Slide Financial Management - Chapter 20 pptx

„ To account for the risk introduced by an uncertain residual value, a higher discount rate should be used to discount the residual value.. A firm wants to issue a bond with warrants pac

„ 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.

In a lease analysis, at what discount rate should cash flows be discounted?

ƒ Since cash flows in a lease analysis are

evaluated on an after-tax basis, we should

use the after-tax cost of borrowing

ƒ Previously, we were told the cost of debt, kd, was 10% Therefore, we should discount

cash flows at 6%

Notes on Cost of Owning Analysis

1 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

Cost of Leasing Analysis

so the after-tax cost of the lease is

(1-T)($340) = -$204.

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 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

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.

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

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 can’t sell for less).

„ Therefore, warrants tend not to be

exercised until just before they expire.

Optimal times to exercise

„ 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

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?

$17.50 for one warrant plus $12.50

The opportunity cost to the company is

warrant exercised

bond basis, opportunity cost =

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

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

convertible bond will sell at its $1,000

par value; straight debt issue would

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

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.

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

What is the formula for the bond’s

expected conversion value in any year?

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.

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

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

„ Input the cash flows from the

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