Exam 20: Hybrid Financing: Preferred Stock, Leasing, Warrants, and Convertibles

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 sale and leaseback arrangement is a type of financial, or capital, lease.

The problem of dilution of stockholders' earnings never results from the sale of call options, but it can arise if warrants are used.

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.

What is the bond's initial conversion value when issued?

The "preferred" feature of preferred stock means that it normally will provide a higher expected return than will common stock.

Which of the following statements is most CORRECT?

Leasing is typically a financing decision and not a capital budgeting decision. Thus, the availability of lease financing cannot affect the size of the capital budget.

Corporations that invest surplus funds in floating-rate preferred stock benefit from getting a relatively stable price, which is desirable for liquidity portfolios, and they also benefit from the 70% tax exemption on preferred dividends received.

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.

In the lease versus buy decision, leasing is often preferable

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?

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.