Chapter 20: Hybrid Financing
Learning Objectives
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Chapter 20
Hybrid Financing: Preferred Stock, Leasing,
Warrants, and Convertibles
Learning Objectives
After reading this chapter, students should be able to:
◆ Identify the basic features of preferred stock and explain its advantages and disadvantages.
◆ Differentiate among the types of leases, discuss the financial statement effects of leasing, and evaluate
a lease.
◆ Explain what warrants are, how they are used, and analyze their cost to the firm.
◆ Explain what convertibles are, how they are used, and analyze their cost to the firm.
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Lecture Suggestions
Chapter 20: Hybrid Financing
Lecture Suggestions
This chapter discusses four types of hybrid securities: preferred stock, leases, warrants, and convertibles.
We have mixed feelings about coverage of the chapter. On the one hand, we are tempted not to spend
much time on it because it gets into relatively technical analysis that would be better left for later courses.
On the other hand, the material is important, and students who will not be taking additional finance courses
ought to be exposed to the subjects covered here. Also, leasing and warrants/convertibles are good
subjects on which to lecture, as they contain a nice mix of new versus review material, and of quantitative
versus qualitative analysis. Lease analysis serves as a good review of time value of money and risk/return
analyses, and the warrants/convertibles analysis is a good review of valuation theory.
What we cover, and the way we cover it, can be seen by scanning the slides and Integrated Case
solution for Chapter 20, which appears at the end of this chapter solution. For other suggestions about the
lecture, please see the “Lecture Suggestions” in Chapter 2, where we describe how we conduct our classes.
DAYS ON CHAPTER: 2 OF 56 days (50-minute periods)
Chapter 20: Hybrid Financing
Answers and Solutions
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Answers to End-of-Chapter Questions
20-1 Preferred stock can be classified only when the one doing the classification is considered. From the
standpoint of the firm, preferred stock is like equity in that it cannot force the firm into bankruptcy,
but it is like debt in that it causes fluctuations in earnings available to the common stockholders.
20-2 Since 70% of preferred dividends received by a corporation are not taxable, the corporation with
20-3 If dividends from preferred stock and interest received from bonds were taxed in the same manner,
bonds would have a lower yield rate. Corporations represent the principal investor group that holds
20-5 An operating lease is frequently cancelable and includes maintenance. Operating leases are,
frequently, for a period significantly shorter than the asset’s economic life, so the lessor often does
20-6 Pros:
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Chapter 20: Hybrid Financing
Cons:
20-7 Lease payments, like depreciation, are deductible for tax purposes. If a 20-year asset were
20-8 Permitting equipment to be depreciated over a shorter period increases the tax shelter value of
leasing. Lowering corporate tax rates decreases the tax shelter value of leasing; however, lowered
20-9 The trend in stock prices subsequent to an issue influences whether or not a convertible issue will be
converted, but conversion itself typically does not provide a firm with additional funds. Indirectly,
20–10 a. 1. The value of a warrant depends primarily on the expected growth of the underlying stock’s
Chapter 20: Hybrid Financing
Answers and Solutions
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Answers and Solutions
Chapter 20: Hybrid Financing
Solutions to End-of-Chapter Problems
20-1 If the company purchased the equipment its balance sheet would look like:
Current assets $300 Debt $500
20-2 First issue: 20-year straight bonds with an 8% annual coupon. Second issue: 20-year bonds with
6% annual coupon with warrants. Both bonds issued at par $1,000. Value of warrants = ?
20-4 a. McDaniel-Edwards balance sheet (thousands of dollars):
Debt $400
Chapter 20: Hybrid Financing
Answers and Solutions
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b. Balance sheet after lease is capitalized:
Jordan-Hocking balance sheet (thousands of dollars):
20-5 a. Year
0
1
2
3
4
Cost of owning:
$198,000
$270,000
$ 90,000
$ 42,000
Cost of leasing:
Net advantage to leasing (NAL)
= $821,823 – $777,533
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Answers and Solutions
Chapter 20: Hybrid Financing
20-6 a. Exercise value = Current price – Striking price.
b. No precise answers are possible, but some “reasonable” warrant prices are as follows:
d. Vpackage = $1,000
Chapter 20: Hybrid Financing
Answers and Solutions
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20-7 a. Investment bankers sometimes use the rule of thumb that, to serve as a sweetener, the
20-8 a. 0 1 2 3 4
6%
6%
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Chapter 20: Hybrid Financing
c. If the firm purchases the machine then the analysis changes as follows:
20-9 a. Howe Computer Company balance sheet:
Alternative 1:
Chapter 20: Hybrid Financing
Answers and Solutions
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b. Original Plan 1 Plan 2 Plan 3
e. Alternative 1 results in the lowest percentage ownership, but Keith Howe would still maintain
20–10 Facts and analysis in the problem:
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Answers and Solutions
Chapter 20: Hybrid Financing
Conversion value:
Chapter 20: Hybrid Financing
Comprehensive/Spreadsheet Problems
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Comprehensive/Spreadsheet Problems
Note to Instructors:
The solution for part a of problem 20–11 is provided at the back of the text; however, the
solutions to the other parts are not. Instructors can access the
Excel
file on the textbook’s
website.
20-11 a. First, we want to lay out all of the input data in the problem.
INPUT DATA
NPV LEASE ANALYSIS OF INCREMENTAL CASH FLOWS
0 1 2 3 4
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Comprehensive/Spreadsheet Problems
Chapter 20: Hybrid Financing
b. All cash flows would remain unchanged except the salvage value. Our new array of cash flows
would resemble the following:
c. We will use Excel’s Goal Seek function to determine the cost of capital when the NPVs of the
20–12 a. The value of the 9% coupon bonds, evaluated at 12%, can be found as follows:
Chapter 20: Hybrid Financing
Comprehensive/Spreadsheet Problems
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