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.

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. 2. Each maintenance payment of $25 is deductible so the after-tax cost of the lease is (1 T)($25) = $15. 3. The ending book value is $0 so the full $125 salvage (residual) value is taxed, (1 - T)($125) = $75.0.
1.

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.

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 (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 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

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%.

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 cant 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 warrants 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 stocks 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.

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.

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.

Is the cost of the convertible consistent with the riskiness of the issue?
To be consistent, we require that kd < kc < ke.
The convertible bonds 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 firms 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 lowcoupon 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.

Slides Distribution:
Slide 1 5 (Huzefa)
Slide 6 11 (Faiza) Slide 12 15 (Tehseen)

Slide 16 19 (Aleeya)
Slide 20 22 (Farrukh)

 'Warrant'
A derivative security that gives the holder the right to purchase securities (usually equity) from the issuer at a specific price within a certain time frame. Warrants are often included in a new debt issue as a "sweetener" to entice investors.

'Preferred Stock'
A class of ownership in a corporation that has a higher claim on the assets and earnings than common stock. Preferred stock generally has a dividend that must be paid out before dividends to common stockholders and the shares usually do not have voting rights.

'Lease '
An agreement in which one party gains a long-term rental agreement, and the other party receives a form of secured long-term debt.

'Convertibles'
Securities, usually bonds or preferred shares, that can be converted into common stock. Convertibles are most often associated with convertible bonds, which allow bond holders to convert their creditor position to that of an equity holder at an agreed upon price. Other convertible securities can include notes and preferred shares, which can possess many different traits.