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Chapter 16: Special Topics in Managerial Finance

1. Principles of Managerial Finance Solution Lawrence J. Gitman Find out more at www.kawsarbd1.weebly.com Last saved and edited by Md.Kawsar Siddiqui PART6 Special Topics…
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  • 1. Principles of Managerial Finance Solution Lawrence J. Gitman Find out more at www.kawsarbd1.weebly.com Last saved and edited by Md.Kawsar Siddiqui PART6 Special Topics in Managerial Finance CHAPTERS IN THIS PART 16 Hybrid and Derivative Securities 17 Mergers, LBOs, Divestitures, and Business Failure 18 International Managerial Finance INTEGRATIVE CASE 6: ORGANIC SOLUTIONS
  • 2. Find out more at www.kawsarbd1.weebly.com Last saved and edited by Md.Kawsar Siddiqui413 CHAPTER 16 Hybrid And Derivative Securities INSTRUCTOR’S RESOURCES Overview This chapter focuses on other sources of long-term financing: leasing, convertible bonds, convertible preferred stock, and warrants. The basic features, costs, and advantages of these financing methods are discussed. The basic types of leases (operating and financial), leasing arrangements, and legal aspects of leasing are presented, as well as the procedure used to analyze a lease versus purchase decision. The student learns how to evaluate convertible securities and stock-purchase warrants. The use and features of stock options are presented. The chapter concludes with a discussion of the use of options to hedge foreign currency exposure. PMF DISK This chapter's topics are not covered on either the PMF Tutor or the PMF Problem-Solver. PMF Templates A spreadsheet template is provided for the following problem: Problem Topic 16-4 Lease-versus-purchase Study Guide The following Study Guide examples are suggested for classroom presentation: Example Topic 3 Stock warrants 4 Lease-versus-purchase analysis
  • 3. Part 6 Special Topics in Managerial Finance Find out more at www.kawsarbd1.weebly.com Last saved and edited by Md.Kawsar Siddiqui414 ANSWERS TO REVIEW QUESTIONS 16-1 Hybrid securities contain characteristics of both debt and equity. Hybrid securities are a form of financing used by the firm. Derivative securities are neither debt nor equity. They are securities that derive their value from another "underlying" asset. Derivatives are not used by the firm for raising funds but are used for managing certain aspects of the firm's risk. 16-2 Leasing is a financing technique that allows a firm to obtain the use of certain fixed assets by making periodic, contractual payments that are tax deductible. An operating lease is a contractual agreement whereby the lessee agrees to make periodic payments to the lessor for five or fewer years for an asset's services. Such leases are generally cancelable at the option of the lessee, who may be required to pay a predetermined cancellation penalty. Assets leased under an operating lease, such as computers, generally have a usable life longer than the term of the lease. Therefore, normally the asset has a positive market value at the termination of the lease. Total lease payments are generally less than the cost of the leased asset. A financial (or capital) lease is a longer-term lease than an operating lease. It is no cancelable and therefore obligates the lessee to make payments for the use of an asset over a predefined period of time. Financial leases are commonly used for leasing land, buildings, and large pieces of equipment. The no cancelable feature of this type of lease makes it quite similar to certain types of long-term debt. The total payments under a financial lease are normally greater than the cost of the leased assets to the lessor. In this case the lease period is closely aligned to the asset's productive life. The FASB Standard No. 13 defines a capitalized (financial) lease as one having any of the following four elements: (1) transfer of property to the lessee by the end of the lease term; (2) a purchase option at a low or "bargain" price, exercisable at a "fair market value;" (3) a lease term equal in length to 75 percent or more of the estimated economic life of the property; (4) the present value of lease payments at the beginning of the lease equal to 90 percent or more of the fair market value of the leased property, less any investment tax credit received by the lessor. Three methods used by lessors to acquire assets to be leased are: (1) a direct lease - the lessor owns or acquires the assets that are leased to the lessee. (2) a sale-leaseback arrangement - the lessor purchases the assets from the lessee and leases them back. (3) a leveraged lease - a financial arrangement which includes one or more third-party lenders. Under a leveraged lease, the lessor acts as an equity participant, supplying only a fraction of the cost of the asset, with the lender(s) supplying the remainder. The direct lease and the sale-leaseback differ according to which party holds title to the asset prior to the lease. The leveraged lease may be a direct lease or sale-leaseback, but is differentiated by the participation of a third-party lender. 16-3 The lease-versus-purchase-decision is made using basic capital budgeting procedures. 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. The cost of exercising a purchase option in the final year is included if applicable.
  • 4. Chapter 16 Hybrid and Derivative Securities Find out more at www.kawsarbd1.weebly.com Last saved and edited by Md.Kawsar Siddiqui415 Step 2: Find the after-tax cash outflows for each year under the purchase alternative. This step involves adjusting the scheduled loan payment and maintenance cost outlay for the tax shields resulting from the tax deductions attributable to maintenance, interest, and depreciation. 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 since this decision involves very low risk. Step 4: Choose the alternative with the lowest present value of cash outflows from Step 3. This will be the least costly financial alternative. Present value techniques must be used because the cash outflows occur over a period of years. 16-4 FASB Standard No. 13 established requirements (see question 18-2) for the explicit disclosure of certain types of lease obligations on the firm's balance sheet. Any lease that meets at least one of these requirements must be capitalized. To do so, the present value of the lease payments is discounted at the appropriate rate of return. Reporting the capitalization of leases must meet FASB Standard No. 13 guidelines, but in general the capitalized value is added to net fixed assets and to long-term liabilities. The caption on the asset side of the balance sheet is "lease property under capital lease." The caption on the liability side of the balance sheet is "obligation under capital lease." 16-5 The key advantages of leasing are the ability to "depreciate" land through tax deductibility of lease payment; the favorable financial ratio effects; the increased liquidity a sale-leaseback arrangement may provide; the ability to get 100 percent financing; the limited claims against the firm in bankruptcy or reorganization; the possible avoidance of the risk of obsolescence; the lack of many restrictive covenants; and the financing flexibility provided. The most important advantages of leasing to a firm are its effect on financial ratios, the ability to increase liquidity, and the ability to obtain 100 percent financing. The disadvantages of leasing include: its high implicit interest cost; the lack of any salvage value benefits; difficulty in making property improvements; and certain obsolescence considerations. 16-6 A conversion feature is an option included as part of a bond or preferred stock issue that permits the holder to convert the security into a specified number of shares of common stock. The conversion ratio is the ratio at which the convertible security can be exchanged for common stock. Contingent securities⎯convertibles, warrants, and stock options that could be converted to common stock⎯affect the reporting of the firm's earnings per share (EPS). Firms with contingent securities, that if converted or exercised would increase the number of shares outstanding by more than 3 percent, must report earnings in two other ways: primary EPS and fully diluted EPS. Primary EPS, which includes any common stock equivalents (CSE), is calculated by dividing earnings available for common stockholders (adjusted for interest and preferred stock dividends that would not be paid given assumed conversion) by the sum of the number of shares outstanding and the CSE. Fully diluted EPS treats as common stock all contingent securities. It is calculated by dividing earnings available for common stockholders (adjusted for interest and preferred stock dividends that would not be paid given assumed conversion of all outstanding convertibles) by the number of shares of common stock that would be outstanding if all contingent securities are converted and exercised.
  • 5. Part 6 Special Topics in Managerial Finance Find out more at www.kawsarbd1.weebly.com Last saved and edited by Md.Kawsar Siddiqui416 Motives for financing with convertible securities include their use as a form of deferred common stock financing; Their use as a "sweetener" for financing since convertible securities are usually sold at lower interest rates; the inclusion of fewer restrictive covenants, and the ability to raise temporarily cheap funds through debt, then shift capital structure through conversion into equity at a later date. 16-7 When the price of the firm's common stock rises above the conversion price, the market price of the convertible security will normally rise to a level close to its conversion value. The convertible security holders may not convert in this situation for two reasons: (1) they already have the market price benefit obtainable from conversion and still receive the fixed periodic interest or dividend payments; and (2) they may have a general lack of confidence in the ability of the current market price of the common stock to remain at its current level. The call feature may be used to force conversion, since the call price of the security generally exceeds the security's par value by an amount equal to one year's stated interest on the security. Although the issuer must pay a premium for calling a security, the call privilege is generally not exercised until the conversion value of the security is 10 to 15 percent above the call price. This call premium assures the issuer that when the call is made, the holders of the convertible will convert it instead of accepting the call price. An overhanging issue is a convertible security that cannot be forced into conversion using the call feature. 16-8 The straight bond value of a convertible security is the price at which the security would sell in the market without the conversion feature. This value is determined by valuing a straight bond with similar payments issued by a firm having the same operating and financial risks. The straight value of a convertible bond can be found by discounting the bond interest payments and maturity value at the rate of interest that has to be charged on a straight bond issued by the company. A convertible feature on a security can only add value or have no effect on value; therefore, the value of the security as a straight issue is often viewed as the minimum value. The conversion stock value of a convertible security is the value of a convertible security measured in terms of the market value of the security into which it may be converted. Since most convertible securities are convertible into common stock, the conversion value may be found by multiplying the conversion ratio by the current market price of the firm's common stock. The market value of a convertible security is greater than its straight or conversion value. The market premium is the amount by which the market value exceeds the straight or conversion value of a convertible security. The relationship between the straight value, conversion stock value, market value, and market premium associated with a convertible security is as follows. The straight bond value is the floor, or minimum price at which a convertible trades. When the market price of the common stock into which the convertible can be converted exceeds the conversion price, the conversion value will be above par. The market value of the convertible bond is usually greater than either the straight or conversion values. As the straight value and the conversion value become closer, the market premium increases (see Figure 18.1 in text). 16-9 Stock-purchase warrants give the holder the option to purchase a certain number of shares of common stock at a specified price. They are often attached to debt issues as “sweeteners," adding to marketability and lowering the required interest rate. The effect of the exercise of warrants is to dilute earnings and
  • 6. Chapter 16 Hybrid and Derivative Securities Find out more at www.kawsarbd1.weebly.com Last saved and edited by Md.Kawsar Siddiqui417 control since a number of new shares of common stock are automatically issued, similar to the conversion of convertibles. The exercise of a warrant shifts the firm's capital structure to a less highly levered position, since new equity capital is created without any change in the firm's debt capital. If a convertible security is converted, the effect is more pronounced, since new common equity is created through a corresponding reduction in debt or preferred stock. Warrants result in an influx of new capital, while convertibles shift debt or preferred stock financing into common stock financing. 16-10 The implied price of a warrant that is attached to a bond is found by first subtracting the straight bond value from the price of the bond with warrants attached. This gives the price of all warrants; to get the price of one warrant, divide by the number of warrants. The straight bond value is the present value of cash inflows discounted by the yield on similar-risk bonds. The theoretical value of each warrant (TVW) is the amount it would be expected to sell for in the marketplace. The formula is: TVW = (P0 - E) x N where TVW = the theoretical value of a warrant P0 = current market price of a share of common stock E = exercise price of the warrant N = number of shares obtainable with one warrant Since the TVW takes into account specific features of the warrant, the implied price is meaningful only when the two are compared. If the implied price is above the theoretical value, the price of the bond with warrants attached may be too high. If the reverse is true, the bond may be quite attractive. Firms should therefore "sweeten" bonds by pricing them so that the implied price is slightly below the theoretical value. This allows it to sell bonds with warrants at a lower coupon rate, resulting in lower debt service costs. 16-11 The market value of a warrant is generally above the theoretical value. Only when the theoretical value of a warrant is very high are the market and theoretical values of a warrant quite close. The market value of a warrant generally exceeds the theoretical value by the greatest amount when the stock's market price is close to the warrant exercise price per share. The amount by which the market value of the warrant exceeds the theoretical value is called the warrant premium. 16-12 An option is a financial instrument that provides its holder with an opportunity to buy or sell an asset at a specified price. The striking price is the price at which the holder of the option can buy or sell the stock at any time prior to the expiration date. Rights and warrants are types of options, since the holder has the option to purchase stock at a specified price. A call is an option to purchase a specified number of shares of stock at a specified price on or before a specified date. A put is an option to sell a specified number of shares of stock at a specified price on or before a specified date. The logic of trading and exercising calls and puts is the expectation that the market price of the underlying stock will change in the desired direction. Call options are purchased with the expectation that the price of the stock will raise enough to cover the cost of the option. Put options are purchased with the expectation that the share price of the stock will decline over the life of the option. Options play no direct role in the fundraising activities of the financial manager as they are not a source of financing.
  • 7. Part 6 Special Topics in Managerial Finance Find out more at www.kawsarbd1.weebly.com Last saved and edited by Md.Kawsar Siddiqui418 16-13 A company can hedge the risk of foreign exchange fluctuations by purchasing currency options. If it makes a sale in a foreign currency that is due to be paid at some point in the future, it can purchase a put option on that foreign currency to protect against appreciation of its own currency against the currency in which the sale was denominated. Such options effectively hedge the risk of adverse price movements but preserve the possibility of profiting from favorable price moves. The drawback to using options for hedging purposes is their high cost relative to hedging with more traditional futures or forward contracts.
  • 8. Chapter 16 Hybrid and Derivative Securities Find out more at www.kawsarbd1.weebly.com Last saved and edited by Md.Kawsar Siddiqui419 SOLUTIONS TO PROBLEMS 16-1 LG 2: Lease Cash Flows Firm Year Lease Payment (1) Tax Benefit (2) After-tax Cash Outflow ((1) - (2)) (3) A 1 - 4 $100,000 $40,000 $60,000 B 1 - 14 80,000 32,000 48,000 C 1 - 8 150,000 60,000 90,000 D 1 - 25 60,000 24,000 36,000 E 1 - 10 20,000 8,000 12,000 16-2 LG 2: Loan Interest Loan Year Interest Amount A 1 $1,400 2 1,098 3 767 4 402 B 1 $2,100 2 1,109 C 1 $312 2 220 3 117 D 1 $6,860 2 5,822 3 4,639 4 3,290 5 1,753 E 1 $4,240 2 3,768 3 3,220 4 2,585 5 1,848 6 993 16-3 LG 2 Loan Payments and Interest Payment = $117,000 ÷ 3.889 = $30,085 (Calculator solution: $30,087.43) Year Beginning Balance Interest Principal
  • 9. Part 6 Special Topics in Managerial Finance Find out more at www.kawsarbd1.weebly.com Last saved and edited by Md.Kawsar Siddiqui420 1 $117,000 $16,380 $13,705 2 103,295 14,461 15,624 3 87,671 12,274 17,811 4 69,860 9,780 20,305 5 49,555 6,938 23,147 6 26,408 3,697 26,388 $ 26,408 $116,980 $117,000 Note: Due to the PVIFA tables in the text presenting factors only to the third decimal place and the rounding of interest and principal payments to the second decimal place, the summed principal payments over the term of the loan will be slightly different from the loan amount. To compensate in problems involving amortization schedules, the adjustment has been made in the last principal payment. The actual amount is shown with the adjusted figure to its right. 16-4 LG 2 Lease versus Purchase a. Lease After-tax cash outflow = $25,200 x (l - .40 ) = $15,120/year for 3years + $5,000 purchase option in year 3 (total for year 3: $20,120) Purchase Year Loan Payment (1) Main- tenance (2) Depre- ciation (3) Interest at 14% (4) Total Deductions (2+3+4) (5) Tax Shields (.40)x(5) (6) After-tax Cash Outflows [(1+2) - (6)] (7) 1 $25,844 $1,800 $19,800 $8,400 $30,000 $12,000 $15,644 2 25,844 1,800 27,000 5,598 34,398 13,759 13,885 3 25,844 1,800 9,000 3,174 13,974 5,590 22,054 b. Lease End of Year After-tax Cash Outflows PVIF8%,n PV of Outflows Calculator Solution 1 $15,120 .926 $14,001 2 15,120 .857 12,958 3 20,120 .794 15,975 $42,934 $42,934.87 Purchase End of Year After-tax Cash Outflows PVIF8%,n PV of Outflows Calculator Solution 1 $15,644 .926 $14,486 2 13,885 .857 11,899 3 22,054 .794 17,5
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