Professional Documents
Culture Documents
HYBRID FINANCING
Definition
A hybrid security is a single financial product that combines different types of financial
securities, or has features of multiple kinds of securities.
Basic examples are the securities that has aspects of both debt (bonds) and equity
(stocks). The security will have the guaranteed payment nature of a bond while also
having the potential for capital appreciation of a
stock.
Examples
1. Preferred stocks
2. Convertible bonds
3. Warrants
LEASING
Definition
Process by which a firm can obtain the use of certain fixed assets for which it must
make a series of contractual, periodic, tax-deductible payments.
Lessee is the receiver of the services of the assets under the leasecontract; the lessor
is the owner of the assets. Leasing can take a number of forms
Often referred to as “off-balance-sheet” financing if a lease is not “capitalized.”
Leasing is a substitute for debt financing and, thus, uses up a firm’s debt capacity.
Depreciation Schedule
Depreciable basis = $1,200,000
What if a cancellation clause were included in the lease? How would this affect the
riskiness of the lease?
A cancellation clause lowers the risk of the lease to the lessee.
However, it increases the risk to the lessor because of a potential loss of income
2. PREFERRED SHARES
These shares are called preferred because owners of preferred stock will receive
dividends before common shareholders.
They also have a higher claim on the company’s assets compared with common
shareholders if the company ceases operations. Most preferred stocks prohibit the
firm from paying common dividends when the preferred is in arrears
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Preferred stock has characteristics of both bonds and common stock which
enhances its appeal to certain investors.
Voting or non-voting. Cumulative or non-cumulative. Participating or non-
participating
Examples: SMC2C, ACP and PNX3A
Adjustable Rate
Dividends are indexed to the rate on treasury securities instead of being fixed. (i.e. 3-
month T-bill + premium or 3-month PDST + premium)
Adjustable rate generally keeps issue trading near par
Excellent S-T corporate investment:
• Only 30% of dividends are taxable to corporations.
However, if the issuer is risky, the adjustable-rate preferred stock may have too much
price instability for the liquid asset portfolios of many corporate investors.
Tax Rate
Good investments because of tax rate
US – 30% to corporations
Philippines – 10% to individuals and 0% to corporations vs. 20% FWT for bonds
3. STOCK RIGHTS
A rights offering (rights issue) is a group of rights offered to existing shareholders
to purchase additional stock shares in proportion to their existing holdings during a
short period of time (1 to 2 weeks)
The subscription price at which each share may be purchased is generally
discounted relative to the current market price
Examples: ACEN (1:1.11 shares) and CEB (1:1.1825 shares)
4. WARRANTS
It entitles the holder to buy a pre-specified amount of common stock of the issuing
company at a pre-specified per share price (called the exercise price or strike
price) prior to a pre-specified expiration date that’s more than one year
Warrants are traded and listed in the exchange
Examples: LRW
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CONVERTIBLES
1. CONVERTIBLE BOND
A convertible bond is a fixed-income corporate debt security that yields interest
payments, but can be converted into a predetermined number of common stock or
equity shares.
The conversion from the bond to stock can be done at certain times during the
bond's life
A convertible bond offers investors features of a bond, such as interest payments,
while also having the option to own the underlying stock.
2. CONVERTIBLE PREFERRED
Convertible preferred stocks are preferred shares that include an option for the
holder to convert the shares into a fixed number of common shares after a
predetermined date
Worth to convert when stock price is above the conversion price
After a preferred shareholder converts their shares, they give up their rights as a
preferred shareholder and become a common shareholder
How can a knowledge of call options help one understand warrants and
convertibles?
A warrant is a long-term call option.
A convertible bond consists of a fixed-rate bond plus a call option.
An understanding of options will help financial managers make decisions regarding
warrant and convertible issues.
What coupon rate should be set for this bond plus warrants package?
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What is the expected rate of return to holders of bonds with warrants, if exercised
in 5 years at P5 = $17.50?
The company will exchange stock worth $17.50 for one warrant plus $12.50. The
opportunity cost to the company is $17.50 – $12.50 = $5.00, for each warrant
exercised.
Each bond has 50 warrants, so on a par bond basis, opportunity cost = 50 ($5.00) =
$250.
Here is the cashflow timeline:
What is the formula for the bond’s expected conversion value in any year?
Conversion value is the amount an investor would received if a convertible security is
changed into common stock. This value is arrived at by multiplying the conversion
ratio (how many shares received per bond) by the market price of the common stock.
Conversion value calculations are useful in determining break-even or floor values
involved with holding convertible securities.
Conversion value = Ct = CR(P0)(1 + g)^t.
At t = 0, the conversion value is
C0 = 80 ($10) (1.08)^0 = $800.
At t = 10, the conversion value is
C10 = 80 ($10) (1.08)^10 = $1,727.14
A key objective with a convertible security is to hold onto it until the market price is
higher than the conversion value, thus generating profit through the conversion and
later sale of the common stock received
It’s like asking how long until l $800 becomes $1,200, when it grows by 8% annually
Conversion value is expected to equal the call price of $1,200 after 5.27 years
What is the convertible’s expected cost of capital to the firm, if converted in Year
5?
Input the cash flows from the convertible bond and solve for YTM/IRR = 13.08%.
Is the cost of the convertible consistent with the risk of the issue?
To be consistent, we require that rd < rc < re.
The convertible bond’s risk is a blend of the risk of debt and equity, so rc should be
between the cost of debt and equity.
• From previous information:
re = $0.74(1.08)/$10 + 0.08 = 16.0%.
rc is between rd and re, and is consistent.
POP QUIZ
Which of the following statements concerning warrants is most CORRECT?
a. Bonds with warrants and convertible bonds both have option features that their
holders can exercise if the underlying stock's price increases. However, if the
option is exercised, the issuing company's debt declines if warrants are used but
remains the same if convertibles are used.
b. 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 price
has risen.
c. A firm's investors would generally prefer to see it issue bonds with warrants than
straight bonds because the warrants dilute the value of new shareholders, and that
value is transferred to existing shareholders.
d. A drawback to using warrants is that if the firm is very successful, investors will be
less likely to exercise the warrants, and this will deprive the firm of receiving any
new capital.
Answer: B
Answer: B
Answer: D
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Clickbait Inc. is considering issuing 15-year, 8% semiannual coupon, $1,000 face value
convertible bonds at a price of $1,000 each. Each bond would be convertible into 25
shares of common stock. If the bonds were not convertible, investors would require an
annual nominal yield of 10%. What is the straight-debt value of each bond at the time of
issue?
a. $725.58
b. $763.76
c. $803.96
d. $846.28
Answer: D
Find the straight-debt value: N = 30, I/YR = 5, PMT = -40, and FV = -1000.
PV = $846.28
CirTechCompany (CTC) is evaluating a potential lease for a truck with a 4-year life that
costs $40,000 and falls into the MACRS 3-year class. If the firm borrows and buys the
truck, the loan rate would be 9%, and the loan would be amortized over the truck’s 4-year
life. The loan payments would be made at the end of each year. The truck will be used
for 4 years, at the end of which time it will be sold at an estimated residual value of
$12,000. If CTC buys the truck, it would purchase a maintenance contract that costs
$1,500 per year, payable at the end of each year. The lease terms, which include
maintenance, call for a $10,000 lease payment (4 payments total) at the beginning of
each year. CTC's tax rate is 35%. What is the net advantage to leasing? (Note: MACRS
rates for Years 1 to 4 are 0.33, 0.45, 0.15, and 0.07.)
a. $609
b. $642
c. $678
d. $715
Answer: D
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