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Exam 20: Hybrid Financing: Preferred Stock, leasing, warrants, and Convertibles

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Question 1

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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

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Question 2

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Operating leases often have terms that include

A) maintenance of the equipment by the lessor.
B) full amortization over the life of the lease.
C) very high penalties if the lease is cancelled.
D) restrictions on how much the leased property can be used.
E) much longer lease periods than for most financial leases.

F) B) and E)
G) C) and D)

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Question 3

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Chocolate Factory's convertible debentures were issued at their $1,000 par value in 2011.At any time prior to maturity on February 1,2031,a debenture holder can exchange a bond for 25 shares of common stock.What is the conversion price,P_c?

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 convertible,investors would require an annual nominal yield of 10%.What is the straight-debt value of each bond at the time of issue?

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.

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.)

Firms generally do not call their convertibles unless the conversion value is greater than the call price.

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 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.

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?

In the lease-versus-buy decision,leasing is often preferable

The "preferred" feature of preferred stock means that it normally will provide a higher expected return than will common stock.

Bev's 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.)

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 straight-debt bonds yield a 10.8% return.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?

Ballentine Inc.,which has a zero tax rate due to tax loss carry-forwards,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-of-year payment of $1,250,000.By how much does the lease payment exceed the loan payment?

Preferred stock normally has no voting rights.However,most preferred issues stipulate that the preferred stockholders can elect a minority number of the directors if the preferred dividend is omitted.

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?

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 sale and leaseback arrangement is a type of financial,or capital,lease.

A warrant is an option,and as such it cannot be used as a "sweetener."