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,Click to edit Master title style,Click to edit Master text styles,Second level,Third level,Fourth level,Fifth level,*,20-,*,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.”,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 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%.,k,d,=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,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,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=10%(1 T)=10%(1 0.4)=,6%,.,0 1 2 3 4,Cost of Owning Analysis,Cost of asset(1,200.0),Dep.tax savings,1,158.4 216.0 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.,Analysis in thousands:,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,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.,0 1 2 3 4,A-T Lease pmt -204,-204,-204,-204,Analysis in thousands:,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 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 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(P,0,)=$10.,k,d,of equivalent 20-year annual payment bonds without warrants=12%.,50 warrants attached to each bond with an exercise price of$12.50.,Each warrants 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,V,Package,=,V,Bond,+,V,Warrants,=$1,000.,V,Warrants,=50($1.50)=$75.,V,Bond,+$75=$1,000,V,Bond,=$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%.,INPUTS,OUTPUT,N,I/YR,PMT,PV,FV,20,12,110,1000,-925,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
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