CHAPTER 20—HYBRID FINANCING: PREFERRED STOCK, LEASING, WARRANTS, AND

CONVERTIBLES
Multiple Choice: Conceptual

25. Operating leases often have terms that include

a. maintenance of the equipment by the lessor.
b. full amortization over the life of the lease.
c. very high penalties if the lease is cancelled.
d. restrictions on how much the leased property can be used.
e. much longer lease periods than for most financial leases.
ANSWER: a

28. IFRS #16 requires that for an unqualified audit report, financial (or capital) leases must be included in the balance
sheet by reporting the
a. residual value as a fixed asset.
b. residual value as a liability.
c. present value of future lease payments as an asset and also showing this same amount as an offsetting liability.
d. undiscounted sum of future lease payments as an asset and as an offsetting liability.
e. undiscounted sum of future lease payments, less the residual value, as an asset and as an offsetting liability.
ANSWER: c

29. Heavy use of off-balance-sheet lease financing will tend to

a. make a company appear more risky than it actually is because its stated debt ratio will be increased.
b. make a company appear less risky than it actually is because its stated debt ratio will appear lower.
c. affect a company's cash flows but not its degree of risk.
d. have no effect on either cash flows or risk because the cash flows are already reflected in the income
statement.
e. affect the lessee's cash flows but only due to tax effects.
ANSWER: b

31. A lease-versus-purchase analysis should compare the cost of leasing to the cost of owning, assuming that the asset
purchased
a. is financed with short-term debt.
b. is financed with long-term debt.
c. is financed with debt whose maturity matches the term of the lease.
d. is financed with a mix of debt and equity based on the firm's target capital structure, i.e., at the WACC.
e. is financed with retained earnings.
ANSWER: c

35. Orient Airlines' common stock currently sells for $33, and its 8% convertible debentures (issued at par, or $1,000) sell
for $850. Each debenture can be converted into 25 shares of common stock at any time before 2022. What is the
conversion value of the bond?
a. $707.33
b. $744.56
c. $783.75
Page 1
 d. $825.00
e. $866.25
ANSWER: d
RATIONALE: Stock price $33.00 Coupon rate 8.00%
Bond price $850 Par value $1,000
Conversion ratio 25.00
Conversion value = Conversion ratio × Stock price = $825.00

36. Chocolate Factory's convertible debentures were issued at their $1,000 par value in 2011. At any time prior to maturity
on February 1, 2031, a debenture holder can exchange a bond for 25 shares of common stock. What is the conversion
price, Pc?
a. $40.00
b. $42.00
c. $44.10
d. $46.31
e. $48.62
ANSWER: a
RATIONALE: Par value $1,000.00
Conversion ratio 25.00
Conversion price = Par value/Conversion ratio = $40.00

39. Sutton Corporation, which has a zero tax rate due to tax loss carry-forwards, is considering a 5-year, $6,000,000 bank
loan to finance service equipment. The loan has an interest rate of 10% and would be amortized over 5 years, with 5 end-
of-year payments. Sutton can also lease the equipment for 5 end-of-year payments of $1,790,000 each. How much larger
or smaller is the bank loan payment than the lease payment? Note: Subtract the loan payment from the lease payment.
a. $177,169
b. $196,854
c. $207,215
d. $217,576
e. $228,455
ANSWER: c
RATIONALE: Years (N) 5
Interest rate (I/YR) 10.0%
Loan amount (PV) $6,000,000
Lease payment $1,790,000
0 1 2 3 4 5
Loan: −6,000,000 PMT PMT PMT PMT PMT
Inputs: N = 5; I/YR = 10; PV = −6000000; FV = 0 Loan payment = PMT = $1,582,785 Difference in
payments = Lease pymt − Loan pymt = $207,215

42. Warren Corporation's stock sells for $42 per share. The company wants to sell some 20-year, annual interest, $1,000
par value bonds. Each bond would have 75 warrants attached to it, each exercisable into one share of stock at an exercise
price of $47. The firm's straight bonds yield 10%. Each warrant is expected to have a market value of $2.00 given that the
stock sells for $42. What coupon interest rate must the company set on the bonds in order to sell the bonds-with-warrants
at par?
a. 7.83%
b. 8.24%
c. 8.65%
Page 2
 d. 9.08%
e. 9.54%
ANSWER: b
RATIONALE: Stock price $42.00 Bond par value $1,000
Exercise price $47.00 Bond maturity 20
No. of warrants 75 Straight-debt yield 10.0%
Value of warrants $2.00
Total value = Straight-debt value + Warrant value
$1,000 = Bond value + $150
VB = $1,000 − $150 = $850
Set N = 20, I/YR = 10, PV = −850, FV = 1000 and solve for PMT: $82.38 To get this payment on a $1,000
bond, the coupon rate = PMT/$1000 = 8.24%

45. Curran Contracting is issuing new 25-year bonds that have warrants attached. If not for the attached warrants, the
bonds would carry an 11% annual interest rate. However, with the warrants attached the bonds will pay an 8% annual
coupon. There are 30 warrants attached to each bond, which have a par value of $1,000. What is the implied value of each
warrant?
a. $8.00
b. $8.42
c. $8.84
d. $9.28
e. $9.75
ANSWER: b
RATIONALE: Bond par value $1,000 No. of warrants 30
Bond maturity 25 Coupon rate 8.0%
Straight-debt yield 11.0% PMT $80
Find the straight-debt value: N = 25, I/YR = 11, PMT = −80, and FV = −1000. PV = $747.35
Total value = Straight-debt value (VB) + Warrant value = $1,000
$1,000 = $747.35 + 30 × Warrant value
$252.65 = 30 × Warrant value
Warrant value = $8.42

49. Cannon Manufacturing is considering issuing 15-year, 8% annual coupon, $1,000 face value convertible bonds at a
price of $1,000 each. Each bond would be convertible into 25 shares of common stock. If the bonds were not convertible,
investors would require an annual yield of 10%. The stock's current price is $25.00, its expected dividend is $2.50, and its
expected growth rate is 5%. The bonds are noncallable for 10 years. What is the bond's conversion value in Year 5?
a. $719.90
b. $757.79
c. $797.68
d. $837.56
e. $879.44
ANSWER: c
RATIONALE: Bond par value $1,000 Bond maturity 15
Conv. ratio (CR) 25 Straight-debt yield 10.0%
P0 $25 Convertible coupon 8.0%
Growth rate (g) 5.0% PMT $80
Conversion year, t 5
Conversion value = P0× CR × (1 + g)t Conversion value = $25 × 25 × 1.0505 Conversion value = $797.68

Page 3
50. Ellis Enterprises is considering whether to lease or buy some necessary equipment it needs for a project that will last
the next 3 years. If the firm buys the equipment, it will borrow $4,800,000 at 8% interest. The firm's tax rate is 35% and
the firm's before-tax cost of debt is 8%. Annual maintenance costs associated with ownership are estimated to be
$300,000 and the equipment will be depreciated on a straight-line basis over 3 years. What is the annual end-of-year lease
payment (in thousands of dollars) for a 3-year lease that would make the firm indifferent between buying or leasing the
equipment? (Suggestion: Delete 3 zeros from dollars and work in thousands.)
a. $1,950
b. $2,052
c. $2,160
d. $2,268
e. $2,382
ANSWER: c
RATIONALE: Life of equipment 3 Tax rate 35%
Loan amount = equip. cost $4,800 Maint. costs $300
BT cost of debt 8.0%
Purchase analysis:
0 1 2 3 Totals
Straight-line factor 0.33330.33330.3333 1.00
Depreciation 1,600 1,600 1,600 4,800

Equipment purchase −$4,800

Maintenance −300 −300 −300
Maint. tax savings (Maint. × T) 105 105 105
Deprec. tax savings (Deprec × T) _____ 560 560 560
Cash flows −4,800 365 365 365
PV cost at I(1 − T) = 5.20% −3,810
Calculate lease PMT that has same PV as owning:
N 3
I/YR 5.20%
PV −3,810
FV 0
PMT = AT leasing PMT = $1,404 BT leasing PMT = AT PMT/(1 − T) = $2,160

Problems:
1. Kohers Inc. is considering a leasing arrangement to finance some manufacturing tools that it needs for the next 3 years.
The tools will be obsolete and worthless after 3 yars. The firm will depreciate the cost of the tools on a straight-line
basis over their 3-year life. It can borrow $4,800,000, the purchase price, at 10% and buy the tools, or it can make 3
equal end-of-year lease payments of $2,100,000 each and lease them. The loan obtained from the bank is a 3-year
simple interest loan, with interest paid at the end of the year. The firm's tax rate is 40%. Annual maintenance costs
associated with ownership are estimated at $240,000 payable at the end of the year, but this cost would be borne by
the lessor if the equipment is leased. What is the net advantage to leasing (NAL), in thousands? (Suggestion: Delete 3
zeros from dollars and work in thousands.)
ANSWER:
: Years 3 Tax rate 40%
Loan amount = equipment cost $4,800 Maintenance costs $240
Interest rate 10.0% Salvage value $0
Lease payment $2,100
After-tax cost of debt = Rate × (1 − T) = 6.0%
Annual depreciation = Cost/Yrs. = $1,600
Tax savings from deprec. = Deprec. × T = $640
0 1 2 3
Page 4
 Purchase analysis:
Net purchase price −$4,800
Maintenance cost −240 −240 −240
Maint. tax savings = Maint × T 96 96 96
Deprec. tax savings 640 640 640
Cash flow −4,800 496 496 496
PV cost of owning (6%) −3,474

Leasing analysis:
Lease payment −2,100 −2,100 −2,100
Tax savings from lease 840 840 840
Cash flow −1,260 −1,260 −1,260
PV cost of leasing (6%) −3,368
NAL = PV cost of owning − PV cost of leasing = $106

2. Bev's Beverages is negotiating a lease on a new piece of equipment that would cost $80,000 if purchased. The
equipment falls into the MACRS 3-year class, and it would be used for 3 years and then sold, because the firm plans to
move to a new facility at that time. The estimated value of the equipment after 3 years is $25,000. A maintenance contract
on the equipment would cost $2,500 per year, payable at the beginning of each year. Alternatively, the firm could lease
the equipment for 3 years for a lease payment of $23,000 per year, payable at the beginning of each year. The lease would
include maintenance. The firm is in the 20% tax bracket, and it could obtain a 3-year simple interest loan, interest payable
at the end of the year, to purchase the equipment at a before-tax cost of 8%. If there is a positive Net Advantage to
Leasing (NAL) the firm will lease the equipment. Otherwise, it will buy it. What is the NAL? (Note: MACRS rates for
Years 1 to 4 are 0.33, 0.45, 0.15, and 0.07.)

ANSWER:
Life of equipment 3 Tax rate 20%
Equipment cost $80,000 Maint. costs $2,500
Interest rate 8.0% Residual value $25,000
Lease payment $23,000
Purchase analysis: 0 1 2 3 Totals
MACRS factor 0.33 0.45 0.15 0.93
Depreciation 26,400 36,00012,000 74,400

Equipment cost −$80,000

Maintenance −2,500 −2,500 −2,500
Maint. tax savings
(Maint. × T) 500 500 500
Deprec. tax savings (Deprec. × T) 5,280 7,200 2,400
Residual value before taxes 25,000
Book value (Cost − Total deprec.) 5,600
Taxable residual value 19,400
Tax on residual value −3,880
AT residual value 21,120
Cash flows −82,000 3,280 5,20023,520

PV cost at I(1 − T) = 6.40% −54,798

Lease analysis: 0 1 2 3
Lease payment −23,000 −23,000−23,000 0
Tax saving on pmt 4,600 4,600 4,600 0
Page 5
AT lease pmt −18,400 −18,400−18,400 0

PV cost of leasing at I(1 − T) −51,946

NAL = $2,852

Page 6