Hybrid Financing - Asset Managment - Lecture Slides, Slides of Management Fundamentals

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20-120-

CHAPTER

Hybrid

Financing:

Preferred

Stock,

Leasing,

Warrants,

and

Convertibles

 Preferred stock  Leasing  Warrants  Convertibles

20-

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-

Depreciation

schedule

Depreciable basis

MACRS

Depreciation End

of

Year Year Rate Expense Book Value 1

20-

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, k d

was 10%. Therefore, we should discount cash flows at 6%. A

T

kd

T)

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20-

Notes

on

Cost

of

Owning

Analysis

Depreciation is a tax deductible expense, so it produces a tax savings of T(Depreciation). Year

Each maintenance payment of

is deductible so the after

tax cost of the lease is

T)($25)

The ending book value is

so the full

salvage (residual) value is taxed,

T)($125)

20-

Cost

of

Leasing

Analysis

Each lease payment of $ is deductible, so the after ‐ tax cost of the lease is ( ‐ T)($340) = ‐ $204. - PV cost of leasing (@6%) = ‐ $749.294. **0 1 2 3 4 A-T Lease pmt

-** Analysis in thousands:

20- Suppose there is a great deal of uncertainty regarding the computer’s residual value

Residual value could range from

to

and has an expected value of

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-

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-

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 floating rate preferred stock may have too much price instability for the liquid asset portfolios of many corporate investors.

20- 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- What coupon rate should be set for this bond plus warrants package?

Step 1

Calculate the value of the bonds in the package V Package = V Bond + V Warrants = $1,000. V Warrants = 50($1.50) = $75. V Bond + $ = $1, V Bond = $925.

20- Calculating required annual coupon rate for bond with warrants package

Step

Find coupon payment and rate.

Solving for PMT, we have a solution of $110, which corresponds to an annual coupon rate of $ / $1, = 11%. INPUTSOUTPUT N I/YR PMT PV FV 20 12 110 1000 -

20-

Assume

the

warrants

expire

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.

20-

Optimal

times

to

exercise

warrants

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.