Hybrid Financing:

Preferred Stock, Leasing, Warrants, and

Convertibles

 Preferred stock
 Leasing
 Warrants
 Convertibles
 PREFERRED STOCK
 Preferred stock is a hybrid—it is similar to bonds in some respects and to
common stock in other ways.
 Preferred stock has a par (or liquidating) value, often either $25 or $100.
The dividend is stated as either a percentage of par, as so many dollars per
share, or both ways.
 If the preferred dividend is not earned, the company does not have to pay it.
However, most preferred issues are cumulative, meaning that the
cumulative total of all unpaid preferred dividends must be paid before
dividends can be paid on the common stock.
 Unpaid preferred dividends are called arrearages. many preferred stocks
accrue arrearages for only a limited number of years, say, three years,
meaning that the cumulative feature ceases after three years. However, the
dividends in arrears continue in force until they are paid.

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 PREFERRED STOCK
 Preferred stock normally has no voting rights.
 Although non-payment of preferred dividends
will not bankrupt a company, corporations
issue preferred with every intention of paying
the dividend.
 Passing the dividend makes it difficult to raise
capital by selling bonds, and virtually
impossible to sell more preferred or common
stock.
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 PREFERRED STOCK
 For investors preferred stock is riskier than
bonds:
(1) Preferred stockholders’ claims are
subordinated to those of bondholders in the
event of liquidation, and
(2) Bondholders are more likely to continue
receiving income during hard times than are
preferred stockholders.

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 PREFERRED STOCK
 Advantages: Major advantages from the issuers’ standpoint:
1) In contrast to bonds, the obligation to pay preferred
dividends is not contractual, and passing a preferred
dividend cannot force a firm into bankruptcy.
2) By issuing preferred stock, the firm avoids the dilution of
common equity that occurs when common stock is sold.
3) Because preferred stock sometimes has no maturity, and
because preferred sinking fund payments, if present, are
typically spread over a long period, preferred issues reduce
the cash flow drain from repayment of principal that occurs
with debt issues.

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 PREFERRED STOCK
 Disadvantages: There are two major disadvantages:

1) Preferred stock dividends are not deductible to the issuer,

hence the after-tax cost of preferred is typically higher
than the after-tax cost of debt.
2) Although preferred dividends can be passed, investors expect
them to be paid, and firms intend to pay the dividends if
conditions permit. Thus, preferred dividends are considered
to be a fixed cost. Therefore, their use, like that of debt,
increases financial risk and thus the cost of common
equity.

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 LEASING
 Types of Leases: Leasing takes three different
forms:

 (1) sale-and-leaseback arrangements,

 (2) operating leases, and
 (3) straight financial, or capital, leases.

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 LEASING
 Sale and Leaseback: An arrangement whereby a
firm sells land, buildings, or equipment and
simultaneously leases the property back for a
specified period under specific terms.
 Operating Lease: A lease under which the lessor
maintains and finances the property; also called a
service lease.
 Financial Lease: A lease that does not provide for
maintenance services, is not cancelable, and is fully
amortized over its life; also called a capital lease.

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 LEASING
• Leasing is often called Off-Balance Sheet
Liability

Balance Sheet Effects of Leasing.

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 Lease vs. Borrow-and-Buy
Data:
 New computer costs $1,200,000.
 3-year MACRS class life; 4-year economic life.
 Tax rate = 40%.
 r = 10%.
d
 Maintenance of $25,000/year, payable at beginning of
each year.
 Residual value in Year 4 of $125,000.
 4-year lease includes maintenance.
 Lease payment is $340,000/year, payable at beginning of
each year.

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 Depreciation Schedule
Depreciable basis = $1,200,000

Year MACRS Depreciation End-of-Year

rate expense Book Value
1 0.33 $396,000 $804,000
2 0.45 540,000 264,000
3 0.15 180,000 84,000
4 0.07 84,000 0
1.00 $1,200,000

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In a lease analysis, at what discount
rate should cash flows be
discounted?
 Since cash flows in a lease analysis are evaluated
on an after-tax basis, we should use the after-tax
cost of borrowing.
 Previously, we were told the cost of debt, rd, was
10%. Therefore, we should discount cash flows at
6%.
A-T rd = 10%(1 – T) = 10%(1 – 0.4) = 6%.

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 Cost of Owning Analysis
0 1 2 3 4
Cost of asset -1,200.0
Depr’n tax savings 158.4 216.0 72.0 33.6
Maintenance (A-T) -15.0 -15.0 -15.0 -15.0
Residual value (A-T) 75.0
Net cash flow -1,215.0 143.4 201.0 57.0 108.6

PV of the cost of owning (@ 6%) = -$766.948

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 Notes on Cost of Owning
Analysis
 Depreciation is a tax deductible expense, so it
produces a tax savings of T(Depreciation).
Year 1 = 0.4($396) = $158.4.
 Each maintenance payment of $25 is
deductible so the after-tax cost of the mortgage
payment is (1 – T)($25) = $15.
 The ending book value is $0 so the full $125
salvage (residual) value is taxed, (1 - T)
($125) = $75.0.

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 Cost of Leasing Analysis
0 1 2 3 4
A-T Lease pmt -204 -204 -204 -204

 Each lease payment of $340 is deductible, so

the after-tax cost of the lease is
(1-T)($340) = $204.

 PV cost of leasing (@6%) = -$749.294.

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 Net advantage of leasing
 NAL = PV cost of owning – PV cost of leasing
 NAL = $766.948 - $749.294
= $17.654 (Dollars in thousands)

 Since the cost of owning outweighs the cost of

leasing, the firm should lease.

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 What if there is a lot of uncertainty
about the computer’s residual value?
 Residual value could range from $0 to $250,000
and has an expected value of $125,000.
 To account for the risk introduced by an uncertain
residual value, a higher discount rate should be
used to discount the residual value.
 Therefore, the cost of owning would be higher and
leasing becomes even more attractive.

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 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.

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 WARRANTS
 Warrant: A long-term option to buy a stated number of shares
of common stock at a specified price.
 Example: When Infomatics Corporation, a rapidly growing high-
tech company, wanted to sell $50 million of 20-year bonds in 2005,
the company’s investment bankers informed the financial vice
president that the bonds would be difficult to sell, and that a coupon
rate of 10 percent would be required. However, as an alternative the
bankers suggested that investors might be willing to buy the bonds
with a coupon rate of only 8 percent if the company would offer 20
warrants with each $1,000 bond, each warrant entitling the holder to
buy one share of common stock at an exercise price of $22 per share.
The stock was selling for $20 per share at the time, and the warrants
would expire in the year 2015 if they had not been exercised
previously.

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 WARRANTS
 A bond with warrants has some characteristics of debt
and some characteristics of equity. It is a hybrid
security that provides the financial manager with an
opportunity to expand the firm’s mix of securities and
thus to appeal to a broader group of investors.
 The exercise price on warrants is generally set some 20
to 30 percent above the market price of the stock on the
date the bond is issued. If the firm grows and prospers,
and if its stock price rises above the exercise price at
which shares may be purchased, warrant holders would
exercise their warrants and buy stock at the stated price.

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 WARRANTS
 There are three conditions that encourage holders to exercise
their warrants:
1) Warrant holders will surely exercise and buy stock if the warrants are about to
expire and the market price of the stock is above the exercise price.
2) Warrant holders will exercise voluntarily if the company raises the dividend on
the common stock by a sufficient amount. No dividend is earned on the warrant,
so it provides no current income. However, if the common stock pays a high
dividend, it provides an attractive dividend yield but limits price growth. This
induces warrant holders to exercise their option to buy the stock.
3) Warrants sometimes have stepped-up exercise prices, which prod owners into
exercising them. For example, Williamson Scientific Company has warrants
outstanding with an exercise price of $25 until December 31, 2009, at which time
the exercise price rises to $30. If the price of the common stock is over $25 just
before December 31, 2009, many warrant holders will exercise their options
before the stepped-up price takes effect and the value of the warrants falls.

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 WARRANTS
 It is extremely important to assign the correct value to the warrants:
 If the value assigned to the warrants is greater than their true
market value, then the coupon rate on the bonds will be set too
low, and it will be impossible to sell the bond-with-warrants
package at its par value. In this case, Infomatics will not be able to
raise the full $50 million that it needs to fund its growth.
 Conversely, if the value of the warrants is underestimated, then
the coupon rate will be set too high. This means that the true
value of the bonds with warrants will be greater than the issue
price. Suppose this happens, and the true value of the bonds with
warrants is $60 million. Investors will eagerly buy all of the bonds
with warrants at the issue price, and Infomatics will receive the full
$50 million that it needs. But this is not good news for the existing
shareholders.

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 CONVERTIBLES
 Convertible Security: A security, usually a bond or
preferred stock, that is exchangeable at the option of
the holder for the common stock of the issuing firm.
 Conversion Ratio (CR): The number of shares of
common stock that are obtained by converting a
convertible bond or share of convertible preferred
stock.
 Conversion Price (Pc): The effective price paid for
common stock obtained by converting a convertible
security.

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 CONVERTIBLES
 The relationship between the conversion ratio and the
conversion price can be illustrated by the Silicon
Valley Software Company’s convertible debentures
issued at their $1,000 par value in August 2005. At
any time prior to maturity on August 15, 2025, a
debenture holder can exchange a bond for 20 shares
of common stock; therefore, the conversion ratio,
CR, is 20. The bond cost purchasers $1,000, the par
value, when it was issued. Dividing the $1,000 par
value by the 20 shares received gives a conversion
price of $50 a share.

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CONVERTIBLES

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 CONVERTIBLES
 Stepped-Up Conversion Price: Generally, the
conversion price and conversion ratio are fixed for the life
of the bond, although sometimes a stepped-up conversion
price is used. For example, the 2005 convertible
debentures for Breedon Industries are convertible into
12.5 shares until 2015; into 11.76 shares from 2015 until
2025; and into 11.11 shares from 2025 until maturity in
2035. The conversion price thus starts at $80, rises to $85,
and then goes to $90. Breedon’s convertibles, like most,
have a 10-year call protection period.

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 CONVERTIBLES
 Convertibles have two important advantages from
the issuer’s standpoint:
1) Convertibles, like bonds with warrants, offer a
company the chance to sell debt with a low
interest rate in exchange for a chance to
participate in the company’s success if it does
well.
2) In a sense, convertibles provide a way to sell
common stock at prices higher than those
currently prevailing.
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 CONVERTIBLES
 From the standpoint of the issuer, convertibles have three important
disadvantages:
1) Although the use of a convertible bond may give the company the
opportunity to sell stock at a price higher than the price at which it
could be sold currently, if the stock greatly increases in price, the
firm would probably find that it would have been better off if it
had used straight debt in spite of its higher cost and then later sold
common stock and refunded the debt.
2) Convertibles typically have a low coupon interest rate, and the
advantage of this low-cost debt will be lost when conversion
occurs.
3) If the company truly wants to raise equity capital, and if the price
of the stock does not rise sufficiently after the bond is issued, then
the company will be stuck with debt.

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 CONVERTIBLES
Convertibles Warrants
Conversion of convertibles results only in The exercise of warrants brings in new
an accounting transfer. equity capital.
Most convertibles contain a call provision. Most warrants are not callable.
Longer maturity. Shorter maturity. Typically expire before
their accompanying debt matures.
Debt converted to equity. Debt remains outstanding.
Generally issued by established Issued by smaller riskier firms.
companies.

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