Business finance ch 20 hybrid financing

CHAPTER 20 Hybrid Financing: Preferred Stock, Leasing, Warrants, and Convertibles     Preferred stock Leasing Warrants Convertibles 20-1 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 firm’s debt capacity Capital leases are different from operating leases:    Capital leases not provide for maintenance service Capital leases are not cancelable Capital leases are fully amortized 20-2 Analysis: Lease vs Borrowand-buy Data:  New computer costs $1,200,000  3-year MACRS class life; 4-year economic life  Tax rate = 40%  k = 10% d  Maintenance of $25,000/year, payable at beginning of each year  Residual value in Year of $125,000  4-year lease includes maintenance  Lease payment is $340,000/year, payable 20-3 at beginning of each year Depreciation schedule Depreciable basis = $1,200,000 MACRS Depreciation End-of-Year Year Rate Expense Book Value 0.33 $ 396,000 $804,000 0.45 540,000 264,000 0.15 180,000 84,000 0.07 84,000 1.00 $1,200,000 20-4 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% 20-5 Cost of Owning Analysis Analysis in thousands: Cost of asset (1,200.0) Dep tax savings1 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 57.0 108.6 PV cost of owning (@ 6%) = -$766.948 20-6 Notes on Cost of Owning Analysis Depreciation is a tax deductible expense, so it produces a tax savings of T(Depreciation) Year = 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 20-7 Cost of Leasing Analysis Analysis in thousands: A-T Lease pmt -204 -204 -204 -204  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 20-8 Net advantage of leasing  NAL = PV cost of owning – PV cost of leasing  in thousands) NAL = $766.948(Dollars - $749.294 = $17.654  Since the cost of owning outweighs the cost of leasing, the firm should lease 20-9 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 20-10 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 20-22 What is the expected rate of return to holders of bonds with warrants, if exercised in 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 20-23 Finding the opportunity cost of capital for the bond with warrants package  Here is the cash flow time line: +1,000 -110  -110 -110 -250 -360 -110 19 20 -110 -110 -1,000 -1,110 Input the cash flows into a financial calculator (or spreadsheet) and find IRR = 12.93% This is the pre-tax cost 20-24 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 20-25 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% coupon Call the bonds when conversion value > $1,200 P0 = $10; D0 = $0.74; g = 8% Conversion ratio = CR = 80 shares 20-26 c implied by this bond issue? is   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 20-27 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 INPUTS OUTPUT 20 12 N I/YR PV 100 1000 PMT FV -850.61 20-28 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 warrant value in the previous example 20-29 What is the formula for the bond’s expected conversion value in any year?  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 20-30 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   C0 = $800 At t = 10, the floor value is $1,727.14   Straight debt value0 = $850.61 Straight debt value10 = $887.00 $1,727.14 C10 = Convertibles usually sell above floor value because convertibility has an additional value 20-31 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 INPUTS N OUTPUT -800 1200 I/YR PV PMT FV 5.27 20-32 What is the convertible’s expected cost of capital to the firm, if converted in Year 5? 1,000 -100  -100 -100 -100 -100 -1,200 -1,300 Input the cash flows from the convertible bond and solve for IRR = 13.08% 20-33 Is the cost of the convertible consistent with the riskiness of the issue?  To be consistent, we require that k d < kc < ke  The convertible bond’s risk is a blend of the risk of debt and equity, so k c 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 20-34 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 20-35 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 20-36 ... $75.0 20- 7 Cost of Leasing Analysis Analysis in thousands: A-T Lease pmt -204 -204 -204 -204  Each lease payment of $340 is deductible, so the after-tax cost of the lease is (1-T)($340) = - $204 ... beginning of each year  Residual value in Year of $125,000  4-year lease includes maintenance  Lease payment is $340,000/year, payable 20- 3 at beginning of each year Depreciation schedule Depreciable... 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   20- 15 What coupon rate should be set for this bond