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CHAPTER 20 Hybrid Financing: Preferred Stock, Leasing, Warrants, and Convertibles

CHAPTER 20 Hybrid Financing: Preferred Stock, Leasing, Warrants, and Convertibles. Preferred stock Leasing Warrants Convertibles Recent innovations. Leasing.

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CHAPTER 20 Hybrid Financing: Preferred Stock, Leasing, Warrants, and Convertibles

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  1. CHAPTER 20Hybrid Financing: Preferred Stock, Leasing, Warrants, and Convertibles • Preferred stock • Leasing • Warrants • Convertibles • Recent innovations

  2. 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 sheet. • Leasing is a substitute for debt financing and, thus, uses up a firm’s debt capacity. (More...)

  3. 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.

  4. Analysis: Lease vs. Borrow-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...)

  5. 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.

  6. 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

  7. In a lease analysis, what discount rate should cash 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-Tkd = 10%(1 – T) = 10%(1 – 0.4) =6%.

  8. Cost of Owning 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 (@ 6%) = -$766,948. (More...)

  9. Notes: 1 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.

  10. Cost of Leasing Analysis(In Thousands) 0 1 2 3 4 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.

  11. NAL = – = $766,948 – $749,294 = $17,654. PV cost of owning PV cost of leasing Net Advantage of Leasing Since the cost of owning outweighs the cost of leasing, the firm should lease.

  12. Suppose computer’s 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 would be increased; therefore, the cost of owning would be even higher. Leasing becomes even more attractive.

  13. 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.

  14. 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. • Most preferred stocks prohibit the firm from paying common dividends when the preferred is in arrears. • Usually cumulative up to a limit.

  15. 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.

  16. However, if the issuer is risky, the floating rate preferred stock may have too much price instability for the liquid asset portfolios of many corporate investors.

  17. How can a knowledge of call options help one understand warrants and convertibles? • A warrant is a long-term call option. • A convertible consists of a fixed rate bond plus a call option.

  18. 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? • P0 = $10. • kd of 20-year annual payment bond without warrants = 12%. • 50 warrants with an exercise price of $12.50 each are attached to bond. • Each warrant’s value will be $1.50.

  19. Step 1: Calculate VBond VPackage = VBond + VWarrants = $1,000. VWarrants = 50($1.50) = $75. VBond + $75 = $1,000 VBond = $925.

  20. Step 2: Find Coupon Payment and Rate 20 12 -925 1000 N I/YR PV PMT FV Solution: 110 Therefore, the required coupon rate is $110/$1,000 = 11%.

  21. If after issue the warrants immediately sell for $2.50 each, what would this imply about the value of the package? • The package would actually have been worth Vpackage = $925 + 50($2.50) = $1,050, which is $50 more than the actual selling price.

  22. 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.

  23. Assume that the warrants expire 10 years after issue. When would you expect them to be exercised? • Generally, a warrant will sell in the open market at a premium above its theoretical value (it can’t sell for less). • Therefore, warrants tend not to be exercised until just before they expire.

  24. 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-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 stock’s dividend rises enough.

  25. Will the warrants bring in additional capital when exercised? • When exercised, each warrant will bring in the exercise price, $12.50. • 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.

  26. Because warrants lower the cost of the accompanying debt issue, should all debt be issued with warrants? No. As we shall see, the warrants have a cost that must be added to the coupon interest cost.

  27. 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? • 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 basis, opportunity cost = 50($5.00) = $250.

  28. 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 in the calculator to find IRR = 12.93%. This is the pre-tax cost of the bond and warrant package.

  29. 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.

  30. Assume the following convertible bond data: • 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.

  31. What conversion price (Pc) is built into the bond? $1,000 80 Par value # Shares received Pc = = = $12.50. The conversion price is typically set 10% to 30% above the stock price on the issue date.

  32. Examples of real convertible bonds issued by Internet companies Issuer Amazon.com Beyond.com CNET DoubleClick Mindspring NetBank PSINet SportsLine.com 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 $122 16 84 134 60 32 55 52

  33. What is (1) the convertible’s straight debt value and (2) the implied value of the convertibility feature? Straight debt value: 20 12 100 1000 N I/YR PV FV PMT Solution: -850.61

  34. 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. $149.39 80 shares

  35. What is the formula for the bond’s expected conversion value in any year? 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.

  36. 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. • Straight debt value0 = $850.61. • C0 = $800. Floor value at Year 0 = $850.61.

  37. Straight debt value10 = $887.00. • 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.

  38. The firm intends to force conversion when C = 1.2($1,000) = $1,200. When is the issue expected to be called? 8 -800 0 1200 PMT PV FV I/YR N Solution: N = 5.27

  39. What is the convertible’s 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%.

  40. Does the cost of the convertible appear to be consistent with the riskiness of the issue? • For consistency, need kd < kc < ke. • Why? • The convertible bond’s risk is a blend of the risk of debt and equity, so kc should be in between the cost of debt and equity.

  41. Check the values: kd = 12% and kc = 13.08%. ks = + g = + 0.08 = 16.0%. Since kc is between kd and ks, the consistency requirement is met. D0(1+g) P0 $0.74(1.08) $10

  42. Besides cost, what other factors should be considered? • 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.

  43. 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.

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