Chapter 20

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
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 4 of $125,000.
 4-year lease includes maintenance.
 Lease payment is $340,000/year, payable at
beginning of each year.
20-3
Depreciation Schedule

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

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, rd,

was 10%. Therefore, we should discount
cash flows at 6%.

A-T rd = 10%(1 – T) = 10%(1 – 0.4) = 6%.

20-5
 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 (A-T) -15.0 -15.0 -15.0 -15.0
Residual value (A-T) 75.0
Net cash flow -1,215.0 143.4 201.0 57.0 108.6

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

20-6
Notes on Cost of Owning Analysis

 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
mortgage 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
Cost of Leasing Analysis

0 1 2 3 4
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
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
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
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 adjustable-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 adjustable rate generally keeps issue trading
near par.
 However, if the issuer is risky, the adjustable-
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

 Current stock price (P0) = $10.

 rd 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
VPackage = VBond + VWarrants = $1,000.

VWarrants = 50($1.50) = $75.

VBond + $75 = $1,000

VBond = $925.

20-16
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 20 12 -925 1000

N I/YR PV PMT FV
OUTPUT 110

20-17
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.

20-18
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.

20-19
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
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
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 20 12 100 1000

N I/YR PV PMT FV
OUTPUT -850.61

20-22
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
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
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
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 8 -800 0 1200

N I/YR PV PMT FV
OUTPUT 5.27

20-26
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

 Input the cash flows from the convertible

bond and solve for IRR = 13.08%.

20-27
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.
 From previous information:
rs = $0.74(1.08)/$10 + 0.08 = 16.0%.
 rc is between rd and rs, and is consistent.

20-28
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.

20-29
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