Part 8
Special Topics in Managerial Finance
Chapters in This Part
Chapter 17 Hybrid and Derivative Securities
Chapter 18 Mergers, LBOs, Divestitures, and Business Failure
Chapter 19 International Managerial Finance
Integrative Case 8: Organic Solutions
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Chapter 17
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. Chapter 17 explains how an
understanding of leasing is critical at the professional and personal levels.
Suggested Answer to Opener-in-Review Question
a. What is the conversion ratio of Nokia’s convertible bonds?
b. What is the conversion price of Nokia’s convertible bonds?
c. What was the conversion value of Nokia’s convertible bonds at the time they were issued?
d. By how much did Nokia’s stock price have to increase (from its starting value of €2.04 per share) before it
would make sense for investors to exchange their bonds for common stock?
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e. If Nokia had attempted to issue nonconvertible bonds after losing their investment-grade rating, the
company would have had to pay an interest rate of 7%. What was the straight bond value of Nokia’s
convertible bonds when they were issued? (For simplicity, assume annual interest payments.)
Answers to Review Questions
1. Hybrid securities contain characteristics of both debt and equity. Hybrid securities are a form of financing
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
The FASB Standard No. 13 defines a capitalized (financial) lease as one having any of the following four
elements:
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Chapter 17 Hybrid and Derivative Securities 366
Three methods used by lessors to acquire assets to be leased are
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
Step 2: Find the after-tax cash outflows for each year under the purchase alternative. This step involves
Step 3: Calculate the present value of the cash outflows associated with the lease (from Step 1) and
Step 4: Choose the alternative with the lowest present value of cash outflows from Step 3. This will be the
4. FASB Standard No. 13 established requirements for the explicit disclosure of certain types of lease
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Chapter 17 Hybrid and Derivative Securities 367
5. The key advantages of leasing are the ability to “depreciate” land through tax deductibility of lease payment;
6. A conversion feature is an option included as part of a bond or preferred stock issue that permits the holder to
7. When the price of the firm’s common stock rises above the conversion price, the market price of the
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Chapter 17 Hybrid and Derivative Securities 368
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
The conversion stock value of a convertible security is the value of a convertible security measured in terms
The market value of a convertible security is greater than its straight or conversion value. The market
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
10. The implied price of a warrant that is attached to a bond is found by first subtracting the straight bond value
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Chapter 17 Hybrid and Derivative Securities 369
11. The market value of a warrant is generally above the theoretical value. Only when the TVW is very high are
12. An option is a financial instrument that provides its holder with an opportunity to buy or sell an asset at a
A call is an option to purchase a specified number of shares of stock at a specified price on or before a
13. A company can hedge the risk of foreign exchange fluctuations by purchasing currency options. If it makes a
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Chapter 17 Hybrid and Derivative Securities 370
Suggested Answer to Focus on Practice Box: Leases to Airlines End on
a Sour Note
Were the Disney leases of aircraft to United Airlines operating leases or financial leases?
Suggested Answer to Focus on Ethics Box: Options Backdating
Why do you think firms chose to backdate options, making it appear as though the options had been
granted with strike prices equal to the current stock market price when in fact the options were in the
money at the time of the grant?
Answers to Warm-Up Exercises
E17-1. Present value of lease cash flows
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Chapter 17 Hybrid and Derivative Securities 371
E17-2. Conversion price of convertible bonds
Answer: a. A $1,000-par-value bond that is convertible into 10 shares of common stock.
b. A $2,000-par-value bond that is convertible into 20 shares of common stock.
c. A $1,500-par-value bond that is convertible into 30 shares of common stock.
E17-3. Convertible bonds
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Chapter 17 Hybrid and Derivative Securities 372
E17-4. Minimum price of a convertible bond
Answer: You may use a financial calculator, a spreadsheet, or a formula to find the solution. The inputs for a
E17-5. Call option
Answer: The cost of each option is $3 per share. The option will not be in the money (above the striking price)
Solutions to Problems
P17-1. Lease cash flows
LG 2; Basic
Firm Year Lease Payment Tax Benefit After-Tax Cash Outflow
[(1) (2)]
(3)
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Chapter 17 Hybrid and Derivative Securities 373
(1) (2)
A1–4 $100,000 $40,000 $60,000
P17-2. Loan interest
LG 2; Intermediate
Loan Year Interest Amount
A 1 $1,400
2 1,098
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Chapter 17 Hybrid and Derivative Securities 374
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Chapter 17 Hybrid and Derivative Securities 375
P17-3. Loan payments and interest
LG 2; Intermediate
Year
Beginning
Balance Interest Principal
1 $117,000.00 $16,380.00 $ 13,707.43
$117,000.03
Note: Due to rounding the payment to cents, the actual amount paid exceeds the amount borrowed by three
cents. The amount paid in the final year is usually adjusted so that there is no balance at the end of the
loan.
P17-4. Lease versus purchase
LG 2; Challenge
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Chapter 17 Hybrid and Derivative Securities 376
a. Lease
Purchase
Year
Loan
Payment
(1)
Main-ten
ance
(2)
Depre-cia
tion
(3)
Interest
at 14%
(4)
Total
Deductions
(2 3 4)
(5)
Tax
Shields
[(0.40) (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
b.
End of Year
Lease
After-Tax
Cash Outflows
Purchase
After-Tax Cash
Outflows
1 $15,120 $15,644
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Chapter 17 Hybrid and Derivative Securities 377
c. Because the PV of leasing is less than the PV of purchasing the equipment, the firm should lease the
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