20-1 CHAPTER 20 Hybrid Financing: Preferred Stock, Leasing, Warrants, and Convertibles  Preferred stock  Leasing  Warrants  Convertibles 20-2 Leasing  Often referred to as “off balance sheet” financing if a lease is not “capitalized.”  Leasing is a substitute for debt financing and, thus, uses up a firm’s debt capacity.  Capital leases are different from operating leases:  Capital leases do not provide for maintenance service.  Capital leases are not cancelable.  Capital leases are fully amortized. 20-3 Analysis: Lease vs. Borrow- and-buy Data:  New computer costs $1,200,000.  3-year MACRS class life; 4-year economic life.  Tax rate = 40%.  k d = 10%.  Maintenance of $25,000/year, payable at beginning of each year.  Residual value in Year 4 of $125,000.  4-year lease includes maintenance.  Lease payment is $340,000/year, payable at beginning of each year. 20-4 Depreciation schedule Depreciable basis = $1,200,000 MACRS Depreciation End-of-Year Year Rate Expense Book Value 1 0.33 $ 396,000 $804,000 2 0.45 540,000 264,000 3 0.15 180,000 84,000 40.07 84,000 0 1.00 $1,200,000 20-5 In a lease analysis, at what discount rate should cash flows be discounted?  Since cash flows in a lease analysis are evaluated on an after-tax basis, we should use the after-tax cost of borrowing.  Previously, we were told the cost of debt, k d , was 10%. Therefore, we should discount cash flows at 6%. A-T kd = 10%(1 – T) = 10%(1 – 0.4) = 6%. 20-6 0 1 2 3 4 Cost of Owning Analysis Cost of asset (1,200.0) Dep. tax savings 1 158.4 216.0 72.0 33.6 Maint. (AT) 2 (15.0) (15.0) (15.0) (15.0) Res. value (AT) 3 ______ _____ _____ _____ 75.0 Net cash flow (1,215.0) 143.4 201.0 57.0 108.6 PV cost of owning (@ 6%) = -$766.948. Analysis in thousands: 20-7 Notes on Cost of Owning Analysis 1. Depreciation is a tax deductible expense, so it produces a tax savings of T(Depreciation). Year 1 = 0.4($396) = $158.4. 2. Each maintenance payment of $25 is deductible so the after-tax cost of the lease is (1 – T)($25) = $15. 3. The ending book value is $0 so the full $125 salvage (residual) value is taxed, (1 - T)($125) = $75.0. 20-8 Cost of Leasing Analysis  Each lease payment of $340 is deductible, so the after-tax cost of the lease is (1-T)($340) = -$204.  PV cost of leasing (@6%) = -$749.294. 0 1 2 3 4 A-T Lease pmt -204 -204 -204 -204 Analysis in thousands: 20-9 Net advantage of leasing  NAL = PV cost of owning – PV cost of leasing  NAL = $766.948 - $749.294 = $17.654  Since the cost of owning outweighs the cost of leasing, the firm should lease. (Dollars in thousands) 20-10 Suppose there is a great deal of uncertainty regarding the computer’s residual value  Residual value could range from $0 to $250,000 and has an expected value of $125,000.  To account for the risk introduced by an uncertain residual value, a higher discount rate should be used to discount the residual value.  Therefore, the cost of owning would be higher and leasing becomes even more attractive. [...]... to the company is $17.50 - $12.50 = $5.00, for each warrant exercised Each bond has 50 warrants, so on a par bond basis, opportunity cost = 50($5.00) = $250 2 0-2 3 Finding the opportunity cost of capital for the bond with warrants package Here is the cash flow time line: 0 1 4 5 6 +1,000 -1 10 19 20 -1 10 -1 10 -1 10 -2 50 -3 60 -1 10 -1 10 -1 ,000 -1 ,110 Input the cash flows into a financial calculator (or... OUTPUT -8 00 0 1200 I/YR PV PMT FV 5.27 2 0-3 2 What is the convertible’s expected cost of capital to the firm, if converted in Year 5? 0 1 1,000 -1 00 2 -1 00 3 -1 00 4 -1 00 5 -1 00 -1 ,200 -1 ,300 Input the cash flows from the convertible bond and solve for IRR = 13.08% 2 0-3 3 Is the cost of the convertible consistent with the riskiness of the issue? To be consistent, we require that kd < kc < k e The convertible... 80 = $12.50 The conversion price is usually set 10% to 30% above the stock price on the issue date 2 0-2 7 What is the convertible’s straight debt value? Recall that the straight debt coupon rate is 12% and the bond’s have 20 years until maturity OUTPUT 20 12 N INPUTS I/YR 100 PV 1000 PMT FV -8 50.61 2 0-2 8 Implied Convertibility Value Because the convertibles will sell for $1,000, the implied value of... convertibility has an additional value 2 0-3 1 The firm intends to force conversion when C = 1.2($1,000) = $1 ,200 When is the issued expected to be called? We are solving for the period of time until the conversion value equals the call price After this time, the conversion value is expected to exceed the call price 8 INPUTS N OUTPUT -8 00 0 1200 I/YR PV PMT FV 5.27 2 0-3 2 What is the convertible’s expected... warrant’s life Because the value of the warrant falls when the exercise price is increased, step-up provisions encourage in-the-money warrant holders to exercise just prior to the step-up Since no dividends are earned on the warrant, holders will tend to exercise voluntarily if a stock’s dividend rises enough 2 0-2 0 Will the warrants bring in additional capital when exercised? When exercised, each warrant... firm is now considering a callable, convertible bond issue, described below: 2 0- year, 10% annual coupon, callable convertible bond will sell at its $1,000 par value; straight debt issue would require a 12% coupon Call the bonds when conversion value > $1 ,200 P0 = $10; D0 = $0.74; g = 8% Conversion ratio = CR = 80 shares 2 0-2 6 What conversion price (Pc) is implied by this bond issue? The conversion... options help one understand warrants and convertibles? A warrant is a long-term call option A convertible bond consists of a fixed rate bond plus a call option 2 0-1 4 A firm wants to issue a bond with warrants package at a face value of $1,000 Here are the details of the issue Current stock price (P0) = $10 kd of equivalent 2 0- year annual payment bonds without warrants = 12% 50 warrants attached to... value to the warrant holders 2 0-1 8 Assume the warrants expire 10 years after issue When would you expect them to be exercised? Generally, a warrant will sell in the open market at a premium above its theoretical value (it can’t sell for less) Therefore, warrants tend not to be exercised until just before they expire 2 0-1 9 Optimal times to exercise warrants In a stepped-up exercise price, the exercise... This is the pre-tax cost 2 0-2 4 Interpreting the opportunity cost of capital for the bond with warrants package The cost of the bond with warrants package is higher than the 12% cost of straight debt because part of the expected return is from capital gains, which are riskier than interest income The cost is lower than the cost of equity because part of the return is fixed by contract 2 0-2 5 The firm is... and is consistent 2 0-3 4 Besides cost, what other factor should be considered when using hybrid securities? The firm’s future needs for capital: Exercise of warrants brings in new equity capital without the need to retire lowcoupon debt Conversion brings in no new funds, and low-coupon debt is gone when bonds are converted However, debt ratio is lowered, so new debt can be issued 2 0-3 5 Other issues regarding . deductible, so the after-tax cost of the lease is (1-T)($340) = -$ 204 .  PV cost of leasing (@6%) = -$ 749.294. 0 1 2 3 4 A-T Lease pmt -2 04 -2 04 -2 04 -2 04 Analysis in thousands: 2 0-9 Net advantage. cancelable.  Capital leases are fully amortized. 2 0-3 Analysis: Lease vs. Borrow- and-buy Data:  New computer costs $1 ,200 ,000.  3-year MACRS class life; 4-year economic life.  Tax rate = 40%. . $125,000.  4-year lease includes maintenance.  Lease payment is $340,000/year, payable at beginning of each year. 2 0-4 Depreciation schedule Depreciable basis = $1 ,200 ,000 MACRS Depreciation End-of-Year Year