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
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 AMD’s convertible bonds?
The conversion rate is simply the number of shares that one receives in exchange for one bond, so in this case, 125
shares.
b. What is the conversion price of AMD’s convertible bonds?
The conversion price is the par value of the bond divided by the conversion ratio. In this case, we have $1,000 /
c. What was the conversion value of AMD’s convertible bonds at the time they were issued?
The chapter opener does not give a stock price for AMD at the time of the bond issue, so from the text alone it is
d. By how much did AMD’s stock price have to increase (from its starting value of $6 per share) before it
would make sense for investors to exchange their bonds for common stock?
Investors would not convert their bonds unless they received stock worth at least $1,000 in exchange. Also,
e. If AMD had attempted to issue nonconvertible bonds after losing their investment-grade rating, the
company would have had to pay an interest rate of 3.5%. What was the straight bond value of AMD’s
Chapter 17 Hybrid and Derivative Securities 117
convertible bonds when they were issued? (For simplicity, assume annual interest payments.)
The straight bond value is just the present value of interest and principal payments discounted at 3.5%. In this case
Answers to Review Questions
1. Hybrid securities contain characteristics of both debt and equity. Hybrid securities are a form of
financing used by the firm. Derivative securities are securities that derive their value from another
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
of an asset over a predefined period of time. Financial leases are commonly used for leasing land, buildings, and
large pieces of equipment. The noncancellable feature of this type of lease makes it quite similar to certain types
The FASB Standard No. 13 defines a capitalized (financial) lease as one having any of the following four
elements:
a. Transfer of property to the lessee by the end of the lease term
Three methods used by lessors to acquire assets to be leased are
a. A direct lease—the lessor owns or acquires the assets that are leased to the lessee.
leaseback but is differentiated by the participation of a third-party lender.
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
118 Zutter/Smart • Principles of Managerial Finance, Fifteenth Edition
purchase option in the final year is included if applicable.
Step 2: Find the after-tax cash outflows for each year under the purchase alternative. This step involves
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.
4. FASB Standard No. 13 established requirements 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
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
The disadvantages of leasing include its high implicit interest cost; the lack of any terminal value benefits;
difficulty in making property improvements; and certain obsolescence considerations.
6. A conversion feature is an option included as part of a bond or preferred stock issue that permits the
Contingent securitiesconvertibles, 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, which if
converted or exercised would dilute (that is, lower) earnings per share, are required to report earnings in two
Motives for financing with convertible securities include their use as a form of deferred common stock
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
current level.
The call feature may be used to force conversion. 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
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
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. Because most convertible securities are
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
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
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
11. The theoretical value of each warrant (TVW) is:
where:
120 Zutter/Smart • Principles of Managerial Finance, Fifteenth Edition
TVW the theoretical value of a warrant
P0current market price of a share of common stock
In general the market value of a warrant is higher than the theoretical value as determined above. If the
The amount by which the market value of the warrant exceeds the theoretical value is called the warrant
premium.
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
the underlying stock will change in the desired direction. Call options are purchased with the expectation that
the price of the stock will rise enough to cover the cost of the option. Put options are purchased with the
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
Suggested Answer to Focus on Practice Box: I’d Like to Return This
(Entire Store) Please
Describe the ways in which the transaction between Seritage and Sears is similar to Seritage’s buying long-
term bonds from Sears?
In return for sending $2.7 million to Sears (analogous to buying $2.7 in bonds), Seritage was promised lease
payments from Sears over several years (like interest payments, or even interest and principal payments combined
Suggested Answer to Focus on Ethics Box: Banking on Options
How should a bank manager weigh her ethical duty to shareholders to “game” regulations to increase value
of the put option in deposit insurance against her duty as a citizen not to saddle taxpayers with the losses?
Governments establish the rules of the game with regard to deposit insurance. Bank managers have an ethical duty
who felt that government regulations created a put option that was “too valuable” for banks (i.e., too costly for
Chapter 17 Hybrid and Derivative Securities 121
Outside the financial services industry, debt and the limited liability structure of a corporation give
managers a put option similar to the one the FDIC gives banks. If a firm’s investments turn out poorly,
managers, on behalf of shareholders, can “put” the firm’s asset in the hands of lenders and walk away by
going bankrupt. How does this influence the risk-taking incentives of managers, and what can bondholders
do about it?
Bondholders are aware of this incentive and can address it in several ways. First, lenders can charge an interest rate
Answers to Warm-Up Exercises
E17-1. Present value of lease cash flows
Answer: After-tax cash outflow from the lease $25,000 × (1 0.34) $16,500
PV of lease payments:
N 5, I 7%, PMT $16,500
E17-2. Conversion price of convertible bonds
Answer: a. A $1,000-par-value bond that is convertible into 10 shares of common stock.
Conversion price $1,000 10 shares $100 per share
E17-3. Convertible bonds
Answer: The conversion ratio is 33.33 shares per bond.
A bondholder should not exercise the conversion option at this time. Because the stock price is below
until encouraged to do so by the issuer via a call feature.
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
financial calculator solution are shown below:
E17-5. Call option
Answer: The cost of each option is $3.20 per share. The option will not be in the money (above the striking
price) until the stock exceeds $80 per share. The breakeven price is $83.20 per share of SRS Corp.
stock.