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554
Integrated Case
Chapter 20: Hybrid Financing
Integrated Case
20-13
Fish & Chips Inc., Part I
Lease Analysis
Martha Millon, financial manager for Fish & Chips Inc., has been asked to
perform a lease-versus-buy analysis on a new computer system. The computer
costs $1,200,000; and if it is purchased, Fish & Chips could obtain a term loan
for the full amount at a 10% cost. The loan would be amortized over the
4-year life of the computer, with payments made at the end of each year. The
computer is classified as special purpose; hence, it falls into the MACRS 3-year
class. The applicable MACRS rates are 33%, 45%, 15%, and 7%.
If the computer is purchased, a maintenance contract must be obtained
at a cost of $25,000, payable at the beginning of each year. After 4 years, the
computer will be sold. Millon’s best estimate of its residual value at that time
is $125,000. Because technology is changing rapidly, however, the residual
value is uncertain.
As an alternative, National Leasing is willing to write a 4-year lease on the
computer, including maintenance, for payments of $340,000 at the beginning
of each year. Fish & Chips’ marginal federal-plus-state tax rate is 40%. Help
Millon conduct her analysis by answering the following questions.
A. (1) Why is leasing sometimes referred to as “off-balance-sheet”
financing?
Answer: [Show S20-1 and S20-2 here.] If an asset is purchased, it must be
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A. (2) What is the difference between a capital lease and an operating
lease?
Answer: Capital leases are differentiated from operating leases in three
A. (3) What effect does leasing have on a firm’s capital structure?
Answer: Leasing is a substitute for debt financing—lease payments, like debt
payments, are contractual obligations that if not met will force the
B. (1) What is Fish & Chips’ present value cost of owning the computer?
(Hint: Set up a table whose bottom line is a “time line” that shows
the cash flows over the period t = 0 to t = 4. Then find the PV of
these cash flows, or the PV cost of owning.)
Answer: [Show S20-3 through S20-7 here.] In order to determine the cost
of owning, it is first necessary to construct a depreciation schedule.
This schedule is given below.
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B. (2) Explain the rationale for the discount rate you used to find the PV.
Answer: The discount rate used depends on the riskiness of the cash flow
stream and the general level of interest rates. The cost of owning
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C. (1) What is Fish & Chips’ present value cost of leasing the computer?
(Hint: Again, construct a time line.)
Answer: [Show S20-8 here.] If Fish & Chips leases the system, its only cash
flow would be its lease payment, as shown below:
C. (2) What is the net advantage to leasing? Does your analysis indicate
that the firm should buy or lease the computer? Explain.
Answer: [Show S20-9 here.] The net advantage to leasing (NAL) is $17,654:
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D. Now assume that Millon believes the computer’s residual value
could be as low as $0 or as high as $250,000, but she stands by
$125,000 as her expected value. She concludes that the residual
value is riskier than the other cash flows in the analysis, and she
wants to incorporate this differential risk into her analysis.
Describe how this can be accomplished. What effect will it have on
the lease decision?
Answer: [Show S20-10 here.] To account for increased risk, the rate used to
discount the residual value cash flow would be increased, resulting
E. Millon knows that her firm has been considering moving its
headquarters to a new location, and she is concerned that these
plans may come to fruition prior to the expiration of the lease. If
the move occurs, the company would obtain new computers; hence,
Millon would like to include a cancellation clause in the lease
contract. What effect would a cancellation clause have on the risk
of the lease?
Answer: [Show S20-11 here.] A cancellation clause would lower the risk of
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20-14
Fish & Chips Inc., Part II
Preferred Stock, Warrants, and Convertibles
Martha Millon, financial manager of Fish & Chips Inc., is facing a dilemma. The
firm was founded 5 years ago to develop a new fast-food concept; and
although Fish & Chips has done well, the firm’s founder and chairman believes
that an industry shake-out is imminent. To survive, the firm must capture
market share now, which requires a large infusion of new capital.
Because the stock price may rise rapidly, Millon does not want to issue
new common stock. On the other hand, interest rates are currently very high
by historical standards; and with the firm’s B rating, the interest payments on
a new debt issue would be too much to handle if sales took a downturn. Thus,
Millon has narrowed her choice to bonds with warrants or convertible bonds.
She has asked you to help in the decision process by answering the following
questions.
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A. How does preferred stock differ from common equity and debt?
Answer: [Show S20-12 here.] Preferred dividends are fixed, but they may
B. What is adjustable-rate preferred?
Answer: [Show S20-13 here.] With a floating-rate preferred issue, dividends
are indexed to the rate on Treasury securities instead of being
C. How can a knowledge of call options help a person understand
warrants and convertibles?
Answer: [Show S20-14 here.] Warrants and convertibles are types of call
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D. One of Millon’s alternatives is to issue a bond with warrants
attached. Fish & Chips’ current stock price is $10, and the
company’s investment bankers estimate its cost of 20-year annual
coupon debt without warrants to be 12%. The bankers suggest
attaching 50 warrants to each bond, with each warrant having an
exercise price of $12.50. It is estimated that each warrant, when
detached and traded separately, will have a value of $1.50.
D. (1) What coupon rate should be set on the bond with warrants if the
total package is to sell for $1,000?
Answer: [Show S20-15 through S20-17 here.] If the entire package is to sell
for $1,000, then
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D. (2) Suppose the bonds are issued and the warrants immediately trade
for $2.50 each. What does this imply about the terms of the issue?
Did the company “win” or “lose”?
Answer: If the warrants traded immediately for $2.50, then the 50 warrants
D. (3) When would you expect the warrants to be exercised?
Answer: In general, a warrant will sell on the open market for a premium
above its exercise value. Thus, prior to expiration, investors would
sell their warrants in the marketplace rather than exercise them,
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D. (4) Will the warrants bring in additional capital when exercised? If so,
how much and what type of capital?
Answer: When exercised, each warrant will bring in the exercise price, or
D. (5) Because warrants lower the cost of the accompanying debt, shouldn’t
all debt be issued with warrants? What is the expected cost of the
bond with warrants if the warrants are expected to be exercised in 5
years, when Fish & Chips’ stock price is expected to be $17.50? How
would you expect the cost of the bond with warrants to compare with
the cost of straight debt? With the cost of common stock?
Answer: [Show S20-18 and S20-19 here.] Even though the coupon rate on
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E. As an alternative to the bond with warrants, Millon is considering
convertible bonds. The firm’s investment bankers estimate that Fish
& Chips could sell a 20-year, 10% annual coupon, callable convertible
bond for its $1,000 par value, whereas a straight-debt issue would
require a 12% coupon. Fish & Chips’ current stock price is $10, its
last dividend was $0.74, and the dividend is expected to grow at a
constant rate of 8%. The convertible could be converted into 80
shares of Fish & Chips stock at the owner’s option.
(1) What conversion price, Pc, is implied in the convertible’s terms?
Answer: [Show S20-20 and S20-21 here.]
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E. (2) What is the straight-debt value of the convertible? What is the
implied value of the convertibility feature?
Answer: [Show S20-22 and S20-23 here.] Since the required rate of return
on 20-year straight debt is 12%, the value of a 10% annual coupon
bond is $850.61 as follows:
E. (3) What is the formula for the bond’s conversion value in any year?
Its value at Year 0? At Year 10?
Answer: [Show S20-24 here.] The conversion value in any year is simply the
value of the stock obtained by converting. Since Fish & Chips is a
constant growth stock, its price is expected to increase by g each
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E. (4) What is meant by the term floor value of a convertible? What is the
convertible’s expected floor value in Year 0? In Year 10?
Answer: [Show S20-25 here.] The floor value is simply the higher of the
straight-debt value and the conversion value. At Year 0, the straight-
E. (5) Assume that Fish & Chips intends to force conversion by calling the
bond when its conversion value is 20% above its par value, or at
1.2($1,000) = $1,200. When is the issue expected to be called?
Answer to the closest year.
Answer: [Show S20-26 here.] If the issue will be called when the
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E. (6) What is the expected cost of the convertible to Fish & Chips? Does
this cost appear consistent with the risk of the issue? Assume
conversion in Year 5 at a conversion value of $1,200.
Answer: [Show S20-27 and S20-28 here.] The firm would receive $1,000
now, pay coupon payments of $100 for about 5 years, and then
F. Millon believes that the cost of the bond with warrants and the cost
of the convertible bond are essentially equal, so her decision must
be based on other factors. What are some factors she should
consider when making her decision between the two securities?
Answer: [Show S20-29 and S20-30 here.] One factor that Millon should
consider is the firm’s future need for capital. If Fish & Chips
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