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1、Preferred stock Leasing Warrants Convertibles Recent innovations,CHAPTER 20 Hybrid Financing: Preferred Stock, Leasing, Warrants, and Convertibles,Leasing,Leasing is sometimes referred to as “off balance sheet” financing if a lease is not “capitalized.” In other words, it is not shown on the balance
2、 sheet. Leasing is a substitute for debt financing and, thus, uses up a firms debt capacity.,(More.),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.,Analysis: Lease vs. B
3、orrow-and-Buy,Data: New machine costs $1,200,000. 3-year MACRS class life; 4-year economic life. Tax rate of 40%. kd = 10%.,(More.),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,
4、 payable at beginning of each year.,Depreciation Schedule,Depreciable basis = $1,200,000,MACRS Depreciation End-of-Year 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, what discount rate should c
5、ash flows be discounted at?,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%.,Cost of Ow
6、ning Analysis (In Thousands),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 ( 6%) = -$766,948.,0,1,2,3,4,(More.),Notes: 1 Depreciation is a tax ded
7、uctible 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.,Cost of Leasing Ana
8、lysis (In Thousands),Lease pmt (AT)1 -204 -204 -204 -204 PV cost of leasing ( 6%) = -$749,294. Note: 1Each lease payment of $340 is deductible, so the after-tax cost of the lease is (1 T)($340) = -$204.,0,1,2,3,4,Net Advantage of Leasing,Since the cost of owning outweighs the cost of leasing, the fi
9、rm should lease.,Suppose computers residual value could be as low as $0 or as high as $250,000, but expected value is $125,000. How could the riskiness of the SV be incorporated in the analysis? What effect would this have on lease decision?,To account for risk, the rate used to discount the SV woul
10、d be increased; therefore, the cost of owning would be even higher. Leasing becomes even more attractive.,What effect would a cancellation clause have on the riskiness of the lease?,A cancellation clause lowers the risk of the lease to the lessee, but increases the risk to the lessor.,Preferred divi
11、dends are fixed, but they may be omitted without placing the firm in default. Most preferred stocks prohibit the firm from paying common dividends when the preferred is in arrears. Usually cumulative up to a limit.,How does preferred stock differ from common equity and debt?,Dividends are indexed to
12、 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.,What is floating rate preferred?,However, if the issuer is risky, the floating rate preferred stoc
13、k may have too much price instability for the liquid asset portfolios of many corporate investors.,A warrant is a long-term call option. A convertible consists of a fixed rate bond plus a call option.,How can a knowledge of call options help one understand warrants and convertibles?,P0 = $10. kd of
14、20-year annual payment bond without warrants = 12%. 50 warrants with an exercise price of $12.50 each are attached to bond. Each warrants value will be $1.50.,Given the following facts, what coupon rate must be set on a bond with warrants if the total package is to sell for $1,000?,Step 1: Calculate
15、 VBond,VPackage = VBond + VWarrants = $1,000. VWarrants = 50($1.50) = $75. VBond + $75 = $1,000 VBond = $925.,Step 2: Find Coupon Payment and Rate,N,I/YR,PV,PMT,FV,20 12 -925 1000,Solution: 110,Therefore, the required coupon rate is $110/$1,000 = 11%.,The package would actually have been worth Vpack
16、age = $925 + 50($2.50) = $1,050, which is $50 more than the actual selling price.,If after issue the warrants immediately 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
17、have offered fewer warrants with a higher exercise price. Current stockholders are giving up value to the warrant holders.,Generally, a warrant will sell in the open market at a premium above its theoretical value (it cant sell for less). Therefore, warrants tend not to be exercised until just befor
18、e they expire.,Assume that the warrants expire 10 years after issue. When would you expect them to be exercised?,In a stepped-up exercise price, the exercise price increases in steps over the warrants life. Because the value of the warrant falls when the exercise price is increased, step-up provisio
19、ns 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 stocks dividend rises enough.,When exercised, each warrant will bring in the exercise price, $12.50. This is equity capital an
20、d 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.,Will the warrants bring in additional capital when exercised?,No. As we shall see, the warrants have a cost that must be added to the coupo
21、n interest cost.,Because warrants lower the cost of the accompanying debt issue, should all debt be issued with warrants?,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. Bond has 50 warrants, so on a par bond bas
22、is, opportunity cost = 50($5.00) = $250.,What is the expected return to the holders of the bond with warrants (or the expected cost to the company) if the warrants are expected to be exercised in 5 years when P = $17.50?,Here is the cash flow time line:,0 1 4 5 6 19 20 +1,000 -110 -110 -110 -110 -11
23、0 -110 -250 -1,000 -360 -1,110,Input the cash flows in the calculator to find IRR = 12.93%. This is the pre-tax cost of the bond and warrant 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,
24、 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-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
25、value $1,200. P0 = $10; D0 = $0.74; g = 8%. Conversion ratio = CR = 80 shares.,Assume the following convertible bond data:,What conversion price (Pc) is built into the bond?,The conversion price is typically set 10% to 30% above the stock price on the issue date.,$1,000 80,Pc = = = $12.50.,Par value
26、 # Shares received,Examples of real convertible bonds issued by Internet companies,Issuer A B CNET DoubleClick Mindspring NetBank PSINet SportsL,Size of issue $1,250 mil 55 mil 173 mil 250 mil 180 mil 100 mil 400 mil 150 mil,Cvt Price $156.05 18.34 74.81 165 62.5 35.67 62.36 65.12,Price at issue $12
27、2 16 84 134 60 32 55 52,What is (1) the convertibles straight debt value and (2) the implied value of the convertibility feature?,PV,FV,20 12 100 1000,Solution: -850.61,I/YR,PMT,N,Straight debt value:,Because the convertibles will sell for $1,000, the implied value of the convertibility feature is $
28、1,000 $850.61 = $149.39. = $1.87 per share. The convertibility value corresponds to the warrant value in the previous example.,Implied Convertibility Value,$149.39 80 shares,Conversion value = Ct = CR(P0)(1 + g)t. t = 0 C0 = 80($10)(1.08)0 = $800. t = 10 C10 = 80($10)(1.08)10 = $1,727.14.,What is th
29、e formula for the bonds expected conversion value in any year?,The floor value is the higher of the straight debt value and the conversion value. Straight debt value0 = $850.61. C0 = $800. Floor value at Year 0 = $850.61.,What is meant by the floor value of a convertible?,Straight debt value10 = $88
30、7.00. C10 = $1,727.14. Floor value10 = $1,727.14. Convertible will generally sell above its floor value prior to maturity because convertibility option has an additional value.,The firm intends to force conversion when C = 1.2($1,000) = $1,200. When is the issue expected to be called?,PV,FV,8 -800 0
31、 1200,Solution: N = 5.27,I/YR,PMT,N,What is the convertibles expected cost of capital to the firm? Assume conversion in Year 5 at $1,200.,0 1 2 3 4 5,1,000 -100 -100 -100 -100 -100 -1,200 -1,300,Input the cash flows in the calculator and solve for IRR = 13.08%.,For consistency, need kd kc ke. Why? T
32、he convertible bonds risk is a blend of the risk of debt and equity, so kc should be in between the cost of debt and equity.,Does the cost of the convertible appear to be consistent with the riskiness of the issue?,kd = 12% and kc = 13.08%. ks = + g = + 0.08 = 16.0%. Since kc is between kd and ks, t
33、he consistency requirement is met.,Check the values:,D0(1+g) P0,$0.74(1.08) $10,The firms 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. H
34、owever, debt ratio is lowered, so new debt can be issued.,Besides cost, what other factors should be considered?,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.,