20
HYBRID CHAPTER FINANCING: PREFERRED STOCK, LEASING, WARRANTS,
AND CONVERTIBLES
(Difficulty Levels: Easy, Easy/Medium, Medium, Medium/Hard, and Hard)
Please see the preface for information on the AACSB letter indicators (F, M, etc.) on the subject
lines.
Multiple Choice: True/False
(20-1) Preferred stock
1
.
FO
Answer: b
EASY
The "preferred" feature of preferred stock means that it normally will
provide a higher expected return than will common stock.
a. True
b. False
(20-1) Cost of preferred stock
2
.
FO
Answer: a
EASY
Unlike bonds, the cost of preferred stock to the issuing firm is the
same on a before-tax and after-tax basis. This is because dividends on
preferred stock are not tax deductible, whereas interest on bonds is
deductible.
a. True
b. False
(20-2) Types of leases
3
.
FO
Answer: a
EASY
A sale and leaseback arrangement is a type of financial, or capital,
lease.
a. True
b. False
(20-2) Operating lease
4
.
FO
Answer: a
EASY
Operating leases help to shift the risk of obsolescence from the user
to the lessor.
a. True
b. False
(20-2) Sale and leaseback
5
.
FO
Answer: a
EASY
Under a sale and leaseback arrangement, the seller of the leased
property is the lessee and the buyer is the lessor.
a. True
b. False
Chapter 20: Hybrid Financing
True/False
Page 219
(20-2) Lease payments
6
.
FO
Answer: a
EASY
The full amount of a lease payment is tax deductible provided the
contract qualifies as a true lease under IRS guidelines.
a. True
b. False
(20-2) Off-bal. sheet leasing
7
.
FO
Answer: a
EASY
Leasing is often referred to as off-balance sheet financing because
lease payments are shown as operating expenses on a firm's income
statement and, under certain conditions, leased assets and associated
liabilities do not appear on the firm's balance sheet.
a. True
b. False
(20-2) Lease financing
8
.
FO
Answer: b
EASY
Leasing is typically a financing decision and not a capital budgeting
decision. Thus, the availability of lease financing cannot affect the
size of the capital budget.
a. True
b. False
(20-3) Warrants
9
.
FO
Answer: b
EASY
A warrant is an option, and as such it cannot be used as a "sweetener."
a. True
b. False
(20-3) Warrants
10
.
FO
Answer: b
EASY
A warrant holder is not entitled to vote, but he or she does receive
any cash dividends paid on the underlying stock.
a. True
b. False
(20-3) Warrants
11
.
FO
Answer: a
EASY
The problem of dilution of stockholders' earnings never results from
the sale of call options, but it can arise if warrants are used.
a. True
b. False
(20-3) Detachable warrant
12
.
FO
Answer: a
EASY
A detachable warrant is a warrant that can be removed from the security
with which it was issued and traded separately from it. Most traded
warrants are originally attached to bonds or preferred stocks.
a. True
b. False
Page 220
True/False
Chapter 20: Hybrid Financing
(20-4) Convertibles
13
.
FO
Answer: a
EASY
The owner of a convertible bond owns, in effect, both a bond and a
call option.
a. True
b. False
(20-4) Convertibles
14
.
FO
Answer: b
EASY
A convertible debenture can never sell for more than its conversion
value or less than its bond value.
a. True
b. False
(20-4) Convertibles
15
.
FO
Answer: a
EASY
Most convertible securities are bonds or preferred stocks that, under
specified terms and conditions, can be exchanged for common stock at
the option of the holder.
a. True
b. False
(20-4) Convertibles
16
.
FO
Answer: a
EASY
Firms generally do not call their convertibles unless the conversion
value is greater than the call price.
a. True
b. False
(20-1) Preferred stock
17
.
FO
Answer: a
MEDIUM
Many preferred stocks extend voting rights to preferred shareholders if
the preferred dividend has been omitted for some specified period, for
example, 4 quarters.
a. True
b. False
(20-1) Preferred stock
18
.
FO
Answer: b
MEDIUM
Preferred stockholders have priority over common stockholders with
respect to dividends, because dividends must be paid on preferred
stock before they can be paid on common stock. However, preferred and
common stockholders normally have equal priority with respect to
liquidating proceeds in the event of bankruptcy.
a. True
b. False
(20-1) Preferred stock
19
.
FO
Answer: a
MEDIUM
Preferred stock typically has a par value, and the dividend is often
stated as a percentage of par. The par value is also important in the
event of liquidation, as the preferred stockholders are generally
Chapter 20: Hybrid Financing
True/False
Page 221
entitled to receive the par value before anything is given to the
common stockholders.
a. True
b. False
(20-1) Preferred stock
20
.
FO
Answer: a
MEDIUM
Preferred stock can provide a financing alternative for some firms when
market conditions are such that they cannot issue either pure debt or
common stock at any reasonable cost.
a. True
b. False
(20-1) Floating-rate preferred
21
.
FO
Answer: a
MEDIUM
Corporations that invest surplus funds in floating-rate preferred stock
benefit from getting a relatively stable price, which is desirable for
liquidity portfolios, and they also benefit from the 70% tax exemption
on preferred dividends received.
a. True
b. False
(20-2) Res value and leases
22
.
FO
Answer: b
MEDIUM
If a leased asset has a negative residual value, for example, as a
result of a statutory requirement to dispose of an asset in an
environmentally sound manner, the lessee of the asset could reasonably
expect to pay a lower lease rate because the asset does not have a
positive residual value.
a. True
b. False
(20-2) Res value and leases
23
.
FO
Answer: b
MEDIUM
Assume that a piece of leased equipment has a relatively high expected
residual value. From the lessee's viewpoint, it might be better to own
the asset rather than lease it because with a high residual value the
lessee will likely face a higher lease rate.
a. True
b. False
Multiple Choice: Conceptual
(20-2) Lease cash flows
24
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Answer: c
EASY
From the lessee viewpoint, the riskiness of the cash flows, with the
possible exception of the residual value, is about the same as the
riskiness of the lessee's
a. equity cash flows.
b. capital budgeting project cash flows.
Page 222
True/False
Chapter 20: Hybrid Financing
c. debt cash flows.
d. pension fund cash flows.
e. sales.
Chapter 20: Hybrid Financing
True/False
Page 223
(20-2) Operating lease
25
.
EASY
maintenance of the equipment by the lessor.
full amortization over the life of the lease.
very high penalties if the lease is cancelled.
restrictions on how much the leased property can be used.
much longer lease periods than for most financial leases.
(20-1) Preferred stock
.
Answer: a
Operating leases often have terms that include
a.
b.
c.
d.
e.
26
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Answer: c
MEDIUM
Which of the following statements is most CORRECT?
a. Preferred stock generally has a higher component cost of capital to
the firm than does common stock.
b. By law in most states, all preferred stock must be cumulative,
meaning that the compounded total of all unpaid preferred dividends
must be paid before any dividends can be paid on the firm's common
stock.
c. From the issuer's point of view, preferred stock is less risky than
bonds.
d. Whereas common stock has an indefinite life, preferred stocks always
have a specific maturity date, generally 25 years or less.
e. Unlike bonds, preferred stock cannot have a convertible feature.
(20-2) Leasing
27
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Answer: e
MEDIUM
Which of the following is most CORRECT?
a. Firms that use "off balance sheet" financing, such as leasing, would
show lower debt ratios if the effects of their leases were reflected
in their financial statements.
b. Capitalizing a lease means that the firm issues equity capital in
proportion to its current capital structure, in an amount sufficient
to support the lease payment obligation.
c. The fixed charges associated with a lease can be as high as, but
never greater than, the fixed payments associated with a loan.
d. Capital, or financial, leases generally provide for maintenance by
the lessor.
e. A key difference between a capital lease and an operating lease is
that with a capital lease, the lease payments provide the lessor
with a return of the funds invested in the asset plus a return on
the invested funds, whereas with an operating lease the lessor
depends on the residual value to realize a full return of and on the
investment.
(20-2) Capitalizing leases
28
.
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Answer: c
MEDIUM
Statement of Financial Accounting Standards #13 requires that for an
unqualified audit report, financial (or capital) leases must be
included in the balance sheet by reporting the
a. residual value as a fixed asset.
b. residual value as a liability.
Page 224
Conceptual M/C
Chapter 20: Hybrid Financing
c. present value of future lease payments as an asset and also showing
this same amount as an offsetting liability.
d. undiscounted sum of future lease payments as an asset and as an
offsetting liability.
e. undiscounted sum of future lease payments, less the residual value,
as an asset and as an offsetting liability.
(20-2) Off-balance sheet leasing
29
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Answer: b
MEDIUM
Heavy use of off-balance sheet lease financing will tend to
a. make a company appear more risky than it actually is because its
stated debt ratio will be increased.
b. make a company appear less risky than it actually is because its
stated debt ratio will appear lower.
c. affect a company's cash flows but not its degree of risk.
d. have no effect on either cash flows or risk because the cash flows
are already reflected in the income statement.
e. affect the lessee's cash flows but only due to tax effects.
(20-2) Lease decision
30
.
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Answer: e
MEDIUM
In the lease versus buy decision, leasing is often preferable
a. because it has no effect on the firm's ability to borrow to make
other investments.
b. because, generally, no down payment is required, and there are no
indirect interest costs.
c. because lease obligations do not affect the firm's risk as seen by
investors.
d. because the lessee owns the property at the end of the lease term.
e. because the lessee may have greater flexibility in abandoning the
project in which the leased property is used than if the lessee
bought and owned the asset.
(20-2) Lease analysis discount rate
31
.
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Answer: c
MEDIUM
A lease versus purchase analysis should compare the cost of leasing to
the cost of owning, assuming that the asset purchased
a.
b.
c.
d.
is financed with short-term debt.
is financed with long-term debt.
is financed with debt whose maturity matches the term of the lease.
is financed with a mix of debt and equity based on the firm's target
capital structure, i.e., at the WACC.
e. is financed with retained earnings.
(20-4) Convertibles
32
.
CO
Answer: e
MEDIUM
Which of the following statements about convertibles is most CORRECT?
a. The coupon interest rate on a firm's convertibles is generally set
higher than the market yield on its otherwise similar straight debt.
b. One advantage of convertibles over warrants is that the issuer
receives additional cash money when convertibles are converted.
Chapter 20: Hybrid Financing
Conceptual M/C
Page 225
c. Investors are willing to accept a lower interest rate on a
convertible than on otherwise similar straight debt because
convertibles are less risky than straight debt.
d. At the time it is issued, a convertible's conversion (or exercise)
price is generally set equal to or below the underlying stock's
price.
e. For equilibrium to exist, the expected return on a convertible bond
must normally be between the expected return on the firm's otherwise
similar straight debt and the expected return on its common stock.
Page 226
Conceptual M/C
Chapter 20: Hybrid Financing
(20-4) Warrants and convertibles
33
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Answer: c
MEDIUM
Which of the following statements concerning warrants is most CORRECT?
a. Bonds with warrants and convertible bonds both have option features
that their holders can exercise if the underlying stock's price
increases. However, if the option is exercised, the issuing
company's debt declines if warrants are used but remains the same if
convertibles are used.
b. Warrants are long-term put options that have value because holders
can sell the firm's common stock at the exercise price regardless of
how low the market price drops.
c. Warrants are long-term call options that have value because holders
can buy the firm's common stock at the exercise price regardless of
how high the stock's price has risen.
d. A firm's investors would generally prefer to see it issue bonds with
warrants than straight bonds because the warrants dilute the value
of new shareholders, and that value is transferred to existing
shareholders.
e. A drawback to using warrants is that if the firm is very successful,
investors will be less likely to exercise the warrants, and this
will deprive the firm of receiving any new capital.
(20-4) Warrants and convertibles
34
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Answer: c
MEDIUM
Which of the following statements is most CORRECT?
a. Warrants have an option feature but convertibles do not.
b. One important difference between warrants and convertibles is that
convertibles bring in additional funds when they are converted, but
exercising warrants does not bring in any additional funds.
c. The coupon rate on convertible debt is normally set below the
coupon rate that would be set on otherwise similar straight debt
even though investing in convertibles is more risky than investing
in straight debt.
d. The value of a warrant to buy a safe, stable stock should exceed the
value of a warrant to buy a risky, volatile stock, other things held
constant.
e. Warrants can sometimes be detached and traded separately from the
security with which they were issued, but this is unusual.
Problems
(20-4) Convertibles: straight debt value C O
35
.
Answer: d
EASY
Orient Airlines common stock currently sells for $33, and its 8%
convertible debentures (issued at par, or $1,000) sell for $850. Each
debenture can be converted into 25 shares of common stock at any time
before 2020. What is the conversion value of the bond?
a.
b.
c.
d.
$707.33
$744.56
$783.75
$825.00
Chapter 20: Hybrid Financing
Problems
Page 227
e. $866.25
Page 228
Problems
Chapter 20: Hybrid Financing
(20-4) Conversion price
36
.
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$40.00
$42.00
$44.10
$46.31
$48.62
(20-4) Conversion ratio
.
CO
CO
EASY/MEDIUM
$177,169
$196,854
$207,215
$217,576
$228,455
(20-2) Comparing loan & lease pymts
.
Answer: c
Sutton Corporation, which has a zero tax rate due to tax loss carryforwards, is considering a 5-year, $6,000,000 bank loan to finance
service equipment. The loan has an interest rate of 10% and would be
amortized over 5 years, with 5 end-of-year payments. Sutton can also
lease the equipment for 5 end-of-year payments of $1,790,000 each. How
much larger or smaller is the bank loan payment than the lease payment?
Note: Subtract the loan payment from the lease payment.
a.
b.
c.
d.
e.
39
EASY
22.56
23.75
25.00
26.25
27.56
(20-2) Diff. in loan/lease pymts
.
Answer: c
Moniker Manufacturing's bonds were recently issued at their $1,000 par
value. At any time prior to maturity (20 years from now), a bond
holder can exchange a bond for a share of common stock at a conversion
price of $40. What is the conversion ratio?
a.
b.
c.
d.
e.
38
EASY
Chocolate Factory's convertible debentures were issued at their $1,000
par value in 2009. At any time prior to maturity on February 1, 2029,
a debenture holder can exchange a bond for 25 shares of common stock.
What is the conversion price, Pc?
a.
b.
c.
d.
e.
37
Answer: a
CO
Answer: e
EASY/MEDIUM
Ballentine Inc. is considering a 6-year, $5,000,000 bank loan in order
to buy a new piece of equipment. The loan will be amortized over 6
years with end-of-year payments and has an interest rate of 9%.
Alternatively, Ballentine can also lease the equipment for an end-ofyear payment of $1,250,000. By how much does the lease payment exceed
the loan payment?
a.
b.
c.
d.
e.
$110,285
$116,090
$122,199
$128,631
$135,401
Chapter 20: Hybrid Financing
Problems
Page 229
Page 230
Problems
Chapter 20: Hybrid Financing
(20-1) Preferred vs. bond yields
40
.
Answer: b
MEDIUM
$96
$106
$112
$117
$123
(20-3) Warrants: coupon
.
CO
Kohers Inc. is considering a leasing arrangement to finance some
manufacturing tools that it needs for the next 3 years. The tools will
be obsolete and worthless after 3 years. The firm will depreciate the
cost of the tools on a straight-line basis over their 3-year life. It
can borrow $4,800,000, the purchase price, at 10% and buy the tools,
or it can make 3 equal end-of-year lease payments of $2,100,000 each
and lease them. The loan obtained from the bank is a 3-year simple
interest loan, with interest paid at the end of the year. The firm's
tax rate is 40%. Annual maintenance costs associated with ownership
are estimated at $240,000 payable at the end of the year, but this cost
would be borne by the lessor if the equipment is leased. What is the
net advantage to leasing (NAL), in thousands? (Suggestion: Delete 3
zeros from dollars and work in thousands.)
a.
b.
c.
d.
e.
42
MEDIUM
6.66%
6.99%
7.34%
7.71%
8.09%
(20-2) Net advantage to leasing
.
Answer: a
Its investment bankers have told Donner Corporation that it can issue a
25-year, 8.1% annual payment bond at par. They also stated that the
company can sell an issue of annual payment preferred stock to
corporate investors who are in the 40% tax bracket. The corporate
investors require an after-tax return on the preferred that exceeds
their after-tax return on the bonds by 1.0%, which would represent an
after-tax risk premium. What coupon rate must be set on the preferred
in order to issue it at par?
a.
b.
c.
d.
e.
41
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Answer: b
MEDIUM
Warren Corporations stock sells for $42 per share. The company wants
to sell some 20-year, annual interest, $1,000 par value bonds. Each
bond would have 75 warrants attached to it, each exercisable into one
share of stock at an exercise price of $47. The firms straight bonds
yield 10%. Each warrant is expected to have a market value of $2.00
given that the stock sells for $42. What coupon interest rate must the
company set on the bonds in order to sell the bonds-with-warrants at
par?
a.
b.
c.
d.
e.
7.83%
8.24%
8.65%
9.08%
9.54%
Chapter 20: Hybrid Financing
Problems
Page 231
Page 232
Problems
Chapter 20: Hybrid Financing
(20-3) Warrants: coupon
43
.
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6.75%
7.11%
7.48%
7.88%
8.27%
(20-3) Warrants
.
CO
Upstate Water Company just sold a bond with
bonds have a 20-year maturity and an annual
were issued at their $1,000 par value. The
straight bonds is 15%. What is the implied
a.
b.
c.
d.
e.
.
CO
50 warrants attached. The
coupon of 12%, and they
current yield on similar
value of each warrant?
Answer: b
MEDIUM
$8.00
$8.42
$8.84
$9.28
$9.75
(20-3) Warrants: straight-debt value
.
MEDIUM
Curran Contracting is issuing new 25-year bonds that have warrants
attached. If not for the attached warrants, the bonds would carry an
11% annual interest rate. However, with the warrants attached the
bonds will pay an 8% annual coupon. There are 30 warrants attached to
each bond, which have a par value of $1,000. What is the implied value
of each warrant?
a.
b.
c.
d.
e.
46
Answer: a
$3.76
$3.94
$4.14
$4.35
$4.56
(20-3) Warrants
45
MEDIUM
Curry Corporation is setting the terms on a new issue of bonds with
warrants. The bonds will have a 30-year maturity and annual interest
payments. Each bond will come with 20 warrants that give the holder
the right to purchase one share of stock per warrant. The investment
bankers estimate that each warrant will have a value of $10.00. A
similar straight-debt issue would require a 10% coupon. What coupon
rate should be set on the bonds-with-warrants so that the package would
sell for $1,000?
a.
b.
c.
d.
e.
44
Answer: d
CO
Answer: b
MEDIUM
Herbert Engineering is issuing new 15-year bonds that have warrants
attached. If not for the attached warrants, the bonds would carry a 9%
annual interest rate. However, with the warrants attached the bonds
will pay a 6% annual coupon. There are 30 warrants attached to each
bond, which has a par value of $1,000. What is the value of the
straight-debt portion of the bonds?
a. $720.27
b. $758.18
Chapter 20: Hybrid Financing
Problems
Page 233
c. $796.09
d. $835.89
e. $877.69
(20-3) Warrants: straight-debt value
47
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$652.55
$686.89
$723.05
$761.10
$799.16
(20-4) Convertibles: straight-debt value C O
.
MEDIUM
$725.58
$763.76
$803.96
$846.28
$888.59
(20-4) Convertibles: conversion value
.
Answer: d
Herring Inc. is considering issuing 15-year, 8% semiannual coupon,
$1,000 face value convertible bonds at a price of $1,000 each. Each
bond would be convertible into 25 shares of common stock. If the
bonds were not investors convertible, would require an annual nominal
yield of 10%. What is the straight-debt value of the bond at the time
of issue?
a.
b.
c.
d.
e.
49
MEDIUM
Thomson Engineering is issuing new 20-year bonds that have warrants
attached. If not for the attached warrants, the bonds would carry an
11% annual interest rate. However, with the warrants attached the
bonds will pay an 8% annual coupon. There are 30 warrants attached to
each bond, which have a par value of $1,000. What is the value of the
straight-debt portion of the bonds?
a.
b.
c.
d.
e.
48
Answer: d
CO
Answer: c
MEDIUM
Cannon Manufacturing is considering issuing 15-year, 8% annual
coupon, $1,000 face value convertible bonds at a price of $1,000 each.
Each bond would be convertible into 25 shares of common stock. If the
bonds were not convertible, investors would require an annual yield of
10%. The stock's current price is $25.00, its expected dividend is
$2.50, and its expected growth rate is 5%. The bonds are noncallable
for 10 years. What is the bond's conversion value in Year 5?
a.
b.
c.
d.
e.
Page 234
$719.90
$757.79
$797.68
$837.56
$879.44
Problems
Chapter 20: Hybrid Financing
(20-2) Breakeven lease payment
50
.
Answer: a
MEDIUM/HARD
$790.48
$830.01
$871.51
$915.08
$960.84
(20-4) Convertibles: floor value
.
CO
Atlas Anglers Inc. is considering issuing a 15-year convertible bond
that will be priced at its $1,000 par value. The bonds have a 6.5%
annual coupon rate, and each bond can be converted into 20 shares of
common stock. The stock currently sells at $30 a share, has an
expected dividend in the coming year of $3, and has an expected
constant growth rate of 5.5%. What is the estimated floor price of the
convertible at the end of Year 3 if the required rate of return on a
similar straight-debt issue is 9.5%?
a.
b.
c.
d.
e.
52
MEDIUM/HARD
$1,950
$2,052
$2,160
$2,268
$2,382
(20-4) Convertibles: floor value
.
Answer: c
Ellis Enterprises is considering whether to lease or buy some necessary
equipment it needs for a project that will last the next 3 years. If
the firm buys the equipment, it will borrow $4,800,000 at 8% interest.
The firm's tax rate is 35% and the firm's before-tax cost of debt is
8%. Annual maintenance costs associated with ownership are estimated
to be $300,000 and the equipment will be depreciated on a straightline basis over 3 years. What is the annual end-of-year lease payment
(in thousands of dollars) for a 3-year lease that would make the firm
indifferent between buying or leasing the equipment? (Suggestion:
Delete 3 zeros from dollars and work in thousands.)
a.
b.
c.
d.
e.
51
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Answer: d
MEDIUM/HARD
Valdes Enterprises is considering issuing a 10-year convertible bond
that would be priced at its $1,000 par value. The bonds would have an
8.00% annual coupon, and each bond could be converted into 20 shares
of common stock. The required rate of return on an otherwise similar
nonconvertible bond is 10.00%. The stock currently sells for $40.00 a
share, has an expected dividend in the coming year of $2.00, and has an
expected constant growth rate of 5.00%. What is the estimated floor
price of the convertible at the end of Year 4?
a.
b.
c.
d.
e.
$901.28
$924.39
$948.09
$972.41
$996.72
Chapter 20: Hybrid Financing
Problems
Page 235
(20-2) Net advantage to leasing
53
.
HARD
$609
$642
$678
$715
$751
(20-2) Net advantage to leasing
.
Answer: d
Carolina Trucking Company (CTC) is evaluating a potential lease for a
truck with a 4-year life that costs $40,000 and falls into the MACRS 3year class. If the firm borrows and buys the truck, the loan rate
would be 9%, and the loan would be amortized over the trucks 4-year
life. The loan payments would be made at the end of each year. The
truck will be used for 4 years, at the end of which time it will be
sold at an estimated residual value of $12,000. If CTC buys the truck,
it would purchase a maintenance contract that costs $1,500 per year,
payable at the end of each year. The lease terms, which include
maintenance, call for a $10,000 lease payment (4 payments total) at the
beginning of each year. CTC's tax rate is 35%. What is the net
advantage to leasing? (Note: MACRS rates for Years 1 to 4 are 0.33,
0.45, 0.15, and 0.07.)
a.
b.
c.
d.
e.
54
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Answer: a
HARD
Bevs Beverages is negotiating a lease on a new piece of equipment that
would cost $80,000 if purchased. The equipment falls into the MACRS
3-year class, and it would be used for 3 years and then sold, because
the firm plans to move to a new facility at that time. The estimated
value of the equipment after 3 years is $25,000. A maintenance
contract on the equipment would cost $2,500 per year, payable at the
beginning of each year. Alternatively, the firm could lease the
equipment for 3 years for a lease payment of $23,000 per year, payable
at the beginning of each year. The lease would include maintenance.
The firm is in the 20% tax bracket, and it could obtain a 3-year simple
interest loan, interest payable at the end of the year, to purchase the
equipment at a before-tax cost of 8%. If there is a positive Net
Advantage to Leasing the firm will lease the equipment. Otherwise, it
will buy it. What is the NAL? (Note: MACRS rates for Years 1 to 4 are
0.33, 0.45, 0.15, and 0.07.)
a.
b.
c.
d.
e.
Page 236
$2,852
$2,994
$3,144
$3,301
$3,466
Problems
Chapter 20: Hybrid Financing
(20-3) Warrants: return
55
.
CO
10.64%
11.20%
11.79%
12.38%
13.00%
(20-4) Convertibles: return
.
HARD
Emerson Electrical Engineering Inc. is issuing new 20-year bonds that
have warrants attached. If not for the attached warrants, the bonds
would carry an 11% interest rate. However, with the warrants attached
the bonds will pay a 9% annual coupon. There are 25 warrants attached
to each bond, which have a par value of $1,000. The exercise price of
the warrants is $25.00 and the expected stock price 10 years from now
(when the warrants may be exercised) is $50.77. What is the investor's
expected overall pre-tax rate of return for this bond-with-warrants
issue?
a.
b.
c.
d.
e.
56
Answer: c
CO
Answer: c
HARD
Quaid Co.'s common stock sells for $28.00, pays a dividend of $2.10,
and has an expected long-term growth rate of 6%. The firm's straightdebt bonds pay 10.8%. Quaid is planning a convertible bond issue.
The bonds will have a 20-year maturity, pay a 10% annual coupon, have a
par value of $1,000, and a conversion ratio of 25 shares per bond.
The bonds will sell for $1,000 and will be callable after 10 years.
Assuming that the bonds will be converted at Year 10, when they become
callable, what will be the expected return on the convertible when it
is issued?
a.
b.
c.
d.
e.
10.36%
10.91%
11.48%
12.06%
12.66%
Multiple Part:
Problems 57 through 60 must be kept together, as Problems 58-60 use data from 57.
(20-4) Conversion ratio
57
.
CO
Answer: b
EASY
The following data apply to Saunders Corporation's convertible bonds.
What is the bond's conversion ratio ?
Maturity
Par value
Annual coupon
a.
b.
c.
d.
e.
10
$1,000
5.00%
Stock price
Conversion price
Straight-debt yield
$30.00
$35.00
8.00%
27.14
28.57
30.00
31.50
33.08
Chapter 20: Hybrid Financing
Problems
Page 237
Follow-up to #57, data from #57 needed.
(20-4) Conversion value
58
.
CO
Answer: e
EASY
What is the bond's initial conversion value when issued?
a.
b.
c.
d.
e.
$698.15
$734.89
$773.57
$814.29
$857.14
Follow-up to #57, data from #57 needed.
(20-4) Convertibles: straight-debt value C O
59
.
Answer: d
EASY/MEDIUM
What is the bond's straight-debt value at the time of issue?
a.
b.
c.
d.
e.
$684.78
$720.82
$758.76
$798.70
$838.63
Follow-up to #57, data from #57 needed.
(20-4) Convertibles: floor price
60
.
CO
Answer: e
EASY/MEDIUM
Based on your answers to the three preceding questions, what is the
minimum price (or "floor" price) at which the Saunders' bonds should
sell?
a.
b.
c.
d.
e.
Page 238
$698.15
$734.89
$773.57
$814.29
$857.14
Problems
Chapter 20: Hybrid Financing
CHAPTER 20
ANSWERS AND SOLUTIONS
Chapter 20: Hybrid Financing
Answers
Page 239
1.
(20-1) Preferred stock
FO
Answer: b
EASY
2.
(20-1) Cost of preferred stock
FO
Answer: a
EASY
3.
(20-2) Types of leases
FO
Answer: a
EASY
4.
(20-2) Operating lease
FO
Answer: a
EASY
5.
(20-2) Sale and leaseback
FO
Answer: a
EASY
6.
(20-2) Lease payments
FO
Answer: a
EASY
7.
(20-2) Off-bal. sheet leasing
FO
Answer: a
EASY
8.
(20-2) Lease financing
FO
Answer: b
EASY
9.
(20-3) Warrants
FO
Answer: b
EASY
10.
(20-3) Warrants
FO
Answer: b
EASY
11.
(20-3) Warrants
FO
Answer: a
EASY
12.
(20-3) Detachable warrant
FO
Answer: a
EASY
13.
(20-4) Convertibles
FO
Answer: a
EASY
14.
(20-4) Convertibles
FO
Answer: b
EASY
15.
(20-4) Convertibles
FO
Answer: a
EASY
16.
(20-4) Convertibles
FO
Answer: a
EASY
17.
(20-1) Preferred stock
FO
Answer: a
MEDIUM
18.
(20-1) Preferred stock
FO
Answer: b
MEDIUM
19.
(20-1) Preferred stock
FO
Answer: a
MEDIUM
20.
(20-1) Preferred stock
FO
Answer: a
MEDIUM
21.
(20-1) Floating-rate preferred
FO
Answer: a
MEDIUM
22.
(20-2) Res value and leases
FO
Answer: b
MEDIUM
23.
(20-2) Res value and leases
FO
Answer: b
MEDIUM
24.
(20-2) Lease cash flows
CO
Answer: c
EASY
25.
(20-2) Operating lease
CO
Answer: a
EASY
26.
(20-1) Preferred stock
CO
Answer: c
MEDIUM
27.
(20-2) Leasing
CO
Answer: e
MEDIUM
28.
(20-2) Capitalizing leases
CO
Answer: c
MEDIUM
29.
(20-2) Off-balance sheet leasing
CO
Answer: b
MEDIUM
30 .
(20-2) Lease decision
CO
Answer: e
MEDIUM
31.
(20-2) Lease analysis discount rate C O
Answer: c
MEDIUM
32.
(20-4) Convertibles
Answer: e
MEDIUM
CO
33 .
(20-4) Warrants and convertibles
CO
Answer: c
MEDIUM
34.
(20-4) Warrants and convertibles
CO
Answer: c
MEDIUM
35 .
(20-4) Convertibles: straight debt value C O
Stock price
Bond price
Conversion ratio
$33.00
$850
25.00
Answer: d
Coupon rate
Par value
EASY
8.00%
$1,000
Conversion value = Conversion ratio Stock price = $825.00
36.
(20-4) Conversion price
Par value
Conversion ratio
CO
Answer: a
EASY
Answer: c
EASY
$1,000.00
25.00
Conversion price = Par value/Conversion ratio = $40.00
37.
(20-4) Conversion ratio
Par value
Conversion price
CO
$1,000.00
$40.00
Conversion ratio = Par value/Conversion price = 25.00
38 .
(20-2) Diff. in loan/lease pymts
Years (N)
Interest rate (I/YR)
Loan amount (PV)
Lease payment
Loan:
0
-6,000,000
CO
Answer: c
EASY/MEDIUM
5
10.0%
$6,000,000
$1,790,000
1
PMT
2
PMT
3
PMT
4
PMT
5
PMT
Inputs: N = 5; I/YR = 10; PV = -Loan amount; FV = 0
Loan payment = PMT = $1,582,785
Difference in payments = Lease pymt Loan pymt =
39 .
$207,215
(20-2) Comparing loan & lease pymts C O
Loan length (N)
Bank loan (PV)
Interest rate on loan (I/YR)
Lease payment
Loan:
0
-1,250,000
Answer: e
EASY/MEDIUM
6
$5,000,000
9.00%
$1,250,000
1
PMT
2
PMT
3
PMT
4
PMT
5
PMT
6
PMT
Find the loan payment:
Inputs: N = 6; I/YR = 10; PV = -5000000; FV = 0
Loan payment = PMT = $1,114,599
Difference in payments = Lease pymt Loan pymt = $135,401
40.
(20-1) Preferred vs. bond yields
Maturity
Coupon rate
Risk premium
25
8.10%
1.00%
CO
Answer: a
Pfd. exclusion
Tax rate
MEDIUM
70%
40.00%
Bond yield AT = BT yield(1 T) = 4.86%
Preferred yield AT = AT bond yield + RP = 5.86%
AT pfd yield = BTpfd yield BT pfd yield(1 Exclusion)(Tax rate)
Preferred yield BT = 5.86%/[1 (0.3)(0.4)] = 6.66%
Check: AT pfd yield = 6.66% Tax
= 6.66% 6.66%(1 Exclusion)(Tax rate)
= 6.66% 6.66%(0.30)(0.40)
= 6.66% 6.66%(0.12)
= 6.66% 0.80%
AT pfd yield = 5.86%
41.
(20-2) Net advantage to leasing
Years
Loan amount = equipment cost
Interest rate
Lease payment
Leasing analysis:
Lease payment
Tax savings from lease
Net cash flow
PV cost of leasing (6%)
Answer: b
3
$4,800
10.0%
$2,100
After-tax cost of debt = Rate (1 T) =
Annual depreciation = Cost/Yrs. =
Tax savings from deprec. = Deprec. T =
Purchase analysis:
Net purchase price
Maintenance cost
Maint. tax savings = Maint T
Deprec. tax savings
Net cash flow
PV cost of owning (6%)
CO
Tax rate
Maintenance costs
Salvage value
MEDIUM
40%
$240
$0
6.0%
$1,600
$640
0
1
2
3
-240
96
640
496
-240
96
640
496
-240
96
640
496
-2,100
840
-1,260
-2,100
840
-1,260
-2,100
840
-1,260
-$4,800
-4,800
-3,474
-3,368
NAL = PV cost of owning PV cost of leasing = $106
42.
(20-3) Warrants: coupon
CO
Answer: b
MEDIUM
Stock price
Exercise price
No. of warrants
Value of warrants
$42.00
$47.00
75
$2.00
Bond par value
Bond maturity
Straight-debt yield
$1,000
20
10.0%
Total value = Straight-debt value + Warrant value
$1,000 = Bond value + $150
VB = $1,000 $150 = $850
Set N = 20, I/YR = 10, PV = -V B, FV = 1000 and solve for PMT: $82.38
To get this payment on a $1,000 bond, the coupon rate = PMT/$1000 = 8.24%
43.
(20-3) Warrants: coupon
Bond par value
Bond maturity
Straight-debt yield
CO
$1,000
30
10.0%
Answer: d
No. of warrants
Value of warrants
MEDIUM
20
$10.00
Total value = Straight-debt value (V B) + Warrant value = $1,000
$1,000 = VB + $200
VB = $1,000 $200.00 = $800.00
44.
Set N = 30, I/YR = 10, PV = -V B, and FV = 1000. Then solve for PMT: $78.78
To get this payment on a $1,000 bond, the coupon rate = PMT/$1000 = 7.88%
(20-3) Warrants
CO
Answer: a
Bond par value
Bond maturity
Straight-debt yield
$1,000
20
15.0%
No. of warrants
Coupon rate
PMT
MEDIUM
50
12.0%
$120
Find the straight-debt value: N = 20, I/YR = 15, PMT = -120, and FV = -1000. PV = $812.22
Total value
$1,000
$187.78
Warrant value
45.
= Straight-debt value (V B) + Warrant value = $1,000
= $812.22 + 50 Warrant value
= 50 Warrant value
= $3.76
(20-3) Warrants
Bond par value
Bond maturity
Straight-debt yield
CO
$1,000
25
11.0%
Answer: b
MEDIUM
No. of warrants
Coupon rate
PMT
30
8.0%
$80
Find the straight-debt value: N = Maturity, I/YR = 11, PMT = -80, and FV = -1000. PV = $747.35
Total value
$1,000
$252.65
Warrant value
46.
= Straight-debt value (VB) + Warrant value = $1,000
= $747.35 + 30 Warrant value
= 30 Warrant value
= $8.42
(20-3) Warrants: straight-debt value C O
Bond par value
Bond maturity
Straight-debt yield
$1,000
15
9.0%
Answer: b
No. of warrants
Coupon rate
PMT
MEDIUM
30
6.0%
$60
Find the straight-debt value: N = 15, I/YR = 9, -PMT, and FV = -1000.
PV = $758.18
47.
(20-3) Warrants: straight-debt value C O
Bond par value
Bond maturity
Straight-debt yield
$1,000
20
11.0%
Answer: d
No. of warrants
Coupon rate
PMT
MEDIUM
30
8.0%
$80
Find the straight-debt value: N = Maturity, I/YR = 11, PMT = -80, and FV = -1000.
PV = $761.10
48.
(20-4) Convertibles: straight-debt value C O
Bond par value
Maturity Years
No. of periods/yr.
N
Conv. ratio (CR)
49.
$1,000
15
2
30
25
Answer: d
Straight-debt yield
I/YR
Convertible coupon
PMT
Find the straight-debt value: N = 30, I/YR = 5, -PMT, and FV = -1000.
PV = $846.28
(20-4) Convertibles: conversion value
CO
Bond par value
Conv. ratio (CR)
P0
Growth rate (g)
Conversion year, t
$1,000
25
$25
5.0%
5
MEDIUM
10.0%
5.0%
8.0%
40
Answer: c
Bond maturity
Straight-debt yield
Convertible coupon
PMT
MEDIUM
15
10.0%
8.0%
$80
Conversion value = P0 CR (1 + g)t
Conversion value = $25 25 1.050 5
Conversion value = $797.68
50 .
(20-2) Breakeven lease payment
Life of equipment
Loan amount = equip. cost
BT cost of debt
CO
3
$4,800
8.0%
Purchase analysis:
0
Straight-line factor
Depreciation
Equipment purchase
Maintenance
Maint. tax savings (Maint. T)
Deprec. tax savings (Deprec T)
Net CFs
PV cost at I(1 T) = 5.20%
Answer: c
Tax rate
Maint. costs
35%
$300
1
0.3333
1,600
2
0.3333
1,600
3
0.3333
1,600
-300
105
560
365
-300
105
560
365
-300
105
560
365
-$4,800
-4,800
-3,810
Calculate lease PMT that has same PV as owning:
N
3
I/YR
5.20%
PV
-3,810
FV
0
PMT = AT leasing PMT = $1,404
BT leasing PMT = AT PMT/(1 T) = $2,160
MEDIUM/HARD
Totals
1.00
4,800
51.
(20-4) Convertibles: floor value
Bond par value
Bond maturity
Evaluation year, t
N
Straight-debt yield
CO
$1,000
15
3
12
9.5%
Answer: a
MEDIUM/HARD
Convertible coupon
PMT
Conversion ratio (shares)
Stock price
Dividend per share
Growth rate
6.5%
$65
20
$30.00
$3.00
5.5%
Find the straight-debt value: N = 12, I/YR = 9.5, PMT = -65, and FV = -1000.
PV = $790.48
Conversion value = P0 CR (1 + g)t
Conversion value = $30 20 1.055 3
Conversion value = $704.54
The floor value is the higher of the bond value or the conversion value, so it is $790.48.
52.
(20-4) Convertibles: floor value
Bond par value
Bond maturity
Evaluation year, t
N
Straight-debt yield, I/YR
PMT
CO
$1,000
10
4
6
10.0%
$80.00
Answer: d
MEDIUM/HARD
Conversion ratio (shares), CR
Stock price, P 0
Dividend per share
Growth rate
Convertible coupon
20
$40.00
$2.00
5.0%
8.0%
Find the straight-debt value: N = 6, I/YR = 10, PMT = -80, and FV = -1000.
PV = $912.89
Conversion value = P0 CR (1 + g)t
Conversion value = $40 20 1.050 4
Conversion value = $972.41
The floor value is the higher of the bond value or the conversion value, so it is $972.41
53 .
(20-2) Net advantage to leasing
Life of equipment
Equipment cost
Interest rate
Lease payment
4
$40,000
9.0%
$10,000
CO
Answer: d
Tax rate
Maint. costs
Salvage value
HARD
35%
$1,500
$12,000
Purchase analysis:
MACRS factor
Depreciation
Equipment purchase
Maintenance
Maint. tax savings (Maint. T)
Deprec. tax savings (Deprec. T)
Net operating CF
Salvage value
Tax on residual
Net residual value
Total net CF
0
1
0.33
13,200
2
0.45
18,000
3
0.15
6,000
4
0.07
2,800
-40,000
-1,500
525
4,620
3,645
-1,500
525
6,300
5,325
-1,500
525
2,100
1,125
-40,000
3,645
5,325
1,125
-1,500
525
980
5
12,000
-4,200
7,800
7,805
1
-10,000
3,500
-6,500
2
-10,000
3,500
-6,500
3
-10,000
3,500
-6,500
-$40,000
PV cost of buying at I(1 T) 5.85%
Lease analysis:
Lease payment
Tax savings on pmt
Net cost of lease
0
-10,000
3,500
-6,500
PV cost of leasing at I(1 T) 5.85%
NAL = $715
54.
-24,638
-23,923
(20-2) Net advantage to leasing
Life of equipment
Equipment cost
Interest rate
Lease payment
Purchase analysis:
MACRS factor
Depreciation
Equipment cost
Maintenance
Maint. tax savings (Maint. T)
Deprec. tax savings (Deprec. T)
3
$80,000
8.0%
$23,000
0
-$80,000
-2,500
500
CO
4
Answer: a
Tax rate
Maint. costs
Salvage value
0
0
0
HARD
20%
$2,500
$25,000
1
0.33
26,400
2
0.45
36,000
3
0.15
12,000
-2,500
500
5,280
-2,500
500
7,200
2,400
Totals
0.93
74,400
Net operating CF
Salvage value before taxes
Book value (Cost Total deprec.)
Taxable salvage value
Tax on salvage value
Salvage value after taxes
Net CFs
-82,000
3,280
5,200
-82,000
3,280
5,200
PV cost at I(1T)=
-54,798
1
-23,000
4,600
-18,400
2
-23,000
4,600
-18,400
6.40%
Lease analysis:
Lease payment
Tax saving on pmt
Net cost of lease
PV cost of leasing at I(1T)
NAL = $2,852
55 .
0
-23,000
4,600
-18,400
-51,946
(20-3) Warrants: return
CO
Bond par value
$1,000
Bond maturity
20
Straight-debt yield
11.0%
P10
$50.77
Value gained from exercise in Yr. 10 per warrant
Total value gained in Year 10
CF0
CF1
CF2
CF3
CF4
CF5
CF6
CF7
CF8
CF9
CF10
-$1,000
90.00
90.00
90.00
90.00
90.00
90.00
90.00
90.00
90.00
734.25
IRR
56.
2,400
25,000
5,600
19,400
-3,880
21,120
23,520
3
0
0
Answer: c
Conversion ratio (shares)
Coupon rate
Exercise price
HARD
25
9.0%
$25.00
$25.77
644.25
CF11
CF12
CF13
CF14
CF15
CF16
CF17
CF18
CF19
CF20
11.79%
(20-4) Convertibles: return
Yield on similar straight debt
Maturity
Coupon rate
Par value
PMT
90.00
90.00
90.00
90.00
90.00
90.00
90.00
90.00
90.00
1,090.00
CO
10.80%
20
10.00%
$1,000
$100
Answer: c
Stock price
Expected dividend
Expected growth rate
Conversion ratio
Convertible after year
Find the straight-debt value: N = 20 10, I/YR = 10.8, PMT = -100, and FV = -1000.
PV = $952.49
Conversion value = P0 CR (1 + g)t
Conversion value = $28 25 1.060 10
Conversion value = $1,253.59
The floor value is the higher of the bond value or the conversion value, so it is $1,253.59.
CF0
CF1
CF2
CF3
CF4
CF5
-$1,000
$100.0
$100.0
$100.0
$100.0
$100.0
IRR
11.48%
CF6
CF7
CF8
CF9
CF10
$100.0
$100.0
$100.0
$100.0
$1,353.6
HARD
$28.00
$2.10
6.00%
25
10
57 .
(20-4) Conversion ratio
Years to maturity
Par value
Annual coupon
CO
10
$1,000.00
5.00%
Answer: b
Stock price
Conversion price
Straight-debt yield
EASY
$30.00
$35.00
8.00%
Conversion ratio = Par value/Conversion price = 28.57
58 .
(20-4) Conversion value
CO
Answer: e
EASY
Conversion value = Conversion ratio Market price of stock = $857.14
59 .
(20-4) Convertibles: straight-debt value C O
Answer: d
EASY/MEDIUM
Answer: e
EASY/MEDIUM
Inputs: N = 10; I/YR = 8; PMT = Coupon rate Par value; FV = 1,000.
PV = $798.70
60.
(20-4) Convertibles: floor price
CO
The floor price is the higher of the bond's conversion value or straight-debt value. Those values as
calculated above are as follows:
Conversion value
Straight-debt value
$857.14
$798.70
Maximum of the two = minimum price = floor value = $857.14