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Hybrid Financing:: Preferred Stock, Leasing, Warrants, and Convertibles
Hybrid Financing:: Preferred Stock, Leasing, Warrants, and Convertibles
Hybrid Financing:
Preferred Stock, Leasing, Warrants,
and Convertibles
Preferred stock
Leasing
Warrants
Convertibles
20-1
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.
20-2
Analysis: Lease vs.
Borrow-and-buy
Data:
New computer costs $1,200,000.
life.
Tax rate = 40%.
k = 10%.
d
Maintenance of $25,000/year, payable at
20-4
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,
kd, was 10%. Therefore, we should
discount cash flows at 6%.
A-T kd = 10%(1 – T) = 10%(1 – 0.4) =
6%.
20-5
Cost of Owning Analysis
Analysis in thousands:
0 1 2 3 4
20-6
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.
20-7
Cost of Leasing Analysis
Analysis in thousands: 0 1 2 3 4
20-8
Net advantage of leasing
NAL = PV cost of owning – PV cost of
leasing
NAL = $766.948(Dollars
- $749.294
in thousands)
= $17.654
20-9
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.
20-10
What if a cancellation clause 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
How does preferred stock differ
from common equity and debt?
Preferred dividends are fixed, but they
may be omitted 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
What is floating rate
preferred?
Dividends are indexed to the rate on
treasury securities instead of being fixed.
Excellent S-T corporate investment:
Only 30% of dividends are taxable to
corporations.
The floating rate generally keeps issue
trading near par.
However, if the issuer is risky, the floating
rate preferred stock may have too much
price instability for the liquid asset
portfolios of many corporate investors.
20-13
How can a knowledge of call
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.
20-14
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 20-year annual
payment bonds without warrants =
12%.
50 warrants attached to each bond
with an exercise price of $12.50.
Each warrant’s value will be $1.50.
20-15
What coupon rate should be set
for this bond plus warrants
package?
Step 1 – Calculate the value of the
bonds in the package
20-17
If after the issue, the warrants sell
for $2.50 each, what would this
imply about the value of the
package?
The package would have been worth $925
+ 50(2.50) = $1,050. This is $50 more
than the actual selling price.
The firm could have set lower interest
payments whose PV would be smaller by
$50 per bond, or it could have offered
fewer warrants with a higher exercise
price.
Current stockholders are giving up value to
the warrant holders.
20-18
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.
20-19
Optimal times to exercise
warrants
In a stepped-up exercise price, the exercise price
increases in steps over the 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.
20-20
Will the warrants bring in
additional capital when
exercised?
When exercised, each warrant will bring
in the exercise price, $12.50, per share
exercised.
This is equity capital and holders will
receive one share of common stock per
warrant.
The exercise price is typically set at 10%
to 30% above the current stock price on
the issue date.
20-21
Because warrants lower the cost
of the accompanying debt issue,
should all debt be issued with
warrants?
No, the warrants have a cost
that must be added to the
coupon interest cost.
20-22
What is the expected rate of return
to holders of bonds with warrants, if
exercised in 5 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.
20-23
Finding the opportunity cost of
capital for the bond with warrants
package
Here is the cash flow time line:
0 1 4 5 6 19 20
... ...
+1,000 -110 -110 -110 -110 -110 -110
-250 -1,000
-360 -1,110
Input the cash flows into a financial
calculator (or spreadsheet) and find
IRR = 12.93%. This is the pre-tax cost.
20-24
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.
20-25
The firm is now considering a
callable, convertible bond issue,
described below:
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.
20-26
c
20-27
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.
20-28
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.
= $1.87 per share.
The convertibility value corresponds to
the warrant value in the previous
example.
20-29
What is the formula for the bond’s
expected conversion value in any
year?
20-30
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.
20-31
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.
20-32
What is the convertible’s expected
cost of capital to the firm, if
converted in Year 5?
0 1 2 3 4 5
20-34
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 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.
20-35
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.
20-36