Chapter 16

Hybrid and
Derivative
Securities
Learning Goals

1.The types of leases, leasing arrangements,

2.Lease vs purchase vs Rent decision,
3.Effects of leasing on future financing,
4.Advantages and disadvantages of leasing.
5.Practical exercise

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An Overview of Hybrids & Derivatives

• In their simplest form, bonds are pure debt and common

stocks are pure equity.
• Preferred stocks, on the other hand, are a hybrid of the
two.
• They are like common stocks in that they promise to pay
dividends, are perpetual, and represent ownership.
• They are like bonds in that dividends are fixed like bond
interest payments.
• Other hybrid securities include financial leases,
convertible securities, and stock purchase warrants.

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Leasing
• Leasing is the 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.

• The lessee is the receiver of the services of the

assets under a lease contract.

• The lessor is the owner of the assets that are

being leased.

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Leasing: Operating Leases

• An operating lease is a cancelable contractual

arrangement whereby the lessee agrees to
make periodic payments to the lessor, often for
5 or fewer years, to obtain an assets services.
• Generally, the total payments over the term of
the lease are less than the lessor’s initial cost of
the leased asset.
• If the operating lease is held to maturity, the
lessee returns the leased asset over to the
lessor, who may lease it again or sell the asset.

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Leasing: Financial (or Capital) Leases

• A financial lease is a longer-term lease than an

operating lease.
• Financial leases are non-cancelable and obligate the
lessee to make payments for the use of an asset over a
predefined period of time.
• The total payments over the term of the lease are
greater than the lessor’s cost of the leased asset. In
other words, lessor must receive more than the asset
purchase price to earn its required rate of return.

• Financial leases are commonly used for leasing land,

buildings and expensive pieces of equipment.
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 Buy, Lease, rent !!!!
Which one is better ?

• https://www.youtube.com/watch?v=mV48f
nztoAI

Leasing or renting? The small difference

• https://www.youtube.com/watch?
v=oQHEVMAjB6Q

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Leasing: Leasing Arrangements

• A direct lease is a lease under which a lessor

owns or acquires the assets that are leased to a
given lessee.
• A sale-leaseback arrangement is a lease under
which the lessee sells an asset for cash to a
prospective lessor and then leases back the same
asset.
• A leveraged lease is a lease under which the
lessor acts as an equity participant, supplying
about 20 percent of the cost of the asset with a
lender supplying the balance.
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Leasing: Leasing Arrangements (cont.)

• Operating leases normally require maintenance

clauses requiring the lessor to maintain the assets and
to make insurance and tax payments.
• Renewal options are provisions that grant the lessee
the option to re-lease assets at the expiration of the
lease.
• Finally, purchase options are provisions frequently
included in both operating and financial leases that allow
the lessee to purchase the asset at maturity—usually at
a pre-specified price.

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Leasing: Advantages of Leasing

• A lessee avoids many of the restrictive agreements

(Such as minimum liquidity, mortgage) that are normally
included as part of a long-term loan.

• Leasing—especially operating leases—may provide the

firm with needed financial flexibility.

• Sale-leaseback arrangements may permit the firm to

increase its liquidity by converting an existing asset into
cash, which may then be used as working capital.
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Leasing: Advantages of Leasing (cont.)

• It results in the receipt of service from an asset possibly

without increasing the assets or liabilities on the firm’s
balance sheet, leasing may result in misleading financial
ratios.
• Leasing provides 100 percent financing.
• When the firm becomes bankrupt or is reorganized, the
maximum claim of lessors against the corporation is 3
years of lease payments, and the lessor gets the
asset back.

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Leasing: Disadvantages of Leasing

• A lease does not have a stated interest cost.

• At the end of the term of the lease agreement, the salvage
value of an asset, if any, is realized by the lessor.
• Under a lease, the lessee is generally prohibited from
making improvements on the leased property or asset
without approval of the lessor.
• If a lessee leases an asset that subsequently becomes
out-of-date, it must still make lease payments over the
remaining term of the lease.(Example: Bangladesh Biman
Aircaft)

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The Lease Vs. Purchase Decision
• The lease-versus-purchase decision is a
common decision faced by firms considering the
acquisition of a new asset.
• This decision involves the application of capital
budgeting techniques as does any other asset
investment acquisition decision.
• The preferred method is the calculation of NPV
based on the incremental cash flows (lease
versus purchase) using the following steps:

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 •Practice

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