ABMF4024 Business Finance Tutorial 5 Answer 23 December 2010

Question 1
If an asset is purchase, it must be shown on the left-hand side on the balance sheet, with an offsetting debt
or equity entry on the right-hand side. However, if an asset is leased, and if the lease is not classified as a
capital lease, than it does not have to be shown directly on the balance sheet, but rather, must only be
reported in the footnotes to the company’s financial statements.

Question 2
Capital leases are used for long-term leases and for items that not become technologically obsolete, such as
many kinds of machinery. Capital leases give the lessee (the person who is leasing) the benefits and
drawbacks of ownership, so they are considered as assets, and they may be depreciated. These leases are
considered as debts of the lessee.

Operating leases, sometimes called service leases are used for short-term leasing and often for assets that
are high-tech or in which the technology changes often, like computer and office equipment. The lessee uses
the property but does not take on the benefits or drawbacks of ownership, which are retained by the lessor.
The rental cost of an operating lease is considered an operating expense.

Question 3
Leasing is a substitute for debt financing, so leasing increases a firm’s financial leverage.

Question 4
Preferred dividends are fixed, but they may be omitted without placing the firm in default. Most preferred
stock prohibits the firm from paying common dividend when the preferred is in arrears. Preferred dividends
are usually cumulative up to time.

Question 5
Convertible bonds are bonds that can be converted into shares of stock in the issuing company, usually at
some pre-determined conversion ratio. The most important difference is that a convertible bond with
warrants is, warrants can be separated into different securities and a convertible bond cannot.

A warrant is a security that entitles the holder to buy stock of the company that issued it at a specified price,
which is much higher than the stock price at time of issue. Warrants tend to have longer maturity periods
than exchange traded options. Warrants are frequently attached to bonds or preferred stock as a sweetener,
allowing the issuer to pay lower interest rates or dividends.
ABMF4024 Business Finance Tutorial 5 Answer 23 December 2010

Question 6
Similarities between warrants and options:
1. Both are American call options on the equity of the firm.
2. Both are usually protected against stock dividends and stock splits.
3. Neither is protected against cash dividends.
Differences between warrants and options:
1. Exercise period of a warrant is usually several years.
2. Warrants are issued by the firm. Options are issued by individuals.
3. When a warrant is exercised the firm receives the exercise price from the investor and the firm
simultaneously issues new shares.
4. When a warrant is exercised, a firm must issue new shares of stock.
5. This can have the effect of diluting the claims of existing shareholders.

Question 7