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  • 8/14/2019 Hybrid 24c

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    Hybrid Financing: PreferredStock, Leasing, Warrants, and

    Convertibles

    Chapter 20

    Preferred Stock

    Leasing

    Warrants

    Convertibles

    20-1

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    Leasing

    Often referred to as off balance sheetfinancing if a lease is not capitalized.

    Leasing is a substitute for debt financing and,

    thus, uses up a firms debt capacity. Capital leases are different from operating

    leases:

    Capital leases do not provide for maintenanceservice.

    Capital leases are not cancelable.

    Capital leases are fully amortized.

    20-2

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    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

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    Depreciation Schedule

    Depreciable basis = $1,200,000

    Year MACRS

    Rate

    Depreciation

    Expense

    End-of-Year

    Book Value

    1 0.33 $ 396,000 $804,000

    2 0.45 540,000 264,000

    3 0.15 180,000 84,0004 0.07 84,000 0

    1.00 $1,200,000

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    In a lease analysis, at what discountrate should cash flows be discounted?

    Since cash flows in a lease analysis areevaluated on an after-tax basis, we shoulduse the after-tax cost of borrowing.

    Previously, we were told the cost of debt, rd,was 10%. Therefore, we should discountcash flows at 6%.

    A-T rd= 10%(1T) = 10%(10.4) = 6%.

    20-5

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    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

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    Notes on Cost of Owning Analysis

    Depreciation is a tax deductible expense, soit produces a tax savings of T(Depreciation).

    Year 1 = 0.4($396) = $158.4.

    Each maintenance payment of $25 isdeductible so the after-tax cost of themortgage payment is (1T)($25) = $15.

    The ending book value is $0 so the full $125

    salvage (residual) value is taxed,(1T)($125) = $75.0.

    20-7

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    Cost of Leasing Analysis

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

    PV cost of leasing (@6%) = -$749.294.

    20-8

    0

    A-T Lease pmt

    1 2 3 4

    -204 -204 -204 -204

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    Net Advantage of Leasing

    NAL = PV cost of owningPV 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

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    What if there is a lot of uncertaintyabout the computers 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 anuncertain residual value, a higher discountrate should be used to discount the residualvalue.

    Therefore, the cost of owning would behigher and leasing becomes even moreattractive.

    20-10

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    What if a cancellation clause were included inthe lease? How would this affect the riskinessof the lease?

    A cancellation clause lowers the risk of thelease to the lessee.

    However, it increases the risk to the lessor.

    20-11

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    How does preferred stock differfrom common equity and debt?

    Preferred dividends are fixed, but they maybe 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 preferredis in arrears.

    20-12

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    What is adjustable-rate preferred?

    Dividends are indexed to the rate on treasurysecurities instead of being fixed.

    Excellent S-T corporate investment:

    Only 30% of dividends are taxable tocorporations.

    The adjustable rate generally keeps issue tradingnear par.

    However, if the issuer is risky, the adjustable-rate preferred stock may have too much priceinstability for the liquid asset portfolios of

    many corporate investors. 20-13

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    How can a knowledge of call options help oneunderstand warrants and convertibles?

    A warrant is a long-term call option.

    A convertible bond consists of a fixed-ratebond plus a call option.

    20-14

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    A Firm Wants to Issue a Bond with WarrantsPackage at a Face Value of $1,000

    Current stock price (P0) = $10.

    rdof equivalent 20-year annual paymentbonds without warrants = 12%.

    50 warrants attached to each bond with anexercise price of $12.50.

    Each warrants value will be $1.50.

    20-15

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    What coupon rate should be set for thisbond plus warrants package?

    Step 1: Calculate the value of the bonds inthe package

    VPackage= VBond+ VWarrants= $1,000.

    VWarrants= 50($1.50) = $75.

    VBond + $75 = $1,000

    VBond= $925.

    20-16

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    Calculating Required Annual Coupon Rate forBond 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

    N I/YR PMTPV FV

    20 12

    110

    1000-925

    20-17

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    What is the expected rate of return to holdersof bonds with warrants, if exercised in 5 yearsat P5= $17.50?

    The company will exchange stock worth$17.50 for one warrant plus $12.50. Theopportunity cost to the company is

    $17.50$12.50 = $5.00, for eachwarrant exercised.

    Each bond has 50 warrants, so on a parbond basis, opportunity cost = 50($5.00)= $250.

    20-18

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    Finding the Opportunity Cost of Capitalfor the Bond with Warrants Package

    Here is the cash flow time line:

    Input the cash flows into a financial calculator(or spreadsheet) and find IRR = 12.93%.This is the pre-tax cost.

    0 1 4 5 6 19 20

    +1,000 -110 -110 -110 -110 -110 -110

    -250 -1,000

    -360 -1,110

    ... ...

    20-19

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    The Firm is Now Considering a Callable,Convertible Bond Issue

    20-year, 10% annual coupon, callableconvertible bond will sell at its $1,000 parvalue; straight-debt issue would require a12% coupon.

    Call the bonds when conversion value >$1,200.

    P0= $10; D0= $0.74; g = 8%.

    Conversion ratio = CR = 80 shares.

    20-20

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    What conversion price (Pc) is implied bythis bond issue?

    The conversion price can be found by dividingthe par value of the bond by the conversionratio, $1,000/80 = $12.50.

    The conversion price is usually set 10% to30% above the stock price on the issue date.

    20-21

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    What is the convertibles straight-debt value?

    Recall that the straight-debt coupon rate is12% and the bonds have 20 years untilmaturity.

    INPUTS

    OUTPUT

    N I/YR PMTPV FV

    20 12 100 1000

    -850.61

    20-22

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    Implied Convertibility Value

    Because the convertibles will sell for$1,000, the implied value of theconvertibility 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 previousexample.

    20-23

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    What is the formula for the bondsexpected 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

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    What is meant by the floor value ofa 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 valuebecause convertibility has an additional value.

    20-25

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    When is the issue expected to becalled?

    The firm intends to force conversion whenC = 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 isexpected to exceed the call price.

    INPUTS

    OUTPUT

    N I/YR PMTPV FV

    5.27

    8 0 1200-800

    20-26

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    What is the convertibles expected cost ofcapital to the firm, if converted in Year 5?

    Input the cash flows from the convertiblebond and solve for IRR = 13.08%.

    20-27

    0

    1,000

    1 2 3 4 5

    -100 -100 -100 -100 -100

    -1,300-1,200

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    Is the cost of the convertible consistentwith the riskiness of the issue?

    To be consistent, we require that rd< rc< re.

    The convertible bonds risk is a blend of therisk of debt and equity, so rcshould be

    between the cost of debt and equity. From previous information:

    rs= $0.74(1.08)/$10 + 0.08 = 16.0%.

    rcis between rdand rs, and is consistent.

    20-28

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    Besides cost, what other factor should beconsidered when using hybrid securities?

    The firms future needs for capital:

    Exercise of warrants brings in new equity capitalwithout 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 canbe issued.

    20-29

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    Other Issues Regarding the Use ofHybrid Securities

    Does the firm want to commit to 20 years ofdebt?

    Conversion removes debt, while the exercise of

    warrants does not. If stock price does not rise over time, then

    neither warrants nor convertibles would beexercised. Debt would remain outstanding.

    20-30