Business finance ch 20 hybrid financing

A firm wants to issue a bond with warrants package at a face value of $1,000.. Calculating required annual coupon rate for bond with warrants package  Step 2 – Find coupon payment and

 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

 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.

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%

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

3. The ending book value is $0 so the

Cost of Leasing Analysis

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

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

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

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

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

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

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.

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.

0 1 4 5 6 19 20

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

-250 -1,000 -360 -1,110

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

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%

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,

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

What is the formula for the bond’s expected conversion value in any

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

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

convertible bond and solve for IRR

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 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