-hybrid And Derivative Securities 4r5xj

Hybrid and Derivative Securities

Overview of Hybrids and Derivatives A hybrid security is a form of debt or equity financing that possesses characteristics of both debt and equity financing. – Examples include • preferred stock • financial leases • convertible securities • stock purchase warrants.

A derivative security is a security that is neither debt nor equity but derives its value from an underlying asset that is often another security; called ”derivatives,” for short. 2

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 assets that are being leased.

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Leasing: Types of 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 asset’s services; generally, the total payments over the term of the lease are less than the lessor’s initial cost of the leased asset. A financial (or capital) lease is a longer-term lease than an operating lease that is noncancelable and obligates 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 initial cost of the leased asset. 4

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 to a prospective lessor and then leases back the same asset, making fixed periodic payments for its use. A leveraged lease is a lease under which the lessor acts as an equity participant, supplying only about 20 percent of the cost of the asset, while a lender supplies the balance. 5

Leasing: Leasing Arrangements (cont.) Maintenance clauses are provisions normally included in an operating lease that require the lessor to maintain the assets and to make insurance and tax payments. Renewal options are provisions especially common in operating leases that grant the lessee the right to re-lease assets at the expiration of the lease. Purchase options are provisions frequently included in both operating and financial leases that allow the lessee to purchase the leased asset at maturity, typically for a prespecified price. 6

Leasing: Lease-versusPurchase Decision The lease-versus-purchase (or lease-versus-buy) decision is the decision facing firms needing to acquire new fixed assets: whether to lease the assets or to purchase them, using borrowed funds or available liquid resources.

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Leasing: Lease-versusPurchase Decision The lease-versus-purchase decision involves application of capital budgeting techniques. First, we determine the relevant cash flows and then apply present value techniques. The following steps are involved in the analysis: Step 1 Find the after-tax cash outflows for each year under the lease alternative. This step generally involves a fairly simple tax adjustment of the annual lease payments. In addition, the cost of exercising a purchase option in the final year of the lease term must frequently be included. 8

Leasing: Lease-versusPurchase Decision (cont.) Step 2 Find the after-tax cash outflows for each year under the purchase alternative. This step involves adjusting the sum of the scheduled loan payment and maintenance cost outlay for the tax shields resulting from the tax deductions attributable to maintenance, depreciation, and interest.

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Leasing: Lease-versusPurchase Decision (cont.) Step 3 Calculate the present value of the cash outflows associated with the lease (from Step 1) and purchase (from Step 2) alternatives using the after-tax cost of debt as the discount rate. The after-tax cost of debt is used to evaluate the lease-versus-purchase decision because the decision itself involves the choice between two financing techniques— leasing and borrowing. Step 4 Choose the alternative with the lower present value of cash outflows from Step 3. It will be the least-cost financing alternative.

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Leasing: Lease-versusPurchase Decision (cont.) Roberts Company, a small machine shop, is contemplating acquiring a new machine that costs P24,000. Arrangements can be made to lease or purchase the machine. The firm is in the 40% tax bracket. Lease The firm would obtain a 5-year lease requiring annual end-ofyear lease payments of P6,000. All maintenance costs would be paid by the lessor, and insurance and other costs would be borne by the lessee. The lessee would exercise its option to purchase the machine for P4,000 at termination of the lease.

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Leasing: Lease-versus-Purchase Decision (cont.) Purchase The firm would finance the purchase of the machine with a 9%, 5-year loan. The machine would be depreciated for 5 years. The firm would pay P1,500 per year for a service contract that covers all maintenance costs; insurance and other costs would be borne by the firm. What is the annual end-of-year installment?

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Leasing: Lease-versus-Purchase Decision (cont.) Purchase The firm would finance the purchase of the machine with a 9%, 5-year loan. The machine would be depreciated for 5 years. The firm would pay P1,500 per year for a service contract that covers all maintenance costs; insurance and other costs would be borne by the firm.

*Annual lease payment = P24,000 ÷ PVIFA 9%, 5= P6,170

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Leasing: Lease-versus-Purchase Decision (cont.) Step 1: Find the after-tax cash outflows for the lease option After-tax cash outflow from lease = P6,000  (1 – T) = P6,000  (1 – 0.40) = P3,600 Year

After-tax Cash Outflows

1

P3,600

2

3,600

3

3,600

4

3,600

5

3,600 + 4,000 = 7,600

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Determining the Interest and Principal Components of Roberts Company Loan Payments Step 2: Find the after-tax cash outflows for the purchase option through the 9% 5-year loan

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After-Tax Cash Outflows Associated with Purchasing for Roberts Company

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Comparison of Cash Outflows Associated with Leasing versus Purchasing for Roberts Company Step 3: Compare cash outflows of both options

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Leasing: Lease-versusPurchase Decision (cont.) Step 4: Choose the lower-cost financing option Because the present value of cash outflows for leasing (P18,491) is lower than that for purchasing (P19,631), the leasing alternative is preferred. Leasing results in an incremental savings of P1,140 (P19,631 – P18,491) and is therefore the less costly alternative.

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Advantages and Disadvantages of Leasing

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Advantages and Disadvantages of Leasing

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Convertible Securities A conversion feature is an option that is included as part of a bond or a preferred stock issue and allows its holder to change the security into a stated number of shares of common stock. – The conversion feature typically enhances the marketability of an issue.

Because the conversion feature provides the purchaser with the possibility of becoming a stockholder on favorable , convertible bonds are generally a less expensive form of financing than similarrisk nonconvertible or straight bonds.

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Convertible Securities: General Features of Convertibles The conversion ratio is the ratio at which a convertible security can be exchanged for common stock. The conversion ratio can be stated in two ways: 1. Sometimes the conversion ratio is stated in of a given number of shares of common stock. To find the conversion price, which is the per-share price that is effectively paid for common stock as the result of conversion of a convertible security, divide the par value of the convertible security by the conversion ratio. Example: Smart Inc., a manufacturer of denim products, has outstanding bond that has a P1,000 par value and is convertible into 25 shares of common stock. The bond’s conversion ratio is 25. The conversion price for the bond is P40 per share (P1,000 ÷ 25). 22

Convertible Securities: General Features of Convertibles (cont.) 2. Sometimes, instead of the conversion ratio, the conversion price is given. The conversion ratio can be obtained by dividing the par value of the convertible by the conversion price. Example: Mosher Company, a franchiser of seafood restaurants, has outstanding a convertible 20-year bond with a par value of P1,000. The bond is convertible at P50 per share into common stock. The conversion ratio is 20 (P1,000 ÷ P50).

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Convertible Securities: General Features of Convertibles (cont.) The conversion (or stock) value is the value of a convertible security measured in of the market price of the common stock into which it can be converted. McNamara Industries, a petroleum processor, has outstanding P1,000 bond that is convertible into common stock at P62.50 per share. The conversion ratio is therefore 16 (P1,000 ÷ P62.50). Because the current market price of the common stock is P65 per share, the conversion value is P1,040 (16  P65). Because the conversion value is above the bond value of P1,000, conversion is a viable option for the owner of the convertible security.

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Convertible Securities: General Features of Convertibles (cont.) Contingent securities include convertibles, warrants, and stock options. Their presence affects the reporting of a firm’s earnings per share (EPS). – Firms with contingent securities, that if converted or exercised would dilute (that is, lower) earnings per share, are required to report earnings in two ways—basic EPS and diluted EPS. – Basic EPS are earnings per share (EPS) calculated without regard to any contingent securities. – Diluted EPS are earnings per share (EPS) calculated under the assumption that all contingent securities that would have dilutive effects are converted and exercised and are therefore common stock.

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Convertible Securities: Financing with Convertibles Convertibles can be used for a variety of reasons: – As a form of deferred common stock financing – As a “sweetener” for financing – To raise cheap funds temporarily

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Stock Purchase Warrants: Key Characteristics A stock purchase warrant is an instrument that gives its holder the right to purchase a certain number of shares of common stock at a specified price over a certain period of time. – Warrants are often attached to debt issues as “sweeteners.” – Often, when a new firm is raising its initial capital, suppliers of debt will require warrants to permit them to share in whatever success the firm achieves. – In addition, established companies sometimes offer warrants with debt to compensate for risk and thereby lower the interest rate and/or provide for fewer restrictive covenants. 27

Stock Purchase Warrants: Key Characteristics (cont.) The exercise (or option) price is the price at which holders of warrants can purchase a specified number of shares of common stock. – If the market price of the stock is less than the exercise price, holders of warrants will not exercise them, because they can purchase the stock cheaper in the marketplace.

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Stock Purchase Warrants: Key Characteristics (cont.) Comparison of Warrants to Stock Rights – Both result in new equity capital. – The life of a right is typically not more than a few months; a warrant is generally exercisable for a period of years. – Rights are issued at a subscription price below the prevailing market price of the stock; warrants are generally issued at an exercise price 10 to 20 percent above the prevailing market price.

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Stock Purchase Warrants: Key Characteristics (cont.) Comparison of Warrants to Convertibles – The exercise of a warrant shifts the firm’s capital structure to a less highly levered position because new common stock is issued without any change in debt. If a convertible bond were converted, the reduction in leverage would be even more pronounced, because common stock would be issued in exchange for a reduction in debt. – In addition, the exercise of a warrant provides an influx of new capital; with convertibles, the new capital is raised when the securities are originally issued rather than when they are converted. 30