LCASTOL

CHAPTER 20
HYBRID FINANCING: PREFERRED STOCK,
LEASING, WARRANTS & CONVERTIBLES
 LCASTOL
LEARNING OBJECTIVES
CH. 20 –Hybrid Financing: Preferred Stock, Leases, Warrants & Convertibles

Learning Objectives
After reading this chapter, students should be able to:
• Identify the basic features of preferred stock and explain its
advantages and disadvantages.
• Differentiate among the types of leases, discuss the financial
statement effects of leasing, and evaluate a lease.
• Explain what warrants are, how they are used, and analyze
their cost to the firm.
• Explain what convertibles are, how they are used, and
analyze their cost to the firm.
 HYBRID FINANCING
Definition
• A hybrid security is a single financial product
that combines different types of financial
securities, or has features of multiple kinds of
securities.
• Basic examples are the securities that has
aspects of both debt (bonds) and equity
(stocks). The security will have the guaranteed
payment nature of a bond while also having
the potential for capital appreciation of a
stock.

Examples
• Preferred stocks
• Convertible bonds
• Warrants
 LEASING
Definition
• 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.
• Lessee is the receiver of the services of the assets under the leasecontract; the lessor is the owner
of the assets. Leasing can take a number of forms
• 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 versus operating leases

• Capital leases do not provide for maintenance service.
• Capital leases are not cancelable.
• Capital leases are fully amortized
 LEASING –AN EXAMPLE
Lease vs. Borrow-and-Buy
Data:
• New computer costs $1,200,000.
• 3-year MACRS class life; 4-year economic life.
• Tax rate = 40%.
• rd = 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.

What discount rate should be used?

• 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, rd, was 10%. Therefore, we should discount cash flows at 6%.
rd(1  T) = 10%(1 – T) = 10%(1 – 0.4) = 6%.
 LEASING –AN EXAMPLE
Depreciation Schedule

Depreciable basis = $1,200,000

Year MACRS Rate Depreciation End-of-Year Book

Expense 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
 LEASING –AN EXAMPLE
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 maintenance payment 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.
0 1 2 3 4
Cost of asset -1,200.0
Deprec. tax savings 158.4 216.0 72.0 33.6
Maintenance (AT) -15.0 -15.0 -15.0 -15.0
Residual value (AT) 75.0
Cash flow -1,215.0 143.4 201.0 57.0 108.6

• PV of the cost of owning (@6%) = -$766.95

 LEASING –AN EXAMPLE

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

 LEASING –AN EXAMPLE
What is the Net Advantage of Leasing?
• A comparison of whether owning or leasing will cost more
PV cost of owning > PV cost of leasing = LEASE
PV cost of owning < PV cost of leasing = OWN
• NAL = PV cost of owning – PV cost of leasing
• NAL = $766.948 – $749.294
= $17.654 (Dollars in thousands)
• Since the cost of owning outweighs the cost of leasing, the firm should lease.
 LEASING –AN EXAMPLE
What if there is a lot of uncertainty about 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 because of a potential loss of income
 TYPES OF EQUITY SECURITIES
COMMON SHARES

1 • Also known as ordinary shares, or voting shares is the main type of equity security
issued by companies.
• A common share represents an ownership interest in a company.
• Common shares have an infinite life; in other words, they are issued without
maturity dates
• Examples: ALI, MBT, JFC, TEL, etc.

PREFERRED SHARES

2 • These shares are called preferred because owners of preferred stock will receive
dividends before common shareholders.
• They also have a higher claim on the company’s assets compared with common
shareholders if the company ceases operations. Most preferred stocks prohibit
the firm from paying common dividends when the preferred is in arrears
• Preferred stock has characteristics of both bonds and common stock which
enhances its appeal to certain investors.
• Voting or non-voting. Cumulative or non-cumulative. Participating or non-
participating
• Examples: SMC2C, ACP and PNX3A
 PREFERRED SHARE COUPON RATE
Fixed Rate
• Most preferred shares are fixed
Adjustable Rate
• Dividends are indexed to the rate on treasury securities instead of being fixed. (i.e. 3-month T-bill +
premium or 3-month PDST + premium)
• Adjustable rate generally keeps issue trading near par
• Excellent S-T corporate investment:
– Only 30% of dividends are taxable to corporations.
• However, if the issuer is risky, the adjustable-rate preferred stock may have too much price
instability for the liquid asset portfolios of many corporate investors.
Tax Rate
• Good investments because of tax rate
US – 30% to corporations
Philippines – 10% to individuals and 0% to corporations vs. 20% FWT for bonds
 TYPES OF EQUITY SECURITIES
STOCK RIGHTS

3 • A rights offering (rights issue) is a group of rights offered to existing shareholders

to purchase additional stock shares in proportion to their existing holdings during
a short period of time (1 to 2 weeks) 
• The subscription price at which each share may be purchased is generally
discounted relative to the current market price
• Examples: ACEN (1:1.11 shares) and CEB (1:1.1825 shares)

WARRANTS

4 • It entitles the holder to buy a pre-specified amount of common stock of the

issuing company at a pre-specified per share price (called the exercise price or
strike price) prior to a pre-specified expiration date that’s more than one year
• Warrants are traded and listed in the exchange
• Examples: LRW
 CONVERTIBLES
CONVERTIBLE BOND
• A convertible bond is a fixed-income corporate
debt security that yields interest payments, but
can be converted into a predetermined number
of common stock or equity shares.
• The conversion from the bond to stock can be
done at certain times during the bond's life
• A convertible bond offers investors features of a
bond, such as interest payments, while also
having the option to own the underlying stock.

CONVERTIBLE PREFERRED
• Convertible preferred stocks are preferred shares
that include an option for the holder to convert
the shares into a fixed number of common shares
after a predetermined date
• Worth to convert when stock price is above the
conversion price
• After a preferred shareholder converts their
shares, they give up their rights as a preferred
shareholder and become a common shareholder
 BONDS WITH WARRANTS
Definition & Features How can a knowledge of call options help one
• Bonds with warrants give the bondholder the understand warrants and convertibles?
right to buy a certain number of shares at a • A warrant is a long-term call option.
fixed price for a specified period of time. • A convertible bond consists of a fixed-rate bond plus a
• A $1,000 bond, for example, could come with a
call option.
warrant to buy 500 shares at $20 each. The
• An understanding of options will help financial
bondholder can exercise the warrant any time
during its life span, which could be a few years, managers make decisions regarding warrant and
or an indefinite future period. convertible issues.
• Warrants are detachable from the bond
• Bonds with warrants normally have lower
interest rates than normal bonds
 BONDS WITH WARRANTS – AN EXAMPLE
A Firm Wants to Issue a Bond with Warrants Package at a Face Value of $1,000
• Current stock price (P0) = $10.
• rd 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.
 BONDS WITH WARRANTS – AN EXAMPLE

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%.
• Coupon rate is less than 12% because the present value of the bond is only $925 and the holder
will receive $1,000 on maturity date

INPUTS 20 12 -925 1000

N I/YR PV PMT FV
OUTPUT 110
 BONDS WITH WARRANTS – AN EXAMPLE
What is the expected rate of return to holders of bonds with warrants, if exercised in 5 years at P 5
= $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.
• Here is the cashflow timeline:

0 1 4 5 6 19 20
... ...
+1,000 -110 -110 -110 -110 -110 -110
-250 -1,000
-360 -1,110

• Solve for YTM or IRR = 12.93% (pre-tax return) to the bondholder

 CONVERTIBLE BONDS – AN EXAMPLE
The firm is now considering a callable, convertible bond issue
• 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.
 CONVERTIBLE BONDS – AN EXAMPLE
What is the convertible’s straight debt value?
• Recall that the straight-debt coupon rate is 12% and the bonds have 20 years until maturity.

INPUTS 20 12 100 1000

N I/YR PV PMT FV
OUTPUT -850.61

• Cashflows is $100 annually and a YTM/IRR of 12%. Compute for PV

• Bond value = $850.61

What is the 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.

$149.39/80 = $1.87 per share

• The convertibility value corresponds to the warrant value in the previous example.
 CONVERTIBLE BONDS – AN EXAMPLE
What is the formula for the bond’s expected conversion value in any year?
• Conversion value is the amount an investor would received if a convertible security is changed into common
stock. This value is arrived at by multiplying the conversion ratio (how many shares received per bond) by
the market price of the common stock.
• Conversion value calculations are useful in determining break-even or floor values involved with holding
convertible securities.
• 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
• A key objective with a convertible security is to hold onto it until the market price is higher than the
conversion value, thus generating profit through the conversion and later sale of the common stock received
 CONVERTIBLE BONDS – AN EXAMPLE
What is meant by the floor value of a convertible?
• It is the lowest market value that the bond can have.
• 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.
 CONVERTIBLE BONDS – AN EXAMPLE
When is the issue expected to be called?
• The firm intends to force conversion when C = 1.2($1,000) = $1,200.
• 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.

INPUTS 8 -800 0 1200

N I/YR PV PMT FV
OUTPUT 5.27

• It’s like asking how long until l $800 becomes $1,200, when it grows by 8% annually
• Conversion value is expected to equal the call price of $1,200 after 5.27 years
 CONVERTIBLE BONDS – AN EXAMPLE
What is the convertible’s expected cost of capital to the firm, if converted in Year 5?
• Input the cash flows from the convertible bond and solve for YTM/IRR = 13.08%.

0 1 2 3 4 5

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

-1,200
-1,300
Is the cost of the convertible consistent with the risk of the issue?
• To be consistent, we require that rd < rc < re.
• The convertible bond’s risk is a blend of the risk of debt and equity, so rc should be between the
cost of debt and equity.
– From previous information:
re = $0.74(1.08)/$10 + 0.08 = 16.0%.
• rc is between rd and re, and is consistent.
OTHER ISSUES & FACTORS WITH HYBRID SECURITIES

Besides cost, what other factors 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
 POP QUIZ
Which of the following statements concerning warrants is most CORRECT?
 
a. Bonds with warrants and convertible bonds both have option features that their holders can exercise
if the underlying stock's price increases. However, if the option is exercised, the issuing company's
debt declines if warrants are used but remains the same if convertibles are used.
b. Warrants are long-term call options that have value because holders can buy the firm's common stock
at the exercise price regardless of how high the stock's price has risen.
c. A firm's investors would generally prefer to see it issue bonds with warrants than straight bonds
because the warrants dilute the value of new shareholders, and that value is transferred to existing
shareholders.
d. A drawback to using warrants is that if the firm is very successful, investors will be less likely to
exercise the warrants, and this will deprive the firm of receiving any new capital.

Answer: B
 POP QUIZ
Which of the following statements is most CORRECT?
 
a. Preferred stock generally has a higher component cost of capital to the firm than does common stock.
b. From the issuer's point of view, preferred stock is less risky than bonds.
c. Whereas common stock has an indefinite life, preferred stocks always have a specific maturity date,
generally 25 years or less.
d. Unlike bonds, preferred stock cannot have a convertible feature.

Answer: B
 POP QUIZ
In the lease-versus-buy decision, leasing is often preferable
 
a. Because, generally, no down payment is required, and there are no indirect interest costs.
b. Because lease obligations do not affect the firm's risk as seen by investors.
c. Because the lessee owns the property at the end of the lease term.
d. Because the lessee may have greater flexibility in abandoning the project in which the leased property
is used than if the lessee bought and owned the asset.

Answer: D
 POP QUIZ
Clickbait Inc. is considering issuing 15-year, 8% semiannual coupon, $1,000 face value convertible bonds at a
price of $1,000 each. Each bond would be convertible into 25 shares of common stock. If the bonds were
not convertible, investors would require an annual nominal yield of 10%. What is the straight-debt value of
each bond at the time of issue?
 
a. $725.58
b. $763.76
c. $803.96
d. $846.28

Answer: D
Bond par value $1,000 Straight-debt yield 10.0%
Maturity Years 15 I/YR 5.0%
No. of periods/yr. 2 Convertible coupon 8.0%
N 30 PMT 40
Conv. ratio (CR) 25
 
Find the straight-debt value: N = 30, I/YR = 5, PMT = -40, and FV = -1000.
PV = $846.28
 POP QUIZ
CirTechCompany (CTC) is evaluating a potential lease for a truck with a 4-year life that costs $40,000 and
falls into the MACRS 3-year class. If the firm borrows and buys the truck, the loan rate would be 9%, and
the loan would be amortized over the truck’s 4-year life. The loan payments would be made at the end of
each year. The truck will be used for 4 years, at the end of which time it will be sold at an estimated residual
value of $12,000. If CTC buys the truck, it would purchase a maintenance contract that costs $1,500 per
year, payable at the end of each year. The lease terms, which include maintenance, call for a $10,000 lease
payment (4 payments total) at the beginning of each year. CTC's tax rate is 35%. What is the net advantage
to leasing? (Note: MACRS rates for Years 1 to 4 are 0.33, 0.45, 0.15, and 0.07.)
 
a. $609
b. $642
c. $678
d. $715

Answer: D
 POP QUIZ
Lease analysis: 0 1 2 3
Life of equipment 4 Tax rate 35% 4
Equipment cost $40,000 Maint. costs $1,500 Lease payment -10,000 -10,000 -10,000
Interest rate 9.0% Residual value $12,000 -10,000 0
Lease payment $10,000 Tax savings on pmt 3,500 3,500 3,500
  3,500 0
Purchase analysis: 0 1 2 3 4 AT lease pmt -6,500 -6,500 -6,500
MACRS factor 0.33 0.45 0.15 0.07 -6,500 0
Depreciation 13,200 18,000 6,000 2,800  
  PV cost of leasing at I(1 – T) 5.85% -23,923
Equipment purchase -$40,000 NAL = $715
Maintenance -1,500 -1,500 -1,500 -1,500 They should therefore LEASE
Maint. tax savings (Maint. × T) 525 525 525 525
Deprec. tax savings (Deprec. × T) 4,620 6,300 2,100 980 Answer: D
Residual value 12,000
Tax on residual -4,200  
AT residual value 7,800
Total CFs -40,000 3,645 5,325 1,125 7,805
 
PV cost of buying at I(1 – T) 5.85% -24,638