Hybrid and Derivative

Securities
Overview
 Hybrid Security- form of debt or equity financing
that possesses characteristics of both debt and
equity financing.

1. Financial Leases
2. Convertible Securities
3. Stock Purchase Warrants
 Derivative Security- security that is neither debt nor
equity but derives its value from an underlying asset that
is often another security; called “derivatives,” for short.

1. Options
2. Future Contract
3. Swap
4. Forward Contract
Leasing
Leasing- 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.

Types of Leases:
1. Operating Lease
2. Financial/Capital Lease
Operating Lease
- 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.
- 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.
The following are the main features of the operating lease
that make if different from other leases:
• The lease term is considerably less than the economic life
of the equipment.
• The lessee can terminate the lease even at the short
notice and without any significant penalty.
• When the ownership along with the risk and rewards lies
with the lessor and is responsible for insuring and
maintaining the equipment, the lease is said to be a “wet
lease”. Whereas, when the lessee bears the cost of
insurance and maintenance of the equipment, the
operating lease is called as a “dry lease”.
Financial/Capital leases
- non-cancelable and obligate the lessee to make
payments for the use of an asset over a predefined
period of time.
-commonly used for leasing land, buildings, and
large pieces of equipment.
The lease is said to be the finance lease if it satisfies the
following requirements:
• Once the lease is expired, the lessee can purchase an
asset at a bargain price.
• The lessee gets the ownership of the asset after the lease
expires.
• The lease term is at least 75% of the estimated economic
life of the asset.
• The present value of lease payment is at least 90% of the
asset’s value
•

•
Leasing Arrangements
 Direct lease- a lease under which a lessor owns or
acquires the assets that are leased to a given lessee.
 Sale-leaseback- a lease under which the lessee sells an
asset for cash to a prospective lessor and then leases back
the same asset.
 Leveraged lease- 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.
Leasing: The Lease-Versus-
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:
Leasing: The Lease-Versus-
Purchase Decision (cont.)
• Step 1: Find the after-tax cash outflows for each year under
the lease alternative.
• Step 2: Find the after-tax cash outflows for each year under
the purchase alternative
• 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.
• Step 4: Choose the alternative with the lower present value
of cash outflows.
Leasing: The Lease-Versus-
Purchase Decision (cont.)
Roberts Company, a small machine shop, is contemplating acquiring a new machine that costs
$24,000. 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-of-year lease
payments of $6,000. 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 $1,200 at termination of the lease.
Leasing: The Lease-Versus-
Purchase Decision (cont.)
 Purchase. The firm would finance the purchase of the machine with a 9%, 5-
year
 loan requiring end-of-year installment payments of $6,170.3 The machine
would
 be depreciated under MACRS using a 5-year recovery period. The firm would
 pay $1,500 per year for a service contract that covers all maintenance costs;
 insurance and other costs would be borne by the firm. The firm plans to keep
the
 machine and use it beyond its 5-year recovery period.
Leasing: The Lease-Versus-
Purchase Decision (cont.)
Step 1: Find the after-tax cash outflows for each year under the lease alternative.
The after-tax cash outflow from the lease payments can be found as follows:
A-T Outflow from Lease = $6,000 x (1 - t)
= $6,000 x (1 - .40)
= $3,600
In the final year, the $1200 cost of the purchase option would be added to the $3,600 lease
outflow to get a year 5 outflow of $4,800 ($3,600 + $1,200).
Leasing: The Lease-Versus-
Purchase Decision (cont.)
Step 2: Find the after-tax cash outflows for each year under the purchase alternative.

First, the annual interest component of each loan payment must be determined since only interest

can be deducted for tax purposes as shown in Table 17.1 on the following slide.

Second, the A-T outflows must be computed as shown in Table 17.2.

Leasing: The Lease-Versus-
Purchase Decision (cont.)
Table 17.1 Determining the Interest and Principal
Components of the Roberts Company Loan Payments
Leasing: The Lease-Versus-
Purchase Decision (cont.)
Table 17.2 After-Tax Cash Outflows Associated with
Purchasing for Roberts Company
Leasing: The Lease-Versus-
Purchase Decision (cont.)
Step 3: Calculate the present value of the cash outflows from Step 1 and Step 2 using the after-

tax cost as the discount rate. This is shown in Table 17.3 on the following slide.
Leasing: The Lease-Versus-
Purchase Decision (cont.)
 Table 17.3 Comparison of Cash Outflows Associated with Leasing versus
Purchasing for Roberts Company
Leasing: The Lease-Versus-
Purchase Decision (cont.)
STEP 4: Choose the alternate with the smaller present value of cash outflows.

Because the present value of cash outflows for leasing ($16,062) is lower than that for purchasing

($19,541), the leasing alternative is preferred—resulting in an incremental savings of $3,479.

Leasing: Effects of Leasing
on Future Financing
• FASB No. 13 requires explicit disclosure of financial lease obligations
on the firm’s balance sheet.
• It must be show as a capitalized lease, meaning that the present value
of all payments are included as an asset and corresponding liability.
• An operating lease on the other hand, need not be capitalized, but must
be reported in the footnotes.
• Because the consequences of missing financial lease payments are the
same as that of missing the principal payment on debt, a financial
analyst must view the lease as a long-term debt payment.
Leasing: Advantages of Leasing

• The firm may avoid the cost of obsolescence if the lessor fails to
accurately anticipate the obsolescence of assets and sets the lease
payment too low.
• A lessee avoids many of the restrictive covenants 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.
Leasing: Advantages of Leasing (cont.)

• Leasing allows the lessee, in effect, to depreciate land, which is

prohibited if the land were purchased.
• Because 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.
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
obsolete, it must still make lease payments over the
remaining term of the lease.
CONVERTIBLE SECURITIES
CONVERSION FEATURE
-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.

 TYPES OF CONVERTIBLE SECURITIES

1. Convertible Bonds- can be changed into a specified number of shares

of common stock.
2. Convertible Preferred Stock- is preferred stock that can be changed
into a specified number of shares of common stock.

Straight Preferred Stock- preferred stock that is nonconvertible, having no

conversion feature.
 GENERAL FEATURES OF CONVERTIBLES
-Limited number of years: 5 to 10 years

Conversion Ratio- is the ratio at which a convertible security can be

exchanged for common stock

TWO WAYS:
1. Stated in terms of a given number of shares of common
stock.

Conversion Price- is the per-share price that is effectively

paid for common stock as the result of conversion of a
convertible security.
Western Wear Company, a manufacturer of denim products, has
outstanding bond that has a $1,000 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 $40 per share ($1000/25).

2. Instead of the conversion ratio, the conversion price is given.

Mosher Company, a franchiser of seafood restaurants, has outstanding a

convertible 20-year bond with a par value of $1000. The bond is
convertible at $50 per share into common stock. The ownership ratio is
20 ($1000/ $50).
Conversion (or stock) Value- the value of the convertible measured in
terms of the market price of the common stock into which it can be
converted.

CONVERSION VALUE= Conversion ratio x current market

price of the firm’s common stock

McNamara Industries, a petroleum processor, has outstanding a $1,000

bond that is convertible into common stock at $62.50 per share. The
conversion ratio is therefore 16 ($1,000/ $62.50). Because the current
market price of the common stock is $65 per share, the conversion value
is $1,040 (16 x $65). Because the conversion value is above the bond
value of $1000, conversion is a viable option for the owner of the
convertible security.
 EFFECTS ON EARNINGS PER SHARE

Contingent Securities affects the reporting of the firm’s earnings per

share.
 FINANCING WITH CONVERTIBLES

 Motives for Convertible Financing

1. Use as a form of deferred common stock financing

2. Use as a “sweetener” for financing

3. To raise cheap funds temporarily

 DETERMINING THE VALUE OF A CONVERTIBLE BOND

 Three values of Convertible Bond

1. Straight Bond Value- the price at which it would sell in the

market without the conversion feature.
-floor or minimum price at which the convertible bond would
be traded
2. Conversion (or Stock) Value- is the value of the convertible
measured in terms of the market price of the common stock
into which the security can be converted.
3. Market Value- it is likely to be greater than its straight value or its
conversion value.