Hybrid Financing: Preferred Stock, Leasing, Warrants, and Convertibles

Chapter 20
Hybrid Financing: Preferred

Stock, Leasing, Warrants, and
Convertibles
 Preferred Stock
 Leasing
 Warrants
 Convertibles
Introduction: Hybrid
 A hybrid security is a form

of debt or equity that
possesses characteristics of
both debt and equity
financing.
preferred stock, leases,
convertible, and warrants.
Preferred Stock
 In their simplest form, bonds

are pure debt and common
stocks are pure equity.
 Preferred stocks, on the
other hand, are a hybrid of
the two.
Preferred Stock
 Preferred stocks are like

common stocks in that they
promise to pay dividends,
are perpetual, and represent
ownership.
Preferred Stock
 Preferred stocks are like

bonds in that dividends are
fixed like bond interest
payments.
Preferred Stock Basic Features
 It has a par value.

 Its dividend is stated as a
percentage of par or a
amount per share.
 Unpaid preferred dividends
are called arrearages.
 Most issues are cumulative

– the total of all unpaid
preferred dividends must be
paid before dividends can be
the paid on the common
stock.
 Preferred stock normally has
no voting rights.
 Some preferred stocks have

no maturity dates.
Many preferred stocks have
a sinking fund provision that
calls for the retirement of a
percentage of the original
issue each year.
Many preferred issues have
call features.
 From the viewpoint of

corporation, preferred stock
is less risky than bonds.
 For investors, preferred stock
is riskier than bonds.
 Adjustable rate preferred

stock is a variation of a
“plain vanilla” variety of
preferred stock.
Dividends are adjusted at
regular intervals.
Dividends may be tied to
LIBOR or securities.
Advantages of Preferred Stock
 Passing a dividend cannot

force a firm into bankruptcy.
 By issuing preferred stock,
no dilution of common
equity.
 Preferred issues can reduce
the cash flow drain from
repayment of principal with
debt.
Disadvantages of Preferred Stock
 Preferred stock dividends are

not deductible to the issuer.
 Although preferred dividends
can be passed, investors
expect them to be paid.
Thus, the preferred
dividends are considered a
fixed cost.
Leasing vs Buying
 Leasing and buying are

different methods of
acquiring assets.
 Leasing finances the USE of
an asset while buying
finances the OWNERSHIP
of an asset.
Leasing
 Leasing is the process by

which a firm can obtain the
use of certain fixed assets
for which it must make a
series of contractual,
periodic, tax-deductible
payments.
Leasing
 The lessee is the receiver of

the services of the assets
under a lease contract.
 The lessor is the owner of
assets that are being leased.
Why Lease
 Lessee may lack sufficient

funds or credit capability to
purchase an asset.
 Provisions for a lease
obligation are less restrictive.
 Conserve the working
capital.
Why Lease
 The lessor may possess

particular expertise in a
given industry.
 Gives economic advantage
because of tax shield.
Why Lease
 Preserves bank credit lines

for other purposes.
 Simplifies budget.
 Avoids expensive mortgage
registration costs since
leasing generally does not
require collateral.
Why Lease
 At the end of the lease, can

return asset and enter into a
new lease for an upgraded
model.
Leasing: Types of Leases
 The basic types of leases:

Sale-and-leaseback
Operating leases
Financial (capital) leases
Sale and Leaseback
 A sale and leaseback

arrangement is a lease under
which the lessee sells an
asset for cash to a
prospective lessor and then
immediately leases back the
same asset for an extended
period of time.
Sale and Leaseback
 The sale and leaseback plan

is an alternative to taking out
a mortgage loan.
 The lessor realizes any
residual value.
Sale and Leaseback
 There may be a tax

advantage as land is not
depreciable, but the entire
lease payment is a
deductible expense.
Operating Lease
 An operating (or service)

lease is a cancelable
contractual arrangement
whereby the lessee agrees to
make periodic payments to
the lessor obtain an asset’s
services.
Operating Lease
 Generally, in an operating
lease the total payments
over the term of the lease
are less than the lessor’s
initial cost of the leased
asset (not fully
amortized).
Operating Lease
 If the operating lease is held

to maturity, the lessee
returns the leased asset over
to the lessor, who may lease
it again or sell the asset.
Operating Lease
 Assets that are leased under

operating leases have a
usable life that is longer than
the term of the lease.
 An operating lease provide
for both financing and
maintenance.
Financial Lease
 A financial (or capital)

lease is a longer-term lease
than an operating lease.
 Financial leases are non-
cancelable and obligates the
lessee to make payments for
the use of an asset over a
predefined period of time.
Financial Lease
 The total payments over the

term of the lease are greater
than the lessor’s initial cost
of the leased asset (fully
amortized).
Financial Lease
 Financial leases are

commonly used for leasing
land, buildings, and large
pieces of equipment.
 Does not provide for
maintenance services.
Financial Lease
 Since financial leases are

non-cancelable, it is similar
to a form of long-term debt.
 The lease payment becomes
a fixed, tax-deductible
expenditure to be paid at
predefined dates.
Financial Lease
 Difference from an operating

lease
 Non-cancelable
 No provision for
maintenance services
 Fully amortized
Leveraged Lease
 A leveraged lease is a
lease under which the lessor
acts as an equity participant,
supplying about 20 percent
of the cost of the asset with
a lender supplying the
balance.
Leveraged Lease
 In a leveraged lease the

role of the lessor changes as
the lessor is borrowing funds
itself to finance the lease for
the lessee (hence, leveraged
lease).
 Involves 3 parties – Lessee,
Lessor, and the Lender.
Leveraged Lease
 Any residual value belongs to

the lessor as well as any net
cash inflows during the
lease.
 Popular for big-ticket assets
such as aircraft, oil rigs, and
railway equipment.
Leasing
 Leasing is a substitute for

debt financing and, thus, uses
up a firm’s debt capacity.
 Often referred to as “off
balance sheet” financing if a
lease is not “capitalized.”
Leasing
 Leasing is “off balance

sheet” financing if neither the
leased assets nor the liabilities
under the lease contract
appear on the firm’s balance
sheet.
Leasing
 Financial lease elements:

The lease transfers
ownership of the property to
the lessee by the end of the
lease term.
Leasing

The lease contains an option
to purchase the property at
a “bargain price.” Such an
option must be exercisable
at a “fair market value.”
Leasing

The lease term is equal to 75
percent or more of the
estimated economic life of
the property (exceptions exist
for property leased toward
the end of its usable
economic life).
Leasing

At the beginning of the
lease, the present value of
the lease payments is equal
to 90 percent or more of the
fair market value of the
leased property.
Lease-Versus-Purchase Decision
 With an investment decision to

acquire an asset, a company
decides how to finance it.
 The lease-versus-purchase
decision is a common decision
faced by firms considering the
acquisition of a new asset.
 The lease-versus-purchase (or

lease-versus-buy) decision:
whether to lease the assets
or to purchase them,
using borrowed funds or
available liquid resources.
“Should I Lease or
Should I Buy?”
 The decision involves the

application of capital
budgeting techniques.
 The preferred method is the
calculation of NPV based on
the incremental cash flows
(lease versus purchase).
 The lease-versus-purchase
decision can be evaluated by
calculating the after-tax cash
outflows associated with the
leasing and purchasing
alternatives.
 Step 1: Find the after-tax cash

outflows for each year under
the lease alternative.
 Step 2: Find the after-tax cash
outflows for each year under
the purchase alternative
 Step 3: Calculate the present

value of the cash outflows
from Step 1 and Step 2 using
the after-tax cost of debt as
the discount rate.
 Step 4: Choose the alternative
with the lower present value
of cash outflows from Step 3.
 Methods of Analysis
Present value method (PV)
Compare PV’s of
alternatives
Lowest PV is the most
desirable
 Methods of Analysis
Internal rate of return (IRR)
Compare costs of lease or
borrowing
After-tax
Select alternative with
lowest rate
Advantages of Leasing
 The firm may avoid the cost

of obsolescence.
 A lessee avoids many of the
restrictive covenants that are
normally included as part of a
long-term loan.
 Sale-leaseback arrangements
may permit the firm to
increase its liquidity by
converting an existing asset
into cash, which may then be
used as working capital.
 Leasing allows the lessee, in

effect, to depreciate land,
which is prohibited if the land
were purchased.
 Leases may provide a larger
tax shield than that provided
by depreciation.
 Leasing—especially operating
leases—may provide the firm
with needed financial
flexibility.
Allows synchronization of
lease payments with the firm’s
cash cycle.
 Leasing provides 100%

financing.
 Ease of obtaining credit
It is often easier for riskier
firms to obtain a lease than to
obtain debt financing.
Conserves working capital.
Lease-Versus-Purchase Example
 New computer costs

$1,200,000.
 Tax rate = 40%.
 rd = 10%.
 Lease payment is
$340,000/year, payable at
beginning of each year.
 4-year lease includes

maintenance.
 Maintenance of $25,000/year,
payable at beginning of each
year.
 3-year MACRS class life (33-

45-15-7); 4-year economic
life.
 Residual value in Year 4 of
$125,000.
Depreciable basis = $1,200,000

Year MACRS Depreciation End-of-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
4 0.07 84,000 0
1.00 $1,200,000
 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.
 rd(1  T) = 10%(1 – 0.4)
= 6%.
 Cost of Owning Analysis

0 1 2 3 4
Cost of asset -1,200.0
Deprec. tax savings 158.4 216.0 72.0 33.6
Maintenance (AT) -15.0 -15.0 -15.0 -15.0
Residual value (AT) 75.0
Cash flow -1,215.0 143.4 201.0 57.0 108.6
PV of the cost of owning (@ 6%) = – $766.948

 Depreciation is a tax
deductible expense, so it
produces a tax savings of
T(Depreciation).
Year 1 = 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.
 Cost of Leasing Analysis

Each lease payment of $340 is
deductible, so the after-tax
cost of the lease is
(1 – T)($340) = $204.
 Cost of Leasing Analysis

0 1 2 3 4
A-T Lease pmt -204 -204 -204 -204
PV of the cost of leasing (@ 6%)

= – $749.294
 Net Advantage of Leasing

NAL = PV cost of owning –
PV cost of leasing
= $766.948 – $749.294
= $17.654
 Net Advantage of Leasing

Since the cost of owning
outweighs the cost of leasing,
the firm should lease.
 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.
 How would a cancellation

clause included in the lease
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.
Warrants
 A warrant is a long-term
option that gives its holder the
right to purchase a certain
number of shares of common
stock at a specified price over
a certain period of time.
Warrants
 A warrant is like an option.

It gives the holder the right
but not the obligation to buy
an underlying security at a
certain price, quantity and
future time.
Warrants
 A warrant is unlike an
option.
It is issued by a company,
whereas an option is an
instrument of the stock
exchange.
Warrants
 A warrant is unlike an
option.
The security represented in
the warrant is delivered by
the issuing company instead
of by an investor holding the
shares.
Warrants vs Call Options
 Major difference between

warrants and call options is
the source of the stocks.
Shares for warrants are new
issues while stocks for option
holders come from the
secondary market.
Warrants
 Warrants are like stock

rights in that
holders of warrants earn no
income from them until they
are exercised or sold.
provide a form of deferred
equity financing for a firm.
Warrants
 Warrants are often attached

to debt issues as “sweeteners”
To add to the marketability
of the issue.
To compensate for risk
thereby lower the required
interest rate.
Warrants
 Often, when a new firm is

raising its initial capital,
suppliers of debt will require
warrants to permit them to
share in whatever success the
firm achieves.
Warrants
 A warrant can also increase a

shareholder's confidence in a
stock, provided the underlying
value of the security actually
does increase over time.
Warrants: Key Characteristics
 The exercise (or strike)

price is the price at which
holders of warrants can
purchase a specified number
of shares of common stock.
This is usually set at 15–30%
above the market price of the
stock at the time of issuance.
 Holders of warrants will not

exercise them until the market
price exceeds the exercise
price.
 Warrants normally have a life
of no more than 10 years
although some have infinite
lives.
 The warrant contains

provisions for:
the number of shares that can
be purchased per warrant.
the price at which the warrant
can be exercised.
the warrant expiration date.
 Warrant holders are not

entitled to any dividends nor
do they have any voting
power.
 The exercise price is generally
adjusted for any common
stock dividends and splits.
 Warrants are usually

“detachable” meaning that
the bondholder may sell the
warrant without selling the
underlying security and are
often listed and actively
traded.
 The conversion ratio is the

number of warrants needed in
order to buy (or sell) one
investment unit.
 If the conversion ratio to buy

stock XYZ is 3:1, the holder
needs three warrants in order
to purchase one share.
 Usually, if the conversion ratio
is high, the price of the share
will be low, and vice versa.
Values of Warrants
 The implied price of a

warrant is the price
effectively paid for each
warrant attached to a bond.
Values of Warrants
 The straight-debt bond

value is the price at which
the bond would sell in the
market without the warrant
attached.
Values of Warrants
 The straight-debt bond

value equals the present
value of the bond’s interest
and principal payments
discounted at the rate the firm
would have to pay on a
straight bond.
Values of Warrants
 Dividing the implied price of

all warrants by the number of
warrants attached to each
bond results in the implied
value of each warrant.
Values of Warrants Example
 Marine Products just issued a

10.5%-coupon-interest-rate,
$1,000-par, 20-year bond
paying annual interest and
having 20 warrants attached
for the purchase of the firm’s
stock.
 The bonds were initially sold

for their $1,000 par value.
When issued, similar-risk
straight bonds were selling to
yield a 12% rate of return.
 The straight value of the bond

would be:
 Substituting the $1,000 price

of the bond with warrants
attached and the $887.96
straight bond value into the
equation:
Implied price of all warrants
= $1,000 -
$887.96 = $112.04
 Dividing the implied price of

all warrants by the number of
warrants attached to each
bond, 20 in this case :
Implied price of each warrant
= $112 ÷ 20 =
$5.60
 Therefore, by purchasing
Martin Marine Products’ bond
with warrants attached for
$1,000, one is effectively
paying $5.60 for each
warrant.
Values of Warrants
 Valuing the warrants correctly

is important.
If value is understated, there
would be more outstanding
warrants diluting equity of
original shareholders.
If value is overstated, the
issue would fail.
 A company recently issued

bonds with attached warrants.
The bond-plus-warrants
package sells at a price equal
to its $1,000 face value.
 The bonds mature in 10 years
and have a 6% annual
coupon.
 The company also has 10-

year with straight debt (with
no warrants) outstanding.
 The straight debt has a yield
to maturity of 8%.
 What is the straight debt

value of the bonds?
$865.80
 What is the value of the
warrants?
$134.20
A Firm Wants to Issue a Bond with Warrants
Package at a Face Value of $1,000
 Current stock price (P ) = $10.

0
 r of equivalent 20-year annual

d
payment bonds without warrants
= 12%.
 50 warrants attached to each
bond with an exercise price of
$12.50.
 Estimate of each warrant’s value
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.
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%.
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 for each warrant
exercised is $17.50
– $12.50 = $5.00.
What is the expected rate of return to holders
of bonds with warrants, if exercised in 5 years
at P5 = $17.50?
 Each bond has 50 warrants,

so on a par bond basis,
Opportunity cost =
50($5.00) = $250.
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
IRR = 12.93%
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.
Interpreting the opportunity cost of capital
for the bond with warrants package
 The cost is lower than the

cost of equity because part of
the return is fixed by contract.
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.
If after the issue, the warrants sell for $2.50
each, what would this imply about the value
of the package?
 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.
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.
Warrants: Stepped-up Exercise Price
 In a stepped-up exercise
price, the exercise price of a
warrant increases in steps
over the warrant’s life.
Optimal Times to Exercise Warrants
 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.
Optimal Times to Exercise Warrants
 Since no dividends are earned

on the warrant, holders will
tend to exercise voluntarily if
a stock’s dividend rises
enough.
Value of a Warrant
 A warrant has both a market

value and theoretical
value.
 The theoretical value of a
warrant is the amount one
would expect the warrant to
sell for in the marketplace.
Value of Warrants
 The warrant premium is the

difference between the
market value and the
theoretical value of a warrant.
 Generally, a warrant will sell
in the open market at a
premium above its theoretical
Value of Warrants
 Only when the theoretical

value is very high, or the
warrant is near its expiration
date are the market value and
theoretical values close.
Value of Warrants
 The greater market value is

generated by the unlimited
upside potential of the stock
price combined with the
limited downside risk to the
warrant holder (minimum
value is 0).
Value of Warrants
 The greater the time to

expiration, the greater the
opportunity of the upside
potential of the stock and the
greater the market value of
the warrant.
Value of Warrants
 The theoretical value of a

warrant: TVW = (P0 – E) x N
where TVW = theoretical
value of a warrant
P0 = current market price of
common stock
E = exercise price of the warrant
N = number of shares of common
Value of Warrants Example
 Stan has $2430 to invest in

Dustin Electronics. Its stock is
currently selling at $45 and its
warrants at $18 per warrant
which entitles holders to
purchase 3 shares of common
stock.
 Should Stan use his money to

buy Dustin Electronics stocks
or the warrants? Which is
more risky?
 He could purchase 54 shares

of common stock at $45 per
share, or 135 warrants at $18
per warrant, ignoring
brokerage fees.
 If Stan purchases the stock

and its price rises to $48, he
will gain $162 ($3 per share x
54 shares) by selling the
stock.
 If instead he purchases the

135 warrants and the stock
price increases by $3 per
share, he will gain $1,215.
 The price of each warrant can
be expected to rise by $9.
Convertibles
 Convertible Security is a
bond or a preferred stock that
is exchanged into a specified
number of shares of common
stock at the option of the
holder.
Convertibles
 The conversion option allows

the company to sell
convertible securities at a
lower yield than it would
have to pay on a straight
bond or preferred stock issue.
Convertibles: General Features
 Convertibles do not provide

additional funds to the firm,
unlike warrants.
 Debt is replaced by common
stock in the balance sheet.
 The conversion ratio (CR)

is the number of shares of
common stock that are
obtained by converting a
convertible security.
 The conversion ratio (CR)

is equal to the face value of
the convertible security
divided by the conversion
price.
 The conversion price (P ) is c

the effective price paid for
common stock obtained by
converting security.
 The Pc is set at 10 to 20%
above the market price of the
common stock.
 The conversion price (P ) is c

equal to the face value of the
convertible security divided by
the number of shares received
(CR).
Convertibles: Example
 Western has outstanding bond

that has a $1,000 par value
and is convertible into 25
shares of common stock. The
bond’s conversion ratio is 25.
 The conversion price for the
bond is $40 per share ($1,000
÷ 25).
Convertibles: Example
 Mosher Co. has outstanding a

convertible 20-year bond with
a par value of $1,000. The
bond is convertible at $50 per
share into common stock.
 The conversion ratio is 20
($1,000 ÷ $50).
 Generally, conversion price

and conversion ratio are fixed
for the life of the bond.
 A stepped-up conversion price
may also be used.
 The conversion price on 20-

year convertible-debt might
“step-up” over time from $30
during the first 5 years, $35
the next 5 years, and $40 for
the remaining 10 years until
maturity.
 What happens to the

conversion ratio on 20-year
convertible-debt with the
“step-up” feature on the
conversion price?
 The conversion value (C ) t

is the value of the convertible
measured in terms of market
price of the common stock
into which it can be
converted.
Ct = Pt x CR
 MC Industries has outstanding

$1,000 bond convertible into
common stock at
$62.50/share.
 The conversion ratio is 16
($1,000 ÷ $62.50).
 If the current market price of

the common stock is
$65/share, the conversion
value is $1,040 (16 x $65).
 Because the conversion is
above the bond value of
$1,000, conversion is a viable
option for the owner.
 3 Values of a Convertible
Bond
Straight bond value
Conversion value
Market value
 The actual market value of

the bond cannot fall below
the higher of the straight
bond value or its conversion
value.
The Firm is 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.
The Firm is Considering a Callable,
Convertible Bond Issue
 Call the bonds when

conversion value > $1,200.
 P0 = $10; D0 = $0.74;
g = 8%.
 Conversion ratio = CR = 80
shares.
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 above the stock
price on the issue date.
What is the convertible’s straight-debt
value?
 The straight-debt value is

$850.61.
 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.
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, conversion value is
C10 = 80($10)(1.08) 10
=
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.
What is meant by the floor value of a
convertible?
 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.
When is the issue expected to be
called?
 The firm intends to force

conversion when C = $1,200.
 Solve 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.
called?
C = CR(P0)(1 + g)
t
t
=
80 ( 10 )(1.08) t
Ct = $1,200
t = 5.27 years
called?
 What is the convertible’s

expected cost of capital to the
firm, if converted in Year 5?
0 1 2 3 4 5
1,000 -100 -100 -100 -100 -100

-1,200
-1,300
 Solving for IRR = 13.08%.
Is the cost of the convertible consistent
with the riskiness 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.
Is the cost of the convertible consistent
with the riskiness of the issue?
 From previous information:

rs = $0.74(1.08)/$10 + 0.08
= 16.0%.
 rc is between rd and rs, and is
consistent.
Convertibles: Advantages to Issuer
 Offer a company the chance

to sell debt with a low interest
rate for a chance to
participate in the company’s
success if it does well.
Convertibles: Advantages to Issuer
 Provide a way to sell common

stock at prices higher than
those currently prevailing.
Convertibles: Disadvantages to
Issuer
 If the stock price increased

greatly, the firm would have
been better off had it used
straight debt and then sold
common stock.
Convertibles: Disadvantages to
Issuer
 Advantage of low cost debt

will be lost when conversion
occurs.
 The company will be stuck
with debt if the stock price
does not rise sufficiently.
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.
Besides cost, what other factor should be
considered when using hybrid securities?
 The firm’s future needs for

capital:
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.
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.
Other Issues Regarding the Use of
Hybrid Securities
 Does the firm want to commit

to 20 years of debt?
If stock price does not rise
over time, then neither
warrants nor convertibles
would be exercised. Debt
would remain outstanding.

Hybrid Financing: Preferred Stock, Leasing, Warrants, and Convertibles

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Hybrid Financing: Preferred Stock, Leasing, Warrants, and Convertibles

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Chapter 20

Hybrid Financing: Preferred

 A hybrid security is a form

 In their simplest form, bonds

 Preferred stocks are like

 Preferred stocks are like

 It has a par value.

 Most issues are cumulative

 Some preferred stocks have

 From the viewpoint of

 Adjustable rate preferred

 Passing a dividend cannot

 Preferred stock dividends are

 Leasing and buying are

 Leasing is the process by

 The lessee is the receiver of

 Lessee may lack sufficient

 The lessor may possess

 Preserves bank credit lines

 At the end of the lease, can

 The basic types of leases:

 A sale and leaseback

 The sale and leaseback plan

 There may be a tax

 An operating (or service)

 If the operating lease is held

 Assets that are leased under

 A financial (or capital)

 The total payments over the

 Financial leases are

 Since financial leases are

 Difference from an operating

 In a leveraged lease the

 Any residual value belongs to

 Leasing is a substitute for

 Leasing is “off balance

 Financial lease elements:

 Financial lease elements:

 Financial lease elements:

 Financial lease elements:

 With an investment decision to

 The lease-versus-purchase (or

 The decision involves the

 Step 1: Find the after-tax cash

 Step 3: Calculate the present

 The firm may avoid the cost

 Leasing allows the lessee, in

 Leasing provides 100%

 New computer costs

 4-year lease includes

 3-year MACRS class life (33-

Depreciable basis = $1,200,000

 In a lease analysis, at what

 Since cash flows in a lease

 Cost of Owning Analysis

PV of the cost of owning (@ 6%) = – $766.948

 Each maintenance payment

 The ending book value is $0

 Cost of Leasing Analysis

 Cost of Leasing Analysis

A-T Lease pmt -204 -204 -204 -204

PV of the cost of leasing (@ 6%)

 Net Advantage of Leasing