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Meeting 10: Tactical

Financing Decisions
Ch 18, 19, 20

CHAPTER 18
Lease Financing

Who are the two parties to


a lease transaction?
The lessee, who uses the asset and makes the lease, or
rental, payments.
The lessor, who owns the asset and receives the rental
payments.
Note that the lease decision is a financing decision for
the lessee and an investment decision for the lessor.

What impact does leasing have


on a firms capital structure?
Leasing is a substitute for debt.
As such, leasing uses up a firms debt capacity.
Assume a firm has a 50/50 target capital structure.
Half of its assets are leased. How should the remaining
assets be financed?

Time Line: After-Tax Cost of Owning


(In Thousands)
0
AT loan pmt

1
2
-60 -60

Dep Shld

132

Maint
Tax sav
RV
Tax

18
0
-20 -20 -20
8
8
8

3
-60

4
1,060
60
28

-20
8
5

200
-80

Note the depreciation shield in each year equals the


depreciation expense times the lessees tax rate. For
Year 1, the depreciation shield is
$330,000(0.40) = $132,000.
The present value of the cost of owning cash flows,
when discounted at 6%, is
-$591,741.

Why use 6% as the discount rate?


Leasing is similar to debt financing.
The cash flows have relatively low risk; most
are fixed by contract.
Therefore, the firms 10% cost of debt is a
good candidate.

The tax shield of interest payments must


be recognized, so the discount rate is:
10%(1 - T) = 10%(1 - 0.4) = 6.0%.

Time Line: After-Tax Cost of Leasing


(In Thousands)
0
Lease pmt
Tax sav
NCF

-260

260 260 260


104 104 104 104

-156

156 156 156

PV cost of leasing @ 6% = -$572,990.


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What is the net advantage to


leasing (NAL)?
NAL = PV cost of leasing - PV cost of
owning
= - $572,990 - (-$591,741)
= $18,751.
Should the firm lease or buy the equipment? Why?

CHAPTER 19
Hybrid Financing: Preferred Stock, Warrants, and
Convertibles

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How does preferred stock differ


from common stock and debt?
Preferred dividends are specified by contract, but they
may be omitted without placing the firm in default.
Most preferred stocks prohibit the firm from paying
common dividends when the preferred is in arrears.
Usually cumulative up to a limit.

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Some preferred stock is perpetual, but


most new issues have sinking fund or call
provisions which limit maturities.
Preferred stock has no voting rights, but
may require companies to place preferred
stockholders on the board (sometimes a
majority) if the dividend is passed.
Is preferred stock closer to debt or
common stock? What is its risk to
investors? To issuers?
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Advantages and Disadvantages


of Preferred Stock
Advantages
Dividend obligation not contractual
Avoids dilution of common stock
Avoids large repayment of principal

Disadvantages
Preferred dividends not tax deductible, so
typically costs more than debt
Increases financial leverage, and hence the
firms cost of common equity

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How can a knowledge of call options help


one understand warrants and
convertibles?
A warrant is a long-term call option.
A convertible consists of a fixed rate bond (or preferred
stock) plus the option to convert the bond into stock.

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When would you expect the


warrants to be exercised?
Generally, a warrant will sell in the open market at a
premium above its exercise value (it would never sell
for less).
Therefore, warrants tend not to be exercised until just
before expiration.

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Recap the differences between


warrants and convertibles.
Warrants bring in new capital, while convertibles do
not.
Most convertibles are callable, while warrants are not.
Warrants typically have shorter maturities than
convertibles, and expire before the accompanying debt.

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Warrants usually provide for fewer common shares than


do convertibles.
Bonds with warrants typically have much higher
flotation costs than do convertible issues.
Bonds with warrants are often used by small start-up
firms. Why?

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How do convertibles help minimize


agency costs?
Agency costs due to conflicts between shareholders
and bondholders
Asset substitution (or bait-and-switch). Firm issues low cost
straight debt, then invests in risky projects
Bondholders suspect this, so they charge high interest rates
Convertible debt allows bondholders to share in upside
potential, so it has low rate.

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CHAPTER 20
Initial Public Offerings, Investment Banking, and Financial
Restructuring

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Why would a company consider


going public?
Advantages of going public

Current stockholders can diversify.


Liquidity is increased.
Easier to raise capital in the future.
Going public establishes firm value.
Makes it more feasible to use stock as employee incentives.
Increases customer recognition.

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Disadvantages of Going Public

Must file numerous reports.


Operating data must be disclosed.
Officers must disclose holdings.
Special deals to insiders will be more difficult to undertake.
A small new issue may not be actively traded, so marketdetermined price may not reflect true value.
Managing investor relations is time-consuming.

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What are the steps of an IPO?


Select investment banker
File registration document (S-1) with SEC
Choose price range for preliminary (or red herring)
prospectus
Go on roadshow
Set final offer price in final prospectus

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What criteria are important in


choosing an investment banker?
Reputation and experience in this industry
Existing mix of institutional and retail (i.e., individual)
clients
Support in the post-IPO secondary market
Reputation of analyst covering the stock

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What are typical first-day returns?


For 75% of IPOs, price goes up on first day.
Average first-day return is 14.1%.
About 10% of IPOs have first-day returns greater than
30%.
For some companies, the first-day return is well over
100%.

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What is meant by going private?


Going private is the reverse of going
public.
Typically, the firms managers team up
with a small group of outside investors
and purchase all of the publicly held
shares of the firm.
The new equity holders usually use a
large amount of debt financing, so such
transactions are called leveraged
buyouts (LBOs).
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Advantages of Going Private


Gives managers greater incentives and more flexibility
in running the company.
Removes pressure to report high earnings in the short
run.
After several years as a private firm, owners typically
go public again. Firm is presumably operating more
efficiently and sells for more.

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Disadvantages of Going Private


Firms that have recently gone private are normally
leveraged to the hilt, so its difficult to raise new
capital.
A difficult period that normally could be weathered
might bankrupt the company.

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