HYBRID FINANCING
PREPARED BY: LEYLA B. MALIJAN
MBAN 1216
OBJECTIVES
• Identify the basic features of preferred stock and explain its advantages
and disadvantages;
• Differentiate among the types of leases, discuss the effects of leasing in
financial statement, and evaluate a lease;
• Explain what warrants are and how they are used, and analyze their cost
to the firm &
• Explain what convertibles are and how they are used, and analyze their
cost to the firm.
HYBRID FINANCING
• Is a combined face of equity and debt
• In which the characteristics of both equity and bonds can be found
Different Types:
 Preferred Stock
 Leasing
 Warrants
 Convertible Debentures/Bonds
PREFERRED STOCK
• Hybrid financing instruments having several benefits and
disadvantages of using them as a source of capital
• Carries a fixed rate of dividend which is payable in the
discretion of directors when the company has distributable
surplus
PREFERRED STOCK
ADVANTAGES
DISADVANTAGES
• No legal obligation for dividend
payment
• Skipping dividend disregard
market image
• Improves borrowing capacity
• Costly source of finance
• No dilution in control
• Preference in claims
• No charge on assets
ADVANTAGES
• NO LEGAL OBLIGATION FOR DIVIDEND PAYMENT
There is no compulsion of payment of preference dividend because
nonpayment of dividend does not amount to bankruptcy. This dividend is not a
fixed liability like the interest on the debt which has to be paid in all circumstances.
• IMPROVES BORROWING CAPACITY
Preference shares become a part of net worth and therefore reduces debt
to equity ratio. This is how the overall borrowing capacity of the company
increases.
ADVANTAGES
• NO DILUTION IN CONTROL
Issue of preference share does not lead to dilution in control of existing
equity shareholders because the voting rights are not attached to the issue of preference
share capital.
• NO CHARGE ON ASSETS
While taking a term loan security needs to be given to the financial institution in
the form of primary security and collateral security. There are no such requirements and
therefore, the company gets the required money and the assets also remain free of any kind
of charge on them.
DISADVANTAGES
• COSTLY SOURCE OF FINANCE
Preference shares are considered very costly source of finance which is apparently
seen when they are compared with debt as a source of finance. The interest on the debt is
a tax-deductible expense whereas the dividend of preference shares is paid out of the
divisible profits of the company i.e. profit after taxes and all other expenses.
• SKIPPING DIVIDEND DISREGARD MARKET IMAGE
Skipping of dividend payment may not harm the company legally but it would
always create a dent on the image of the company.
DISADVANTAGES
• PREFERENCE IN CLAIMS
Preference shareholders enjoy a similar situation like that of an equity shareholder
but still gets a preference in both payment of their fixed dividend and claim on assets at the
time of liquidation.
LEASE
• Often referred to as “off balance sheet” financing if a lease is
not “capitalized.”
• Is a substitute for debt financing and, thus, uses up a firm’s debt
capacity.
• Is a very important financing option for an entrepreneur with
no or inadequate money for financing the initial investment
required in plant and machinery.
TYPES OF LEASE
Finance/Capital Lease - is a type of lease wherein the lessor transfers
substantially all the risks and rewards related to the asset to the lessee.
Ex. Big equipment
 Ownership is transferred to the lessee
 The lease term is spread over the asset life
 Not cancellable
 Does not provide for maintenance service
 Fully amortized
TYPES OF LEASE
Operating Lease - risk and rewards are not transferred completely to
the lessee. Ex. Sound system
 The term of a lease is very small compared to the finance lease
 The lessor depends on many different lessees for recovering his cost
 The lessor provides additional services such as maintenance in using
the equipment
TYPES OF LEASE
Sale and Leaseback – occurs when the seller transfers an asset to the
buyer, and then leases the asset from the buyer
 The consideration paid for the asset is accounted for as a financing transaction by
both parties.
 If there is a repurchase option under which the seller can later buy back the asset,
then the initial transaction cannot be considered a sale.
 If a sale and leaseback transaction is not considered a sale, then the seller-lessee
cannot derecognize the asset, and accounts for any amounts received as a liability.
Also, the buyer-lessor does not recognize the transferred asset, and accounts for any
amount paid as a receivable.
TYPES OF LEASE
Single Investor Lease - The lessor arranges the money to finance the asset
or equipment by way of equity or debt. The lender is entitled to recover money
from the lessor only and not from the lessee in case of default by a lessor. Lessee
is entitled to pay the lease rentals only to the lessor.
Leveraged Lease – Three parties are involved – lessor, lessee and the financier
or lender. Equity is arranged by the lessor and debt is financed by the lender or
financier. There is a direct connection of the lender with the lessee and in case of
default by the lessor, the lender is also entitled to receive money from the lessee.
TYPES OF LEASE
Domestic Lease - when all the parties to the lease agreement reside in
the same country.
International Lease
 Import Lease - when lessor and lessee reside in the same country
and equipment supplier stays in a different country.
 Cross-boarder Lease - when the lessor and lessee are residing in
two different countries and no matter where the equipment supplier
stays.
ANALYSIS: LEASE VS. BORROW-AND-BUY
Data:
• New computer costs $1,200,000.
• 3-year MACRS class life; 4-year economic life.
• Tax rate = 40%.
• kd = 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.
DEPRECIATION SCHEDULE
Depreciable basis = $1,200,000
MACRS
Year Rate
1
0.33
2
0.45
3
0.15
4
0.07
1.00
Depreciation
Expense
$ 396,000
540,000
180,000
84,000
$1,200,000
End-of-Year
Book Value
$804,000
264,000
84,000
0
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
COST OF OWNING ANALYSIS
Analysis in thousands:
0
1
2
3
4
Cost of asset
(1,200.0)
Dep. tax savings1
158.4 216.0
72.0 33.6
Maint. (AT)2
(15.0) (15.0) (15.0) (15.0)
Res. value (AT)3 ______ _____ _____ _____ 75.0
Net cash flow
(1,215.0) 143.4 201.0
57.0 108.6
PV cost of owning 4 (@ 6%) = -$766.948.
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.
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.
1.
NOTES ON COST OF OWNING ANALYSIS
4. Computation of PV cost of owning (Discounted Cash Flow)
0 yr
1st yr DCF=143.4/(1+6%)1 =
2nd yr DCF=143.4/(1+6%)2 =
3rd yr DCF=143.4/(1+6%)3 =
4th yr DCF=143.4/(1+6%)4 =
(1,215.0 )
135.283
178.889
47.858
86.021
(766.948)
COST OF LEASING ANALYSIS
Analysis in thousands:
A-T Lease pmt
0
1
2
3
-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.
4
NET ADVANTAGE OF LEASING
• NAL = PV cost of owning – PV cost of leasing
• NAL = $766.948 - $749.294
(Dollars in thousands)
= $17.654
DECISION:
• Since the cost of owning outweighs the cost of
leasing, the firm should lease.
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.
WARRANTS AND CONVERTIBLES
• Warrants bring in new capital while convertibles do not.
• Warrants typically have shorter maturities than convertibles,
and expire before the accompanying debt.
• A convertible bond consists of a fixed rate bond plus a call
option.
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.
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%.
INPUTS
OUTPUT
20
12
-925
N
I/YR
PV
1000
PMT
110
FV
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.
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-themoney 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.
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.
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.
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.
FINDING THE OPPORTUNITY COST OF
CAPITAL FOR THE BOND WITH
WARRANTS PACKAGE
• Here is the cash flow time line:
0
1
...
+1,000 -110
4
-110
-250
-360
5
-110
6
-110
-1,000
-1,110
19
...
-110
20
-110
• Input the cash flows into a financial calculator (or spreadsheet) and find IRR = 12.93%.
This is the pre-tax cost.
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.
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.
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.
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.
INPUTS
OUTPUT
20
12
N
I/YR
PV
-850.61
100
1000
PMT
FV
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.
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.
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.
Thank you and
Thank
youus
& all !!!
God bless
God bless us all !!!