Chapter 20 Hybrid Financing: Preferred Stock, Leasing, Warrants, and Convertibles Learning b!ectives
After reading reading this chapter chapter,, students students should be able able to:
Identify the basic features of preferred stock and explain its advantages and disadvantages. Differentiate among the types of leases, discuss the financial statement effects of leasing, and evaluate a lease. Explain what warrants are and how they are used and analye their cost to the firm. Explain what convertibles are and how they are used and analye their cost to the firm.
Chapter 20: Hybrid Financing
Learning b!ectives
"#
Lect$re S$ggestions
!his chapter discusses four types of hybrid securities: preferred stock, leases, warrants, and convertibles. "e have mixed feelings about coverage coverage of the chapter. #n the one hand, we are are tempted not to spend much time on it because it gets into relatively technical analysis that would be better left for later courses. #n the other hand, the material is important, and students who will not be taking additional finance courses ought to be exposed to the sub$ects covered here. Also, leasing and warrants%convertibles are good sub$ects on which to lecture, as they contain a nice mix of new versus review material, and of &uantitative versus &ualitative analysis. 'ease analysis serves as a good review of time time value of money and risk%return analyses, and the warrants%convertibles analysis is a good review of valuation theory. "hat we cover, and the way we cover it, can be seen by scanning the slides and Integrated (ase solution for (hapter )*, which appears at the end of this chapter solution. +or other suggestions about the lecture, please see the 'ecture -uggestions in (hapter ), where we describe how we conduct our classes.
%&'S ( CH&P)*+: 2 F # days -#0./in$te periods
"1
Lect$re S$ggestions
Chapter 20: Hybrid Financing
Lect$re S$ggestions
!his chapter discusses four types of hybrid securities: preferred stock, leases, warrants, and convertibles. "e have mixed feelings about coverage coverage of the chapter. #n the one hand, we are are tempted not to spend much time on it because it gets into relatively technical analysis that would be better left for later courses. #n the other hand, the material is important, and students who will not be taking additional finance courses ought to be exposed to the sub$ects covered here. Also, leasing and warrants%convertibles are good sub$ects on which to lecture, as they contain a nice mix of new versus review material, and of &uantitative versus &ualitative analysis. 'ease analysis serves as a good review of time time value of money and risk%return analyses, and the warrants%convertibles analysis is a good review of valuation theory. "hat we cover, and the way we cover it, can be seen by scanning the slides and Integrated (ase solution for (hapter )*, which appears at the end of this chapter solution. +or other suggestions about the lecture, please see the 'ecture -uggestions in (hapter ), where we describe how we conduct our classes.
%&'S ( CH&P)*+: 2 F # days -#0./in$te periods
"1
Lect$re S$ggestions
Chapter 20: Hybrid Financing
&nsers to *nd.of.Cha *nd.of.Chapter pter 3$estions 3$estions
20."
/referred stock can be classified only when the one doing the classification is considered. +rom the standpoint of the firm, preferred stock is like e&uity in that it cannot force the firm into bankruptcy, but it is like debt in that it causes fluctuations in earnings available to the common stockholders. (onse&uently, if the firm is concerned primarily with survival, it would probably classify preferred stock as e&uity. 0owever, if there is essentially no danger of bankruptcy, management would view preferred stock as simply another fixed1charge security and treat it internally as debt. E&uity investors would have a similar viewpoint, and in general they should treat preferred stock in much the same manner as debt. +or creditors, the position is reversed. !hey take preference over preferred stockholders, and the preferred issues act as a cushion. (onse&uently, a bond analyst would probably want to treat preferred as e&uity. #bviously, in all these applications, there would have to be some &ualifications2 in a strict sense, preferred stock is neither debt nor e&uity, but a hybrid.
20.2
-ince 3*4 of preferred dividends received by a corporation are not taxable, the corporation with the higher 56748 tax rate is is more likely to have bought the preferred. In addition, the company in the 674 tax bracket would be less likely to issue the preferred since preferred dividends paid out are not deductible as a tax expense.
20.4
If dividends from preferred stock and interest received from bonds were taxed in the same manner, bonds would have a lower yield rate. (orporations represent the principal investor group that holds preferred stock. !he reason for this is that current tax laws allow allow a 3*4 tax exclusion for intercorporate dividends received2 thus, preferred stock is attractive to corporations and prices are bid up, lowering yields below those for bonds.
20.5
+loating1rate preferred preferred stock, because of the floating floating rate of return, has a relatively stable stable price. !his constant price, as well as the 3*4 tax exemption for preferred dividends, makes floating1rate preferred attractive to corporate investors and, thus, allows the issuing firm to raise capital at a low cost.
20.#
An operating operating lease lease is fre&uently fre&uently cancelable cancelable and and includes includes maintenanc maintenance. e. #perating #perating leases leases are, are, fre&uently, for a period significantly shorter than the asset9s economic life, so the lessor often does not recover his full investment during the period of the basic basic lease. A financial lease, on the other hand, is not cancelable, is fully amortied, and generally does not include maintenance provisions. +or these reasons, an operating lease would probably be used for a fleet of trucks, while a financial lease 5or a sale1and1leaseback8 would be used for a manufacturing plant.
20.1
a6 /ros: . !he use of the the leased premises premises or ob$ects ob$ects is actually actually an exclusive exclusive right, right, and the payment payment for the premises is a liability that often must be met. !herefore, leases should be treated as both assets and liabilities. ). A fixed policy policy of capitali capitaliing ing leases leases among all all companies companies would add to the the comparabilit comparability y of different firms. 6. !he capitali capitaliation ation highlight highlightss the contract contractual ual nature nature of the leased property. property. ;. (apitaliatio (apitaliation n of leases leases could could help management management make make useful comparisons comparisons of operating operating results2 that is, return on investment data.
Chapter 20: Hybrid Financing
&ns2ers &ns2ers and Sol$tions Sol$tions
"7
b6 (ons: .
'ease payments, like depreciation, are deductible for tax purposes. If a )*1year asset were depreciated over a )*1year life, depreciation charges would be %)* per year 5more if =A(>- were used8. 0owever, if the asset were leased for, say, 6 years, tax deductions would be %6 each year for 6 years. !hus, the tax deductions would be greatly accelerated. !he same total taxes would be paid over the )* years, but they would be deferred more under the lease?no taxes at all in @ears through 6. !he / of the future taxes would be reduced under the lease.
20.
/ermitting e&uipment to be depreciated over a shorter period increases the tax shelter value of leasing. 'owering corporate tax rates decreases the tax shelter value of leasing2 however, lowered corporate tax rates decrease the tax deductibility of interest?the net effect is indeterminate. >einstating the investment tax credit increases the tax shelter value of leasing. !he general rule is, if a company is in a high tax bracket it will generally own e&uipment, while if a company is in a low tax bracket it is generally to its benefit to lease. (ompanies in low tax brackets can sell their tax shelters through leasing arrangements, being paid in the form of lower lease payments. A high1 bracket lessor can earn a higher after1tax return with a lower rental charge because the lessor will get larger depreciation write1offs. If the I!( were reinstated, leases would become even more attractive.
20.8
!he trend in stock prices subse&uent to an issue influences whether or not a convertible issue will be converted, but conversion itself typically does not provide a firm with additional funds. Indirectly, however, conversion may make it easier for a firm to obtain additional funds by lowering the debt ratio, thus making it easier for the firm to borrow. In the case of warrants, on the other hand, if the price of the stock rises sufficiently, the warrants are likely to be exercised and thus to bring in additional funds directly.
20."0 a6 . !he value of a warrant depends primarily on the expected growth of the underlying stock9s price. !his growth, in turn, depends in a ma$or way on the plowback of earnings2 the higher the dividend payout, the lower the retention 5or plowback8 rate2 hence the slower the growth rate. !hus, other things held constant, the higher the firm9s dividend payout policy, the lower the value of the warrant. !his effect is more pronounced for long1term than for short1term warrants. ). !he same general arguments as in /art hold for convertibles. If a convertible is selling above its conversion value, raising the dividend will lower growth prospects, and, at the same time, increase the cost of holding convertibles 5or warrants8 in terms of forgone cash returns. !hus, raising the dividend payout rate before a convertible9s conversion value exceeds its call price will lower the probability of eventual conversion, but raising the dividend after a convertible9s conversion value exceeds its call price raises the probability that it will be converted soon. 6. !he same arguments as in /art ) apply to warrants. "
&ns2ers and Sol$tions
Chapter 20: Hybrid Financing
b6 An investor who held warrants or convertibles would probably be displeased if the firm raised its payout ratio since the higher payout ratio would lower the prospects for an increase in the price of the firm9s stock. 0owever, if you held bonds convertible into a stock whose market value exceeded its call price and you desired current income, you would probably go ahead and convert. In this case, you might prefer the higher payout ratio. 20."" !he statement is made often. It is not really true, as a convertible9s issue price reflects the underlying stock9s present price. +urther, when the bond is converted, the holder receives shares valued at the then1existing price. 20."2 !he convertible bond has an expected return that consists of an interest yield 5B48 plus an expected capital gain. "e know the expected capital gain must be at least 64, because the total expected return on the convertible must be at least e&ual to that on the nonconvertible bond, )4. In all likelihood, the expected return on the convertible would be higher than that on the straight bond, because a capital gains yield is riskier than an interest yield. !he convertible would, therefore, probably be regarded as being riskier than the straight bond, and r c would exceed rd. 0owever, the convertible, with its interest yield, would probably be regarded as being less risky than common stock. !herefore, r d C rc C rs.
Chapter 20: Hybrid Financing
&ns2ers and Sol$tions
"8
Sol$tions to *nd.of.Chapter Proble/s
20."
If the company purchased the e&uipment its balance sheet would look like: (urrent assets +ixed assets !otal assets
6** ** B**
Debt E&uity !otal claims
7** ;** B**
!herefore, the company9s debt ratio F 7**%B** F 77.4. If the company leases the asset and does not capitalie the lease, its debt ratio F ;**%G** F 7*4. !he company9s financial risk 5assuming the implied interest rate on the lease is e&uivalent to the loan8 is no different whether the e&uipment is leased or purchased.
20.2
+irst issue: )*1year straight bonds with an G4 annual coupon. -econd issue: )*1year bonds with 4 annual coupon with warrants.
F rd F G4. 5-ince it sold for par, we should know that r d F G4.8 -econd issue: ,*** F F rd F G2 /=! F *, + F ***, and solve for / F G*6.;. alue of warrants F ,*** K G*6.; F B.6.
20.4
(onvertible bond9s par value F ,***2 (onversion price, / c F ;*2 (> F H (> F
20.5
/ar Aalue /c
F
D:,*** F )7 shares . D;*
a6
!otal assets
**
Debt E&uity !otal liabilities and e&uity
;** )** **
Debt%assets ratio F ;**%** F 34.
20
&ns2ers and Sol$tions
Chapter 20: Hybrid Financing
Lordan10ocking balance sheet 5thousands of dollars8:
!otal assets
Debt E&uity !otal liabilities and e&uity
;**
)** )** ;**
Debt%assets ratio F )**%;** F 7*4. b6
;** )**
Debt / of lease payments E&uity !otal liabilities and e&uity
**
)** )** )** **
Debt%assets ratio F ;**%** F 34. c6 /erhaps. et income, as reported, might well be less under leasing because the lease payment might be larger than the interest expense plus reported depreciation. Additionally, total assets are significantly less under leasing without capitaliation. !he net result is difficult to predict, but we can state positively that both >#A and >#E are affected by the choice of financing.
20.#
a6
@ear *
I.
(ost of owning: et purchase price Depr. tax savingsa et cash flow
5,7**,***8
(ost of leasing: 'ease payment 5A!8 /urch. option price b
b
;
BG,*** BG,***
)3*,*** )3*,***
B*,*** B*,***
;),*** ;),***
5);*,***8
5);*,***8
5);*,***8
5);*,***8 5)7*,***8
5);*,*** 8
5);*,*** 8
5);*,*** 8
5;B*,***8
/ cost of leasing at B4
a
6
5 BB,G;78
et cash flow
III.
)
5,7**,***8
/ cost of owning at B4 II.
*
5 B7;,6B8
(ost comparison: et advantage to leasing 5A'8
F / cost of owning K / cost of leasing F BB,G;7 K B7;,6B F 63,)*.
(ost of new machinery: ,7**,***. @ear
=A(> Allowance +actor
) 6 ;
*.66 *.;7 *.7 *.*3
Depreciation ;B7,*** 37,*** ))7,*** *7,***
Deprec. !ax -avings !5Depreciation8 BG,*** )3*,*** B*,*** ;),***
(ost of purchasing the machinery after the lease expires. ote that the maintenance expense is excluded from the analysis since =orris1=eyer will have to bear the cost whether it buys or leases the machinery. -ince the cost of leasing the machinery is less than the cost of owning
Chapter 20: Hybrid Financing
&ns2ers and Sol$tions
2"
it, =orris1=eyer should lease the e&uipment.
b6 "e assume that =orris1=eyer will buy the e&uipment at the end of ; years if the lease plan is used2 hence the )7*,*** is an added cost under leasing. "e discounted it at B4, but it is risky, so should we use a higher rateH If we do, leasing looks even better. 0owever, it really makes more sense in this instance to use a lower rate so as to penalie the lease decision, because the residual value uncertainty increases the uncertainty of operations under the lease alternative. In general, for risk1averse decision makers, it makes intuitive sense to discount riskier future inflows at a higher rate, but risky future outflows at a lower rate. 5ote that if =orris1=eyer did not plan to continue using the e&uipment, then the )7*,*** salvage value 5less taxes8 should be a positive 5inflow8 value in the cost of owning analysis. In this case, it would be appropriate to use a higher discount rate.8 !he cash flows for borrowing and leasing, except for the residual value cash flow, are relatively certain because they9re fixed by contract, and thus, are not very risky. 20.1
a6 Exercise value F (urrent price K -triking price. /s F G: Exercise value F 16 which is considered *. /s F ): Exercise value F *. /s F )7: Exercise value F ;. /s F 3*: Exercise value F ;B. b6 o precise answers are possible, but some reasonable warrant prices are as follows: /s F G: "arrant F .7*2 /remium F ;.7*. /s F ): "arrant F 6.**2 /remium F 6.**. /s F )7: "arrant F 7.7*2 /remium F .7*. /s F 3*: "arrant F 7*.**2 /remium F .**. c6 . !he longer the life, the higher the warrant value. ). !he less variable the stock price, the lower the warrant value. 6. !he higher the expected E/- growth rate, the higher the warrant price. ;. Moing from a * to **4 payout would have two possible effects. +irst, it might affect the stock price causing a change in the exercise value of the warrant2 however, it is not at all clear that the stock price would change, let alone what the change would be. -econd, and more important here, the increase in the payout ratio would drastically lower the expected growth rate. !his would reduce the chance of the stock9s price going up in the future. !his would lower the expected value of the warrant, hence the premium and the price of the warrant. d6 package F ,*** -traight debt F value of the bond
Aalue of the warrants
F < J 7*5.7*8. ,*** F < J 37 22
&ns2ers and Sol$tions
Chapter 20: Hybrid Financing
< F ,*** K 37 < F B)7. Nsing a financial calculator, input the following: F )*, I%@> F *, / F 1B)7, + F ***, /=! F H /=! F B.B O B*. (onse&uently, the coupon interest rate F B*%,*** F B4.
20.7
a6 Investment bankers sometimes use the rule of thumb that, to serve as a sweetener, the premium over the present price should be in the range between )*4 and 6*4. -ince the stock has an indicated growth in earnings of *4 a year, a good argument could be made for setting the premium near the midpoint of the range, that is, )74. A )74 premium results in a conversion price of )5.)78 F ).)7. !here has been heavy use of )*4 to 6*4 premiums in recent years. b6 @es, to be able to force conversion if the market price rises above the call price. If, in fact, E/rises to ).;) in )**7, and the /%E ratio remains at ; , the stock price will go to 66.GG, making forced conversion possible. 0owever, potential investors will insist on call protection for at least 7 and possibly for * years.
20.
a6 et purchase price Depr9n tax savings a =aintenance 5A!8 -alvage value et cash flow
* 4 P 5)7*,***8
5)7*,***8
P
) P
6 P
; P
)*,*** 5),***8
6),*** 5),***8
B,*** 5),***8
),*** 5),***8 ;),7** ;),7**
G,***
)*,***
3,***
/ cost of owning at 4 F 1G7,). otes: . !here is no tax associated with the loom9s salvage value since salvage value e&uals book value. ). !he appropriate discount rate is the after1tax cost of debt F r d5 K !8 F *45 K *.;8 F 4. a
Depreciation tax savings are calculated as follows:
@ear ) 6 ;
=A(> Allowance +actor *.)* *.6) *.B *.)
QDepreciation Expense 7*,*** G*,*** ;3,7** 6*,***
End of @ear
Depreciation !ax -avings )*,*** 6),*** B,*** ),***
Qote that the loom9s depreciable basis is )7*,***. !he cost of leasing can be placed on a time line as follows:
'ease payment 5A!8
* 4 P 1;),***
P 1;),***
) P 1;),***
6 P 1;),***
; P 1;),***
/ at 4 F 1G3,76;. Chapter 20: Hybrid Financing
&ns2ers and Sol$tions
24
!hus, the present value of the cost of owning is G3,76; K G7,) F ),;)) less than the present value of the cost of leasing. !anner1"oods !extile should purchase the loom. b6 0ere we merely discount all cash flows in the cost of owning analysis at 4 except the salvage value cash flow, which we discount at B4, the after1tax discount rate R745 K *.;8S: * P 5)7*,***8 3,7;3 3,G** 7,G33 * 6*,*G / F 5GG,G8
P
) 6 P P /s of all other cash flows T 4
T B4
; P
;),7**
"hen differential risk is considered, the cost of owning is now higher than the G3,76; cost of leasing2 thus, the firm should lease the loom. c6 !his merely shifts the salvage value cash flow from the cost of owning analysis to the cost of leasing analysis. If !anner1"oods !extile needed the loom after four years, it would have it if the loom were purchased, but would have to buy it if the loom were leased. !he decision would remain the same. If differential salvage value risk is not considered, the loom should be purchased. In fact, the advantage to purchasing would be exactly the same.
20.8
a6 0owe (omputer (ompany balance sheet: Alternative :
!otal assets
637,***
!otal current liabilities 'ong1term debt (ommon stock, par /aid1in capital >etained earnings !otal liabilities and e&uity
7*,*** ? 37,*** ))7,*** )7,*** 637,***
637,***
!otal current liabilities 'ong1term debt (ommon stock, par /aid1in capital >etained earnings !otal liabilities and e&uity
7*,*** ? 3*,*** )6*,*** )7,*** 637,***
)7,***
!otal current liabilities 'ong1term debt 5*48 (ommon stock, par /aid1in capital >etained earnings !otal liabilities and e&uity
7*,*** )7*,*** 3*,*** )6*,*** )7,*** )7,***
Alternative ):
!otal assets Alternative 6:
!otal assets
25
&ns2ers and Sol$tions
Chapter 20: Hybrid Financing
b6
#riginal ;*,*** 7*,*** G*4
/lan ;*,*** 37,*** 764
/lan ) ;*,*** 3*,*** 734
/lan 6 ;*,*** 3*,*** 734
!otal assets
#riginal )37,***
/lan 637,***
/lan ) 637,***
/lan 6 )7,***
E
77,*** 7,*** ;*,*** ,*** );,***
37,*** * 37,*** 6*,*** ;7,***
37,*** * 37,*** 6*,*** ;7,***
)7,*** )7,*** **,*** ;*,*** *,***
umber of shares
7*,***
37,***
3*,***
3*,***
Earnings per share
*.;G
*.*
*.;
*.G
)**,***
7*,***
7*,***
6**,***
364
64
64
;G4
umber of Ueith 0owe9s shares !otal shares /ercent ownership c6
d6 !otal debt Debt%assets ratio
e6 Alternative results in the lowest percentage ownership, but Ueith 0owe would still maintain control. Indicated earnings per share increases, and the debt ratio is reduced considerably 5by *48. Alternative ) also results in maintenance of control 57348 for Ueith 0owe. Earnings per share increases, while a reduction in the debt ratio like that in Alternative occurs. Nnder Alternative 6 there is also maintenance of control 57348 for Ueith 0owe. !his plan results in the highest earnings per share 5G cents8, which is an increase of 3B4 on the original earnings per share. !he debt ratio is reduced to ;G4. (onclusions: If the assumptions of the problem are borne out in fact, Alternative is inferior to ), since earnings per share increases more in the latter. !he debt1to1assets ratio 5after conversion8 is the same in both cases. !hus, the analysis must center on the choice between ) and 6. !he differences between these two alternatives, which are illustrated in /arts c and d, are that the increase in earnings per share is substantially greater under Alternative 6, but so is the debt ratio. "ith its low debt ratio 5648, the firm is in a good position for future growth under ). 0owever, the ;G4 ratio under 6 is not unbearable and is a great improvement over the original situation. !he combination of increased earnings per share and reduced debt ratios indicates favorable stock price movements in both cases, particularly under Alternative 6. !here is the remote chance that 0owe could lose its commercial bank financing under 6, since it was the bank that initiated the permanent financing suggestion. !he additional funds, especially under 6, may enable 0owe to become more current on its trade credit. Also, the bonds will doubtless be subordinated debentures.
20."0 +acts and analysis in the problem: rd F )42 D* F ).;2 g F G42 / * F 6G. rs F D %/* J g F ).%6G.** J G4 F 74. Chapter 20: Hybrid Financing
&ns2ers and Sol$tions
2#
(onvertible: /ar F ,***, )*1year2 (oupon F *42 (> F )* shares. (all F +ive1year deferment2 (all price F ,*37 in @ear , declines by 7 per year. "ill be called when ( t F .)5/ar8 F ,)**. +ind 5number of years8 to anticipated call%conversion: 5/*85(>85 J g8 F ,)** 56G85)*85 J *.*G8 F ,)** 53*85.*G8 F ,)**. Nsing a financial calculator, input the following: I%@> F G, / F 13*, /=! F *, + F )**, F H F 7.B6 . -traight1debt value of the convertible at t F *: 5Assumes annual payment of coupon8 Nsing a financial calculator, input the following: F )*, I%@> F ), /=! F **, + F ***, / F H / F G7*. G7. / at t F 7 5 F 78: G;. / at t F * 5 F *8: GG3. / at t F 7 5 F 78: B)G. / at t F )* 5 F *8: ,***. (onversion value: (t F /*5.*G85)*8. (* F 6G5)*8 F 3*. (7 F 6G5.*G875)*8 F ,3. ( F 6G5.*G85)*8 F ,)*. (* F 6G5.*G8*5)*8 F ,;. a6 -ee the graph to the right. $
#easoale b6 /) F 6G5.*G8) F ;;.6) F /rice of 1,300 %ar&et price Ct stock $ust before change in growth Call pre%i"% expectation. /6 F ).G3%*.7 F B.6 1,100 F /rice of stock after changed growth 900 expectations. /ercentage decline in Straight-det !al"e 700 stock price F 734. Floor Assuming ero future growth, the value of the stock will not increase, and the value of the convertible will depend 0 56 10 15 20 Years only upon its value as a straight bond. First call date Expected call date -ince the firm9s interest payments are relatively low compared to what they would have been had straight debt been issued originally, the firm is unlikely to call the bond issue. !herefore, it would be valued according to its coupon, the current market rate on debt of that risk, and years remaining to maturity 5G8: :G
t :
D:** D:,*** F G77. 5:.:)8 t 5:.:)8:G
/rior to the change in expected growth from G4 to *4, the market value would have been above the straight1bond value: According to the graph, the bond would sell for about ,*)7.
21
&ns2ers and Sol$tions
Chapter 20: Hybrid Financing
!hus, there would be a percentage decline of 34 in the value of the convertible, about one1 third the 734 loss on the stock.
Chapter 20: Hybrid Financing
&ns2ers and Sol$tions
27
Co/prehensive9Spreadsheet Proble/s
(ote to nstr$ctors: )he sol$tion for Part a of Proble/ 20."" is provided at the back of the te;t< hoever, the sol$tions to the other parts are not6 nstr$ctors can access the *;cel file on the te;tbook=s eb site or the nstr$ctor=s +eso$rce C%6 20."" a6 +irst, we want to lay out all of the input data in the problem.
+irst, we can determine the annual loan payment that must be made on the new e&uipment. "e will do so using the function wiard for /=!.
ow, we see that the decision being made is whether to purchase the e&uipment at a net cost of )7*,*** 5with annual payments of 3G,GG8 or lease the e&uipment and make annual payments of 3*,***. !o make this decision, we must analye the incremental cash flows.
"e can now construct our table of incremental cash flows from these two alternatives. >emember, that the appropriate discount rate in this scenario is the after tax cost of borrowing, or *4Q5 K ;*48 F 4.
2
Co/prehensive9Spreadsheet Proble/s
Chapter 20: Hybrid Financing
#ur / Analysis has told us that there is a negative advantage to leasing. "e interpret that as an indication that the firm should forego the opportunity to lease and buy the new e&uipment. b6 All cash flows would remain unchanged except that of the salvage value. #ur new array of cash flows would resemble the following:
Nnder this new assumption of using a greater discount factor for the salvage value, we find that the firm should lease, and not buy, the e&uipment. c6 "e will use the Moal -eek function to determine the cost of capital when leasing and purchasing alternatives are the same.
20."2 a6 !he value of the B4 coupon bonds, evaluated at )4, can be found as follows: F )*2 I%@> F )2 /=! F B*2 and + F ***. -olve for / F 337.B). If investors are willing to pay ,*** for these bonds with warrants attached, then the value of the warrants must be ,*** K 337.B) F ));.*G. -ince there are )* warrants issued with each bond, the value per warrant must be .)*. Chapter 20: Hybrid Financing
Co/prehensive9Spreadsheet Proble/s
28
b6 !he firm9s current market value of e&uity is )7 x * million shares F )7* million. (ombined with a ** million bond issue 5,*** x **,*** bonds8, the firm9s current total value is 67* million. !he firm9s operations and investments are expected to grow at a constant rate of .;4. 0ence, the expected total value of the firm in * years is: !otal firm value 5t F *8 F 67*,***,*** 5.;8* !otal firm value 5t F *8 F ,*6*,B,))). "ith * years left to maturity, each of the **,*** bonds will be worth2 F *2 I%@> F )2 /=! F B*2 and + F ***. -olve for / F G6*.;B. !hus, the total value of debt would be G6*.;B x **,*** F G6,*;B,66. 0ence, the value of e&uity would be ,*6*,B,))) K G6,*;B,66 F B;3,;,GB. If no warrants were issued, there would still be * million shares outstanding, which would each have a value of B;.3. "ith warrants being issued and exercised, there would be )* warrants exercised for each of the **,*** bonds, resulting in ) million new shares. !herefore, there will be ) million shares outstanding if the warrants are exercised, and an additional * million of e&uity 5) million warrants x 6* exercise price8. !he value of each share of stock would be 5B;3,;,GB J *,***,***8%),***,*** F G6.B6. !he investors would be expected to receive B* per year and ,*** in @ear )* 5the face value8. In addition, if warrants are exercised then the investors will receive a profit of G6.B6 K 6*.** F 76.B6 per share, or a total cash flow of ,*3G.* 576.B6 x )*8 in @ear *. !herefore, in @ear * investors will receive B* J ,*3G.* F ,G.*. 0ence, the component cost of these bonds can be found by determining the I>> of a cash flow stream consisting of each coupon payment, the face value, and the profit from exercising the warrants. Input (+* F 1***, (+1B F B*, (+* F G.*, (+1B F B*, and (+ )* F *B*. -olve for I>> F 6.;4. !he component cost is 6.;4, and the premium associated with the warrants is 6.;4 K )4 F .;4, or roughly ; basis points.
40
Co/prehensive9Spreadsheet Proble/s
Chapter 20: Hybrid Financing
ntegrated Case
20."4
Fish > Chips nc6, Part Lease &nalysis ?artha ?illon, financial /anager for Fish > Chips nc6, has been asked to perfor/ a lease.vers$s.b$y analysis on a ne co/p$ter syste/6 )he co/p$ter costs @",200,000, and if it is p$rchased, Fish > Chips co$ld obtain a ter/ loan for the f$ll a/o$nt at a "0A cost6 )he loan o$ld be a/ortiBed over the 5.year life of the co/p$ter, ith pay/ents /ade at the end of each year6 )he co/p$ter is classified as special p$rpose< hence, it falls into the ?&C+S 4.year class6 )he applicable ?&C+S rates are 44A, 5#A, "#A, and 7A6 f the co/p$ter is p$rchased, a /aintenance contract /$st be obtained at a cost of @2#,000, payable at the beginning of each year6 &fter 5 years the co/p$ter ill be sold6 ?illon=s best esti/ate of its resid$al val$e at that ti/e is @"2#,0006 eca$se technology is changing rapidly, hoever, the resid$al val$e is $ncertain6 &s an alternative, (ational Leasing is illing to rite a 5.year lease on the co/p$ter, incl$ding /aintenance, for pay/ents of @450,000 at the beginning of each year6 Fish > Chips= /arginal federal.pl$s.state ta; rate is 50A6 Help ?illon cond$ct her analysis by ansering the folloing D$estions6 &6
-" Why is leasing so/eti/es referred to as Eoff balance sheet financingG
&nser:
Sho S20." and S20.2 here6I f an asset is p$rchased, it /$st be shon on the left.hand side of the balance sheet, ith an offsetting debt or eD$ity entry on the right.hand side6 Hoever, if an asset is leased, and if the lease is not classified as a capital lease, then it
Chapter 20: Hybrid Financing
ntegrated Case
4"
does not have to be shon directly on the balance sheet, b$t, rather, /$st only be reported in the footnotes to the co/pany=s financial state/ents6 &6
-2 What is the difference beteen a capital lease and an operating leaseG
&nser:
Capital leases are differentiated fro/ operating leases in three respects: -" they do not provide for /aintenance service, -2 they are not cancelable, and -4 they are f$lly a/ortiBed6 -)hat is, the lessor receives rental pay/ents that are eD$al to the f$ll price of the leased co/p$ter syste/ pl$s a ret$rn on the invest/ent6
&6
-4 What effect does leasing have on a fir/=s capital str$ct$reG
&nser:
Leasing is a s$bstit$te for debt financingJlease pay/ents, like debt pay/ents, are contract$al obligations that if not /et ill force the fir/ into bankr$ptcy6 )h$s, leasing $ses $p a fir/=s debt capacity6 )o ill$strate, if Fish > Chips= opti/al capital str$ct$re is #0A debt and #0A eD$ity, and if the fir/ leases half its assets, then the other half sho$ld be financed by co//on eD$ity6
6
-" What is Fish > Chips= present val$e cost of oning the co/p$terG -Hint: Set $p a table hose botto/ line is a Eti/e line that shos the net cash flos over the period t K 0 to t K 56 )hen find the P of these net cash flos, or the P cost of oning6
&nser:
Sho S20.4 thro$gh S20.7 here6I n order to deter/ine the cost of oning, it is first necessary to constr$ct a depreciation sched$le6 )his sched$le is given belo6
42
ntegrated Case
Chapter 20: Hybrid Financing
%epreciation sched$le: depreciable basis K @",200,0006 ?&C+S +ate
'ear " 2 4 5
0644 065# 06"# 0607 "600
%epreciation *;pense
*nd.of.'ear ook al$e
@ 481,000 #50,000 "0,000 5,000 @",200,000
@05,000 215,000 5,000 0
)he costs associated ith oning are laid o$t on a ti/e line belo: Cost of oning ti/e line: 0 " 2 1A M M M Cost of asset -",200,000 %ep6 ta; savingsN "#,500 2"1,000 ?aintenance -&) -"#,000 -"#,000 -"#,000 +esid$al val$e -&)NN (et cash flo -",2"#,000 "54,500 20",000
4 M
5 M
72,000 -"#,000
44,100
#7,000
7#,000 "0,100
P cost of oning -O 1A K .@711,856 N%epreciation is a ta;.ded$ctible e;pense, so it prod$ces a ta; savings of )-%epreciation6 For e;a/ple, the savings in 'ear " is 065-@481,000 K @"#,5006 NN)he book val$e is @0, so ta;es /$st be paid on the f$ll @"2#,000 salvage val$e, leaving @"2#,000-" ) K @7#,0006 6
-2 *;plain the rationale for the disco$nt rate yo$ $sed to find the P6
&nser:
)he disco$nt rate $sed depends on the riskiness of the cash flo strea/ and the general level of interest rates6 )he cost of oning cash flos, e;cept for the resid$al val$e, is fi;ed by contract, and hence not very risky6 n fact, they have abo$t the sa/e risk as the
Chapter 20: Hybrid Financing
ntegrated Case
44
fir/=s debt flos, hich are also contract$al in nat$re6 F$rther, leasing $ses $p debt capacity, and th$s has the sa/e i/pact on the fir/=s financial risk as does debt financing6 )h$s, the appropriate interest rate is Fish > Chips= cost of debt, and since the flos are after.ta; flos, the rate is the after.ta; cost of debt6 Fish > Chips= before.ta; debt cost is "0A, and since the fir/ is in the 50A ta; bracket, its after.ta; cost of debt is "060A-" 0650 K 160A6 C6
-" What is Fish > Chips= present val$e cost of leasing the co/p$terG -Hint: &gain, constr$ct a ti/e line6
&nser:
Sho S20. here6I f Fish > Chips leases the syste/, its only cash flo o$ld be its lease pay/ent, as shon belo: 0 " 1A M M Lease pay/ent -&) -205,000 -205,000
2 M -205,000
4 M -205,000
P cost of leasing -O 1A K .@758,2856 C6
-2 What is the net advantage to leasingG %oes yo$r analysis indicate that the fir/ sho$ld b$y or lease the co/p$terG *;plain6
&nser:
Sho S20.8 here6I )he net advantage to leasing -(&L is @"7,1#5: (&L K P cost of oning P cost of leasing K @711,85 @758,285 K @"7,1#56 Since the (&L is positive, Fish > Chips sho$ld lease the co/p$ter syste/ rather than p$rchase it6
45
ntegrated Case
Chapter 20: Hybrid Financing
%6
(o ass$/e that ?illon believes the co/p$ter=s resid$al val$e co$ld be as lo as @0 or as high as @2#0,000, b$t she stands by @"2#,000 as her e;pected val$e6 She concl$des that the resid$al val$e is riskier than the other cash flos in the analysis, and she ants to incorporate this differential risk into her analysis6 %escribe ho this can be acco/plished6 What effect ill it have on the lease decisionG
&nser:
Sho S20."0 here6I )o acco$nt for increased risk, the rate $sed to disco$nt the resid$al val$e cash flo o$ld be increased, res$lting in a loer present val$e6 Since the resid$al val$e is an inflo, the loer P leads to a higher cost of oning6 )h$s, the greater the risk of the resid$al val$e, the higher the cost of oning, and the /ore attractive leasing beco/es6 )he oner of the asset bears the resid$al val$e risk, so leasing passes this risk to the lessor6 f co$rse, the lessor recogniBes this, and assets ith highly $ncertain resid$al val$es o$ld carry higher lease pay/ents than assets ith relatively certain resid$al val$es6
*6
?illon knos that her fir/ has been considering /oving its headD$arters to a ne location, and she is concerned that these plans /ay co/e to fr$ition prior to the e;piration of the lease6 f the /ove occ$rs, the co/pany o$ld obtain ne co/p$ters< hence, ?illon o$ld like to incl$de a cancellation cla$se in the lease contract6 What effect o$ld a cancellation cla$se have on the riskiness of the leaseG
&nser:
Sho S20."" here6I & cancellation cla$se o$ld loer the risk of the lease to Fish > Chips, the lessee, beca$se the fir/ o$ld not be obligated to /ake the lease pay/ents for the entire ter/ of the
Chapter 20: Hybrid Financing
ntegrated Case
4#
lease6 f its sit$ation changes, and the fir/ no longer needs the co/p$ter, or if it ants to change to a /ore technologically advanced syste/, then it can ter/inate the lease6 Conversely, a cancellation cla$se /akes the contract /ore risky for the lessor6 (o the lessor not only bears the resid$al val$e risk, b$t also the $ncertainty of hen the contract ill be ter/inated6 )o acco$nt for the additional risk, the lessor o$ld increase the ann$al lease pay/ent6 &dditionally, the lessor /ight incl$de cla$ses that o$ld prohibit cancellation for so/e period and9or i/pose a penalty fee for cancellation that /ight decline over ti/e6
20."5
Fish > Chips nc6, Part Preferred Stock, Warrants, and Convertibles ?artha ?illon, financial /anager of Fish > Chips nc6, is facing a dile//a6 )he fir/ as fo$nded # years ago to develop a ne fast.food concept< and altho$gh Fish > Chips has done ell, the fir/=s fo$nder and chair/an believes that an ind$stry shake.o$t is i//inent6 )o s$rvive, the fir/ /$st capt$re /arket share no, hich reD$ires a large inf$sion of ne capital6 eca$se the stock price /ay rise rapidly, ?illon does not ant to iss$e ne co//on stock6 n the other hand, interest rates are c$rrently very high by historical standards< and ith the fir/=s rating, the interest pay/ents on a ne debt iss$e o$ld be too /$ch to handle if sales took a dont$rn6 )h$s, ?illon has narroed her choice to bonds ith arrants or convertible bonds6 She has asked yo$ to help in the decision process by ansering the folloing D$estions6
41
ntegrated Case
Chapter 20: Hybrid Financing
&6
Ho does preferred stock differ fro/ co//on eD$ity and debtG
&nser:
Sho S20."2 here6I Preferred dividends are fi;ed, b$t they /ay be o/itted itho$t placing the fir/ in defa$lt6 ?ost preferred stock prohibits the fir/ fro/ paying co//on dividends hen the preferred is in arrears6 Preferred dividends are $s$ally c$/$lative $p to a li/it6
6
What is ad!$stable.rate preferredG
&nser:
Sho S20."4 here6I With a floating.rate preferred iss$e, dividends are inde;ed to the rate on )reas$ry sec$rities instead of being fi;ed6 t is an e;cellent short.ter/ corporate invest/ent beca$se only 40A of the dividends are ta;able to corporations and the floating rate generally keeps the iss$e trading near par6
C6
Ho can a knoledge of call options help a person $nderstand arrants and convertiblesG
&nser:
Sho S20."5 here6I Warrants and convertibles are types of call options, and hence an $nderstanding of options ill help financial /anagers /ake decisions regarding arrant and convertible iss$es6
%6
ne of ?illon=s alternatives is to iss$e a bond ith arrants attached6 Fish > Chips= c$rrent stock price is @"0, and the co/pany=s invest/ent bankers esti/ate its cost of 20.year ann$al co$pon debt itho$t arrants to be "2A6 )he bankers s$ggest attaching #0 arrants to each bond, ith each arrant having an e;ercise price of @"26#06 t is esti/ated that each arrant, hen detached and traded separately, ill have a val$e of @"6#06
Chapter 20: Hybrid Financing
ntegrated Case
47
%6
-" What co$pon rate sho$ld be set on the bond ith arrants if the total package is to sell for @",000G
&nser:
Sho S20."# thro$gh S20."7 here6I f the entire package is to sell for @",000, then Package K ond Q Warrants K @",0006 t is e;pected that the #0 arrants ill be orth @"6#0 each, so arrants K #0-@"6#0 K @7#6 )h$s, ond Q @7# K @",000 ond K @82#6 )herefore, the bonds /$st carry a co$pon, (), s$ch that each bond ill sell for @82#6 We can solve for () as follos: Rsing a financial calc$lator enter ( K 20, 9'+ K "2, P K .82#, F K "000, and solve for P?) K @""06 With an ""A co$pon, the bonds o$ld have a val$e of @82#, and hence the package of one bond pl$s #0 arrants o$ld be orth @",0006
%6
-2 S$ppose the bonds are iss$ed and the arrants i//ediately trade for @26#0 each6 What does this i/ply abo$t the ter/s of the iss$eG %id the co/pany Ein or EloseG
&nser:
f the arrants traded i//ediately for @26#0, then the #0 arrants o$ld be orth #0-@26#0 K @"2#, and the package o$ld act$ally be orth @82# Q @"2# K @",0#06 Selling so/ething orth @",0#0 for @",000 i/poses a @#0 per bond cost on Fish > Chips= shareholders, beca$se the package co$ld have been sold ith a
4
ntegrated Case
Chapter 20: Hybrid Financing
loer.co$pon.rate bond, and hence loer f$t$re interest pay/ents6 )h$s, the co/pany Elost beca$se the fir/ is paying /ore in interest e;pense than it co$ld have been paying if the bond had been iss$ed ith a loer co$pon rate6 %6
-4 When o$ld yo$ e;pect the arrants to be e;ercisedG
&nser:
n general, a arrant ill sell on the open /arket for a pre/i$/ above its e;ercise val$e6 )h$s, prior to e;piration, investors o$ld sell their arrants in the /arketplace rather than e;ercise the/, provided the stock sells at a price over the e;ercise price6 So/e arrants contain e;ercise price step.$p provisions, hereby the e;ercise price increases in steps over the life of the arrant6 Since the val$e of the arrant falls hen the e;ercise price is increased, step.$p provisions enco$rage holders to e;ercise their arrants6 Finally, arrant holders ill tend to e;ercise vol$ntarily if the dividend on the stock beco/es high eno$gh6 (o dividend is earned on a arrant, and high dividends increase the attractiveness of stocks over arrants6
%6
-5 Will the arrants bring in additional capital hen e;ercisedG f so, ho /$ch and hat type of capitalG
&nser:
When e;ercised, each arrant ill bring in the e;ercise price, or @"26#0 of eD$ity capital, and holders ill receive one share of co//on stock per arrant6 (ote that the e;ercise price is typically set at "0A to 40A above the c$rrent stock price6 High.groth fir/s o$ld set the e;ercise price toards the high end of the range, and lo.groth fir/s o$ld set the price toards the botto/ end6
Chapter 20: Hybrid Financing
ntegrated Case
48
%6
-# eca$se arrants loer the cost of the acco/panying debt, sho$ldn=t all debt be iss$ed ith arrantsG What is the e;pected cost of the bond ith arrants if the arrants are e;pected to be e;ercised in # years, hen Fish > Chips= stock price is e;pected to be @"76#0G Ho o$ld yo$ e;pect the cost of the bond ith arrants to co/pare ith the cost of straight debtG With the cost of co//on stockG
&nser:
Sho S20." and S20."8 here6I *ven tho$gh the co$pon rate on the debt co/ponent is loered, the overall cost of the iss$e is higher than straight debt6 For investors, so/e of the ret$rn -the debt portion is contract$al in nat$re, b$t the rest of the ret$rn -the arrant portion is related to stock price /ove/ents, and hence has a cost /$ch higher than debt6 )he overall risk of the iss$e, and hence the overall cost, is greater than the cost of debt6 f the arrants are e;ercised in # years, hen P K @"76#0, then Fish > Chips o$ld be e;changing stock orth @"76#0 for " arrant pl$s @"26#06 )h$s, the fir/ o$ld realiBe an opport$nity cost of @# on each arrant6 Since each bond has #0 arrants, the total cost per bond o$ld be @2#06 Fish > Chips /$st also /ake the interest pay/ents over the bond=s 20.year life, as ell as repay the principal after 20 years6 Co/bining these flos, e have the folloing sit$ation: 0 " M M ",000 -""0
5 # 1 M M M -""0 -""0 -""0 -2#0 -410
"8 20 M M -""0 -""0 -",000 -",""0
)he ++ of this cash flo strea/, "2684A, is the overall cost of the debt ith arrants iss$ed6 )his cost is higher than the "2A cost of straight debt beca$se, fro/ the investors= standpoint, the iss$e is 50
ntegrated Case
Chapter 20: Hybrid Financing
riskier than straight debt< hoever, the bond ith arrants is less risky than co//on stock, so the bond ith arrants o$ld have a loer cost than co//on stock6 *6
&s an alternative to the bond ith arrants, ?illon is considering convertible bonds6 )he fir/=s invest/ent bankers esti/ate that Fish > Chips co$ld sell a 20.year, "0A ann$al co$pon, callable convertible bond for its @",000 par val$e, hereas a straight.debt iss$e o$ld reD$ire a "2A co$pon6 Fish > Chips= c$rrent stock price is @"0, its last dividend as @0675, and the dividend is e;pected to gro at a constant rate of A6 )he convertible co$ld be converted into 0 shares of Fish > Chips stock at the oner=s option6 -" What conversion price, Pc , is i/plied in the convertible=s ter/sG
&nser:
Sho S20.20 and S20.2" here6I Conversion price K Pc K K
Par val$e S shares received
Par val$e @",000 K K @"26#0 6 C+ 0
)he conversion price can be tho$ght of as the convertible=s e;ercise price, altho$gh it has already been paid6 &s ith arrants, the conversion price is typically set at 20A to 40A above the prevailing stock price6 *6
-2 What is the straight.debt val$e of the convertibleG What is the i/plied val$e of the convertibility feat$reG
&nser:
Sho S20.22 and S20.24 here6I Since the reD$ired rate of ret$rn on 20.year straight debt is "2A, the val$e of a "0A ann$al co$pon bond is @#061" as follos:
Chapter 20: Hybrid Financing
ntegrated Case
5"
Rsing a financial calc$lator, ( K 20, 9'+ K "2, P?) K "00, F K "000, and solve for P K @#061"6 $t the convertible o$ld sell for @",000, P K "000, so the i/plied val$e of convertibility is @",000 @#061" K @"586486 Since each bond can be converted into 0 shares, the convertibility val$e is @"5864890 K @"67 per share6 *6
-4 What is the for/$la for the bond=s conversion val$e in any yearG ts val$e at 'ear 0G &t 'ear "0G
&nser:
Sho S20.25 here6I )he conversion val$e in any year is si/ply the val$e of the stock obtained by converting6 Since Fish > Chips is a constant groth stock, its price is e;pected to increase by g each year, and hence Pt K P0-" Q gt6 )he val$e of converting at any year is C+-Pt here C+ is the n$/ber of shares received6 )h$s, the conversion val$e in any year is Ct K C+-Pt K C+-P0-" Q gt K 0-@"0-"60 t6 'ear 0:
C0 K 0-@"0-"60 0 K @006
'ear "0: C"0 K 0-@"0-"60 "0 K @",7276"56 *6
-5 What is /eant by the ter/ Efloor val$e of a convertibleG What is the convertible=s e;pected floor val$e in 'ear 0G n 'ear "0G
&nser:
Sho S20.2# here6I )he floor val$e is si/ply the higher of the straight.debt val$e and the conversion val$e6 &t 'ear 0, the straight. debt val$e is @#061" hile the conversion val$e is @00, and hence the floor val$e is @#061"6 &t 'ear "0, the conversion val$e of @",7276"5 is clearly higher than the straight.debt val$e, and hence the conversion val$e sets the floor price6 )he convertible, hoever,
52
ntegrated Case
Chapter 20: Hybrid Financing
ill sell above its floor val$e at any ti/e prior to /at$rity, beca$se the convertibility option carries additional val$e6 *6
-# &ss$/e that Fish > Chips intends to force conversion by calling the bond hen its conversion val$e is 20A above its par val$e, or at "62-@",000 K @",2006 When is the iss$e e;pected to be calledG &nser to the closest year6
&nser:
Sho S20.21 here6I f the iss$e ill be called hen the conversion val$e reaches @",200, then Ct K 0-@"0-"60 t @00-"60t -"60t t ln-"60 060770t t
K @",200 K @",200 K "6#0 K ln "6#0 K 0650## K #627 years
# years6
)his val$e can also be fo$nd ith a financial calc$lator6 np$t 9'+ K < P K .00< P?) K 0< and F K "2006 Press ( to find ( K #627 years T # years6 *6
-1 What is the e;pected cost of the convertible to Fish > ChipsG %oes this cost appear consistent ith the riskiness of the iss$eG &ss$/e conversion in 'ear # at a conversion val$e of @",2006
&nser:
Sho S20.27 and S20.2 here6I )he fir/ o$ld receive @",000 no, pay co$pon pay/ents of @"00 for abo$t # years, and then iss$e stock orth @",2006 )he cash flo strea/ looks like this: 0 M ",000
Chapter 20: Hybrid Financing
" M -"00
2 M -"00
4 M -"00
5 M -"00
# M -"00 -",200 -",400
ntegrated Case
54
