Assignment 6 controllership

Tesla’s Investors Love the Convertible

Although most companies primarily rely on tra- ditional debt and equity financing, a significant number of companies also utilize “hybrid” investments that aren’t completely debt or equity. One example of a hybrid investment is convertible securities—generally bonds or pre- ferred stock that can be exchanged for com- mon stock of the issuing corporation.

A recent report, using data from Bank of America Merrill Lynch, estimates that at year-end 2013, there were more than $200 billion of convertible securities trading in the open market.1 Why do companies use convertibles so heavily? To answer this question, recognize that convertibles virtually always have coupon rates that are lower than would be required on

straight nonconvertible bonds or preferred stock. Therefore, if a company raised $500 million by issuing convertible bonds, its interest expense would be lower than if it financed with nonconvertible debt. But why would investors be willing to buy convertibles, given their lower cash payments? The answer lies in the conversion feature. If the price of the issuer’s stock rises, the option to convert to common stock becomes more valuable, which in turn increases the value of the convertible security. So convertibles hold down the cash costs of financing by giving investors an opportunity for capital gains.

In 2014, Tesla Motors attracted a great deal of interest when it successfully issued $2 billion

C H A P T E R

20 Hybrid Financing: Preferred Stock, Leasing, Warrants, and Convertibles

© EpicStockMedia / Shutterstock.com

1Refer to Eric N. Harthun and Robert L. Salvin, “Holding the Middle Ground With Convertible Securities,” Putnam Investments White Paper, January 2014.

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of convertible bonds. The company plans to use the money to help pay for the cost of its $5 billion “gigafactory” that is being constructed to manufacture its batteries. The bonds were extremely well received in the market; indeed, the issue raised 25% more than the company’s initial forecast.

Some analysts view the strong offering as a very promis- ing sign. For example, The Wall Street Journal quoted a note that Thomas Tzitzouris (who is the head of fixed-income research at Strategas Research Partners) sent to his clients after the Tesla offering:

As a general rule, firms issue convertible bonds when they need to expand their capital stock, because they believe growth opportunities are strong, but perhaps too uncertain to garner the otherwise cheap financing rates offered up to unsecured investment grade borrowers. In other words, it can be inferred as a signal of management’s bullishness on

intermediate to long-term investment opportunities. But this is precisely what’s been lacking in the muddle through GDP numbers that have dominated the post-crisis landscape. So is Tesla a signal of a rising appetite for corporate Capex? Probably not, at least not yet, but it’s certainly a positive sign that corporate managers have not been deterred from their capital spending plans by the weak first quarter data and the stress in the emerging markets.

More broadly, convertible bonds are just one example of hybrid financing. In this chapter, we will discuss four specific types of hybrid investments: preferred stock, leases, warrants, and convertible securities. Each has its own interesting fea- tures. We will provide an overview of each hybrid, and then highlight the opportunities each presents to both issuers and investors.

Source: Steven Russolillo, “Tesla’s Convertible Bonds: A Positive Economic Indicator?,” The Wall Street Journal (online.wsj.com), March 5, 2014.

In previous chapters, we examined common stocks and the various types of long-term debt. In this chapter, we examine four other types of long-term capital: (1) preferred stock, which is a hybrid security that represents a cross between debt and common equity; (2) leasing, which is used by financial managers as an alter- native to borrowing to finance fixed assets; (3) warrants, which are derivative securities issued by firms to facilitate the issuance of some other type of security; and (4) convertibles, which combine the features of debt (or preferred stock) and warrants. We discuss how these financing instruments can be used to raise capital efficiently and at a relatively low cost, and how investors should evaluate their use.

When you finish this chapter, you 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 and how they are used, and analyze their cost to the firm.

• Explain what convertibles are and how they are used, and analyze their cost to the firm.

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20-1 PREFERRED STOCK Preferred stock is a hybrid—it is similar to bonds in some respects and to common stock in other ways. Accountants classify preferred stock as equity; hence, they show it on the balance sheet as an equity account. However, from a finance perspective, preferred stock lies somewhere between debt and common equity. It imposes a fixed charge, so it increases the firm’s financial leverage. However, omitting the preferred dividend does not force a company into bankruptcy. We describe the basic features of preferred, explain its advantages and disadvantages, and then discuss some different types of preferred.

20-1A BASIC FEATURES Preferred stock has a par (or liquidating) value, often $25 or $100. The dividend is stated as a percentage of par, or as so many dollars per share, or both ways. For example, several years ago Klondike Paper Company sold 150,000 shares of $100 par value perpetual preferred stock for a total of $15 million. This preferred had a stated annual dividend of $12 per share, so the preferred dividend yield was $12=$100 ¼ 0:12, or 12%, at the time of issue. The dividend was set when the stock was issued; it will not be changed in the future. Therefore, if the required rate of return on preferred, rp, changes from 12% after the issue date—as it actually did— the market price of the preferred stock will increase or decrease. Currently, rp for Klondike Paper’s preferred is 9%, and the price of the preferred has risen from $12=0:12 ¼ $100 to $12=0:09 ¼ $133:33.

If the preferred dividend is not earned, the company does not have to pay it. However, most preferred issues are cumulative, meaning that the total of all unpaid preferred dividends must be paid before dividends can be paid on the common stock. Unpaid preferred dividends are called arrearages. Dividends in arrears do not earn interest; thus, arrearages do not grow in a compound interest sense—they grow only from additional nonpayments of the preferred dividend. Also, many preferred stocks accrue arrearages for only a limited number of years (say, 3 years), meaning that the cumulative feature ceases after 3 years. However, the dividends in arrears continue in force until they are paid.

Preferred stock normally has no voting rights. However, most preferred issues stipulate that the preferred stockholders can elect a minority of the directors—say, 3 out of 10—if the preferred dividend is passed (omitted). Jersey Central Power & Light, one of the companies that owned a share of the Three Mile Island (TMI) nuclear plant, had preferred stock outstanding that could elect a majority of the directors if the preferred dividend was passed for four successive quarters. Jersey Central kept paying its preferred dividends even during the dark days following the TMI accident. Had the preferred not been entitled to elect a majority of the directors, the dividend probably would have been passed.

Although nonpayment of preferred dividends will not bankrupt a company, corporations issue preferred with every intention of paying the dividend. Even if passing the dividend does not give the preferred stockholders control of the company, failure to pay a preferred dividend precludes payment of common dividends. In addition, passing the dividend makes it difficult to raise capital by selling bonds and virtually impossible to sell more preferred or common stock. However, having preferred stock outstanding does give a firm the chance to overcome its difficulties—if bonds had been used instead of preferred stock, Jersey Central might have been forced into bankruptcy before it had a chance to straighten out its problems. Thus, from the viewpoint of the corporation, preferred stock is less risky than bonds.

However, for investors, preferred stock is riskier than bonds: (1) Preferred stockholders’ claims are subordinated to those of bondholders in the event of

Arrearages Unpaid preferred dividends.

Cumulative A protective feature on preferred stock that requires preferred dividends previously not paid to be paid before any common dividends can be paid.

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liquidation, and (2) bondholders are more likely to continue receiving income during hard times than are preferred stockholders. Accordingly, investors require a higher after-tax rate of return on a given firm’s preferred stock than on its bonds. However, because 70% of preferred dividends is exempt from corporate taxes, preferred stock is attractive to corporate investors. In recent years, high-grade preferred stock, on average, has sold on a lower pretax yield basis than high-grade bonds. As an example, Georgia Power Company’s preferred stock recently had a market yield of about 5.47%, whereas its bonds recently provided a yield of 5.65%, or about 0.2 percentage point more than its preferred. The tax treatment accounted for this differential; the after-tax yield to corporate investors was 4.90% on the preferred versus 3.67% on the bonds.2 Traditionally, a large portion of the out- standing nonconvertible preferred stock has been owned by corporations (and other institutions), which can take advantage of the 70% dividend exclusion to obtain a higher after-tax yield on preferred stock than on bonds.

Some preferred stocks are similar to perpetual bonds in that they have no maturity date, but most new issues now have specified maturities. For example, many preferred shares have a sinking fund provision that calls for the retirement

PREFERRED STOCK: DOES IT MAKE SENSE FOR INDIVIDUAL INVESTORS?

In the text, we mention that historically nonconvertible stock has largely been held by institutional investors who can take advantage of the 70% dividend exclusion. How- ever, for some individuals, preferred stocks may still be an appealing investment—this is particularly true when the tax rates on dividends are relatively low. Nevertheless, many analysts advise individual investors to be cautious when investing in preferred stock. The tax treatment is often complicated and may vary over time, and the “fine print” of the agreement can be quite complex. In recent years, some investors have chosen to use

exchange traded funds (ETFs) as a relatively simple way to invest in preferred stock. For example, Jason Zweig, in a 2011 column in The Wall Street Journal, pointed out that:

The iShares S&P U.S. Preferred Stock Index Fund was the fourth-most popular exchange-traded fund in 2010, returning 14% and doubling in size to more than $6 billion … Fidelity Investments, Charles Schwab and TD Ameritrade all report rising interest in preferred stock among their brokerage clients.

The 2011 article goes on to point out that, despite this performance, there are significant risks when investing in preferred stock. These risks relate to tax uncertainty, the risk that the issue may be called, and the underlying risk related to the issuing company’s performance. Moreover, although safer than holding a single preferred security, these invest- ment funds may not be all that diversified. Indeed in early 2011, more than 80% of the assets held in the iShares fund were preferred stocks issued by financial firms. This observa- tion led Mariana Bush, a Wells Fargo analyst, to conclude: “If you work in the financial sector you should definitely not buy a preferred fund.” Echoing this concern, Jason Zweig agreed: “With your career riding on the health of the finan- cial industry, you shouldn’t put more money in the same place.” Although the value of this ETF has bounced around during the three years since this article, it is still the case that the preferred market is heavily dominated by financial issues. Consequently, the old phrase “buyer beware” rings true here for sure.

Source: Jason Zweig, “Preferred Stock: Are Those Juicy Yields Worth the Extra Risk?,” The Wall Street Journal (online.wsj.com), February 5, 2011.

2The after-tax yield on a 5.65% bond to a corporate investor in the 35% marginal tax rate bracket is 5.65%(1 − T) ¼ 5.65%(0.65) ¼ 3.67%. The after-tax yield on a 5.47% preferred stock is 5.47%(1 � Effective T) ¼ 5.47%[ 1 − (0.30)(0.35) ] ¼ 5.47%(0.895) ¼ 4.90%. Note that tax law prohibits firms from issuing debt and then using the proceeds to purchase another firm’s preferred or common stock. If debt is used for stock purchases, the 70% dividend exclusion will be voided. This provision is designed to prevent a firm from engaging in “tax arbitrage,” using tax-deductible debt to purchase largely tax- exempt preferred stock.

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of 2% of the original issue each year, meaning that the issue will “mature” in a maximum of 50 years. Also, many preferred issues are callable by the issuing corporation, which also can limit the life of the preferred.3

For issuers, preferred stock has a tax disadvantage relative to debt—interest expense is deductible, but preferred dividends are not. Still, firms with low tax rates may have an incentive to issue preferred stock that can be bought by corporate investors with high tax rates, who can take advantage of the 70% dividend exclusion. If a firm has a lower tax rate than potential corporate buyers, the firm might be better off issuing preferred stock than debt. The key here is that the tax advantage to a high-tax-rate corporation is greater than the tax disadvan- tage to a low-tax-rate issuer. To illustrate, assume that risk differentials between debt and preferred would require an issuer to set the interest rate on new debt at 10% and the dividend yield on new preferred at 12% in a no-tax world. However, when taxes are considered, a corporate buyer with a high tax rate (say, 40%) might be willing to buy the preferred stock if it had an 8% before-tax yield. This would produce an 8% 1 � Effective Tð Þ ¼ 8% 1 � 0:30 0:40ð Þ½ � ¼ 7:04% after-tax return on the preferred versus 10% 1 � 0:40ð Þ ¼ 6:0% on the debt. If the issuer has a low tax rate (say, 10%), its after-tax costs would be 10% 1 � Tð Þ ¼ 10% 0:90ð Þ ¼ 9% on the bonds and 8% on the preferred. Thus, the security with lower risk to the issuer, preferred stock, also has a lower cost. Such situations can make preferred stock a logical financing choice.4

20-1B ADJUSTABLE-RATE PREFERRED STOCK In addition to the “plain vanilla” variety of preferred stocks, several variations also are used. One of these is adjustable-rate preferred stock, which has divi- dends tied to the LIBOR rate, the rate on Treasury securities, or, in some instances, to periodic auctions. Unfortunately, in 2008, the auction rate security market froze and many businesses were unable to access their money to pay bills. These businesses were unaware of the risks that they had assumed by investing in these securities. In 2011, fines and settlements were imposed on a number of financial institutions resulting from improper marketing and sales of these types of securities.

About half of all “regular, fixed-rate” preferred stock issued in recent years has been converted into the issuing firm’s common stock. See Section 20-4 for a more detailed discussion regarding convertibles.

20-1C ADVANTAGES AND DISADVANTAGES OF PREFERRED STOCK There are advantages and disadvantages to financing with preferred stock. Here are the major advantages from the issuers’ standpoint:

1. Passing a preferred dividend cannot force a firm into bankruptcy, whereas failure to pay interest on a bond can lead to bankruptcy.

2. By issuing preferred stock, the firm avoids the dilution of common equity that occurs when common stock is sold.

Adjustable-Rate Preferred Stock Preferred stock with a dividend that is adjusted at regular intervals.

3Prior to the late 1970s, virtually all preferred stock was perpetual and almost no issues had sinking funds or call provisions. Then insurance company regulators, worried about the unrealized losses the companies had been incurring on preferred holdings as a result of rising interest rates, put into effect some regulatory changes that essentially mandated that insurance companies buy only limited-life preferreds. From that time on, virtually no new preferred has been perpetual. This example illustrates the way securities change as a result of changes in the economic environment. 4For a more rigorous treatment of the tax hypothesis of preferred stock, see Iraj Fooladi and Gordon S. Roberts, “On Preferred Stock,” Journal of Financial Research, Winter 1986, pp. 319–324. For an example of an empirical test of the hypothesis, see Arthur L. Houston Jr. and Carol Olson Houston, “Financing with Preferred Stock,” Financial Management, Autumn 1990, pp. 42–54.

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3. Because preferred stock sometimes has no maturity, and preferred sinking fund payments, if present, are typically spread over a long time period, preferred issues can reduce the cash flow drain from principal repayments that occurs with debt issues.

There are two major disadvantages:

1. Preferred stock dividends are not deductible to the issuer; consequently, the after-tax cost of preferred is typically higher than the after-tax cost of debt. However, the tax advantage of preferreds to corporate purchasers lowers its pretax cost and thus its effective cost.

2. Although preferred dividends can be passed, investors expect them to be paid, and firms intend to pay the dividends if conditions permit. Thus, preferred dividends are considered a fixed cost. Therefore, their use, like that of debt, increases the firm’s financial risk and thus its cost of common equity.

20-2 LEASING5

Firms generally own fixed assets and report them on their balance sheets; but it is the use of buildings and equipment that is important, not their ownership per se. One way of obtaining the use of assets is to buy them, but an alternative is to lease them. Leasing was originally associated with real estate—land and buildings. Today, however, it is possible to lease virtually any kind of fixed asset. According to the 2010 edition of World Leasing Yearbook, leasing activity in 2008 was estimated to be worth $640 billion; however, a large number of these leases did not show up on any balance sheet.6

20-2A TYPES OF LEASES Leasing takes three different forms: (1) sale-and-leaseback arrangements; (2) operating leases; and (3) straight financial, or capital, leases.

Sale and Leaseback Under a sale and leaseback, a firm that owns land, buildings, or equipment sells the property and simultaneously executes an agreement to lease the property back for a specified period under specific terms. The purchaser could be an insurance company, a commercial bank, a specialized leasing company, or even an indivi- dual investor. The sale-and-leaseback plan is an alternative to taking out a mort- gage loan.

S E L F T E S T

Should preferred stock be considered as equity or debt? Explain.

Who are the major purchasers of “regular” preferred stock? How do tax considerations affect these purchases?

What are the advantages and disadvantages of preferred stock from the perspective of its issuer?

Sale and Leaseback An arrangement whereby a firm sells land, buildings, or equipment and simultaneously leases the property back for a specified period under specific terms.

5For a detailed treatment of leasing, see James S. Schallheim, Lease or Buy? Principles for Sound Decision Making (Boston, MA: Harvard Business School Press, 1994). 6This point alone demonstrates why the International Accounting Standards Board (IASB) and the U.S. Financial Accounting Standards Board (FASB) have been working on an accounting standard that would change the financial reporting of leases. (See the box titled, “Are Changes to the Financial Reporting of Leases on the Horizon?”)

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The firm that is selling the property, or the lessee, immediately receives the purchase price put up by the buyer, or the lessor.7 At the same time, the seller- lessee firm retains the use of the property as if it had borrowed and mortgaged the property to secure the loan. Note that under a mortgage arrangement, the finan- cial institution would normally receive a series of equal payments that amortized the loan while providing a specified rate of return to the lender on the outstanding balance. Under a sale-and-leaseback arrangement, the lease payments are set up exactly the same way; the payments return the purchase price to the investor- lessor while providing a specified rate of return on the lessor’s outstanding investment.

Operating Leases Operating leases, sometimes called service leases, provide for both financing and maintenance. IBM is one of the pioneers of the operating lease contract; and computers and office copying machines, together with automobiles and trucks, are the primary types of equipment involved. Ordinarily, these leases call for the lessor to maintain and service the leased equipment and the cost of providing maintenance is built into the lease payments.

Another important characteristic of operating leases is the fact that they are frequently not fully amortized; in other words, the payments required under the lease contract are not sufficient to recover the full cost of the equipment. However,

ARE CHANGES TO THE FINANCIAL REPORTING OF LEASES ON THE HORIZON?

In Chapter 3, we discussed the efforts between the IASB and the FASB to merge international and U.S. standards into a single set of global accounting standards meant to improve financial statement transparency and comparability among firms. One of the projects that is still “in the works” is the standard on lease accounting. In fact, a revised draft of the proposed standard was issued in May 2013. To date (June 2014), the FASB and IASB continue to deliberate on this proposal. Although we may not know all of the final provisions of

this document, there are some things of which we can be fairly certain. The “new” standard will, for all intents and purposes, eliminate operating leases (off-balance-sheet leases) except for those leases with terms of 12 months or less. Consequently, all other leases will be “capitalized” and reported on a firm’s balance sheet. A lessee firm will report a “right-to-use asset” and a liability on its balance sheet equal to the present value of the lease payments. The discount rate used to determine the present value of the lease pay- ments would be the rate charged by the lessor if this value is

known to the lessee; otherwise, the lessee would use its incremental borrowing rate as its before-tax discount rate. The asset would be depreciated, and the liability would be amortized. What is the impact to the lessee’s income state- ment? For most leases of assets other than property, the lessee will no longer report a lease payment in operating expenses but would instead report depreciation expense in operating expenses and a financing expense for the interest incurred on the liability. Consequently, the lessee’s EBITDA would increase. The intent of the new standard is to consider the

substance of the lease transaction rather than its form. How the U.S. Tax Code will change due to this new standard remains to be seen. It’s obvious that once the new standard is implemented investors will have better (more transparent) information with which to compare different firms, and hopefully they can use this informa- tion to make better investment decisions. However, when this proposal will be finalized and implemented is still very uncertain.

Sources: Andy Thompson, “Lease Accounting: More Decisions—But Big Issues Still on Hold,” leaseaccounting.nl, May 8, 2014; Gerorge Azih, “FASB and IASB Lease Accounting ‘Divergence’,” accountingforleases.com, April 16, 2014; Joseph C. DiFalco, “What’s Up With the New Lease Accounting Rules?,” New Jersey CPA Magazine, March/April 2014; “What Do the Proposed Lease Accounting Changes Mean for You?,” Ernst & Young (ey.com/IFRS), August 23, 2010; and “The Future of Lease Accounting,” KPMG, IFRS-Lease Newsletter, Issue 4, March 2011.

Lessor The owner of the leased property.

7The term lessee is pronounced “less-ee,” not “lease-ee”; lessor is pronounced “less-or.”

Lessee The party that uses, rather than the one who owns, the leased property.

Operating Leases A lease under which the lessor maintains and finances the property; also called a service lease.

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the lease contract is written for a period considerably shorter than the expected economic life of the leased equipment, and the lessor expects to recover all investment costs through subsequent renewal payments, through subsequent leases to other lessees, or through the sale of the leased equipment.

A final feature of operating leases is that they frequently contain a cancellation clause, which gives the lessee the right to cancel the lease before the expiration of the basic agreement. This is important to the lessee, for it means that the equip- ment can be returned if it is rendered obsolete by technological developments or is no longer needed because of a decline in the lessee’s business.

Financial, or Capital, Leases Financial leases, sometimes called capital leases, are differentiated from operating leases in three respects: (1) They do not provide for maintenance services, (2) they are not cancelable, and (3) they are fully amortized (i.e., the lessor receives rental payments that are equal to the full price of the leased equipment plus a return on the investment). In a typical financial lease, the firm that will use the equipment (the lessee) selects the specific items it requires and negotiates the price and delivery terms with the manufacturer. The user firm then negotiates terms with a leasing company and once the lease terms are set, arranges to have the lessor buy the equipment from the manufacturer or the distributor. When the equipment is purchased, the user firm simultaneously signs the lease contract.

Financial leases are similar to sale-and-leaseback arrangements, the major difference being that the leased equipment is new, and the lessor buys it from a manufacturer or a distributor instead of from the user-lessee. A sale and leaseback may thus be thought of as a special type of financial lease, and both sale and leasebacks and financial leases are analyzed in the same manner.8

20-2B FINANCIAL STATEMENT EFFECTS Lease payments are shown as operating expenses on a firm’s income statement, but under certain conditions, neither the leased assets nor the liabilities under the lease contract appear on the firm’s balance sheet. For this reason, leasing is often called off-balance-sheet financing. This point is illustrated in Table 20.1 by the balance sheets of two hypothetical firms, B (for Buy) and L (for Lease). Initially, the balance sheets of both firms are identical, and both have debt ratios of 50%. Each firm then decides to acquire fixed assets that cost $100. Firm B borrows $100

TABLE 2 0.1 Balance Sheet Effects of Leasing

Before Asset Increase After Asset Increase

Firms B and L Firm B, Which Borrows and Buys Firm L Which Leases

Current assets $ 50 Debt $ 50 Current assets $ 50 Debt $ 150 Current assets $ 50 Debt $ 50

Fixed assets 50 Equity 50 Fixed assets 150 Equity 50 Fixed assets 50 Equity 50

Total $100 $100 Total $200 $ 200 Total $100 $100

Debt ratio: 50% Debt ratio: 75% Debt ratio: 50%

Off-Balance-Sheet Financing Financing in which the assets and liabilities involved do not appear on the firm’s balance sheet.

8For a lease transaction to qualify as a lease for tax purposes, and thus for the lessee to be able to deduct the lease payments, the life of the lease must not exceed 80% of the expected life of the asset and the lessee cannot be permitted to buy the asset at a nominal value. These conditions are IRS requirements, and they should not be confused with the FASB requirements discussed later in the chapter concerning the capitalization of leases and financial statement presentation. It is important to consult lawyers and accountants to ascertain whether a prospective lease meets current IRS regulations.

Financial Leases A lease that does not provide for maintenance services, is not cancelable, and is fully amortized over its life; also called a capital lease.

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to make the purchase; so both an asset and a liability are recorded on its balance sheet, and its debt ratio is increased to 75%. Firm L leases the equipment, so its balance sheet is unchanged. The lease may call for fixed charges as high as or even higher than those on the loan, and the obligations assumed under the lease may be equally or more dangerous from the standpoint of financial safety; but the firm’s debt ratio remains at 50%.

To correct this problem, the Financial Accounting Standards Board issued FAS 13 (now referred to as Accounting Standards Codification Topic 840 or ASC 840), which requires that for an unqualified audit report firms that enter into financial (or capital) leases must restate their balance sheets to (1) report leased assets as fixed assets and (2) show the present value of future lease payments as liabilities.This process is called capitalizing the lease, and its net effect is to cause Firm L to report a balance sheet similar to that for Firm B after the asset increase.9

The logic behind ASC 840 is simple. If a firm signs a lease contract, its obligation to make lease payments is just as binding as if it had signed a loan agreement. The failure to make lease payments can bankrupt a firm as surely as failure to make a loan’s principal and interest payments. Therefore, for all intents and purposes, a financial lease is identical to a loan.10 That being the case, when a firm signs a lease agreement, it has, in effect, raised its “true” debt ratio and thereby has changed its “true” capital structure. Accordingly, if the firm had previously established a target capital structure and if there is no reason to believe that the optimal capital structure has changed, then using lease financing requires additional equity just as debt financing does.

If disclosure of the lease in the Table 20.1 example is not made, investors could be deceived into thinking that Firm L’s financial position is stronger than it actually is. Even if the lease was disclosed in a footnote, investors might not fully recognize its impact and might not see that Firms B and L are in essentially the same financial position. If this was the case, Firm L would have increased its true amount of debt through a lease arrangement; but its required returns on debt and equity, rd and rs, and consequently its weighted average cost of capital, would not have increased as much as those of Firm B, which borrowed directly. Thus, investors would be willing to accept a lower return from Firm L because they would mistakenly view it as being in a stronger financial position than Firm B. These benefits of leasing would accrue to stockholders at the expense of new investors, who were, in effect, being deceived by the fact that the firm’s balance sheet did not fully reflect its true liability situation. That is why FAS 13 was issued.

FAS 13Ss Financial Accounting Standard, issued by the FASB, that details the conditions and procedures for capitalizing leases.

9ASC 840 (Leasing) cites FAS 13, “Accounting for Leases,” issued in November 1976. It spells out in detail the conditions under which leases must be capitalized and the procedures for doing so. Also, refer to Schallheim, op. cit., Chapter 4, for more on the accounting treatment of leases. As part of the international convergence project, the IASB and FASB issued a revised exposure draft in May 2013 that may change the financial reporting of leases within the next several years. 10There are certain legal differences between loans and leases. In a bankruptcy liquidation, the lessor is entitled to take possession of the leased asset; and if the value of the asset is less than the required payments under the lease, the lessor can claim (as a general creditor) 1 year’s lease payments. In a bankruptcy reorganization, the lessor receives the asset plus 3 years’ lease payments, if needed, to bring the value of the asset up to the remaining investment in the lease. Under a secured loan arrangement, on the other hand, the lender has a security interest in the asset, meaning that if it is sold, the lender will be given the proceeds and the full unsatisfied portion of the lender’s claim will be treated as a general creditor obligation (see Web Appendix 7C). It is not possible to state as a general rule whether a supplier of capital is in a stronger position as a secured creditor or as a lessor. Because one position is usually regarded as being about as good as the other at the time the financial arrangements are being made, a lease is about as risky as a secured term loan from both the lessor- lender’s and the lessee-borrower’s viewpoints.

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A lease must be classified as a capital lease—and hence be capitalized and shown directly on the balance sheet—if any one of the following conditions exists:

• Under the terms of the lease, ownership of the property is effectively transferred from the lessor to the lessee.

• The lessee can purchase the property or renew the lease at less than a fair market price when the lease expires.

• The lease runs for a period equal to or greater than 75% of the asset’s life.

• The present value of the lease payments is equal to or greater than 90% of the initial value of the asset.11

These rules, together with strong footnote disclosures for operating leases, are sufficient to ensure that no one will be fooled by lease financing. Thus, leases are recognized to be essentially the same as debt, and they have the same effects as debt on the firm’s required rate of return. Therefore, leasing will not generally permit a firm to use more financial leverage than could be obtained with conventional debt.

20-2C EVALUATION BY THE LESSEE Any prospective lease must be evaluated by the lessee and the lessor. The lessee must determine whether leasing an asset will be less costly than buying it, and the lessor must decide whether the lease will provide a reasonable rate of return. Because our focus is primarily on financial management as opposed to invest- ments, we restrict our analysis to that conducted by the lessee.12

In the typical case, the events leading to a lease arrangement follow the sequence described in the following list. A great deal of theoretical literature exists about the correct way to evaluate lease-versus-purchase decisions, and some very complex decision models have been developed to aid in the analysis. The analysis given here, however, leads to the correct decision in every case we have encoun- tered.

1. The firm decides to acquire a particular building or piece of equipment. This decision is based on regular capital budgeting procedures, and the decision to acquire the asset is a “done deal” before the lease analysis begins. In other words, the asset has a positive NPV. Therefore, in a lease analysis, we are concerned simply with whether to finance the machine by a lease or by a loan.

2. Once the firm has decided to acquire the asset, the next question is how to finance it. Well-run businesses do not have excess cash lying around, so new assets must be financed in some manner.

3. Funds to purchase the asset could be obtained by borrowing, by retaining earnings, or by issuing new stock. Alternatively, the asset could be leased. Because of FAS 13 capitalization/disclosure provisions for leases, a lease would have the same capital structure effect as a loan.

As indicated earlier, a lease is comparable to a loan because the firm must make a specified series of payments and failure to make those payments may result in bankruptcy. Thus, it is most appropriate to compare the cost of leasing with the

11The discount rate used to calculate the present value of the lease payments must be the lower of (1) the rate used by the lessor to establish the lease payments or (2) the interest rate that the lessee would have paid for new debt with a term to maturity equal to that of the lease. 12The lessee is typically offered a set of lease terms by the lessor, which is generally a bank, a finance company such as GE Commercial Finance (the largest U.S. lessor), or some other institutional lender. The lessee can accept or reject the lease or shop around for a better deal. In this chapter, we take the lease terms as given for purposes of our analysis. See Chapter 19, “Lease Financing,” of Eugene F. Brigham and Phillip R. Daves, Intermediate Financial Management, 12th edition (Mason, OH: Cengage Learning, 2016), for a discussion of lease analysis from the lessor’s standpoint, including a discussion of how a potential lessee can use such an analysis in bargaining for better terms.

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cost of debt financing.13 The lease-versus-borrow-and-purchase analysis is illustrated with data on the Mitchell Electronics Company, and the following conditions are assumed:

1. Mitchell plans to acquire equipment with a 5-year life that has a cost of $10,000,000 delivered and installed.

2. Mitchell can borrow the required $10 million using a 10% loan to be amortized over 5 years.

3. Alternatively, Mitchell can lease the equipment for 5 years at a rental charge of $2,800,000 per year payable at the end of the year.14 The lessor will own the asset at the expiration of the lease. The lease payment schedule is established by the potential lessor, and Mitchell can accept it, reject it, or negotiate different terms.

4. The equipment will be used for 5 years, at which time its estimated net salvage value will be $715,000. Mitchell does not plan to continue using the equipment beyond Year 5. So, if Mitchell buys the equipment, it would expect to receive $715,000 before taxes when the equipment is sold in 5 years. This is the asset's residual value.

5. The lease contract stipulates that the lessor will maintain the equipment. However, if Mitchell borrows and buys, it will incur the cost of maintenance. This service will be performed by the equipment manufacturer at a fixed contract rate of $500,000 per year, payable at year-end.

6. The equipment falls into the MACRS 5-year class life, and Mitchell’s effective federal-plus-state tax rate is 40%. Also, the depreciable basis is the original cost of $10,000,000. The MACRS depreciation rates are 20%, 32%, 19%, 12%, 11%, and 6%.

NPV Analysis Table 20.2 shows the cash flows that would be incurred each year under the two financing plans. The table is set up to produce two cash flow time lines, one for owning as shown on row 56 and one for leasing as shown on row 62. All cash flows occur at the end of the year.

The top section of the table (rows 38 to 41) shows the inputs required for the analysis. Row 43 shows the annual loan payments required to amortize a $10 million loan at a 10% interest rate. The loan payments are found with a calculator by inputting N ¼ 5, 1=YR ¼ 10, PV ¼ �10000, and FV ¼ 0, with PMT ¼ $2,637:97 (in thousands) or by using Excel as we did in the table.

Annual depreciation expense and the resulting tax savings are shown on rows 47 and 48. Next, rows 51 through 57 show the cost of owning analysis, which represents the firm’s borrowing and buying the equipment. Rows 51 through 55 show the individual cash flow items, and row 56 is a time line that summarizes the annual cash flows if Mitchell finances the equipment with a loan. Because Mitchell does not plan to continue using the equipment after 5 years, it will receive as an inflow the equipment's after-tax salvage value. The salvage value is $115,000 greater than the book value, so Mitchell will pay $46,000 in taxes. Therefore, it will receive a cash inflow of $715,000 − $46,000 = $669,000 in Year 5, which

13The analysis should compare the cost of leasing to the cost of debt financing regardless of how the asset is financed. The asset may be purchased with available cash if it is not leased; but because leasing is a substitute for debt financing, a comparison between the two is still appropriate. 14Lease payments can occur at the beginning of the year or at the end of the year. In this example, we assume end-of-year payments, but we demonstrate beginning-of-year payments in Self-Test Problem ST-2.

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is shown on row 55. The present value of these cash flows is found and shown in cell C57; this number represents the present value of the cost of owning. (Note that we could do the same analysis with a financial calculator. We would input the cash flows as shown on row 56 into the cash flow register; input the interest rate, I=YR ¼ 6; and press the NPV key to obtain the PV cost of owning the equipment.)

On rows 60 through 63, we calculate the present value cost of leasing. The lease payments are $2,800 (shown in thousands) per year. This payment, which in this example (but not in all cases) includes maintenance, was established by the prospective lessor and then offered to Mitchell Electronics. If Mitchell accepts the lease, the full amount of the lease payment will be a deductible expense, so the tax savings will be Tax rateð Þ Lease payment

� � ¼ 0:4ð Þ $2,800ð Þ ¼ $1; 120.

These amounts are shown on rows 60 and 61. Row 62 shows the annual cash flows associated with leasing, and cell C63 shows the PV cost of leasing. (As indicated earlier in the cost of owning analysis, using a financial calculator, we would input the cash flows as shown on row 62 into the cash flow register,

T A B L E 2 0 . 2 Lease vs. Purchase Analysis (Dollars in Thousands)

37 38 39 40 41 42 43 44 45 46 47 48 49 50 51 52 53 54 55 56 57 58 59 60 61 62 63 64 65 66 67 68 69 70

A B C D E F G H I

Inputs (All dollar figures in thousands) New equipment cost $10,000 Tax rate 40% New equipment life 5 Loan interest rate 10% Salvage value $715 After-tax cost rate 6% = G39*(1-G38) Annual maintenance costs $500 Annual lease pymts $2,800

Loan payments $2,637.97 = PMT(G39,C39,-C38)

Depreciation 1 2 3 4 5 6 Depreciation rate 20% 32% 19% 12% 11% 6% Depreciation expense $2,000 $3,200 $1,900 $1,200 $1,100 $600 Depreciation tax savings = Deprn x T * 800 1,280 760 480 440 240

Cost of Owning Year = 0 1 2 3 4 5 Net purchase price ($10,000) Maintenance costs ($500) ($500) ($500) ($500) ($500) Maint. tax sav. = Maint x T 200 200 200 200 200 Tax savings from deprn. 800 1,280 760 480 440 After-tax salvage value $669 Cash flows ($10,000) $500 $980 $460 $180 $809 PV ownership cost @ 6% ($7,523)

Cost of Leasing Lease payments ($2,800) ($2,800) ($2,800) ($2,800) ($2,800) Tax savings = Lease pymt x T 1,120 1,120 1,120 1,120 1,120 Cash flows $0 ($1,680) ($1,680) ($1,680) ($1,680) ($1,680) PV of leasing @ 6% ($7,077)

Cost Comparison PV ownership cost @ 6% ($7,523) PV of leasing @ 6% ($7,077) Net Advantage to Leasing (NAL) $446 Leasing costs less, so lease should be done.

*Depreciation is a non-cash charge, so its only cash flow effect is the tax savings it provides.© C en

g ag

e Le ar n in g ®

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input the interest rate I=YR ¼ 6ð Þ, and then press the NPV key to obtain the PV cost of leasing the equipment.)15

The rate used to discount the cash flows is a critical issue. We know that the riskier a cash flow, the higher the discount rate used to find its present value. This principle applies in lease analysis. But just how risky are these cash flows? Most of them are relatively certain, at least when compared with the types of cash flow estimates used in capital budgeting analysis. For example, the lease, loan, and maintenance payments are set by contract, and depreciation expense is established by law and is not likely to change. The tax savings are somewhat uncertain because tax rates may change, but tax rates do not change very often. The $715 estimated salvage value is the least certain of the cash flows, but even here the estimate is based on historical experience.

Because the cash flows under both the lease and the borrow-and-purchase alternatives are reasonably certain, they should be discounted at a relatively low rate. Most analysts recommend that the company’s cost of debt be used, and this rate seems reasonable in our example. Further, since all the cash flows are on an after-tax basis, the after-tax cost of debt, which is 6%, should be used. Accordingly, in Table 20.2, we used a 6% discount rate to obtain the present values. The financing method that results in the smaller present value of costs is the one that should be selected. In our example, leasing has a net advantage over buying: The present value of the cost of leasing is $446,000 less than that of buying, so Mitchell should lease the equipment.

20-2D OTHER FACTORS THAT AFFECT LEASING DECISIONS The basic analysis set forth in Table 20.2 is sufficient to handle most situations. However, two factors warrant additional comments.

Estimated Residual Value It is important to note that the lessor will own the property upon the expiration of the lease. The estimated end-of-lease salvage value is called the residual value. Super- ficially, it would appear that if estimated residual values are expected to be large, owning would have an advantage over leasing. However, if expected residual values are large—as they may be under inflation for certain types of equipment as well as for real property—competition among leasing companies will force leasing rates down to the point where potential residual values will be fully recognized in the lease contract rates. Thus, the existence of large residual values on equipment is not likely to bias the decision against leasing.

Increase Credit Availability As noted in our earlier discussion of Table 20.1, leasing could have an advantage for firms that are seeking the maximum degree of financial leverage. Because some leases are not shown on the balance sheet, lease financing can give the firm a stronger appearance in a superficial credit analysis, thus permitting it to use more leverage than it could if it did not lease. This may be true for smaller firms, but larger firms are required to capitalize major leases and to report them on their balance sheets, so this point is of questionable validity.16

15If Mitchell had planned on using the equipment beyond Year 5, and the lease allowed Mitchell to purchase the equipment at the residual value, no entry would have been made on row 55 in the cost of owning analysis, and the firm would depreciate the equipment for one more year. However, in the cost of leasing analysis, an outflow would be added in Year 5 for the purchase price of the equipment. In addition, Mitchell would now include depreciation tax savings cash flows for depreciation based on that purchase price over the asset's depreciable life. Refer to Brigham and Daves, Intermediate Financial Management, 12th edition, Chapter 19 for this analysis. 16Enron, in a widely publicized financial fraud that was uncovered in 2000, used illegal leases to hide debts with the assistance of its accounting firm, Arthur Andersen. Both Enron and Andersen were put out of business, and some high-ranking officers received long jail sentences and huge fines.

Residual Value The value of leased property at the end of the lease term.

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20-3 WARRANTS A warrant is a long-term option from a company that gives the holder the right to buy a stated number of shares of the firm’s stock at a specified price for a specified length of time. Generally, warrants are distributed with debt, and they are used to induce investors to buy long-term debt that carries a lower coupon rate than would otherwise be required. For example, when Infomatics Corporation, a rapidly growing high-tech company, wanted to sell $50 million of 20-year bonds in 2015, the investment bankers informed management that the bonds would be difficult to sell and that a 10% coupon rate would be required. However, as an alternative, the bankers suggested that investors would be willing to buy the bonds with a coupon rate of only 8% if the company offered 20 warrants with each $1,000 bond, each warrant having a 10-year life and entitling the holder to buy one share of common stock at an exercise price of $22 per share at any time during their 10-year life. The stock was selling for $20 per share at the time, and the warrants would expire in 2025 if they were not previously exercised.

Thus, investors were willing to buy Infomatics’s bonds with a yield of only 8% in a 10% market because warrants were offered as part of the package. The 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 market price climbs. This option offsets the low interest rate on the bonds and makes the package of low-yield bonds and warrants attractive to investors (refer to Chapter 18 for a more complete discussion of options).

20-3A INITIAL MARKET PRICE OF A BOND WITH WARRANTS The Infomatics bonds, if they had been issued as straight debt, would have carried a 10% interest rate. However, with warrants attached, the bonds were sold to yield 8%. Someone buying the bonds at their $1,000 initial offering price would thus be receiving a package consisting of an 8%, 20-year bond plus 20 warrants. Because the going interest rate on bonds as risky as those of Infomatics was 10%, we can find the straight-debt value of the bonds, assuming an annual coupon for ease of illustration, as follows:

210 10% 3 20

PV

PV = $829.73 ≈ $830

80 8080 80 1‚000

Using a financial calculator, input N ¼ 20, I=YR ¼ 10, PMT ¼ 80, and FV ¼ 1000. Then press the PV key to obtain the bond’s value, $829.73, or approximately $830.

S E L F T E S T

Define each of these terms: (1) sale and leaseback; (2) operating lease; and (3) financial, or capital, lease.

What is off-balance-sheet financing; what is ASC 840; and how are the two related?

List the sequence of events for the lessee that leads to a lease arrangement.

Why is it appropriate to compare the cost of lease financing with that of debt financing?

Warrant A long-term option to buy a stated number of shares of common stock at a specified price.

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Thus, a person buying the bonds in the initial underwriting would pay $1,000 and receive in exchange a straight bond worth about $830 plus 20 warrants presum- ably worth about $1,000 � $830 ¼ $170.

Price paid for bond with warrants

¼ Straight-debt value of bond

þ Value of warrants

$1,000 ¼ $830 þ $170 20.1

Because investors receive 20 warrants with each bond, each warrant has an implied value of $170=20 ¼ $8:50.

Typically, the 20 warrants would be detachable warrants; that is, they can be detached from the bond and the two securities would be traded separately. If the bonds and warrants were priced correctly, the bonds would sell for $830 in the aftermarket, the warrants would sell for $8.50 each, and the package would be in equilibrium at the $1,000 offering price.

However, it is possible for the bankers to price the issue incorrectly. They can estimate the straight-debt value quite accurately, but it is more difficult to estimate the proper value of the warrants. For example, if the bankers estimate the war- rants’ value too low, they may think that each warrant will sell for $6, and will attach $170=$6 ¼ 28:3333 warrants to each bond. Then when the issue is offered to the public, its price will rise from the $1,000 offer price to

Market price of bond ¼ $830 þ $8:50 28:3333ð Þ ¼ $1,070:83

Thus, the firm would have sold for $1,000 something that should have been sold for $1,070.83. More warrants would be outstanding than necessary; so when those warrants are exercised, there would be more dilution of the original shareholders’ equity than was necessary. On the other hand, if the bankers overestimated the value of the warrants (perhaps valuing them at $10 versus the true $8.50), the issue would fail—it could not be sold at the $1,000 offering price, and the firm would not obtain the funds it needed. So valuing the warrants correctly is important.

We discussed in Chapter 18 the Black-Scholes Option Pricing Model (OPM) for finding the value of a call option. It is tempting to use this model to find the value of a warrant, because call options are similar to warrants in many respects: Both give the investor the right to buy a share of stock at a fixed exercise price on or before the expiration date. However, there is a major difference between call options and warrants. When call options are exercised, the stock provided to the option holder comes from the secondary market, but when warrants are exercised, the shares provided are newly issued. As a result, the exercise of warrants dilutes the value of the original equity, which could cause the value of the original warrant to differ from the value of a similar call option. Therefore, investment bankers cannot use the Black-Scholes model to determine the value of warrants.

Even though the Black-Scholes model cannot be used to value warrants, investment bankers can query potential buyers and compare the new warrants with others that are outstanding, to estimate their value. The querying would be done during the “road show,” where the firm’s officers travel around the country with the investment bankers and hold meetings with potential investors. The company officers provide facts about the firm and the issue, answer questions, and obtain a sense from the potential buyers of how many shares (or bonds in this case) they would buy under different offering terms (coupon rates, number of warrants, life of warrants, and so forth). The bankers “make a book,” taking down names and prices of potential customers. And because this information is used when the issue is allocated to buyers, the potential buyers tell the truth about their intentions. In any event, good investment bankers can set new issue prices close to equilibrium prices.

Detachable Warrants Warrants that can be detached from a bond and traded independently of the bond.

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20-3B USE OF WARRANTS IN FINANCING Small, rapidly growing firms generally use warrants as “sweeteners” when they sell debt or preferred stock. Such firms frequently are regarded by investors as being highly risky, so their bonds can be sold only with high coupon rates and very restrictive indenture provisions. To avoid this, firms such as Infomatics often offer warrants along with the bonds. Receiving warrants along with bonds enables investors to share in the company’s growth, assuming it does in fact grow and prosper. Therefore, they are willing to accept a lower interest rate and less restrictive indenture provisions. A bond with warrants has some characteristics of debt and some characteristics of equity. It is a hybrid security that provides the financial manager with an opportunity to expand the firm’s mix of securities and thus to appeal to a broader group of investors.

Virtually all warrants today are detachable. Thus, after a bond with attached warrants is sold, the warrants can be detached and traded separately from the bond. Further, even after the warrants have been exercised, the bond (with its low coupon rate) remains outstanding.

The exercise price on warrants is generally set at some 15% to 30% above the market price of the stock on the date the bond is issued. If the firm grows and prospers and if its stock price rises above the exercise price at which shares may be purchased, warrant holders can exercise their warrants and buy stock at the stated price. However, as we saw in connection with pure options, without some incen- tive, warrants would never be exercised prior to maturity—their value in the open market at least would be equal to and probably would be greater than their value if exercised; so holders would sell warrants rather than exercise them. Three conditions encourage holders to exercise their warrants: (1) Warrant holders will exercise and buy stock if the warrants are about to expire and the market price of the stock is above the exercise price. (2) Warrant holders will exercise voluntarily if the company raises the dividend on the common stock by a sufficient amount. No dividend is earned on the warrant, so it provides no current income. However, if the common stock pays a high dividend, it provides an attractive dividend yield, and the dividend limits future price growth because less earnings will be retained. This induces warrant holders to exercise their option to buy the stock. (3) Warrants sometimes have stepped-up exercise prices, which prod owners into exercising them. For example, Williamson Scientific Company has warrants outstanding with an exercise price of $25 until December 31, 2016, at which time the exercise price rises to $30. If the price of the common stock is over $25 just before December 31, 2016, many warrant holders will exercise their options before the stepped-up price takes effect and the value of the warrants falls.

Another desirable feature of warrants is that they generally bring in funds only when funds are needed. If the company grows, it will probably need new equity capital. At the same time, growth will cause the stock price to rise and the warrants to be exercised; hence, the firm will obtain additional cash. If the company is not successful and it cannot profitably employ additional money, its stock price probably will not rise sufficiently to induce exercise of the warrants.

20-3C THE COMPONENT COST OF BONDS WITH WARRANTS When Infomatics issued its debt with warrants, the firm received $50 million, or $1,000 for each bond. Simultaneously, the company assumed an obligation to pay $80 interest for 20 years plus $1,000 at the end of 20 years. The pretax cost of the money would have been 10% if no warrants had been attached, but each Info- matics bond had 20 warrants, each of which entitled its holder to buy one share of stock for $22. What is the percentage cost of the $50 million? As we shall see, the cost is well above the 8% coupon rate on the bonds.

Stepped-Up Exercise Prices Exercise prices that are specified to rise if warrants are not exercised before designated dates.

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First, note that when the warrants expire 10 years from now, the stock is expected to sell for $51.87, given the $20 initial price and the 10% expected growth rate:

P10 ¼ $20 1:10ð Þ10 ¼ $51:87

Therefore, investors could exercise their warrants and receive one share of stock worth $51.87 for each warrant exercised. Thus, if the investor held the complete package, he or she would realize a profit in Year 10 of $51:87 � $22 ¼ $29:87 on each warrant. Because each bond has 20 warrants attached, investors would have a gain of 20 $29:87ð Þ ¼ $597:40 per bond at the end of Year 10. Here is a time line of the cash flow stream to an investor:

91 10 11

80

0

�1‚000

20

8080 80 1‚000 1‚080

80.00 597.40 677.40

The IRR of this stream is 10.66%, which is the investor’s overall pretax rate of return on the issue. This return is 66 basis points higher than the return on straight debt. The issue is riskier to investors than a straight-debt issue because part of the return is expected to come in the form of stock price appreciation, and that part of the return is riskier than the interest payments on the bonds. The before-tax cost to the company is the same as the before-tax return to investors—this was true of common stocks, straight bonds, and preferred stocks, and it is also true of bonds sold with warrants.

20-3D PROBLEMS WITH WARRANT ISSUES Although warrants are bought by investors with the expectation of receiving a total return commensurate with the overall riskiness of the package of securities being purchased, things do not always work out as expected. For example, in 1989, Sony paid $3.4 billion for Columbia Pictures, a U.S. movie studio. To help finance the deal, in 1990, Sony sold $470 million of 4-year bonds with warrants at an incredibly low 0.3% coupon interest rate. The rate was so low because the warrants, which also had a maturity of 4 years, allowed investors to purchase Sony stock at 7,670 yen per share, only 2.5% above the share price at the time the package was issued.

Investors snapped up the issue, and many of the warrants were “peeled off” and sold separately on the open market. The warrant buyers obviously believed that Sony’s stock would climb well above the exercise price. From Sony’s point of view, the bond-with-warrants package provided a very low-cost “bridge loan” (the bonds) that would be replaced with equity financing when the warrants were exercised, presumably in 4 years. This very low-cost capital encouraged Japanese firms to acquire foreign companies and to invest huge amounts in new plants and equipment.

However, the willingness of investors to buy Japanese warrants suffered a severe blow when the Japanese stock market fell by 40%. By 1994, when the warrants expired, Sony’s stock sold for only 5,950 yen versus the 7,670 yen exercise price, so the warrants were not exercised. Thus, Sony’s planned infusion of equity capital never materialized, and it had to refinance the 4-year bond issue at much higher interest rates.

Both Sony and its investors lost on the deal. The investors lost because they did not earn the return they had expected on the issue. Sony lost because it had to alter its financing plans and ended up paying a high interest rate on its debt. In spite of presumably good planning by the company and investors, this bond-with-warrants issue, and many like it, did not work out as anticipated.

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20-4 CONVERTIBLES Convertible securities are bonds or preferred stock that, under specified terms and conditions, can be exchanged for common stock at the option of the holder. Unlike the exercise of warrants, which brings in additional funds to the firm, conversion does not provide capital: Debt (or preferred stock) is simply replaced on the balance sheet by common stock. Of course, reducing the debt or preferred stock will improve the firm’s financial strength and make it easier to raise addi- tional capital, but raising additional capital requires a separate action.

20-4A CONVERSION RATIO AND CONVERSION PRICE One of the most important provisions of a convertible security is the conversion ratio, CR, defined as the number of shares of stock a bondholder will receive upon conversion. Related to the conversion ratio is the conversion price, Pc, which is the effective price investors pay for common stock bought through a convertible. The relationship between the conversion ratio and the conversion price can be illustrated by the Silicon Valley Software Company’s $1,000 par value convertible debentures issued in August 2015. At any time prior to maturity on August 15, 2035, a debenture holder can exchange a bond for 20 shares of common stock; therefore, the conversion ratio, CR, is 20. The bond cost purchasers $1,000, the par value, when it was issued. Dividing the $1,000 par value by the 20 shares received (CR) gives a conversion price Pcð Þ of $50 a share.

Conversion price ¼ Pc ¼ Par value of bond given up

Shares received

¼ $1,000 CR

¼ $1,000 20

¼ $50 20.2

Conversely, we obtain the conversion ratio (CR) by dividing the $1,000 par value by the $50 per share conversion price, Pc.

Conversion ratio ¼ CR ¼ Par value of bond given up Conversion price

¼ $1,000 Pc

¼ $1,000 $50

¼ 20 20.3

Once CR is set, the value of Pc is established and vice versa.

S E L F T E S T

What is a warrant?

Describe how a new bond issue with warrants is valued.

How are warrants used in corporate financing?

The use of warrants lowers the coupon rate on the corresponding debt issue. Does this mean that the component cost of a debt-plus-warrants package is less than the cost of straight debt? Explain.

A company recently issued bonds with attached warrants. The bond-plus- warrants package sells at a price equal to its $1,000 face value. The bonds mature in 10 years and have a 6% annual coupon. The company also has 10-year straight debt (with no warrants attached) outstanding. The straight debt has a yield to maturity of 8%. What is the straight-debt value of each bond? What is the value of the warrants attached to each bond? ($865.80, $134.20)

Convertible Securities Bonds or preferred stock that can be exchanged at the option of the holder for the common stock of issuing firms.

Conversion Ratio, CR The number of shares of common stock that are obtained by converting a convertible bond or share of convertible preferred stock.

Conversion Price, Pc The effective price paid for common stock obtained by converting a convertible security.

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Like a warrant’s exercise price, the conversion price is typically set at 15% to 30% above the market price of the common stock at the time the issue is sold. Exactly how the conversion price is established can best be understood after examining some of the reasons firms use convertibles.

Generally, the conversion price and conversion ratio are fixed for the life of the bond, although sometimes a stepped-up conversion price is used. For example, the 2015 convertible debentures for Breedon Industries are convertible into 12.5 shares until 2025; into 11.76 shares from 2026 until 2035; and into 11.11 shares from 2036 until maturity in 2045. The conversion price thus starts at $80, rises to $85, and then goes up to $90. Breedon’s convertibles, like most, have 10 years of call protection.

Another factor that may cause a change in the conversion price and ratio is a standard feature of almost all convertibles—the clause protecting the convertible against dilution from stock splits, stock dividends, and the sale of common stock at a price below the conversion price. The typical provision states that if common stock is sold at a price below the conversion price, the conversion price must be lowered to the price at which the new stock was issued and the conversion ratio raised correspondingly. Also, if the stock is split or if a stock dividend is declared, the conversion price must be lowered by the percentage amount of the stock dividend or split. For example, if Breedon Industries were to have a 2-for-l stock split during the first 10 years of its convertible’s life, the conversion ratio would automatically be adjusted from 12.5 to 25 and the conversion price lowered from $80 to $40. If this protection was not contained in the contract, a company could completely thwart conver- sion by the use of stock splits and stock dividends. Warrants are similarly protected against dilution.

The standard protection against dilution from selling new stock at prices below the conversion price can, however, get a company into trouble. For example, assume that Breedon’s stock was selling for $65 per share at the time the convertible was issued. Further, suppose the market dropped sharply, and Breedon’s stock price fell to $50 per share. If Breedon needed new equity to support operations, a new common stock sale would require the company to lower the conversion price on the convertible debentures from $80 to $50. That would raise the value of the convertibles and, in effect, transfer wealth from current shareholders to convertible holders. Firms considering the use of con- vertibles or bonds with warrants should remember potential problems such as these.

20-4B THE COMPONENT COST OF CONVERTIBLES In spring 2015, Silicon Valley Software was evaluating the use of the convertible bond issue described earlier. The issue would consist of 20-year convertible bonds offered at a price of $1,000 per bond; this $1,000 would also be the bond’s par (and maturity) value. The bond would pay a 10% annual coupon interest rate, or $100 per year. Each bond would be convertible into 20 shares of stock, so the conversion price would be $1; 000=20 ¼ $50. The stock was expected to pay a dividend of $2.80 during the coming year, and it sold at $35 per share. Further, the stock price was expected to grow at a constant rate of 8% per year. Therefore, rs ¼r̂s ¼ D1=P0 þ g ¼ $2:80=$35 þ 8% ¼ 8% þ 8% ¼ 16%. If the bonds were not made convertible, they would have to offer a yield of 13%, given their riskiness and the general level of interest rates. The convertible bonds would not be callable for 10 years, after which they could be called at a price of $1,050, with this price declining by $5 per year thereafter. If, after 10 years, the conver- sion value exceeds the call price by at least 20%, management would probably call the bonds.

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Figure 20.1 shows the expectations of an average investor and the company.17

Note the following observations regarding this figure:

1. The horizontal line at M ¼ $1; 000 represents the par (and maturity) value. Also, $1,000 is the price at which the bond is initially offered to the public.

2. The bond is protected against call for 10 years. It is initially callable at a price of $1,050, and the call price declines thereafter by $5 per year. Thus, the call price is represented by the solid section of the line V0M”.

F I G U R E 2 0 . 1 Silicon Valley Software: Convertible Bond Model

5 10

N

15 20

2,000

1,500

M = 1,000

Dollars

M"

Years

V0 = 1,100

B0 = 789 C0 = 700

Market Value

Expected Market Value at Time of Conversion, C10 = $1,511

X

Straight-Bond Value, Bt

Call Price

Conversion Value, Ct

0

© C en

g ag

e Le ar n in g ®

Year Pure-Bond Value, Bt

Conversion Value, Ct

Maturity Value, M

Market Value

Floor Value Premium

0 $789 $700 $1,000 $1,000 $789 $211 1 792 756 1,000 1,023 792 231 2 795 816 1,000 1,071 816 255 3 798 882 1,000 1,147 882 265 4 802 952 1,000 1,192 952 240 5 806 1,029 1,000 1,241 1,029 212 6 811 1,111 1,000 1,293 1,111 182 7 816 1,200 1,000 1,344 1,200 144 8 822 1,296 1,000 1,398 1,296 102 9 829 1,399 1,000 1,453 1,399 54 10 837 1,511 1,000 1,511 1,511 0 11 836 1,632 1,000 1,632 1,632 0 . . . . . . . . . . . . . . . . . . . . . 20 1,000 3,263 1,000 3,263 3,263 0

17For a more complete discussion of how the terms of a convertible offering are determined, see M. Wayne Marr and G. Rodney Thompson, “The Pricing of New Convertible Bond Issues,” Financial Management, Summer 1984, pp. 31–37.

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3. Because the convertible has a 10% annual coupon rate and because the yield on a nonconvertible bond of similar risk was stated to be 13%, the expected “straight-bond” value of the convertible, Bt, must be less than par. At the time of issue, B0 is $789 calculated as follows:

Pure-debt value at time of issue ¼ B0 ¼

XN

t¼1

Coupon interest

1 þ rdð Þt þ Maturity value

1 þ rdð ÞN

¼ X20

t¼1

$100

1:13ð Þt þ $1; 000

1:13ð Þ20 ¼ $789

20.4

Note, however, that the bond’s straight-debt value must be $1,000 just prior to maturity, so the straight-debt value rises over time. Bt follows the line B0M” in the graph.

4. The bond’s initial conversion value, Ct, or the value of the stock the investor would receive if the bonds were converted at t ¼ 0, is $700: The bond’s conversion value is Pt CRð Þ, so at t ¼ 0, conversion value ¼ P0(CR) ¼ $35(20 shares) ¼ $700. Because the stock price is expected to grow at an 8% rate, the conversion value should rise at this same rate over time. For example, in Year 5, it should be P5 CRð Þ ¼ $35 1:08ð Þ5 20ð Þ ¼ $1; 029. The expected conversion value over time is given by the line Ct in Figure 20.1.

5. The actual market price of the bond cannot fall below the higher of its straight- debt value or its conversion value. If the market price dropped below the straight-bond value, those who wanted bonds would recognize the bargain and buy the convertible as a bond. Similarly, if the market price dropped below the conversion value, people would buy the convertibles, exercise them to get stock, and then sell the stock at a profit. Therefore, the higher of the bond value and conversion value curves in the graph represents a floor price for the bond. In Figure 20.1, the floor price is represented by the thicker shaded line, B0XCt.

6. The bond’s market value will typically exceed its floor value. It will exceed the straight-bond value because the option to convert is worth something—a 10% bond with conversion possibilities is worth more than a 10% bond without this option. The convertible’s price will also exceed its conversion value because holding the convertible is equivalent to holding a call option, and prior to expiration, the option’s true value is higher than its expiration (or conversion) value. We cannot say exactly where the market value line will lie, but we do know that it will be at or above the floor set by the straight-bond and conversion value lines.

7. At some point, the market value line will touch the conversion value line. This convergence will occur for two reasons. First, the stock should pay higher dividends as time passes, but the interest payments on the convertible are fixed. For example, Silicon’s convertibles would pay $100 in interest annually, while the dividends on the 20 shares received upon conversion would initially be 20 $2:80ð Þ ¼ $56. However, at an 8% growth rate, the dividends after 10 years would be up to $120.90, while the interest would still be $100. Thus, at some point, rising dividends could be expected to push against the fixed interest payments, causing the premium to disappear and investors to convert voluntarily. Second, once the bond becomes callable, its market value cannot exceed the higher of the conversion value and the call price without exposing investors to the danger of a call. For example, suppose that 10 years after issue (when the bonds were callable), the market value of the bond was $1,600, the conversion value was $1,500, and the call price was $1,050. If the company called the bonds the day after you bought 10 bonds for $16,000, you would be forced to convert them into stock worth only $15,000, so you would suffer a loss of $100 per bond, or $1,000, in one day. Recognizing

Conversion Value, Ct The value of common stock obtained by converting a convertible security.

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this danger, you and other investors would not pay much of a premium over the higher of the call price or the conversion value once the bond becomes callable. Therefore, in Figure 20.1, we assume that the market value line hits the conversion value line in Year 10, when the bond becomes callable.

8. Let N represent the year when investors expect conversion to occur, either voluntarily because of rising dividends or because the company calls the convertibles to strengthen its balance sheet by substituting equity for debt. In our example, we assume that N ¼ 10, the first call date.

9. Because N ¼ 10, the expected market value at Year 10 is $35 1:08ð Þ10 20ð Þ ¼ $1; 511. An investor can find the expected rate of return on the convertible bond, rc, by finding the IRR of the following cash flow stream:

910 10

�1‚000 100 100 1‚511 1‚611

100

The solution is rc ¼ IRR ¼ 12:8%. 10. The return on a convertible is expected to come partly from interest income

and partly from capital gains; in this case, the total expected return is 12.8%, with 10% representing interest income and 2.8% representing the expected capital gain. The interest component is relatively assured, while the capital gain component is riskier. Therefore, a convertible’s expected return is riskier than that of a straight bond. This leads us to conclude that rc should be larger than the cost of straight debt, rd. Thus, it would seem that the expected rate of return on Silicon’s convertibles, rc, should lie between its cost of straight debt, rd ¼ 13%, and its cost of common stock, rs ¼ 16%.

11. Investment bankers use the type of model described here in addition to a knowledge of the market to set the terms on convertibles (the conversion ratio, coupon interest rate, and years of call protection) such that the security will just “clear the market” at its $1,000 offering price. In our example, the required conditions do not hold—the calculated rate of return on the convertible is only 12.8%, which is less than the 13% cost of straight debt. Therefore, the terms on the convertible bond must be made more attractive to investors. Silicon Valley Software would have to increase the coupon interest rate on the convertible above 10%; raise the conversion ratio above 20 (and thereby lower the conversion price from $50 to a level closer to the stock’s current $35 market price); lengthen the call-protected period; or use a combination of these terms such that the convertible’s expected return is between 13% and 16%.18

20-4C USE OF CONVERTIBLES IN FINANCING Convertibles have two important advantages from the issuer’s standpoint: (1) Convertibles, like bonds with warrants, offer a company the chance to sell debt with a low interest rate in exchange for a chance to participate in the company’s success if it does well. (2) In a sense, convertibles provide a way to sell common stock at prices higher than those currently prevailing. Some companies want to sell common stock, not debt, but believe the stock price is temporarily depressed. Management may know, for example, that earnings are depressed because of start-up costs associated with a new project, but they expect earnings to rise sharply during the next year or so, pulling up the stock price. Thus, if the company sold

18In this discussion, we ignore the tax advantages to investors associated with capital gains. In some situations, tax effects could result in rc being less than rd.

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stock now, it would be giving up more shares than necessary to raise a given amount of capital. However, if it set the conversion price 20% to 30% above the stock’s present market price, 20% to 30% fewer shares would be given up when the bonds were converted than if stock were sold directly at the current time. Note, however, that management is counting on the stock’s price to rise above the conversion price to make the bonds attractive in conversion. If earnings do not rise and pull up the stock price (hence, conversion does not occur), the company will be saddled with debt in the face of low earnings, which could be disastrous.

How can the company make sure that conversion will occur if the stock price rises above the conversion price? Typically, convertibles contain a call provision that enables the issuing firm to force holders to convert. Suppose the conversion price is $50, the conversion ratio is 20, the market price of the common stock has risen to $60, and the call price on a convertible bond is $1,050. If the company calls the bond, bondholders can convert the bond into common stock with a market value of 20 $60ð Þ ¼ $1; 200 or allow the company to redeem the bond for $1,050. Naturally, bondholders prefer $1,200 to $1,050, so conversion would occur. The call provision gives the company a way to force conversion, provided the market price of the stock is greater than the conversion price. Note, however, that most convertibles have a fairly long period of call protection—10 years is typical. Therefore, if the company wants to be able to force conversion fairly early, it must set a short call-protection period. This will, in turn, require that it set a higher coupon rate on the convertible bond or a lower conversion price.

From the standpoint of the issuer, convertibles have three important disad- vantages: (1) Although the use of a convertible bond may give the company the opportunity to sell stock at a price higher than the price at which stock could be sold currently, if the stock price increased greatly, the firm probably would have been better off had it used straight debt in spite of its higher cost and then later sold common stock and refunded the debt. (2) Convertibles typically have a low coupon interest rate, and the advantage of this low-cost debt will be lost when conversion occurs. (3) If the company truly wants to raise equity capital and if the stock price does not rise sufficiently after the bond is issued, the company will be stuck with debt rather than the desired equity.

20-4D CONVERTIBLES CAN REDUCE AGENCY COSTS A potential agency problem between bondholders and stockholders is asset sub- stitution. Stockholders have an “option-related” incentive to take on projects with high upside potential even though these projects increase the firm’s risk. When such an action is taken, the potential exists for a wealth transfer from bondholders to stockholders. However, when convertible debt is issued, actions that increase a company’s risk may also increase the value of its convertible debt. Thus, some of the gains to shareholders from undertaking high-risk projects must be shared with convertible bondholders. This sharing of benefits lowers agency costs. The same general logic applies to convertible preferred and to bonds with warrants.

S E L F T E S T

What is a conversion ratio? A conversion price? A straight-bond value?

What is meant by a convertible’s floor value?

What are the advantages and disadvantages of convertibles to issuers? To investors?

How do convertibles reduce agency costs?

A convertible bond has a par value of $1,000 and a conversion price of $40. The stock currently trades for $30 a share. What are the bond’s conversion ratio and conversion value at t ¼ 0? (CR = 25; P0(CR) = $30 · 25 = $750)

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20-5 A FINAL COMPARISON OF WARRANTS AND CONVERTIBLES Convertible debt can be thought of as straight debt with nondetachable warrants. Thus, at first, it might appear that debt with warrants and convertible debt are more or less interchangeable. However, a closer look reveals one major difference and several minor differences between the two securities.19 First, as we discussed previously, the exercise of warrants brings in new equity capital, while the con- version of convertibles results in replacing debt with equity on the firm’s balance sheet.

A second difference involves flexibility. Most convertible issues contain a call provision that allows the issuer to refund the debt, which could force conversion if the conversion value exceeds the call price. However, most war- rants are not callable, so firms generally must wait until maturity for the war- rants to generate new equity capital. Also, maturities generally differ between warrants and convertibles—warrants typically have much shorter lives than convertibles, and warrants typically expire before their accompanying debt matures. Further, warrants provide for fewer future common shares than do convertibles because with convertibles, all of the debt is converted to common, whereas debt remains outstanding when warrants are exercised. Together these facts suggest that debt-plus-warrant issuers are more interested in selling debt than in selling equity and that the warrants are primarily a sweetener to induce investors to buy the firm’s debt.

In general, firms that issue bonds with warrants are smaller and riskier than those that issue convertibles. One possible rationale for the use of option securities, especially the use of debt with warrants by small firms, is the difficulty investors have assessing the risk of small companies. If a start-up firm with a new, untested product seeks debt financing, it is very difficult for potential lenders to judge the risk of the venture; hence, it is difficult to set a fair interest rate. Under these circumstances, many potential investors would be reluctant to invest, making it necessary to set very high interest rates to attract debt capital. However, such high interest rates can bankrupt a new firm trying to develop and market a new product. By issuing debt with warrants, investors obtain a package that offers upside potential to offset the risks of loss.

Finally, there is a significant difference in issuance costs between debt with warrants and convertible debt. Bonds with warrants typically require higher flotation costs than required for convertibles. In general, bond-with-warrant finan- cings have underwriting fees that closely reflect the weighted average of the fees associated with debt and equity issues, while underwriting costs for convertibles are substantially lower.

S E L F T E S T

What are some differences between debt-with-warrant financing and convertible debt?

Explain how bonds with warrants might help small, risky firms sell debt secu- rities.

19For a more detailed comparison of warrants and convertibles, see Michael S. Long and Stephen F. Sefcik, “Participation Financing: A Comparison of the Characteristics of Convertible Debt and Straight Bonds Issued in Conjunction with Warrants,” Financial Management, Autumn 1990, pp. 23–34.

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20-6 REPORTING EARNINGS WHEN WARRANTS OR CONVERTIBLES ARE OUTSTANDING

If warrants or convertibles are outstanding, a firm can theoretically report earn- ings per share in one of three ways:

1. Basic EPS, where earnings available to common stockholders are divided by the average number of shares outstanding during the period.

2. Primary EPS, where earnings available are divided by the average number of shares that would have been outstanding if warrants and convertibles “likely to be converted in the near future” had been exercised or converted. In calculating primary EPS, earnings are adjusted by “backing out” the interest on the convertibles, after which the adjusted earnings are divided by the adjusted number of shares. Accountants have a formula that compares the conversion or exercise price with the actual market value of the stock to determine the likelihood of conversion when deciding on the need to use this adjustment procedure.

3. Diluted EPS, which is similar to primary EPS except that all warrants and convertibles are assumed to be exercised or converted, regardless of the likelihood of exercise or conversion.

Under SEC rules, firms are required to report both basic and diluted EPS. For firms with large numbers of option securities outstanding, there can be a sub- stantial difference between basic and diluted EPS. For financial statement pur- poses, firms reported diluted EPS until 1997, when the Financial Accounting Standards Board (FASB) changed to basic EPS (ASC 260, Earnings Per Share). According to FASB, the change was made to give investors a simpler picture of a company’s underlying performance. Also, the change makes it easier for investors to compare the performance of U.S. firms with their foreign counterparts, which tend to use basic EPS.

While common stock and long-term debt provide most of the capital that corpora- tions use, companies also use several forms of “hybrid securities.” The hybrids include preferred stock, leasing, convertibles, and warrants, each of which has some characteristics of debt and some of equity. We discussed the pros and cons of the hybrids from the standpoints of issuers and investors, how to determine when they should be used, and the factors that impact their valuation. The basic rationale for these securities and the procedures used to evaluate them are based on valuation concepts developed in earlier chapters.

S E L F T E S T

What are the three possible methods for reporting EPS when warrants and con- vertibles are outstanding?

Which methods are most used in practice?

Why should investors be concerned about a firm’s outstanding warrants and convertibles?

Chapter 20 Hybrid Financing: Preferred Stock, Leasing, Warrants, and Convertibles 707

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(Solutions Appear in Appendix A)

ST-1 KEY TERMS Define each of the following terms: a. Cumulative; adjustable-rate preferred stock b. Arrearages c. Lessee; lessor d. Sale and leaseback; operating lease; financial lease e. Off-balance-sheet financing; FAS 13 (or ASC 840) f. Residual value g. Warrant; detachable warrant; stepped-up exercise price h. Convertible security; conversion ratio, CR; conversion price, Pc; conversion value, Ct i. Basic EPS; primary EPS; diluted EPS

ST-2 LEASE ANALYSIS The Olsen Company has decided to acquire a new truck. One alter- native is to lease the truck on a 4-year contract for a lease payment of $10,000 per year, with payments to be made at the beginning of each year. The lease would include maintenance. Alternatively, Olsen could purchase the truck outright for $40,000, finan- cing with a bank loan for the net purchase price, amortized over a 4-year period at an interest rate of 10% per year, payments to be made at the end of each year. Under the borrow-to-purchase arrangement, Olsen would have to maintain the truck at a cost of $1,000 per year, payable at year-end. The truck falls into the MACRS 3-year class. The applicable MACRS depreciation rates are 33%, 45%, 15%, and 7%. The truck has a salvage value of $10,000, which is the expected market value after 4 years, at which time Olsen plans to replace the truck regardless of whether the firm leases the truck or purchases it. Olsen has a federal-plus-state tax rate of 40%.

a. What is Olsen’s PV cost of leasing? b. What is Olsen’s PV cost of owning? Should the truck be leased or purchased? c. The appropriate discount rate for use in Olsen’s analysis is the firm’s after-tax cost of

debt. Why? d. The salvage value is the least certain cash flow in the analysis. How might Olsen

incorporate the higher risk of this cash flow into the analysis?

QUESTIONS

20-1 For purposes of measuring a firm’s leverage, should preferred stock be classified as debt or equity? Does it matter whether the classification is being made (a) by the firm’s manage- ment, (b) by creditors, or (c) by equity investors?

20-2 You are told that one corporation just issued $100 million of preferred stock and another purchased $100 million of preferred stock as an investment. You are also told that one firm has an effective tax rate of 20%, whereas the other is in the 35% tax bracket. Which firm is more likely to have bought the preferred? Explain.

20-3 One often finds that a company’s bonds have a higher yield than its preferred stock, even though an investor considers the bonds to be less risky than the preferred. What causes this yield differential?

20-4 Why would a company choose to issue floating-rate as opposed to fixed-rate preferred stock?

20-5 Distinguish between operating leases and financial leases. Would a firm be more likely to finance a fleet of trucks or a manufacturing plant with an operating lease? Explain.

20-6 One alleged advantage of leasing voiced in the past was that it kept liabilities off the balance sheet, thus making it possible for a firm to obtain more leverage than it otherwise could have. This raised the question of whether the lease obligation and the asset involved

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should be capitalized and shown on the balance sheet. Discuss the pros and cons of capitalizing leases and related assets.

20-7 Suppose there were no IRS restrictions on what constitutes a valid lease. Explain in a manner that a legislator might understand why some restrictions should be imposed.

20-8 Suppose Congress changed the tax laws in a way that (1) permitted equipment to be depreciated over a shorter period, (2) lowered corporate tax rates, and (3) reinstated the investment tax credit. Discuss how each of these changes would affect the relative use of leasing versus conventional debt in the U.S. economy.

20-9 What effect does the expected growth rate of a firm’s stock price (subsequent to issue) have on its ability to raise additional funds through (1) convertibles and (2) warrants?

20-10 a. How would a firm’s decision to pay out a higher percentage of its earnings as dividends affect each of the following?

1. The value of its long-term warrants 2. The likelihood that its convertible bonds will be converted 3. The likelihood that its warrants will be exercised

b. If you owned the warrants or convertibles of a company, would you be pleased or displeased if it raised its payout rate from 20% to 80%? Why?

20-11 Evaluate the following statement: Issuing convertible securities represents a means by which a firm can sell common stock at a price above the existing market price.

20-12 Suppose a company simultaneously issues $50 million of convertible bonds with a coupon rate of 9% and $50 million of nonconvertible bonds with a coupon rate of 12%. Both bonds have the same maturity. Because the convertible issue has the lower coupon rate, is it less risky than the nonconvertible bond? Would you regard the cost of capital as being lower on the convertible than on the nonconvertible bond? Explain. (Hint: Although it might appear at first glance that the convertible’s cost of capital is lower, this is not necessarily the case, because the interest rate on the convertible understates its true cost. Think about this.)

PROBLEMS

20-1 LEASING Connors Construction needs a piece of equipment that can be leased or pur- chased. The equipment costs $100. One option is to borrow $100 from the local bank and use the money to buy the equipment. The other option is to lease the equipment. The company’s balance sheet prior to the equipment purchase or lease is shown below:

Current assets $300 Debt $400

Fixed assets 500 Equity 400

Total assets $800 Total liabilities and equity $800

What would be the company’s debt ratio if it chose to purchase the equipment? What would be the company’s debt ratio if it leased the equipment and it could keep the lease off its balance sheet? Is the company’s financial risk any different whether the equipment is leased or purchased? Explain.

20-2 WARRANTS Gregg Company recently issued two types of bonds. The first issue consisted of 20-year straight (no warrants attached) bonds with an 8% annual coupon. The second issue consisted of 20-year bonds with a 6% annual coupon with warrants attached. Both bonds were issued at par ($1,000). What is the value of the warrants that were attached to the second issue?

20-3 CONVERTIBLES Petersen Securities recently issued convertible bonds with a $1,000 par value. The bonds have a conversion price of $40 per share. What is the bonds’ conversion ratio, CR?

Easy Problems 1–3

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20-4 BALANCE SHEET EFFECTS OF LEASING Two textile companies, McDaniel-Edwards Manu- facturing and Jordan-Hocking Mills, began operations with identical balance sheets. A year later both required additional manufacturing capacity at a cost of $200,000. McDaniel- Edwards obtained a 5-year, $200,000 loan at an 8% interest rate from its bank. Jordan- Hocking, on the other hand, decided to lease the required $200,000 capacity from National Leasing for 5 years; an 8% return was built into the lease. The balance sheet for each company, before the asset increases, is as follows:

Debt $200,000

Equity 200,000

Total assets $400,000 Total liabilities and equity $400,000

a. Show the balance sheet of each firm after the asset increase, and calculate each firm’s new debt ratio. (Assume that Jordan-Hocking’s lease is kept off the balance sheet.)

b. Show how Jordan-Hocking’s balance sheet would have looked immediately after the financing if it had capitalized the lease.

c. Would the rate of return (1) on assets and (2) on equity be affected by the choice of financing? If so, how?

20-5 LEASE VERSUS BUY Morris-Meyer Mining Company must install $1.5 million of new machinery in its Nevada mine. It can obtain a bank loan for 100% of the required amount. Alternatively, a Nevada investment banking firm that represents a group of investors believes that it can arrange for a lease financing plan. Assume that the following facts apply:

1. The equipment falls in the MACRS 3-year class. The applicable MACRS rates are 33%, 45%, 15%, and 7%.

2. Estimated maintenance expenses are $75,000 per year. 3. Morris-Meyer’s federal-plus-state tax rate is 40%. 4. If the money is borrowed, the bank loan will be at a rate of 15%, amortized in 4 equal

installments to be paid at the end of each year. 5. The tentative lease terms call for end-of-year payments of $400,000 per year for

4 years. 6. Under the proposed lease terms, the lessee must pay for insurance, property taxes, and

maintenance. 7. The equipment has an estimated salvage value of $400,000, which is the expected

market value after 4 years, at which time Morris-Meyer plans to replace the equipment regardless of whether the firm leases or purchases it. The best estimate for the salvage value is $400,000, but it may be much higher or lower under certain circumstances.

To assist management in making the proper lease-versus-buy decision, you are asked to answer the following questions.

a. Assuming that the lease can be arranged, should Morris-Meyer lease or borrow and buy the equipment? Explain.

b. Consider the $400,000 estimated salvage value. Is it appropriate to discount it at the same rate as the other cash flows? What about the other cash flows—are they all equally risky? Explain.

WARRANTS Pogue Industries Inc. has warrants outstanding that permit its holders to purchase 1 share of stock per warrant at a price of $21. (Refer to Chapter 18 for parts a, b, and c.) a. Calculate the exercise value of Pogue’s warrants if the common stock sells at each of

the following prices: $18, $21, $25, and $70. b. At what approximate price do you think the warrants would sell under each condition

indicated in part a? What premium is implied in your price? Your answer will be a guess, but your prices and premiums should bear reasonable relationships to each other.

20-6

Intermediate Problems 4–7

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c. How would each of the following factors affect your estimates of the warrants’ prices and premiums in part b?

1. The life of the warrant is lengthened. 2. The expected variability sp

� � in the stock’s price decreases.

3. The expected growth rate in the stock’s EPS increases. 4. The company announces the following change in dividend policy: Whereas it

formerly paid no dividends, henceforth it will pay out all earnings as dividends.

d. Assume that Pogue’s stock now sells for $18 per share. The company wants to sell some 20-year, annual interest, $1,000 par value bonds. Each bond will have 50 warrants, and each warrant entitles the holder to buy 1 share of stock at a price of $21. Pogue’s straight debt yields 10%. Regardless of your answer to part b, assume that the warrants will have a market value of $1.50 when the stock sells at $18. What annual coupon interest rate and annual dollar coupon must the company set on the bonds with warrants if the bonds are to clear the market (i.e., the market is in equilibrium)? Round to the nearest dollar or percentage point.

20-7 CONVERTIBLES In the summer of 2015, the Hadaway Company was planning to finance an expansion with a convertible security. It considered a convertible debenture but feared the burden of fixed interest charges if the common stock price did not rise enough to make conversion attractive. The firm decided on an issue of convertible preferred stock, which would pay a dividend of $1.05 per share.

The common stock was selling for $21 a share at the time. Management projected earnings for 2015 at $1.50 a share and expected a future growth rate of 10% per year in 2016 and beyond. The investment bankers and management agreed that the common stock would continue to sell at 14 times earnings, the current price/earnings ratio.

a. What conversion price should the issuer set? The conversion rate will be 1.0; that is, each share of convertible preferred can be converted into 1 share of common. Therefore, the convertible’s par value (as well as the issue price) will be equal to the conversion price, which in turn will be determined as a percentage over the current market price of the common. Your answer will be a guess, but it should be a reasonable one.

b. Should the preferred stock include a call provision? Why or why not?

20-8 LEASE ANALYSIS As part of its overall plant modernization and cost reduction program, the management of Tanner-Woods Textile Mills has decided to install a new automated weaving loom. In the capital budgeting analysis of this equipment, the IRR of the project was 20% versus a project required return of 12%.

The loom has an invoice price of $250,000, including delivery and installation charges. The funds needed could be borrowed from the bank through a 4-year amortized loan at a 10% interest rate, with payments to be made at year-end. In the event the loom is purchased, the manufacturer will contract to maintain and service it for a fee of $20,000 per year paid at year-end. The loom falls in the MACRS 5-year class, and Tanner-Woods’s marginal federal-plus-state tax rate is 40%. The applicable MACRS rates are 20%, 32%, 19%, 12%, 11%, and 6%.

United Automation Inc., maker of the loom, has offered to lease the loom to Tanner- Woods for $70,000 upon delivery and installation at t ¼ 0ð Þ plus 4 additional annual lease payments of $70,000 to be made at the end of Years 1 through 4. (Note that there are 5 lease payments in total.) The lease agreement includes maintenance and servicing. Actually, the loom has an expected life of 10 years, at which time its expected salvage value is zero; however, after 4 years, its market value is expected to equal its book value of $42,500. Tanner-Woods plans to build an entirely new plant in 4 years, so it has no interest in leasing or owning the proposed loom for more than that period.

a. Should the loom be leased or purchased? b. The salvage value is clearly the most uncertain cash flow in the analysis. Assume that

the appropriate salvage value pretax discount rate is 15%. What would be the effect of a salvage value risk adjustment on the decision?

c. The original analysis assumed that Tanner-Woods would not need the loom after 4 years. Now assume that the firm will continue to use the loom after the lease

Challenging Problems 8–10

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expires. Thus, if it leased, Tanner-Woods would have to buy the asset after 4 years at the then existing market value, which is assumed to equal the book value. What effect would this requirement have on the basic analysis? (No numerical analysis is required; just verbalize.)

20-9 FINANCING ALTERNATIVES The Howe Computer Company has grown rapidly during the past 5 years. Recently, its commercial bank urged the company to consider increasing its permanent financing. Its bank loan under a line of credit has risen to $150,000, carrying a 10% interest rate, and Howe has been 30 to 60 days late in paying trade creditors.

Discussions with an investment banker have resulted in the decision to raise $250,000 at this time. Investment bankers have assured Howe that the following alternatives are feasible (flotation costs will be ignored):

• Alternative 1: Sell common stock at $10 per share. • Alternative 2: Sell convertible bonds at a 10% coupon, convertible into 80 shares of

common stock for each $1,000 bond (i.e., the conversion price is $12.50 per share).

• Alternative 3: Sell debentures with a 10% coupon; each $1,000 bond will have 80 warrants to buy 1 share of common stock at $12.50.

Keith Howe, the president, owns 80% of Howe’s common stock and wants to maintain control of the company; 50,000 shares are outstanding. The following are summaries of Howe’s latest financial statements:

Balance Sheet

Current liabilities $200,000

Common stock, $1 par 50,000

Retained earnings 25,000

Total assets $275,000 Total liabilities and equity $275,000

Income Statement

Sales $550,000

All costs except interest 495,000

EBIT $ 55,000

Interest 15,000

EBT $ 40,000

Taxes (40%) 16,000

Net income $ 24,000

Shares outstanding 50,000

Earnings per share $0.48

Price/earnings ratio 18

Market price of stock $8.64

a. Show the new balance sheet under each alternative. For alternatives 2 and 3, show the balance sheet after conversion of the debentures or exercise of the warrants. Assume that $150,000 of the funds raised will be used to pay off the bank loan and the rest used to increase total assets.

b. Show Keith Howe’s control position under each alternative, assuming that he does not purchase additional shares.

c. What is the effect on earnings per share of each alternative if it is assumed that earnings before interest and taxes will be 20% of total assets?

d. What will be the debt ratio under each alternative? e. Which of the three alternatives would you recommend to Keith Howe? Why?

20-10 CONVERTIBLES O’Brien Computers Inc. needs to raise $35 million to begin producing a new microcomputer. O’Brien’s nonconvertible debentures currently yield 12%. Its stock sells for $38 per share; the last dividend was $2.46; and the expected growth rate is a constant 8%. Investment bankers have tentatively proposed that O’Brien raise the $35 million by issuing convertible debentures. These convertibles would have a $1,000 par

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value, carry an annual coupon rate of 10%, have a 20-year maturity, and be convertible into 20 shares of stock. The bonds would be noncallable for 5 years, after which they would be callable at a price of $1,075; this call price would decline by $5 per year in Year 6 and each year thereafter. Management has called convertibles in the past (and presumably will call them again in the future), once they were eligible for call, as soon as their conversion value was about 20% above their par value (not their call price).

a. Draw an accurate graph, similar to Figure 20.1, representing the expectations set forth in the problem.

b. Suppose the previously outlined projects work out on schedule for 2 years, but then O’Brien begins to experience extremely strong competition from Japanese firms. As a result, O’Brien’s expected growth rate drops from 8% to zero. Assume that the dividend at the time of the drop is $2.87. The company’s credit strength is not impaired, and its value of rs is also unchanged. What would happen (1) to the stock price and (2) to the convertible bond’s price? Be as precise as you can.

COMPREHENSIVE/SPREADSHEET PROBLEM

20-11 LEASE ANALYSIS Use the spreadsheet model to rework parts a and b of problem 20-8. Then answer the following question.

c. Accepting that the corporate WACC should be used equally to discount all anticipated cash flows, at what cost of capital would the firm be indifferent between leasing and buying?

20-12 WARRANTS Storm Software wants to issue $100 million in new capital to fund new opportunities. If Storm raised the $100 million of new capital in a straight-debt 20-year bond offering, Storm would have to offer an annual coupon rate of 12%. However, Storm’s advisers have suggested a 20-year bond offering with warrants. According to the advisers, Storm could issue 9% annual coupon-bearing debt with 20 warrants per $1,000 face value bond. Storm has 10 million shares of stock outstanding at a current price of $25. The warrants can be exercised in 10 years (on December 31, 2025) at an exercise price of $30. Each warrant entitles its holder to buy one share of Storm Software stock. After issuing the bonds with warrants, Storm’s operations and investments are expected to grow at a constant rate of 11.4% per year.

a. If investors pay $1,000 for each bond, what is the value of each warrant attached to the bond issue?

b. What is the component cost of these bonds with warrants? What premium is associated with the warrants?

FISH & CHIPS INC., PART I

20-13 LEASE ANALYSIS Martha Millon, financial manager for Fish & Chips Inc., has been asked to perform a lease-versus-buy analysis on a new computer system. The computer costs $1,200,000, and if it is purchased, Fish & Chips could obtain a term loan for the full amount at a 10% cost. The loan would be amortized over the 4-year life of the computer, with payments made at the end of each year. The computer is classified as special purpose; hence, it falls into the MACRS 3-year class. The applicable MACRS rates are 33%, 45%, 15%, and 7%.

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If the computer is purchased, a maintenance contract must be obtained at a cost of $25,000, payable at the beginning of each year. After 4 years, the computer will be sold. Millon’s best estimate of its residual value at that time is $125,000. Because technology is changing rapidly, however, the residual value is uncertain.

As an alternative, National Leasing is willing to write a 4-year lease on the computer, including maintenance, for payments of $340,000 at the beginning of each year. Fish & Chips’s marginal federal-plus-state tax rate is 40%. Help Millon conduct her analysis by answering the following questions.

a. 1. Why is leasing sometimes referred to as “off-balance-sheet” financing? 2. What is the difference between a capital lease and an operating lease? 3. What effect does leasing have on a firm’s capital structure?

b. 1. What is Fish & Chips’s present value cost of owning the computer? (Hint: Set up a table whose bottom line is a “time line” that shows the cash flows over the period t ¼ 0 to t ¼ 4. Then find the PV of these cash flows, or the PV cost of owning.)

2. Explain the rationale for the discount rate you used to find the PV.

c. 1. What is Fish & Chips’s present value cost of leasing the computer? (Hint: Again, construct a time line.) 2. What is the net advantage to leasing? Does your analysis indicate that the firm should buy or lease the

computer? Explain.

d. Now assume that Millon believes that the computer’s residual value could be as low as $0 or as high as $250,000, but she stands by $125,000 as her expected value. She concludes that the residual value is riskier than the other cash flows in the analysis, and she wants to incorporate this differential risk into her analysis. Describe how this can be accomplished. What effect will it have on the lease decision?

e. Millon knows that her firm has been considering moving its headquarters to a new location, and she is concerned that these plans may come to fruition prior to the expiration of the lease. If the move occurs, the company would obtain new computers; hence, Millon would like to include a cancellation clause in the lease contract. What effect would a cancellation clause have on the risk of the lease?

FISH & CHIPS INC., PART II

20-14 PREFERRED STOCK, WARRANTS, AND CONVERTIBLES Martha Millon, financial manager of Fish & Chips Inc., is facing a dilemma. The firm was founded 5 years ago to develop a new fast-food concept; and although Fish & Chips has done well, the firm’s founder and chairman believes that an industry shake-out is imminent. To survive, the firm must capture market share now, which requires a large infusion of new capital.

Because the stock price may rise rapidly, Millon does not want to issue new common stock. On the other hand, interest rates are currently very high by historical standards, and with the firm’s B rating, the interest payments on a new debt issue would be too much to handle if sales took a downturn. Thus, Millon has narrowed her choice to bonds with warrants or convertible bonds. She has asked you to help in the decision process by answering the following questions.

a. How does preferred stock differ from common equity and debt? b. What is adjustable-rate preferred? c. How can a knowledge of call options help a person understand warrants and convertibles? d. One of Millon’s alternatives is to issue a bond with warrants attached. Fish & Chips’s current stock price is

$10, and the company’s investment bankers estimate its cost of 20-year annual coupon debt without warrants to be 12%. The bankers suggest attaching 50 warrants to each bond, with each warrant having an exercise price of $12.50. It is estimated that each warrant, when detached and traded separately, will have a value of $1.50.

1. What coupon rate should be set on the bond with warrants if the total package is to sell for $1,000? 2. Suppose the bonds are issued and the warrants immediately trade for $2.50 each. What does this imply

about the terms of the issue? Did the company “win” or “lose”? 3. When would you expect the warrants to be exercised? 4. Will the warrants bring in additional capital when exercised? If so, how much and what type of capital?

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5. Because warrants lower the cost of the accompanying debt, shouldn’t all debt be issued with warrants? What is the expected cost of the bond with warrants if the warrants are expected to be exercised in 5 years, when Fish & Chips’s stock price is expected to be $17.50? How would you expect the cost of the bond with warrants to compare with the cost of straight debt? With the cost of common stock?

e. As an alternative to the bond with warrants, Millon is considering convertible bonds. The firm’s investment bankers estimate that Fish & Chips could sell a 20-year, 10% annual coupon, callable convertible bond for its $1,000 par value, whereas a straight-debt issue would require a 12% coupon. Fish & Chips’s current stock price is $10, its last dividend was $0.74, and the dividend is expected to grow at a constant rate of 8%. The convertible could be converted into 80 shares of Fish & Chips stock at the owner’s option.

1. What conversion price, Pc, is implied in the convertible’s terms? 2. What is the straight-debt value of the convertible? What is the implied value of the convertibility

feature? 3. What is the formula for the bond’s conversion value in any year? Its value at Year 0? At Year 10? 4. What is meant by the term floor value of a convertible? What is the convertible’s expected floor

value in Year 0? In Year 10? 5. Assume that Fish & Chips intends to force conversion by calling the bond when its conversion

value is 20% above its par value, or at 1:2 $1,000ð Þ ¼ $1,200. When is the issue expected to be called? Answer to the closest year.

6. What is the expected cost of the convertible to Fish & Chips? Does this cost appear consistent with the risk of the issue? Assume conversion in Year 5 at a conversion value of $1,200.

f. Millon believes that the cost of the bond with warrants and the cost of the convertible bond are essentially equal, so her decision must be based on other factors. What are some factors she should consider when making her decision between the two securities?

Use online resources to work on this chapter’s questions. Please note that website information changes over time, and these changes may limit your ability to answer some of these questions.

USING THE INTERNET TO FOLLOW HYBRID SECURITIES

This chapter discussed alternative types of long-term capital that are considered hybrids—meaning that they have elements of both debt and equity. We will look at a few of these different hybrid securities. To answer these questions, you will find the following websites helpful: Yahoo! Finance, Google Finance, MSN Money, and Morningstar.com.

1. Look up Alcoa Inc.’s (AA) 3.75% preferred stock. You will find this information on Yahoo! Finance (AA-P) or on Morningstar.com (AA.PR).

a. What is the preferred’s current stock price? b. What is its yield?

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2. Look up Alcoa Inc.’s 5.9% fixed-coupon debt maturing on February 1, 2027. You will find this information on Morningstar.com. At the company’s overview screen, just click the “Bonds” tab, and you will see its various debt issues.

a. What is the bond’s yield to maturity? b. What is the difference in the two securities’ yields? Which security has the higher yield? What explains

this situation? c. If you were a corporation in the top marginal tax bracket (35%) that had invested in Alcoa’s preferred

stock, what would be your after-tax return? d. If you were a corporation in the top marginal tax bracket (35%) that had invested in Alcoa’s 5.9% fixed

coupon debt maturing on February 1, 2027, what would be your after-tax return?

3. Look up the Tesla Motors’s (TSLA) convertible bond issues through the Yahoo! Finance Bonds Center (finance.yahoo.com/bonds). Once on this screen, click Bond Screener. Now, you can select the type and different criteria to find matching bond issues. Select corporate, a minimum Fitch rating of B, and not callable. Then click Find Bonds. You will see that there are numerous issues that meet these criteria. If you click the column heading “Issue” twice, this will allow you to search alphabetically from the back of the alphabet to find the Tesla Motors’ bond issues so you can answer the following questions.

a. How many Tesla Motors’ bond issues are shown? b. What are the price, coupon rate, Fitch bond rating, and yield to maturity of the issue with a March 1,

2019, maturity? c. What is the price, coupon rate, Fitch bond rating, and yield to maturity of the issue with a March 1,

2021, maturity?

4. Look up the quotation for the iShares U.S. Preferred Stock Index Fund (PFF).

a. What is its current price? b. What is the net asset amount in the fund? c. What is the fund’s year-to-date return? d. What has the fund’s average trading volume been over the past 3 months?

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