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Chapter 20: Hybrid Financing True/False Page 653
(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
1. The “preferred” feature of preferred stock means that it normally will
provide a higher expected return than will common stock.
a. True
b. False
2. 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
3. A sale and leaseback arrangement is a type of financial, or capital,
lease.
a. True
b. False
4. Operating leases help to shift the risk of obsolescence from the user
to the lessor.
a. True
b. False
5. 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
6. The full amount of a lease payment is tax deductible provided the
contract qualifies as a true lease under IRS guidelines.
CHAPTER 20
HYBRID FINANCING: PREFERRED STOCK, LEASING, WARRANTS,
AND CONVERTIBLES
Page 654 True/False Chapter 20: Hybrid Financing
a. True
b. False
7. 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
8. A warrant is an option, and as such it cannot be used as a “sweetener.”
a. True
b. False
9. 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
10. 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
11. 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
12. The owner of a convertible bond owns, in effect, both a bond and a call
option.
a. True
b. False
13. A convertible debenture can never sell for more than its conversion
value or less than its bond value.
a. True
b. False
Chapter 20: Hybrid Financing True/False Page 655
Page 656 True/False Chapter 20: Hybrid Financing
14. 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
15. Firms generally do not call their convertibles unless the conversion
value is greater than the call price.
a. True
b. False
16. 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.
a. True
b. False
17. 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
18. 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
entitled to receive the par value before anything is given to the
common stockholders.
a. True
b. False
19. 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
Chapter 20: Hybrid Financing Conceptual M/C Page 657
20. Corporations that invest surplus funds in floating-rate preferred stock
benefit from getting a relatively stable price, and they also benefit
from the 70% tax exemption on preferred dividends received.
a. True
b. False
21. Leasing is typically a financing decision and not a capital budgeting
decision. The decision to acquire the asset is a “done deal” before
the lease analysis begins. Therefore, in a lease analysis, we are
concerned simply with whether to finance the asset with a lease or with
a loan.
a. True
b. False
22. 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
23. 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
24. 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.
c. debt cash flows.
d. pension fund cash flows.
e. sales.
25. Operating leases often have terms that include
Page 658 Conceptual M/C Chapter 20: Hybrid Financing
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.
26. 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.
27. 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.
28. FAS 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.
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.
Chapter 20: Hybrid Financing Conceptual M/C Page 659
29. 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.
30. 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.
31. A lease-versus-purchase analysis should compare the cost of leasing to
the cost of owning, assuming that the asset purchased
a. is financed with short-term debt.
b. is financed with long-term debt.
c. is financed with debt whose maturity matches the term of the lease.
d. 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.
32. 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.
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 660 M/C Problems Chapter 20: Hybrid Financing
33. 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.
34. 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.
Multiple Choice: Problems
35. 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 2022. What is the conversion value of the bond?
a. $707.33
b. $744.56
c. $783.75
d. $825.00
e. $866.25
Chapter 20: Hybrid Financing M/C Problems Page 661
36. 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, Pc?
a. $40.00
b. $42.00
c. $44.10
d. $46.31
e. $48.62
37. Moniker Manufacturing's bonds were recently issued at their $1,000 par
value. At any time prior to maturity (20 years from now), a bondholder
can exchange a bond for a share of common stock at a conversion price
of $40. What is the conversion ratio?
a. 22.56
b. 23.75
c. 25.00
d. 26.25
e. 27.56
38. Sutton Corporation, which has a zero tax rate due to tax loss carry-
forwards, 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. $177,169
b. $196,854
c. $207,215
d. $217,576
e. $228,455
39. 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?
a. $110,285
b. $116,090
c. $122,199
d. $128,631
e. $135,401
Page 662 M/C Problems Chapter 20: Hybrid Financing
40. 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. 6.66%
b. 6.99%
c. 7.34%
d. 7.71%
e. 8.09%
41. 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. $ 96
b. $106
c. $112
d. $117
e. $123
42. Warren Corporation’s 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 firm’s 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. 7.83%
b. 8.24%
c. 8.65%
d. 9.08%
e. 9.54%
Chapter 20: Hybrid Financing M/C Problems Page 663
43. 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. 6.75%
b. 7.11%
c. 7.48%
d. 7.88%
e. 8.27%
44. Upstate Water Company just sold a bond with 50 warrants attached. The
bonds have a 20-year maturity and an annual coupon of 12%, and they
were issued at their $1,000 par value. The current yield on similar
straight bonds is 15%. What is the implied value of each warrant?
a. $3.76
b. $3.94
c. $4.14
d. $4.35
e. $4.56
45. 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. $8.00
b. $8.42
c. $8.84
d. $9.28
e. $9.75
46. 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
c. $796.09
d. $835.89
Page 664 M/C Problems Chapter 20: Hybrid Financing
e. $877.69
Chapter 20: Hybrid Financing M/C Problems Page 665
47. 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. $652.55
b. $686.89
c. $723.05
d. $761.10
e. $799.16
48. 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?
a. $725.58
b. $763.76
c. $803.96
d. $846.28
e. $888.59
49. 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. $719.90
b. $757.79
c. $797.68
d. $837.56
e. $879.44
Page 666 M/C Problems Chapter 20: Hybrid Financing
50. 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 straight-line
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. $1,950
b. $2,052
c. $2,160
d. $2,268
e. $2,382
51. 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. $790.48
b. $830.01
c. $871.51
d. $915.08
e. $960.84
52. 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. $901.28
b. $924.39
c. $948.09
d. $972.41
e. $996.72
Chapter 20: Hybrid Financing M/C Problems Page 667
53. 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 3-
year class. If the firm borrows and buys the truck, the loan rate
would be 9%, and the loan would be amortized over the truck’s 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. $609
b. $642
c. $678
d. $715
e. $751
54. 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.)
a. $2,852
b. $2,994
c. $3,144
d. $3,301
e. $3,466
55. 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. 10.64%
