Chapter 20 Hybrid Financing: Preferred Stock, Leasing, Warrants, and Convertibles Preferred Stock Leasing Warrants Convertibles 20-1 © 2013 Cengage Learning All Rights Reserved May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part 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 not provide for maintenance service – Capital leases are not cancelable – Capital leases are fully amortized 20-2 © 2013 Cengage Learning All Rights Reserved May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part Lease vs Borrow-and-Buy Data: • New computer costs $1,200,000 • 3-year MACRS class life; 4-year economic life • Tax rate = 40% • rd = 10% • Maintenance of $25,000/year, payable at beginning of each year • Residual value in Year of $125,000 • 4-year lease includes maintenance • Lease payment is $340,000/year, payable at beginning of each year 20-3 © 2013 Cengage Learning All Rights Reserved May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part Depreciation Schedule Depreciable basis = $1,200,000 Year MACRS Rate 0.33 0.45 0.15 0.07 1.00 Depreciation End-of-Year Expense Book Value $ 396,000 $804,000 540,000 264,000 180,000 84,000 84,000 $1,200,000 20-4 © 2013 Cengage Learning All Rights Reserved May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part 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, rd, was 10% Therefore, we should discount cash flows at 6% rd(1 − T) = 10%(1 – T) = 10%(1 – 0.4) = 6% 20-5 © 2013 Cengage Learning All Rights Reserved May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part Cost of Owning Analysis Cost of asset Deprec tax savings Maintenance (AT) -1,200.0 158.4 216.0 72.0 33.6 -15.0 -15.0 -15.0 -15.0 Residual value (AT) Cash flow -1,215.0 143.4 201.0 57.0 75.0 108.6 PV of the cost of owning (@ 6%) = -$766.948 20-6 © 2013 Cengage Learning All Rights Reserved May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part Notes on Cost of Owning Analysis • Depreciation is a tax deductible expense, so it produces a tax savings of T(Depreciation) Year = 0.4($396) = $158.4 • Each maintenance payment of $25 is deductible so the after-tax cost of the maintenance payment is (1 – T)($25) = $15 • The ending book value is $0 so the full $125 salvage (residual) value is taxed, (1 – T)($125) = $75.0 20-7 © 2013 Cengage Learning All Rights Reserved May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part Cost of Leasing Analysis A-T Lease pmt • -204 -204 -204 -204 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 20-8 © 2013 Cengage Learning All Rights Reserved May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part Net Advantage of Leasing • NAL = PV cost of owning – PV cost of leasing • NAL = $766.948 – $749.294 = $17.654 (Dollars in thousands) • Since the cost of owning outweighs the cost of leasing, the firm should lease 20-9 © 2013 Cengage Learning All Rights Reserved May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part What if there is a lot of uncertainty about 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 20-10 © 2013 Cengage Learning All Rights Reserved May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part What coupon rate should be set for this bond plus warrants package? • Step 1: Calculate the value of the bonds in the package VPackage = VBond + VWarrants = $1,000 VWarrants = 50($1.50) = $75 VBond + $75 = $1,000 VBond = $925 20-16 © 2013 Cengage Learning All Rights Reserved May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part Calculating Required Annual Coupon Rate for Bond with Warrants Package • Step 2: Find coupon payment and rate – Solving for PMT, we have a solution of $110, which corresponds to an annual coupon rate of $110/$1,000 = 11% INPUTS OUTPUT 20 12 -925 N I/YR PV 1000 PMT FV 110 20-17 © 2013 Cengage Learning All Rights Reserved May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part What is the expected rate of return to holders of bonds with warrants, if exercised in years at P5 = $17.50? • The company will exchange stock worth $17.50 for one warrant plus $12.50 The opportunity cost to the company is $17.50 – $12.50 = $5.00, for each warrant exercised • Each bond has 50 warrants, so on a par bond basis, opportunity cost = 50($5.00) = $250 20-18 © 2013 Cengage Learning All Rights Reserved May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part Finding the Opportunity Cost of Capital for the Bond with Warrants Package • Here is the cash flow time line: +1,000 -110 • -110 -110 -250 -360 -110 19 -110 20 -110 -1,000 -1,110 Input the cash flows into a financial calculator (or spreadsheet) and find IRR = 12.93% This is the 20-19 pre-tax cost © 2013 Cengage Learning All Rights Reserved May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part The Firm is Now Considering a Callable, Convertible Bond Issue • 20-year, 10% annual coupon, callable convertible bond will sell at its $1,000 par value; straight-debt issue would require a 12% coupon • • • Call the bonds when conversion value > $1,200 P0 = $10; D0 = $0.74; g = 8% Conversion ratio = CR = 80 shares 20-20 © 2013 Cengage Learning All Rights Reserved May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part What conversion price (Pc) is implied by this bond issue? • The conversion price can be found by dividing the par value of the bond by the conversion ratio, $1,000/80 = $12.50 • The conversion price is usually set 10% to 30% above the stock price on the issue date 20-21 © 2013 Cengage Learning All Rights Reserved May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part What is the convertible’s straight-debt value? • Recall that the straight-debt coupon rate is 12% and the bonds have 20 years until maturity INPUTS OUTPUT 20 12 N I/YR PV 100 1000 PMT FV -850.61 20-22 © 2013 Cengage Learning All Rights Reserved May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part Implied Convertibility Value • Because the convertibles will sell for $1,000, the implied value of the convertibility feature is $1,000 – $850.61 = $149.39 $149.39/80 = $1.87 per share • The convertibility value corresponds to the warrant value in the previous example 20-23 © 2013 Cengage Learning All Rights Reserved May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part What is the formula for the bond’s expected conversion value in any year? • Conversion value = Ct = CR(P0)(1 + g)t • At t = 0, the conversion value is C0 = 80($10)(1.08)0 = $800 • At t = 10, the conversion value is C10 = 80($10)(1.08)10 = $1,727.14 20-24 © 2013 Cengage Learning All Rights Reserved May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part What is meant by the floor value of a convertible? • The floor value is the higher of the straight-debt value and the conversion value • At t = 0, the floor value is $850.61 Straight-debt value0 = $850.61 C0 = $800 • At t = 10, the floor value is $1,727.14 Straight-debt value10 = $887.00 C10 = $1,727.14 • Convertibles usually sell above floor value because convertibility has an additional value 20-25 © 2013 Cengage Learning All Rights Reserved May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part When is the issue expected to be called? • The firm intends to force conversion when C = 1.2($1,000) = $1,200 • 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 INPUTS N OUTPUT -800 1200 I/YR PV PMT FV 5.27 © 2013 Cengage Learning All Rights Reserved May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part What is the convertible’s expected cost of capital to the firm, if converted in Year 5? • Input the cash flows from the convertible bond and solve for IRR = 13.08% 1,000 -100 -100 -100 -100 -100 -1,200 -1,300 20-27 © 2013 Cengage Learning All Rights Reserved May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part Is the cost of the convertible consistent with the risk of the issue? • • To be consistent, we require that rd < rc < re The convertible bond’s risk is a blend of the risk of debt and equity, so rc should be between the cost of debt and equity – From previous information: rs = $0.74(1.08)/$10 + 0.08 = 16.0% • rc is between rd and rs, and is consistent 20-28 © 2013 Cengage Learning All Rights Reserved May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part Besides cost, what other factors 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 low-coupon debt – Conversion brings in no new funds, and low-coupon debt is gone when bonds are converted However, debt ratio is lowered, so new debt can be issued 20-29 © 2013 Cengage Learning All Rights Reserved May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part Other Issues Regarding the Use of Hybrid Securities • Does the firm want to commit to 20 years of debt? – Conversion removes debt, while the exercise of warrants does not – If stock price does not rise over time, then neither warrants nor convertibles would be exercised Debt would remain outstanding 20-30 © 2013 Cengage Learning All Rights Reserved May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part [...]... 20-15 © 2013 Cengage Learning All Rights Reserved May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part What coupon rate should be set for this bond plus warrants package? • Step 1: Calculate the value of the bonds in the package VPackage = VBond + VWarrants = $1,000 VWarrants = 50($1.50) = $75 VBond + $75 = $1,000 VBond = $925 20-16 © 2013 Cengage. .. the issue date 20-21 © 2013 Cengage Learning All Rights Reserved May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part What is the convertible’s straight-debt value? • Recall that the straight-debt coupon rate is 12% and the bonds have 20 years until maturity INPUTS OUTPUT 20 12 N I/YR PV 100 1000 PMT FV -850.61 20-22 © 2013 Cengage Learning All Rights... FV 5.27 © 2013 Cengage Learning All Rights Reserved May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part What is the convertible’s expected cost of capital to the firm, if converted in Year 5? • Input the cash flows from the convertible bond and solve for IRR = 13.08% 0 1 2 3 4 1,000 -100 -100 -100 -100 5 -100 -1,200 -1,300 20-27 © 2013 Cengage Learning... option • An understanding of options will help financial managers make decisions regarding warrant and convertible issues A convertible bond consists of a fixed-rate bond plus a call option 20-14 © 2013 Cengage Learning All Rights Reserved May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part A Firm Wants to Issue a Bond with Warrants Package at... were included in the lease? How would this affect the riskiness of the lease? • A cancellation clause lowers the risk of the lease to the lessee • However, it increases the risk to the lessor 20-11 © 2013 Cengage Learning All Rights Reserved May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part How does preferred stock differ from common equity and... Find coupon payment and rate – Solving for PMT, we have a solution of $110, which corresponds to an annual coupon rate of $110/$1,000 = 11% INPUTS OUTPUT 20 12 -925 N I/YR PV 1000 PMT FV 110 20-17 © 2013 Cengage Learning All Rights Reserved May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part What is the expected rate of return to holders of bonds... plus $12.50 The opportunity cost 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 20-18 © 2013 Cengage Learning All Rights Reserved May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part Finding the Opportunity Cost of Capital for the Bond... +1,000 -110 • 4 5 6 -110 -110 -250 -360 -110 19 -110 20 -110 -1,000 -1,110 Input the cash flows into a financial calculator (or spreadsheet) and find IRR = 12.93% This is the 20-19 pre-tax cost © 2013 Cengage Learning All Rights Reserved May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part The Firm is Now Considering a Callable, Convertible Bond... 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 20-20 © 2013 Cengage Learning All Rights Reserved May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part What conversion price (Pc) is implied by this bond issue?... without placing the firm in default • • Preferred dividends are cumulative up to a limit Most preferred stocks prohibit the firm from paying common dividends when the preferred is in arrears 20-12 © 2013 Cengage Learning All Rights Reserved May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part What is adjustable-rate preferred? • Dividends are indexed