20 - 1
Copyright © 2001 by Harcourt, Inc. All rights reserved.
Leasing
Leasing is sometimes
referred to as “off balance
sheet” financing if a lease
is not “capitalized.” In
other words, it is not
shown on the balance
sheet.
Leasing is a substitute for
debt financing and, thus,
uses up a firm’s debt
capacity.
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20 - 2
Copyright © 2001 by Harcourt, Inc. All rights reserved.
Capital leases are
different from operating
leases:
Capital leases do not
provide for
maintenance service.
Capital leases are not
cancelable.
Capital leases are fully
amortized.
20 - 3
Copyright © 2001 by Harcourt, Inc. All rights reserved.
Analysis: Lease vs. Borrow-
and-Buy
Data:
New machine costs
$1,200,000.
3-year MACRS class
life; 4-year economic
life.
Tax rate of 40%.
kd = 10%.
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20 - 4
Copyright © 2001 by Harcourt, Inc. All rights reserved.
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.
20 - 5
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Depreciation Schedule
Depreciable basis = $1,200,000
MACRS Depreciation End-of-Year
Year Rate Expense Book Value
1 $ 396,000 $804,000
2 540,000 264,000
3 180,000 84,000
4 84,000 0
$1,200,000
20 - 6
Copyright © 2001 by Harcourt, Inc. All rights reserved.
In a lease analysis, what
discount rate should cash
flows be discounted at?
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, kd, was 10%.
Therefore, we should discount cash
flows at 6%.
A-T kd = 10%(1 – T) = 10%(1 – ) =
6%.
20 - 7
Copyright © 2001 by Harcourt, Inc. All rights reserved.
Cost of Owning Analysis
(In Thousands)
Cost of asset (1,)
Dep. tax savings1
Maint. (AT)2 () () () ()
Res. value (AT)3 ______ _____ _____ _____
Net cash flow (1,)
PV cost of owning (@ 6%) = -$766,948.
0 1 2 3 4
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20 - 8
Copyright © 2001 by Harcourt, Inc. All rights reserved.
Notes:
1 Depreciation is a tax deductible
expense, so it produces a tax
savings of T(Depreciation). Year 1
= ($396) = $.
2 Each maintenance payment of $25
is deductible so the after-tax cost
of the lease is (1 – T)($25) = $15.
3 The ending book value is $0 so the
full $125 salvage (residual) value is
taxed.
20 - 9
Copyright © 2001 by Harcourt, Inc. All rights reserved.
Cost of Leasing Analysis
(In Thousands)
Lease pmt (AT)1 -204 -204 -204 -204
PV cost of leasing (@ 6%) = -$749,294.
Note:
1Each lease payment of $340 is
deductible, so the after-tax cost of the
lease is (1 – T)($340) = -$204.
0 1 2 3 4
20 - 10
Copyright © 2001 by Harcourt, Inc. All rights reserved.
Net Advantage of Leasing
NAL = –
= $766,948 – $749,294
= $17,654.
PV cost
of owning
PV cost
of leasing
Since the cost of owning outweighs
the cost of leasing, the firm should
lease.
20 - 11
Copyright © 2001 by Harcourt, Inc. All rights reserved.
Suppose computer’s residual
value could be as low as $0
or as high as $250,000, but
expected value is $125,000.
How could the riskiness of
the SV be incorporated in the
analysis? What effect would
this have on lease decision?To account for risk, the rate used to
discount the SV would be increased;
therefore, the cost of owning would be
even higher. Leasing becomes even
more attractive.
20 - 12
Copyright © 2001 by Harcourt, Inc. All rights reserved.
What effect would a
cancellation clause have on
the riskiness of the lease?
A cancellation clause lowers the
risk of the lease to the lessee, but
increases the risk to the lessor.
20 - 13
Copyright © 2001 by Harcourt, Inc. All rights reserved.
Preferred dividends are
fixed, 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.
How does preferred stock differ from
common equity and debt?
20 - 14
Copyright © 2001 by Harcourt, Inc. All rights reserved.
Dividends are indexed to
the rate on treasury
securities instead of being
fixed.
Excellent S-T corporate
investment:
Only 30% of dividends
are taxable to
corporations.
The floating rate
generally keeps issue
trading near par.
What is floating rate preferred?
20 - 15
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However, if the issuer is
risky, the floating rate
preferred stock may have
too much price instability
for the liquid asset
portfolios of many
corporate investors.
20 - 16
Copyright © 2001 by Harcourt, Inc. All rights reserved.
A warrant is a long-term
call option.
A convertible consists of a
fixed rate bond plus a call
option.
How can a knowledge of call options
help one understand warrants and
convertibles?
20 - 17
Copyright © 2001 by Harcourt, Inc. All rights reserved.
P0 = $10.
kd of 20-year annual
payment bond without
warrants = 12%.
50 warrants with an
exercise price of $
each are attached to bond.
Each warrant’s value will
be $.
Given the following facts, what
coupon rate must be set on a bond
with warrants if the total package is to
sell for $1,000?
20 - 18
Copyright © 2001 by Harcourt, Inc. All rights reserved.
Step 1: Calculate
VBond
VPackage = VBond + VWarrants =
$1,000.
VWarrants = 50($) = $75.
VBond + $75 = $1,000
VBond = $925.
20 - 19
Copyright © 2001 by Harcourt, Inc. All rights reserved.
Step 2: Find Coupon Payment
and Rate
N I/YR PV PMT FV
20 12 -925 1000
Solution: 110
Therefore, the required coupon rate
is $110/$1,000 = 11%.
20 - 20
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The package would
actually have been worth
Vpackage = $925 + 50($) =
$1,050,
which is $50 more than the
actual selling price.
If after issue the warrants immediately
sell for $ each, what would this
imply about the value of the package?
20 - 21
Copyright © 2001 by Harcourt, Inc. All rights reserved.
The firm could have set
lower interest payments
whose PV would be
smaller by $50 per bond,
or it could have offered
fewer warrants with a
higher exercise price.
Current stockholders are
giving up value to the
warrant holders.
20 - 22
Copyright © 2001 by Harcourt, Inc. All rights reserved.
Generally, a warrant will sell
in the open market at a
premium above its
theoretical value (it can’t
sell for less).
Therefore, warrants tend
not to be exercised until
just before they expire.
Assume that the warrants expire 10
years after issue. When would you
expect them to be exercised?
20 - 23
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In a stepped-up exercise
price, the exercise price
increases in steps over the
warrant’s life. Because the
value of the warrant falls
when the exercise price is
increased, step-up
provisions encourage in-the-
money warrant holders to
exercise just prior to the
step-up.
Since no dividends are
earned on the warrant,
holders will tend to exercise
voluntarily if a stock’s
dividend rises enough.
20 - 24
Copyright © 2001 by Harcourt, Inc. All rights reserved.
When exercised, each
warrant will bring in the
exercise price, $.
This is equity capital and
holders will receive one
share of common stock per
warrant.
The exercise price is
typically set at 10% to 30%
above the current stock
price on the issue date.
Will the warrants bring in additional
capital when exercised?
20 - 25
Copyright © 2001 by Harcourt, Inc. All rights reserved.
No. As we shall see, the
warrants have a cost that
must be added to the
coupon interest cost.
Because warrants lower the cost of
the accompanying debt issue, should
all debt be issued with warrants?
20 - 26
Copyright © 2001 by Harcourt, Inc. All rights reserved.
The company will exchange stock worth
$ for one warrant plus $. The
opportunity cost to the company is
$ – $ = $.
Bond has 50 warrants, so on a par bond
basis, opportunity cost = 50($) =
$250.
What is the expected return to the
holders of the bond with warrants (or
the expected cost to the company) if the
warrants are expected to be exercised
in 5 years when P = $?
20 - 27
Copyright © 2001 by Harcourt, Inc. All rights reserved.
Here is the cash flow time line:
0 1 4 5 6 19 20
+1,000 -110 -110 -110 -110 -110 -110
-250 -1,000
-360 -1,110
Input the cash flows in the calculator to
find IRR = %. This is the pre-tax
cost of the bond and warrant package.
... ...
20 - 28
Copyright © 2001 by Harcourt, Inc. All rights reserved.
The cost of the bond with
warrants package is
higher than the 12% cost
of straight debt because
part of the expected
return is from capital
gains, which are riskier
than interest income.
The cost is lower than the
cost of equity because
part of the return is fixed
by contract.
20 - 29
Copyright © 2001 by Harcourt, Inc. All rights reserved.
20-year, 10% annual
coupon, callable
convertible bond will sell
at its $1,000 par value;
straight debt issue would
require a 12% coupon.
Call the bonds when
conversion value > $1,200.
P0 = $10; D0 = $; g =
8%.
Conversion ratio = CR = 80
shares.
Assume the following convertible
bond data:
20 - 30
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What conversion price (Pc) is built into
the bond?
The conversion price is typically set
10% to 30% above the stock price on
the issue date.
$1,0
00
80
Pc =
= = $.
Par value
# Shares received
20 - 31
Copyright © 2001 by Harcourt, Inc. All rights reserved.
Examples of real convertible bonds
issued by Internet companies
Issuer
CNET
DoubleClick
Mindspring
NetBank
PSINet
Size of issue
$1,250 mil
55 mil
173 mil
250 mil
180 mil
100 mil
400 mil
150 mil
Cvt Price
$
165
Price at issue
$122
16
84
134
60
32
55
52
20 - 32
Copyright © 2001 by Harcourt, Inc. All rights reserved.
What is (1) the convertible’s straight
debt value and (2) the implied value of
the convertibility feature?
PV FV
20 12 100 1000
Solution:
I/YR PMTN
Straight debt value:
20 - 33
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Because the convertibles
will sell for $1,000, the
implied value of the
convertibility feature is
$1,000 – $ =
$.
= $ per share.
The convertibility value
corresponds to the warrant
value in the previous
example.
Implied Convertibility Value
$
80 shares
20 - 34
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Conversion value = Ct =
CR(P0)(1 + g)t.
t = 0
C0 = 80($10)()0 =
$800.
t = 10
C10 = 80($10)()10
= $1,.
What is the formula for the bond’s
expected conversion value in any
year?
20 - 35
Copyright © 2001 by Harcourt, Inc. All rights reserved.
The floor value is the
higher of the straight debt
value and the conversion
value.
Straight debt value0 =
$.
C0 = $800.
Floor value at Year 0 =
$.
What is meant by the floor value of a
convertible?
20 - 36
Copyright © 2001 by Harcourt, Inc. All rights reserved.
Straight debt value10 =
$.
C10 = $1,.
Floor value10 = $1,.
Convertible will generally
sell above its floor value
prior to maturity because
convertibility option has an
additional value.
20 - 37
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The firm intends to force conversion
when C = ($1,000) = $1,200. When
is the issue expected to be called?
PV FV
8 -800 0 1200
Solution: N =
I/YR PMTN
20 - 38
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What is the convertible’s expected
cost of capital to the firm? Assume
conversion in Year 5 at $1,200.
0 1 2 3 4 5
1,000 -100 -100 -100 -100 -100
-1,200
-1,300
Input the cash flows in the calculator
and solve for IRR = %.
20 - 39
Copyright © 2001 by Harcourt, Inc. All rights reserved.
For consistency, need kd <
kc < ke.
Why?
The convertible bond’s
risk is a blend of the risk
of debt and equity, so kc
should be in between the
cost of debt and equity.
Does the cost of the convertible
appear to be consistent with the
riskiness of the issue?
20 - 40
Copyright © 2001 by Harcourt, Inc. All rights reserved.
kd = 12% and kc = %.
ks = + g =
+
= %.
Since kc is between kd and ks,
the consistency requirement
is met.
Check the values:
D0(1+g)
P0
$()
$10
20 - 41
Copyright © 2001 by Harcourt, Inc. All rights reserved.
The firm’s future needs for
capital:
Exercise of warrants
brings in new equity
capital without the need to
retire low-coupon debt.
Conversion brings in no
new funds, and low-
coupon debt is gone when
bonds are converted.
However, debt ratio is
lowered, so new debt can
be issued.
Besides cost, what other factors
should be considered?
