Principles of Managerial Finance Brief Edition

1. Principles of Managerial FinanceBrief Edition Chapter 18 Hybrid And Derivative Securities

2. Learning Objectives • Differentiate between hybrid and derivative securities and their roles in the corporation. • Review the basic types of leases, leasing arrangements, the lease versus purchase decision, the effects of leasing on future financing, and the advantages and disadvantages of leasing. • Describe the basic types of convertible securities, their general features, and financing with convertibles.

3. Learning Objectives • Demonstrate the procedures for determining the straight bond value, conversion (or stock) value, and market value of a convertible bond. • Explain the basic characteristics of stock purchase warrants, the implied price of an attached warrant, and the values of warrants. • Define the options and discuss the basics of calls and puts, options markets, options trading, the role of call and put options in fund raising, and hedging foreign currency exposures with options.

4. An Overview of Hybrids & Derivatives • In their simplest form, bonds are pure debt and common stocks are pure equity. • Preferred stocks, on the other hand, are a hybrid of the two. • They are like common stocks in that they promise to pay dividends, are perpetual, and represent ownership. • They are like bonds in that dividends are fixed like bond interest payments. • Other hybrid securities include financial leases, convertible securities, and stock purchase warrants.

5. An Overview of Hybrids & Derivatives • The latter part of this chapter focuses on derivative securities. • Derivatives are securities that is neither debt nor equity but derives its value from an underlying asset that is often another security. • Derivative securities are not used by corporations to raise funds. • Rather, they serve as a useful tool for managing certain aspects of firm risk.

6. Leasing 租賃 • Leasing is the process by which a firm can obtain the use of certain fixed assets for which it must make a series of contractual, periodic, tax-deductible payments. • The lessee is the receiver of the services of the assets under a lease contract. • The lessor is the owner of the assets that are being leased. 承租人 出租人

7. Leasing 如電腦、汽車 承租人可選擇取消此租約，但需付罰款 Operating Leases • An operating lease is a cancelable contractual arrangement whereby the lessee agrees to make periodic payments to the lessor, often for 5 or fewer years, to obtain an assets services. • Generally, the total payments over the term of the lease are less than the lessor’s initial cost of the leased asset. • If the operating lease is held to maturity, the lessee returns the leased asset over to the lessor, who may lease it again or sell the asset，有時租約會載明給承租人在到期時優先購置此資產的權利 • 該租賃資產之壽命通常長於租約期間

8. Leasing Financial (or Capital) Leases • A financial lease is a longer-term lease than an operating lease. • Financial leases are non-cancelable and obligate the lessee to make payments for the use of an asset over a predefined period of time. • The total payments over the term of the lease are greater than the lessor’s initial cost of the leased asset. • Financial leases are commonly used for leasing land, buildings, and large pieces of equipment. 所以對承租人而言，資本租賃就像長期負債，其租賃費用就像利息支出，可節稅，沒繳錢也會導致破產

9. Leasing Leasing Arrangements • A direct lease is a lease under which a lessor owns or acquires the assets that are leased to a given lessee. • A sale-leaseback arrangement is a lease under which the lessee sells an asset for cash to a prospective lessor and then leases back the same asset. • A leveraged lease is a lease under which the lessor acts as an equity participant, supplying about 20 percent of the cost of the asset with a lender supplying the balance. 當承租人有資產但需要現金時 適用於非常昂貴的資產

10. Leasing Leasing Arrangements 維護條款 • Operating leases normally require maintenance clauses requiring the lessor to maintain the assets and to make insurance and tax payments. • Renewal options are provisions that grant the lessee the option to re-lease assets at the expiration of the lease. • Finally, purchase options are provisions frequently included in both operating and financial leases that allow the lessee to purchase the asset at maturity -- usually at a pre-specified price. 出租人 續約權 承租人 承租人

11. Leasing The Lease-Versus-Purchase Decision • The lease-versus-buy decision is a common decision faced by firms considering the acquisition of a new asset. • This decision involves the application of capital budgeting techniques as does any other asset investment acquisition decision. • The preferred method is the calculation of NPV based on the incremental cash flows (lease versys buy) using the following steps:

12. Leasing 指借錢購置 The Lease-Versus-Purchase Decision • STEP 1: Find the after-tax cash outflows for each year under the lease alternative. • STEP 2: Find the after-tax cash outflows for each year under the purchase alternative • STEP 3: Calculate the present value of the cash outflows from Step 1 and Step 2 using the after-tax cost of debt as the discount rate. • STEP 4: Choose the alternative with the lower present value of cash outflows.

13. Leasing The Lease-Versus-Purchase Decision Roberts Company, a small machine shop, is contemplating acquiring a new machine tool costing $24,000. Arrangements can be made to lease or purchase. The firm is in the 40 percent tax bracket. Lease. The firm would obtain a 5-year lease requiring annual end-of-year payments of $6,000. All maintenance costs will be borne by the lessor, and the lessee would exercise the option to purchase the machine for $4,000 at termination of the lease. Assume this is an operatinglease! 出租人 承租人

14. Leasing The Lease-Versus-Purchase Decision Purchase. The firm would finance the purchase of the machine with a 9%, 5-year loan requiring end-of-year installment payments of $6,170. It would be depreciated under MACRS using a 5-year recovery period. The firm would pay $1,500 per year for a service contract that covers all maintenance costs; insurance and other costs would be borne by the firm. The firm plans to keep the machine and use it beyond its 5-year recovery period.

15. Leasing The Lease-Versus-Purchase Decision STEP 1: Find the after-tax cash outflows for each year under the lease alternative. The after-tax cash outflow from the lease payments can be found as follows: A-T Outflow from Lease = $6,000 x (1 - t) = $6,000 x (1 - .40) = $3,600 In the final year, the $4,000 cost of the purchase option would be added to the $3,600 lease outflow to get a year 5 outflow of $7,600. After tax

16. Leasing The Lease-Versus-Purchase Decision STEP 2: Find the after-tax cash outflows for each year under the purchase alternative. First, the annual interest component of each loan payment must be determined since only interest can be deducted for tax purposes as shown in Table 18.1 on the following slide. Second, the A-T outflows must be computed as shown in Table 18.2.

17. Leasing The Lease-Versus-Purchase Decision

18. Leasing The Lease-Versus-Purchase Decision p.96 20% 32% 19% 12% 12% 5% 可忽略，雖較不精確，在此只考慮5年內的cash flows

19. Leasing The Lease-Versus-Purchase Decision STEP 3: Calculate the present value of the cash outflows from Step 1 and Step 2 using the after-tax cost as the discount rate

20. Leasing The Lease-Versus-Purchase Decision 9%×(1-40%)=5.4%，但考慮舉債的發行成本，所以用6% why not consider營運收入及其他營業費用? ∵lease和purchase都會有

21. Leasing The Lease-Versus-Purchase Decision STEP 4: Choose the alternate with the smaller present value of cash outflows. Because the present value of cash outflows for leasing ($18,151) is lower than that for purchasing ($19,539), the leasing alternative is preferred -- resulting in an incremental savings of $1,388.

22. Leasing Effects of Leasing on Future Financing • FASB, No. 13 requires explicit disclosure of financial lease obligations on the firm’s balance sheet. • Financial lease must be shown as a capitalized lease, meaning that the present value of all payments are included as an asset and corresponding liability. • An operating lease on the other hand, need not be capitalized, but must be reported in the footnotes. • Because the consequences of missing financial lease payments are the same as that of missing the principal and interest payment on debt, a financial analyst must view the lease as a long-term debt payment.

23. Leasing Advantages of Leasing • The firm may avoid the cost of obsolescence if the lessor fails to accurately anticipate the obsolescence of assets and sets the lease payment too low. • A lessee avoids many of the restrictive covenants that are normally included as part of a long-term loan. • Leasing -- especially operating leases -- may provide the firm with needed financial flexibility. • Sale-leaseback arrangements may permit the firm to increase its liquidity by converting an existing asset into cash, which may then be used as working capital. 營業租賃較易發生 低成本，不會常需要購置的資產 因不需要安排其他的融資

24. Leasing 會計處理(承租人) 1.營業租賃 2.資本租賃 資本租賃每期認列depreciation expense ，每期再攤銷應付租賃款並認列利息費用 在資本租賃裡，要將應付租賃款分年攤還(資本化處理)，所以應付租賃款(也就是Capitalized lease value)= 租金費用 xxx 現金 xxx 租賃資產 xxx 應付租賃款 xxx 固定資產 長期負債 應付租賃款 xxx 利息費用 xxx 現金 xxx

25. Leasing 承租人承租土地後，每期租賃費用可節稅 Advantages of Leasing • Leasing allows the lessee, in effect, to depreciate land, which is prohibited if the land were purchased. • Because it results in the receipt of service from an asset possibly without increasing the assets or liabilities on the firm’s balance sheet, leasing may result in misleading financial ratios. • Leasing provides 100 percent financing. • When the firm becomes bankrupt or is reorganized, the maximum claim of lessors against the corporation is 3 years of lease payments, and the lessor gets the asset back. i.e.低估資產與負債，可美化報表，如asset turnover, 但這只會發生在營業租賃 與一般之債權人相較

26. Leasing 很多時候出租人的報酬其實是相當高的 Disadvantages of Leasing • A lease does not have a stated interest cost. • At the end of the term of the lease agreement, the salvage value of an asset, if any, is realized by the lessor. • Under a lease, the lessee is generally prohibited from making improvements on the leased property or asset without approval of the lessor. • If a lessee leases an asset that subsequently becomes obsolete, it must still make lease payments over the remaining term of the lease. 除非承租人於期滿後買下該資產

27. Convertible Securities • A conversion feature is an option that is included as part of a bond or preferred stock issue that allows its holder to change the security into a stated number of shares of common stock. • The conversion feature typically enhances the value of the issue.

28. Convertible Securities Types of Convertible Securities • A convertible bond can be changed into a specified number of shares of common stock. • It is almost always a debenture - an unsecured bond - with a call feature. • Because the conversion feature provides the purchaser with the possibility of becoming a shareholder on favorable terms, convertible bonds are generally a less expensive form of financing than similar-risk nonconvertible or straight bonds. Issuer可retire或encourage conversion of outstanding convertible bonds when appropriate Cost of capital較低

29. Convertible Securities Types of Convertible Securities • A convertible preferred stock is a preferred stock that can be changed into a specified number of shares of common stock. • It can normally be sold with a lower stated dividend than a similar-risk nonconvertible preferred stock. • This is because the convertible preferred holder is assured of the fixed dividend payment and also may receive the appreciation resulting from increases in the market price of the underlying common stock.

30. Convertible Securities General Features of Convertibles • The conversion ratio is the ratio at which a convertible security can be exchanged for common stock and can be state in two ways: • in terms of a given number of shares of common Western Wear Company, a manufacturer of denim products, has anoutstanding bond with a $1,000 par value and convertible into 25 shares of common stock. The bond’s conversion ratio is 25. The conversion price for the bond is $40 per share ($1,000 ÷25).

31. Convertible Securities General Features of Convertibles • The conversion ratio is the ratio at which a convertible security can be exchanged for common stock and can be state in two ways: • in terms of a given number of shares of common • by dividing the par value of the convertible by the conversion price Mosher Company, a franchisor of seafood restaurants, has outstanding a convertible 20-year bond with a par value of $1,000. The bond is convertible at $50 per share into common stock. The conversion ratio is 20 ($1,000÷ $50). issuer在發行可轉債時，會將conversion price設定在當時的股票市價之上

32. Convertible Securities General Features of Convertibles • The conversion (or stock) value is the value of the convertible measured in terms of market price of the common stock into which it can be converted. McNamara Industries, a petroleum processor, has outstanding a $1,000 bond that is convertible into common stock at $62.50 per share. The conversion ratio is therefore 16 ($1,000 ÷ $62.50). Because the current market price of the common stock is $65 per share, the conversion value is $1,040 (16 x $65). Because the conversion value is above the bond value of $1,000, conversion is a viable option for the owner.

33. Convertible Securities General Features of Convertibles • The presence of contingent securities, which include convertibles, warrants, and stock options, affects the reporting of the firm’s EPS. • Firms with contingent securities that if converted would dilute EPS are required to report earnings in two ways -- basic EPS and diluted EPS. Basic EPS are calculated without regard to contingent securities. They are found by dividing earnings available to common stockholders by the number of shares of common stock outstanding.

34. Convertible Securities General Features of Convertibles • The presence of contingent securities, which include convertibles, warrants, and stock options, affects the reporting of the firm’s EPS. • Firms with contingent securities that if converted would dilute EPS are required to report earnings in two ways -- basic EPS and diluted EPS. Diluted EPS are calculated under the assumption that all contingent securities are converted, and are therefore common stock.

35. Convertible Securities 公司發行C.B.的動機 • Convertible securities can be used as a form of deferred common stock financing. • Convertible securities can be used as a sweetener by giving the purchaser an opportunity to share in the firm’s success by converting to common stock. • Convertibles can normally be sold with lower interest rates than nonconvertibles. • Convertibles can be sold with fewer restrictive covenants than nonconvertibles. • Convertibles can be used to raise cheap funds temporarily. 日後股價上升後，可轉債才會真的被轉換成普通股，等於可以發行較少的股數，減少EPS的dilution Debt，而非一開始就用較貴的普通股去募資。 等日後公司的投資案成功，股價上漲後，convertibles會被轉換成普通股，公司的資本結構也會轉成less leveraged

36. Convertible Securities Overhanging Issue of a Convertible Bond 當股價上升到超過conversion price時，通常C.B.的市價也會上升到很接近conversion value，所以C.B. holder不會選擇convert。為了預防發生這樣的情形，issuer會加入call feature to encourage or “force” conversion。例如：設定call price為C.B.的par value再加上一個call premium(如：C.B.的一年票面利息 通常issuer會等股價上升到使得conversion value超過 call price的10%-15%以上，才會去行使call privilege。因為唯有這樣，issuer才能確保當他exercise call privilege時，C.B. holder會自動convert成股票，不是接受issuer的call 但是當股價上升程度不夠，使得“force conversion”不會產生時，這樣的callable C.B.稱為「overhanging issue」，這對 issuer很不好，因為issuer若要call, C.B. holder會選擇不要convert，就讓issuer去call, 這時 issuer要花大錢 。 *去call這些C.B.，資金來源若是發行股票，則需發行較多的張數，因為股價還可以更高，現在股價相對較低，所以會稀釋股東之所有權) 。資金來源若是舉債，則會提高leverage(或是不變)。

37. Convertible Securities Determining the Value of a Convertible Bond • The straight bond value of a convertible bond is the price at which it would sell in the market without the conversion feature. • The straight value is typically the floor, or minimum, price at which it would be traded. Duncan Company, a southeastern discount chain, has just sold a $1,000 par value, 20-year convertible with a 12% coupon rate. Interest will be paid at the end of each year, and the principal will be repaid at maturity. A straight bond could have been sold with a 14% coupon but the conversion feature compensates for the lower rate on the convertible. The straight value could be calculated as:

38. Convertible Securities Determining the Value of a Convertible Bond • The straight bond value of a convertible bond is the price at which it would sell in the market without the conversion feature. • The straight value is typically the floor, or minimum, price at which it would be traded. N=20 years Par value=$1,000 Coupon rate=12% Yield to maturity k=14%

39. Convertible Securities Determining the Value of a Convertible Bond • The straight bond value of a convertible bond is the price at which it would sell in the market without the conversion feature. • The straight value is typically the floor, or minimum, price at which it would be traded. • This value, $867.76, is the minimum price at which the convertible is expected to sell.

40. Convertible Securities Conversion (or Stock) Value • The conversion value of a convertible is the value of the convertible measured in terms of the market price of the common stock into which the security can be converted. • When the market price of the common stock exceeds the conversion price, the conversion value exceeds the par value. Duncan Company’s convertible bond described earlier is convertible at $50 per share. Each bond can therefore be converted into 20 shares of common stock. The conversion values of the bond when the stock is selling at $30, $40, $50, $60, $70, and $80 are shown as follows:

41. Convertible Securities Conversion (or Stock) Value 股票市價超過conversion price時 Conversion value也會超過par value

42. Convertible Securities Conversion (or Stock) Value • When the market price of the common stock exceeds the $50 conversion price, the conversion value exceeds the $1,000 par value. • Because the straight bond is $876.76, the bond will never sell for less than this amount regardless of how low its conversion value is. • If the market price were $30, the bond would still sell for $876,76 -- not $600 -- because its value as a bond would dominate.

43. Convertible Securities Market Value • The market value of a convertible bond is likely to be greater than its straight value or conversion value. • The amount by which its market value exceeds its straight or conversion value is called the market premium. • This relationship can be described graphically as shown in Figure 18.1

44. Convertible Securities Market Value Straight bond 是降低損失的保障，而market premium則是因為conversion value帶來的capital gain of C.B. $876.76 當股價超過x點時，conversion value 就超過straight bond value ，此時。Conversion value就成為C.B.的market value的下限。反之當股價下跌到低於x點時，straight bond value就會為C.B.的market value 的下限。 斜率=20 =conversion ratio Conversion price

45. Stock Purchase Warrants • A stock purchase warrant is a security that gives its holder the right to purchase a certain number of shares of common stock at a pre-specified price over a certain period of time. • Warrants are like stock rights (described in Chapter 2) in that holders of warrants earn no income from them until they are exercised or sold. • They also bear some similarity to convertibles in that they provide for the injection of additional equity capital into the firm at some future date.

46. Stock Purchase Warrants Basic Characteristics • Warrants are often attached to debt issues as “sweeteners” to add to the marketability of the issue and lower the required interest rate. • The price at which warrant holders can purchase a specified number of common shares is normally referred to as the exercise (or option) price which is normally set at 10 to 20 percent above the market price of the common stock at the time of issuance. • Warrants normally have a life of no more than 10 years although some have infinite lives. 通常是non-callable • 當股票市價超過exercise price時，warrant holder 才會去exercise 或者減少restrictive covenant

47. Stock Purchase Warrants Basic Characteristics • Warrants are usually “detachable” meaning that the bondholder may sell the warrant without selling the underlying security and are often listed and actively traded. • Like rights, warrants provide a form of deferred equity financing. • Unlike rights, warrants are exercisable for a period of years and are issued at a exercise price above the prevailing market price of the firm’s common stock. • Warrant和C.B.的比較： • C.B. convert 後 leverage減少的程度要超過warrant 被 exercise 後 leverage減少的程度 • C.B.被convert後，並沒有現金流入公司，但warrant被exercise(通常是股價大漲)後，會有現金流入公司。 Rights的壽命只有幾個月，且其subscription price (exercise price)通常比當時股票市價還低

48. Stock Purchase Warrants The Implied Price of an Attached Warrant • When attached to a bond, the implied price of a warrant can be found by using the following equation. Implied price of all warrants = price of bond with warrants attached – straight bond value (18.1) • The straight bond value is found in a fashion similar to that found using convertible bonds. • Dividing the implied price of all warrants by the number of warrants attached to each bond results in the implied price of each warrant.

49. Stock Purchase Warrants The Implied Price of an Attached Warrant Martin Marine Products, a manufacturer of marine drive shafts and propellers, just issued a 10.5% coupon, $1,000 par value, 20-year bond paying annual interest and having 20 warrants attached for the purchase of common stock. The bonds were initially sold at $1,000. When issued the similar risk straight bonds were selling to yield 12%. The straight value of the bond would be the present value of its payments discounted at the 12% yield on similar-risk straight bonds.

50. Stock Purchase Warrants The Implied Price of an Attached Warrant • Substituting the $1,000 price of the bond with warrants attached and the $888 straight bond value into equation 18.1, we get an implied price of all warrants of $112 as follows: