Chapter 20 hybrid financing preferred stock leasing warrants and convertibles
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CHAPTER 20 Hybrid Financing: Preferred Stock, Leasing, Warrants, and Convertibles. Preferred stock Leasing Warrants Convertibles. Leasing. Often referred to as “off balance sheet” financing if a lease is not “capitalized.”

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

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

Preferred stock

Leasing

Warrants

Convertibles


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.


Analysis: Lease vs. Borrow-and-buy

Data:

  • New computer costs $1,200,000.

  • 3-year MACRS class life; 4-year economic life.

  • Tax rate = 40%.

  • kd = 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.


Depreciation schedule

Depreciable basis = $1,200,000

MACRS DepreciationEnd-of-Year

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

    A-T kd = 10%(1 – T) = 10%(1 – 0.4) =6%.


Cost of Owning Analysis

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 57.0108.6

PV cost of owning (@ 6%) = -$766.948.


Notes on Cost of Owning Analysis

  • Depreciation is a tax deductible expense, so it produces a tax savings of T(Depreciation). Year 1 = 0.4($396) = $158.4.

  • Each maintenance payment of $25 is deductible so the after-tax cost of the lease is (1 – T)($25) = $15.

  • The ending book value is $0 so the full $125 salvage (residual) value is taxed, (1 - T)($125) = $75.0.


Cost of Leasing Analysis

0 1 2 3 4

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

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

Analysis in thousands:

A-T Lease pmt -204 -204 -204 -204


Net advantage of leasing

  • NAL = PV cost of owning – PV cost of leasing

  • NAL= $766.948 - $749.294

    = $17.654

  • Since the cost of owning outweighs the cost of leasing, the firm should lease.

(Dollars in thousands)


Suppose there is a great deal of uncertainty regarding the computer’s 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 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.


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.


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.

  • Preferred dividends are cumulative up to a limit.

  • Most preferred stocks prohibit the firm from paying common dividends when the preferred is in arrears.


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.


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.


A firm wants to issue a bond with warrants package at a face value of $1,000. Here are the details of the issue.

  • Current stock price (P0) = $10.

  • kd of equivalent 20-year annual payment bonds without warrants = 12%.

  • 50 warrants attached to each bond with an exercise price of $12.50.

  • Each warrant’s value will be $1.50.


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

  • Step 1 – Calculate the value of the bonds in the package

    VPackage = VBond + VWarrants = $1,000.

    VWarrants = 50($1.50) = $75.

    VBond + $75= $1,000

    VBond= $925.


Calculating required annual coupon rate for bond 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%.

20

12

-925

1000

INPUTS

N

I/YR

PV

PMT

FV

OUTPUT

110


If after the issue, the warrants sell for $2.50 each, what would this imply about the value of the package?

  • The package would have been worth $925 + 50(2.50) = $1,050. This is $50 more than the actual selling price.

  • 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.


Assume 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.


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.


Will the warrants bring in additional capital when exercised?

  • When exercised, each warrant will bring in the exercise price, $12.50, per share exercised.

  • 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.


Because warrants lower the cost of the accompanying debt issue, should all debt be issued with warrants?

  • No, the warrants have a cost that must be added to the coupon interest cost.


What is the expected rate of return to holders of bonds with warrants, if exercised in 5 years at P5 = $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, for each warrant exercised.

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


0 1 4 5 6 19 20

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

-250-1,000

-360 -1,110

...

...

Finding the opportunity cost of capital for 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.


Interpreting the opportunity cost of capital for the bond with warrants 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, which are riskier than interest income.

  • The cost is lower than the cost of equity because part of the return is fixed by contract.


The firm is now considering a callable, convertible bond issue, described below:

  • 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.


What conversion price (Pc) is implied by this bond issue?

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

  • The conversion price is usually set 10% to 30% above the stock price on the issue date.


What is the convertible’s straight debt value?

  • Recall that the straight debt coupon rate is 12% and the bond’s have 20 years until maturity.

20

12

100

1000

INPUTS

N

I/YR

PV

PMT

FV

OUTPUT

-850.61


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.


What is the formula for the bond’s expected 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.


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.

  • 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 value because convertibility has an additional value.


The firm intends to force conversion when C = 1.2($1,000) = $1,200. When is the issued expected to be called?

  • We are solving for the period of time until the conversion value equals the call price. After this time, the conversion value is expected to exceed the call price.

8

-800

0

1200

INPUTS

N

I/YR

PV

PMT

FV

OUTPUT

5.27


What is the convertible’s expected cost of capital to the firm, if converted in Year 5?

0 1 2 3 4 5

  • Input the cash flows from the convertible bond and solve for IRR = 13.08%.

1,000 -100 -100-100 -100 -100

-1,200

-1,300


Is the cost of the convertible consistent with the riskiness of the issue?

  • To be consistent, we require that kd < kc < ke.

  • The convertible bond’s risk is a blend of the risk of debt and equity, so kc should be between the cost of debt and equity.

    • From previous information, ks = $0.74(1.08) / $10 + 0.08 = 16.0%.

  • kc is between kd and ks, and is consistent.


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

  • 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.


Other issues regarding the use of hybrid securities

  • 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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