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
rate
Depreciation End-of-Year
expense
Book Value
1
2
3
4
0.33
0.45
0.15
0.07
$396,000
540,000
180,000
84,000
1.00
$1,200,000
$804,000
264,000
84,000
0
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
Cost of asset
Depr’n tax savings
Maintenance (A-T)
Residual value (A-T)
Net cash flow
0
-1,200.0
1
2
3
158.4 216.0 72.0
-15.0 -15.0 -15.0 -15.0
-1,215.0 143.4 201.0
4
33.6
75.0
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
A-T Lease pmt


0
1
2
-204
-204
-204
3
4
-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
(Dollars in thousands)
= $17.654
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 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 floatingrate 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.
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
OUTPUT
20
12
-925
N
I/YR
PV
1000
PMT
FV
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

0
Here is the cash flow time line:
1
4
5
6
...
+1,000 -110

19
20
-110
-110
-1,000
-1,110
...
-110
-110 -110
-250
-360
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, 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.
20-20
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
OUTPUT
20
12
N
I/YR
PV
100
1000
PMT
FV
-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.


C0 = $800.
At t = 10, the floor value is $1,727.14.


Straight-debt value0 = $850.61.
Straight-debt value10 = $887.00.
C10 = $1,727.14.
Convertibles usually sell above floor value
because convertibility has an additional value.
20-25
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.
INPUTS
N
OUTPUT
8
-800
0
1200
I/YR
PV
PMT
FV
5.27
20-26
What is the convertible’s expected cost of
capital to the firm, if converted in Year 5?
0
1
1,000
-100

2
-100
3
-100
4
-100
5
-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 lowcoupon 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