these options, which themselves are securities. Threebasic forms of options are rights, warrants, and calls and puts. Rights are dis-cussed in Chapter 7, and warrants were described in the preceding section.

Calls and PutsThe two most common types of options are calls and puts. A call option is anoption to purchase a specified number of shares of a stock (typically 100) on orbefore a specified future date at a stated price. Call options usually have initiallives of 1 to 9 months, occasionally 1 year. The striking price is the price at whichthe holder of the option can buy the stock at any time prior to the option’s expi-ration date; it is generally set at or near the prevailing market price of the stock atthe time the option is issued. For example, if a firm’s stock is currently selling for


put optionAn option to sell a specifiednumber of shares of a stock(typically 100) on or before aspecified future date at a statedprice.

Hint Put and call optionsare created by individuals andother firms. The firm itself hasnothing to do with the creationof these options. Convertiblesand warrants, by contrast, arecreated by the issuing firm.

$50 per share, a call option on the stock initiated today will probably have astriking price set at $50 per share. One must pay a specified price (normally a fewhundred dollars) to purchase a call option.

A put option is an option to sell a specified number of shares of a stock (typ-ically 100) on or before a specified future date at a stated striking price. Like thecall option, the striking price of the put is set close to the market price of theunderlying stock at the time of issuance. The lives and costs of puts are similar tothose of calls.

Options MarketsThere are two ways of making options transactions. The first involves making atransaction through one of 20 or so call and put options dealers with the help ofa stockbroker. The other, more popular mechanism is the organized optionsexchanges. The dominant exchange is the Chicago Board Options Exchange(CBOE), which was established in 1973. Other exchanges on which options aretraded include the American Stock Exchange, the Philadelphia Stock Exchange,and the Pacific Stock Exchange. The options traded on these exchanges are stan-dardized and thus are considered registered securities. Each option is for 100shares of the underlying stock. The price at which options transactions can bemade is determined by the forces of supply and demand.

Options TradingThe most common motive for purchasing call options is the expectation that themarket price of the underlying stock will rise by more than enough to cover thecost of the option and thereby allow the purchaser of the call to profit.

E X A M P L E Assume that Cindy Peters pays $250 for a 3-month call option on Wing Enter-prises, a maker of aircraft components, at a striking price of $50. This meansthat by paying $250, Cindy is guaranteed that she can purchase 100 shares ofWing at $50 per share at any time during the next 3 months. The stock pricemust climb $2.50 per share ($250�100 shares) to $52.50 per share to cover thecost of the option (ignoring any brokerage fees or dividends). If the stock pricewere to rise to $60 per share during the period, Cindy’s net profit would be $750[(100 shares�$60/share)� (100 shares�$50/share)�$250].

Because this return would be earned on a $250 investment, it illustrates thehigh potential return on investment that options offer. Of course, had the stockprice not risen above $50 per share, Cindy would have lost the $250 she invested,because there would have been no reason to exercise the option. Had the stockprice risen to between $50 and $52.50 per share, Cindy probably would haveexercised the option to reduce her loss to an amount less than $250.

Put options are purchased in the expectation that the share price of a givensecurity will decline over the life of the option. Purchasers of puts commonly ownthe shares and wish to protect a gain they have realized since their initial pur-chase. Buying a put locks in the gain because it enables them to sell their shares ata known price during the life of the option. Investors gain from put options whenthe price of the underlying stock declines by more than the per-share cost of the


hedgingOffsetting or protecting againstthe risk of adverse pricemovements.

option. The logic underlying the purchase of a put is exactly the opposite of thatunderlying the use of call options.

E X A M P L E Assume that Don Kelly pays $325 for a 6-month put option on Dante United, abaked goods manufacturer, at a striking price of $40. Don purchased the putoption in expectation that the stock price would drop because of the introductionof a new product line by Dante’s chief competitor. By paying $325, Don isassured that he can sell 100 shares of Dante at $40 per share at any time duringthe next 6 months. The stock price must drop by $3.25 per share ($325�100shares) to $36.75 per share to cover the cost of the option (ignoring any broker-age fees or dividends). If the stock price were to drop to $30 per share during theperiod, Don’s net profit would be $675 [(100 shares�$40/share)� (100 shares�$30/share)�$325].

Because the return would be earned on a $325 investment, it again illustratesthe high potential return on investment that options offer. Of course, had thestock price risen above $40 per share, Don would have lost the $325 he invested,because there would have been no reason to exercise the option. Had the stockprice fallen to between $36.75 and $40.00 per share, Don probably would haveexercised the option to reduce his loss to an amount less than $325.

The Role of Call and Put Options in Fund RaisingAlthough call and put options are extremely popular investment vehicles, theyplay no direct role in the fund-raising activities of the financial manager. Theseoptions are issued by investors, not businesses. They are not a source of financingto the firm. Corporate pension managers, whose job it is to invest and managecorporate pension funds, may use call and put options as part of their investmentactivities to earn a return or to protect or lock in returns already earned on secu-rities. The presence of options trading in the firm’s stock could—by increasingtrading activity—stabilize the firm’s share price in the marketplace, but the finan-cial manager has no direct control over this. Buyers of options have neither anysay in the firm’s management nor any voting rights; only stockholders are giventhese privileges. Despite the popularity of call and put options as an investmentvehicle, the financial manager has very little need to deal with them, especially aspart of fund-raising activities.

Hedging Foreign-Currency Exposures with OptionsThe Chicago Mercantile Exchange (CME) and the Philadelphia Stock Exchange(PHLX) offer exchange-traded options contracts on the Canadian dollar, theeuro, the Japanese yen, the Swiss franc, and several other important currencies.Currency options are used by a wide range of traders—from the largest multina-tional companies to small exporters and importers, as well as by individualinvestors and speculators. Unlike futures and forward contracts, options offer thekey benefit of hedging, which involves offsetting or protecting against the risk ofadverse price movements, while simultaneously preserving the possibility of prof-iting from favorable price movements. The key drawback to using options tohedge foreign-currency exposures is its high cost relative to using more tradi-tional futures or forward contracts.


S U M M A RYFOCUS ON VALUE

In addition to the basic corporate securities (bonds, common stock, and preferred stock),the firm can use various types of hybrid securities to improve its fund-raising activities. Thefinancial manager can use these securities, which possess characteristics of both debt andequity, to raise funds more inexpensively or to provide for desired future changes in thefirm’s capital structure.

Leasing, particularly financial (capital) leases, may enable the firm to use the lease as asubstitute for the debt-financed purchase of a given asset. Because of differing tax bracketsof lessors and lessees, different tax treatments of leases and purchases, and different risksand borrowing costs for lessor and lessee, leasing may provide more attractive risk–returntradeoffs to the firm than would result from using debt financing to purchase a given asset.Similarly, by issuing convertible rather than straight debt or by attaching stock purchasewarrants to a bond issue or debt financing, the firm may provide lenders with the potentialto benefit from stock price movements in exchange for being charged a lower interest rateor including less restrictive covenants in the bond or debt agreement. Although options arenot a source of financing to the firm, the presence of this derivative security can help stabi-lize the firm’s share price. Currency options can be used to hedge, or protect against,adverse currency movements in international transactions.

E X A M P L E Assume that a U.S. exporter just booked a sale denominated in Swiss francs withpayment due upon delivery in 3 months. The company could hedge the risk ofdepreciation in the dollar by purchasing a Swiss franc put option. This wouldgive the company the right to sell Swiss francs at a fixed price (say, $0.60/Sf).This option would become valuable if the Swiss franc were to depreciate fromtoday’s $0.63/Sf to, say, $0.55/Sf before the exporter receives payment in Swissfrancs. On the other hand, if the Swiss franc were to appreciate from $0.63/Sf to,say, $0.70/Sf, the U.S. exporter would allow the put option to expire unexercisedand would instead convert the Swiss francs received in payment into dollars atthe new, higher dollar price. The exporter would be protected from adverse pricerisk but would still be able to profit from favorable price movements.


16–12 What is an option? Define calls and puts. What role, if any, do call andput options play in the fund-raising activities of the financial manager?

16–13 How can the firm use currency options to hedge foreign-currency expo-sures resulting from international transactions? Describe the key benefitand the key drawback of using currency options rather than futures andforward contracts.


Clearly, the financial manager should use hybrid and derivative securities to increasereturn (often by lowering financing costs) and reduce risk. By taking only those actionsbelieved to result in attractive risk–return tradeoffs can the financial manager positivelycontribute to the firm’s goal of maximizing the stock price.

REVIEW OF LEARNING GOALS

Differentiate between hybrid and derivative se-curities and their roles in the corporation. Hy-

brid securities are forms of debt or equity financingthat possess characteristics of both debt and equityfinancing. Popular hybrid securities include preferredstock, financial leases, convertible securities, andstock purchase warrants. Derivative securities areneither debt nor equity and derive their value froman underlying asset that is often another security.Options, which are sometimes used by corporationsto manage risk, are a popular derivative security.

Review the basic types of leases, leasingarrangements, the lease-versus-purchase deci-

sion, the effects of leasing on future financing, andthe advantages and disadvantages of leasing. A leaseenables the firm to make contractual, tax-deductiblepayments to obtain the use of fixed assets. Operat-ing leases are generally 5 or fewer years in term,cancelable, and renewable, and they provide formaintenance by the lessor. Financial leases arelonger-term, noncancelable, and not renewable, andthey require the lessee to maintain the asset. FASBStandard No. 13 provides specific guidelines fordefining a financial (or capital) lease. A lessor canobtain assets to be leased through a direct lease, asale–leaseback arrangement, or a leveraged lease.The lease-versus-purchase decision can be evaluatedby calculating the after-tax cash outflows associatedwith the leasing and purchasing alternatives. Themore desirable alternative is the one that has thelower present value of after-tax cash outflows.FASB Standard No. 13 requires firms to show fi-nancial (or capital) leases as assets and correspond-ing liabilities on their balance sheets; operatingleases must be shown in footnotes to the financialstatements. A number of commonly cited advan-tages and disadvantages should be considered whenmaking lease-versus-purchase decisions.

Describe the basic types of convertible securities,their general features, and financing with con-

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LG1 vertibles. Corporate bonds and preferred stock mayboth be convertible into common stock. The conver-sion ratio indicates the number of shares for which aconvertible can be exchanged and determines theconversion price. A conversion privilege is nearly al-ways available at any time in the life of the security.The conversion (or stock) value is the value of theconvertible measured in terms of the market price ofthe common stock into which it can be converted.The presence of convertibles and other contingent se-curities (warrants and stock options) often requiresthe firm to report both basic and diluted earnings pershare (EPS). Convertibles are used to obtain deferredcommon stock financing, to “sweeten” bond issues,to minimize restrictive covenants, and to raise cheapfunds temporarily. The call feature is sometimes usedto encourage or “force” conversion; occasionally, anoverhanging issue results.

Demonstrate the procedures for determiningthe straight bond value, the conversion (or

stock) value, and the market value of a convertiblebond. The straight bond value of a convertible is theprice at which it would sell in the market withoutthe conversion feature. It typically represents theminimum value at which a convertible bond trades.The conversion (or stock) value of the convertible isfound by multiplying the conversion ratio by thecurrent market price of the underlying commonstock. The market value of a convertible generallyexceeds both its straight and conversion values, thusresulting in a market premium. The premium,which is largest when the straight and conversionvalues are nearly equal, is due to the attractive gainspotential from the stock and the risk protection pro-vided by the straight value of the convertible.

Explain the basic characteristics of stock pur-chase warrants, the implied price of an at-

tached warrant, and the values of warrants. Stockpurchase warrants enable their holders to purchasea certain number of shares of common stock at the

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specified exercise price. Warrants are often at-tached to debt issues as “sweeteners,” generallyhave limited lives, are detachable, and may belisted and traded on securities exchanges. Warrantsare similar to stock rights, except that the life of awarrant is generally longer than that of a right, andthe exercise price of a warrant is initially set abovethe underlying stock’s current market price. War-rants are similar to convertibles, but exercisingthem has a less pronounced effect on the firm’sleverage and brings in new funds. The implied priceof an attached warrant can be found by dividingthe difference between the bond price with war-rants attached and the straight bond value by thenumber of warrants attached to each bond. Themarket value of a warrant usually exceeds its theo-retical value, creating a warrant premium. The pre-mium results from positive investor expectationsand the ability of investors to get more leveragefrom trading warrants than from trading the un-derlying stock.

Define options and discuss calls and puts,options markets, options trading, the role of

call and put options in fund-raising, and hedgingforeign-currency exposures with options. An optionprovides its holder with an opportunity to purchaseor sell a specified asset at a stated price on or beforea set expiration date. Rights, warrants, and callsand puts are all options. Calls are options to pur-chase common stock, and puts are options to sellcommon stock. Options exchanges, such as theChicago Board Options Exchange (CBOE), provideorganized marketplaces in which purchases andsales of both call and put options can be made in anorderly fashion. The options traded on the ex-changes are standardized, and the price at whichthey trade is determined by the forces of supply anddemand. Call and put options do not play a directrole in the fund-raising activities of the financialmanager. On the other hand, currency options canbe used to hedge the firm’s foreign currency expo-sures resulting from international transactions.

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SELF-TEST PROBLEMS (Solutions in Appendix B)

ST 16–1 Lease versus purchase The Hot Bagel Shop wishes to evaluate two plans, leas-ing and borrowing to purchase, for financing an oven. The firm is in the 40% taxbracket.

Lease The shop can lease the oven under a 5-year lease requiring annual end-of-year payments of $5,000. All maintenance costs will be paid by the lessor,and insurance and other costs will be borne by the lessee. The lessee will exerciseits option to purchase the asset for $4,000 at termination of the lease.

Purchase The oven costs $20,000 and will have a 5-year life. It will be depreci-ated under MACRS using a 5-year recovery period. (See Table 3.2 on page 100for the applicable depreciation percentages.) The total purchase price will befinanced by a 5-year, 15% loan requiring equal annual end-of-year payments of$5,967. The firm will pay $1,000 per year for a service contract that covers allmaintenance costs; insurance and other costs will be borne by the firm. The firmplans to keep the equipment and use it beyond its 5-year recovery period.

a. For the leasing plan, calculate the following:(1) The after-tax cash outflow each year.(2) The present value of the cash outflows, using a 9% discount rate.

b. For the purchasing plan, calculate the following:(1) The annual interest expense deductible for tax purposes for each of the 5

years.(2) The after-tax cash outflow resulting from the purchase for each of the 5

years.


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(3) The present value of the cash outflows, using a 9% discount rate.c. Compare the present values of the cash outflow streams for these two plans,

and determine which plan would be preferable. Explain your answer.

ST 16–2 Finding convertible bond values Mountain Mining Company has an outstand-ing issue of convertible bonds with a $1,000 par value. These bonds are convert-ible into 40 shares of common stock. They have an 11% annual coupon interestrate and a 25-year maturity. The interest rate on a straight bond of similar risk iscurrently 13%.a. Calculate the straight bond value of the bond.b. Calculate the conversion (or stock) value of the bond when the market price

of the common stock is $20, $25, $28, $35, and $50 per share.c. For each of the stock prices given in part b, at what price would you expect

the bond to sell? Why?d. What is the least you would expect the bond to sell for, regardless of the

common stock price behavior?

PROBLEMS

16–1 Lease cash flows Given the lease payments and terms shown in the followingtable, determine the yearly after-tax cash outflows for each firm, assuming thatlease payments are made at the end of each year and that the firm is in the 40%tax bracket. Assume that no purchase option exists.

16–2 Loan interest For each of the loan amounts, interest rates, annual payments,and loan terms shown in the following table, calculate the annual interest paideach year over the term of the loan, assuming that the payments are made at theend of each year.

16–3 Loan payments and interest Schuyler Company wishes to purchase an assetcosting $117,000. The full amount needed to finance the asset can be borrowed

Loan Amount Interest rate Annual payment Term

A $14,000 10% $ 4,416 4 years

B 17,500 12 10,355 2

C 2,400 13 1,017 3

D 49,000 14 14,273 5

E 26,500 16 7,191 6

Firm Annual lease payment Term of lease

A $100,000 4 years

B 80,000 14

C 150,000 8

D 60,000 25

E 20,000 10


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at 14% interest. The terms of the loan require equal end-of-year payments forthe next 6 years. Determine the total annual loan payment, and break it into theamount of interest and the amount of principal paid for each year. (Hint: Usetechniques presented in Chapter 4 to find the loan payment.)

16–4 Lease versus purchase JLB Corporation is attempting to determine whether tolease or purchase research equipment. The firm is in the 40% tax bracket, andits after-tax cost of debt is currently 8%. The terms of the lease and of the pur-chase are as follows:

Lease Annual end-of-year lease payments of $25,200 are required over the 3-year life of the lease. All maintenance costs will be paid by the lessor; insuranceand other costs will be borne by the lessee. The lessee will exercise its option topurchase the asset for $5,000 at termination of the lease.

Purchase The research equipment, costing $60,000, can be financed entirelywith a 14% loan requiring annual end-of-year payments of $25,844 for 3 years.The firm in this case will depreciate the equipment under MACRS using a 3-year recovery period. (See Table 3.2 on page 100 for the applicable depreciationpercentages.) The firm will pay $1,800 per year for a service contract that cov-ers all maintenance costs; insurance and other costs will be borne by the firm.The firm plans to keep the equipment and use it beyond its 3-year recoveryperiod.

a. Calculate the after-tax cash outflows associated with each alternative.b. Calculate the present value of each cash outflow stream, using the after-tax

cost of debt.c. Which alternative, lease or purchase, would you recommend? Why?

16–5 Lease versus purchase Northwest Lumber Company needs to expand its facili-ties. To do so, the firm must acquire a machine costing $80,000. The machinecan be leased or purchased. The firm is in the 40% tax bracket, and its after-taxcost of debt is 9%. The terms of the lease and purchase plans are as follows:

Lease The leasing arrangement requires end-of-year payments of $19,800 over5 years. All maintenance costs will be paid by the lessor; insurance and othercosts will be borne by the lessee. The lessee will exercise its option to purchasethe asset for $24,000 at termination of the lease.

Purchase If the firm purchases the machine, its cost of $80,000 will be financedwith a 5-year, 14% loan requiring equal end-of-year payments of $23,302. Themachine will be depreciated under MACRS using a 5-year recovery period. (SeeTable 3.2 on page 100 for the applicable depreciation percentages.) The firmwill pay $2,000 per year for a service contract that covers all maintenance costs;insurance and other costs will be borne by the firm. The firm plans to keep theequipment and use it beyond its 5-year recovery period.

a. Determine the after-tax cash outflows of Northwest Lumber under eachalternative.

b. Find the present value of each after-tax cash outflow stream, using the after-tax cost of debt.

c. Which alternative, lease or purchase, would you recommend? Why?


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16–6 Capitalized lease values Given the lease payments, terms remaining until theleases expire, and discount rates shown in the following table, calculate the capi-talized value of each lease, assuming that lease payments are made annually atthe end of each year.

16–7 Conversion price Calculate the conversion price for each of the following con-vertible bonds:a. A $1,000-par-value bond that is convertible into 20 shares of common stock.b. A $500-par-value bond that is convertible into 25 shares of common stock.c. A $1,000-par-value bond that is convertible into 50 shares of common stock.

16–8 Conversion ratio What is the conversion ratio for each of the following bonds?a. A $1,000-par-value bond that is convertible into common stock at $43.75

per share.b. A $1,000-par-value bond that is convertible into common stock at $25 per

share.c. A $600-par-value bond that is convertible into common stock at $30 per

share.

16–9 Conversion (or stock) value What is the conversion (or stock) value of each ofthe following convertible bonds?a. A $1,000-par-value bond that is convertible into 25 shares of common stock.

The common stock is currently selling at $50 per share.b. A $1,000-par-value bond that is convertible into 12.5 shares of common

stock. The common stock is currently selling for $42 per share.c. A $1,000-par-value bond that is convertible into 100 shares of common

stock. The common stock is currently selling for $10.50 per share.

16–10 Conversion (or stock) value Find the conversion (or stock) value for each ofthe convertible bonds described in the following table.

Conversion Current marketConvertible ratio price of stock

A 25 $42.25

B 16 50.00

C 20 44.00

D 5 19.50

Lease Lease payment Remaining term Discount rate

A $ 40,000 12 years 10%

B 120,000 8 12

C 9,000 18 14

D 16,000 3 9

E 47,000 20 11


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16–11 Straight bond value Calculate the straight bond value for each of the bondsshown in the following table.

16–12 Determining values—Convertible bond Eastern Clock Company has an out-standing issue of convertible bonds with a $1,000 par value. These bonds areconvertible into 50 shares of common stock. They have a 10% annual couponinterest rate and a 20-year maturity. The interest rate on a straight bond of simi-lar risk is currently 12%.a. Calculate the straight bond value of the bond.b. Calculate the conversion (or stock) value of the bond when the market price

of the common stock is $15, $20, $23, $30, and $45 per share.c. For each of the stock prices given in part b, at what price would you expect

the bond to sell? Why?d. What is the least you would expect the bond to sell for, regardless of the

common stock price behavior?

16–13 Determining values—Convertible bond Craig’s Cake Company has an out-standing issue of 15-year convertible bonds with a $1,000 par value. These bondsare convertible into 80 shares of common stock. They have a 13% annual couponinterest rate, whereas the interest rate on straight bonds of similar risk is 16%.a. Calculate the straight bond value of this bond.b. Calculate the conversion (or stock) value of the bond when the market price

is $9, $12, $13, $15, and $20 per share of common stock.c. For each of the common stock prices given in part b, at what price would you

expect the bond to sell? Why?d. Graph the straight value and conversion value of the bond for each common

stock price given. Plot the per-share common stock prices on the x axis andthe bond values on the y axis. Use this graph to indicate the minimum marketvalue of the bond associated with each common stock price.

16–14 Implied prices of attached warrants Calculate the implied price of each warrantfor each of the bonds shown in the following table.

Price of bond Coupon Interest rate Number with warrants interest rate on equal-risk Years to of warrants

Bond attached Par value (paid annually) straight bond maturity attached to bond

A $1,000 $1,000 12 % 13% 15 10

B 1,100 1,000 9.5 12 10 30

C 500 500 10 11 20 5

D 1,000 1,000 11 12 20 20

Interest rate Coupon interest rate on equal-risk Years to

Bond Par value (paid annually) straight bond maturity

A $1,000 10% 14% 20

B 800 12 15 14

C 1,000 13 16 30

D 1,000 14 17 25


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16–15 Evaluation of the implied price of an attached warrant Dinoo Mathur wishesto determine whether the $1,000 price asked for Stanco Manufacturing’s bondis fair in light of the theoretical value of the attached warrants. The $1,000-par,30-year, 11.5%-coupon-interest-rate bond pays annual interest and has 10warrants attached for purchase of common stock. The theoretical value ofeach warrant is $12.50. The interest rate on an equal-risk straight bond is cur-rently 13%.a. Find the straight value of Stanco Manufacturing’s bond.b. Calculate the implied price of all warrants attached to Stanco’s bond.c. Calculate the implied price of each warrant attached to Stanco’s bond.d. Compare the implied price for each warrant calculated in part c to its theo-

retical value. On the basis of this comparison, what assessment would yougive Dinoo with respect to the fairness of Stanco’s bond price? Explain.

16–16 Warrant values Kent Hotels has warrants that allow the purchase of threeshares of its outstanding common stock at $50 per share. The common stockprice per share and the market value of the warrant associated with that stockprice are shown in the table.

a. For each of the common stock prices given, calculate the theoretical warrantvalue.

b. Graph the theoretical and market values of the warrant on a set of axeswith per-share common stock price on the x axis and warrant value on they axis.

c. If the warrant value is $12 when the market price of common stock is $50,does this contradict or support the graph you have constructed? Explain.

d. Specify the area of warrant premium. Why does this premium exist?e. If the expiration date of the warrants is quite close, would you expect your

graph to look different? Explain.

16–17 Common stock versus warrant investment Susan Michaels is evaluating theBurton Tool Company’s common stock and warrants to choose the betterinvestment. The firm’s stock is currently selling for $50 per share; its warrants topurchase three shares of common stock at $45 per share are selling for $20.Ignoring transactions costs, Ms. Michaels has $8,000 to invest. She is quite opti-mistic with respect to Burton because she has certain “inside information” aboutthe firm’s prospects with respect to a large government contract.a. How many shares of stock and how many warrants can Ms. Michaels

purchase?

Common stock Market valueprice per share of warrant

$42 $ 2

46 8

48 9

54 18

58 28

62 38

66 48


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b. Suppose Ms. Michaels purchased the stock, held it 1 year, and then sold it for$60 per share. What total gain would she realize, ignoring brokerage fees andtaxes?

c. Suppose Ms. Michaels purchased warrants and held them for 1 year and themarket price of the stock increased to $60 per share. Ignoring brokerage feesand taxes, what would be her total gain if the market value of the warrantsincreased to $45 and she sold out?

d. What benefit, if any, would the warrants provide? Are there any differencesin the risk of these two alternative investments? Explain.

16–18 Common stock versus warrant investment Tom Baldwin can invest $6,300 inthe common stock or the warrants of Lexington Life Insurance. The commonstock is currently selling for $30 per share. Its warrants, which provide for thepurchase of two shares of common stock at $28 per share, are currently sellingfor $7. The stock is expected to rise to a market price of $32 within the nextyear, so the expected theoretical value of a warrant over the next year is $8. Theexpiration date of the warrant is 1 year from the present.a. If Mr. Baldwin purchases the stock, holds it for 1 year, and then sells it for

$32, what is his total gain? (Ignore brokerage fees and taxes.)b. If Mr. Baldwin purchases the warrants and converts them to common stock

in 1 year, what is his total gain if the market price of common shares is actu-ally $32? (Ignore brokerage fees and taxes.)

c. Repeat parts a and b, assuming that the market price of the stock in 1 year is(1) $30 and (2) $28.

d. Discuss the two alternatives and the tradeoffs associated with them.

16–19 Options profits and losses For each of the 100-share options shown in the fol-lowing table, use the underlying stock price at expiration and other informationto determine the amount of profit or loss an investor would have had, ignoringbrokerage fees.

16–20 Call option Carol Krebs is considering buying 100 shares of Sooner Products,Inc., at $62 per share. Because she has read that the firm will probably soonreceive certain large orders from abroad, she expects the price of Sooner toincrease to $70 per share. As an alternative, Carol is considering purchase of acall option for 100 shares of Sooner at a striking price of $60. The 90-dayoption will cost $600. Ignore any brokerage fees or dividends.a. What will Carol’s profit be on the stock transaction if its price does rise to

$70 and she sells?

Underlying stockType Cost Striking price per share

Option of option of option price per share at expiration

A Call $200 $ 50 $55

B Call 350 42 45

C Put 500 60 50

D Put 300 35 40

E Call 450 28 26


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b. How much will Carol earn on the option transaction if the underlying stockprice rises to $70?

c. How high must the stock price rise for Carol to break even on the optiontransaction?

d. Compare, contrast, and discuss the relative profit and risk associated with thestock and the option transactions.

16–21 Put option Ed Martin, the pension fund manager for Stark Corporation, isconsidering purchase of a put option in anticipation of a price decline in thestock of Carlisle, Inc. The option to sell 100 shares of Carlisle, Inc., at any timeduring the next 90 days at a striking price of $45 can be purchased for $380.The stock of Carlisle is currently selling for $46 per share.a. Ignoring any brokerage fees or dividends, what profit or loss will Ed make if

he buys the option, and the lowest price of Carlisle, Inc., stock during the 90days is $46, $44, $40, and $35?

b. What effect would the fact that the price of Carlisle’s stock slowly rose fromits initial $46 level to $55 at the end of 90 days have on Ed’s purchase?

c. In light of your findings, discuss the potential risks and returns from usingput options to attempt to profit from an anticipated decline in share price.

CHAPTER 16 CASE Financing L. Rashid Company’s Chemical Waste Disposal System

L.Rashid Company, a rapidly growing chemical processor, needs to raise $3million in external funds to finance the acquisition of a new chemical

waste disposal system. After carefully analyzing alternative financing sources,Denise McMahon, the firm’s vice president of finance, reduced the financingpossibilities to three alternatives: (1) debt, (2) debt with warrants, and (3) afinancial lease. The key terms of each of these financing alternatives follow.

Debt The firm can borrow the full $3 million from First Shreveport Bank. Thebank will charge 12% annual interest and require annual end-of-year paymentsof $1,249,050 over the next 3 years. The disposal system will be depreciatedunder MACRS using a 3-year recovery period. (See Table 3.2 on page 100 forthe applicable depreciation percentages.) The firm will pay $45,000 at the end ofeach year for a service contract that covers all maintenance costs; insurance andother costs will be borne by the firm. The firm plans to keep the equipment anduse it beyond its 3-year recovery period.

Debt with Warrants The firm can borrow the full $3 million from SouthernNational Bank. The bank will charge 10% annual interest and will, in addition,require a grant of 50,000 warrants, each allowing the purchase of two shares ofthe firm’s stock for $30 per share at any time during the next 10 years. Thestock is currently selling for $28 per share, and the warrants are estimated tohave a market value of $1 each. The price (market value) of the debt with thewarrants attached is estimated to equal the $3 million initial loan principal. Theannual end-of-year payments on this loan will be $1,206,345 over the next 3years. Depreciation, maintenance, insurance, and other costs will have the samecosts and treatments under this alternative, as those described before for thestraight debt financing alternative.


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Financial Lease The waste disposal system can be leased from First Interna-tional Capital. The lease will require annual end-of-year payments of$1,200,000 over the next 3 years. All maintenance costs will be paid by thelessor; insurance and other costs will be borne by the lessee. The lessee will exer-cise its option to purchase the system for $220,000 at termination of the lease atthe end of 3 years.

Denise decided first to determine which of the debt financing alternatives—debt or debt with warrants—would least burden the firm’s cash flows over thenext 3 years. In this regard, she felt that very few, if any, warrants would beexercised during this period. Once the better debt financing alternative wasfound, Denise planned to use lease-versus-purchase analysis to evaluate it inlight of the lease alternative. The firm is in the 40% bracket, and its after-taxcost of debt would be 7% under the debt alternative and 6% under the debtwith warrants.

Required

a. Under the debt with warrants, find the following:(1) Straight debt value.(2) Implied price of all warrants.(3) Implied price of each warrant.(4) Theoretical value of a warrant.

b. On the basis of your findings in part a, do you think the price of the debtwith warrants is too high or too low? Explain.

c. Assuming that the firm can raise the needed funds under the specified terms,which debt financing alternative—debt or debt with warrants—would yourecommend in view of your findings above? Explain.

d. For the purchase alternative, financed as recommended in part c, calculatethe following:(1) The annual interest expense deductible for tax purposes for each of the

next 3 years.(2) The after-tax cash outflow for each of the next 3 years.(3) The present value of the cash outflows using the appropriate discount

rate.e. For the lease alternative, calculate the following:

(1) The after-tax cash outflow for each of the next 3 years.(2) The present value of the cash outflows using the appropriate discount

rate applied in part d(3). f. Compare the present values of the cash outflow streams for the purchase [in

part d(3)] and lease [in part e(2)] alternatives, and determine which would bepreferable. Explain and discuss your recommendation.

WEB EXERCISE Go to the Equipment Leasing Association’s Lease Assistant educational portal,www.leaseassistant.org. Click on Leasing Basics and work through the links toanswer the following questions.

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Remember to check the book’s Web site at

www.aw.com/gitman

for additional resources, including additional Web exercises.

1. What are the three ways to finance equipment through leases?2. Summarize the benefits of leasing equipment. Which would be the most

important to you if you were a small business owner? If you were a financialmanager at a major corporation?

3. Compare and contrast leases and loans.

Then click on Informed Decisions and How Others Have Leveraged Leasing.Choose one of the cases and answer the following questions on the basis of theinformation presented.

4. What type of equipment was the company leasing, and why?5. What benefits did the company achieve through leasing?

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