Hybrid Securitiesand Other Financing

Considerations

Debt and Equity are not the only securities that firms issue. Instead, you can think of them as extreme points on a continuum of securities:

◦ Convertible Bonds

◦ Preferred Stock

◦ Convertible Preferred Stock

Financial engineering in investment banks is about creating new securities, often combining features of debt and equity to solve a particular contracting problem

Hybrid Securities

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Firm Value

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Payoff Diagram of DebtFace Value is $300

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Debt Equity

Payoff Diagram of EquityFace Value is $300

A convertible bond is like a straight bond with the option of converting it to a pre-specified number of shares

◦ Coupon Payments

◦ Face Value

◦ Maturity

What is a Convertible Bond?

Conversion Ratio◦ The number of shares into which each bond can

be converted

Conversion Price◦ The effective price an investor is paying per share

if they convert their bond

Mathematics of Convertibles

Mathematics of Convertibles Conversion Premium

◦ The conversion price premium over the current price

Valuing a Convertible Bond:

Assume that the $300 in debt our firm issued also included the option to convert the debt into 15 shares of stock

Assume that there are currently 20 equity shares outstanding

What is the conversion price?

At what firm value will the stock have this price?

Convertible BondExample

Payoff Diagram of a Convertible Bond

So, what will be the firm value when the stock is priced at $ ?

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Payoff Diagram of a Convertible Bond

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Payoff Diagram of a Convertible Bond

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Conv. Debt Equity

Payoff Diagram of Equity when the debt is Convertible Debt

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Conv. Debt Equity

Payoff Diagram of Equity when the debt is Convertible Debt

When issued, what would the convertible debt have sold for relative to the straight debt?

◦ The debt holders get all of the security of straight debt plus the option to convert.

◦ Therefore, convertible debt with the same face value and coupon rate will sell for more than straight debt.

Convertible Debt Price

Some firms issue convertibles thinking they are cheap debt

◦ Firms can raise the same amount of money as issuing straight debt but have a lower coupon rate

◦ What are they missing?

Why Issue Convertible Debt?

Other firms issue convertibles because they think they are issuing cheap Equity

◦ Firms can essentially issue equity and get investors to pay more for the convertible debt than straight equity

◦ What are managers forgetting?

Why Issue Convertible Debt?

Disagreements about risk◦ If investors think the firm is more risky than the

managers, they will over pay for the option component

Reduce the incentive to risk shift◦ If bondholders now get some of the upside, the

return to equity holders of increasing the risk of the firm is lower

Good Reasons to Issue Convertibles

What do Firms Tell Us?

Graham, John R., and Campbell Harvey, 2001, Journal of Financial Economics

Should they convert before the bond matures?

What do they get by converting early?

What do they lose by converting early?

Investors Decision to Convert

Pays dividends◦ Amounts are often stipulated at the time of issue

◦ Other times they are paid at the discretion of the Board of Directors but must be paid before common stock dividends are paid

Carries a par value

Higher priority in bankruptcy than common equity, lower priority than debt

May or may not carry voting rights

Dividends are not tax deductible

Convertible Preferred Shares offer the option to convert to common

Preferred Stock

Leasing vs. Purchasing

Lessee◦ Uses the asset

◦ Makes payments for its use

◦ Maintenance of asset if negotiated at time of lease

Lessor◦ Receives the payments

◦ Owns the asset

Leasing

Long Term Debt

Capital Leases

Operating Leases

% of Firms Using 88.1% 52.6% 99.9%

% of Firm’s Market Value 14.2% 1.6% 8.0%

% of Fixed Claims 52.4% 6.3% 41.2%

Prevalence of LeasingUse of Debt and Leases by U.S. Firms

SIC Codes 2000 to 5999 in the years 1981 to 1992.(Graham, Lemmon, and Schallheim, 1998)

Operating Leases◦ Off Balance Sheet◦ Tend to be for periods shorter than the economic

life of the asset◦ Often cancelable

Capital Leases◦ On Balance Sheet◦ Equipment is an asset of the firm, lease payments

are a liability

Lease Accounting

Capital Lease (meets one of the following)◦ Automatic transfer of ownership

◦ Purchase option at significantly below expected residual value

◦ Lease lasts at least 75% of economic life of asset

◦ The present value of the lease represents at least 90% of the assets value

Lease Accounting

A lease is a true lease for the IRS if:

1. Lessor makes minimum 20% equity investment

2. Equipment has residual value of at least 20%

3. Purchase price close to fair value

4. Transaction expected to generate profit

5. No lessee investment

6. Rents must be reasonably stable

7. Must be a market for the equipment at conclusion of lease beyond the lessee

Leasing for Tax Purposes

Cash Flows – what are the incremental cash flows from a lease relative to a purchase◦ Lease Payments◦ Purchase price of asset◦ Depreciation tax shield◦ Residual Price◦ Operating Profits?

Discount Rate◦ What is the appropriate discount rate for a lease?◦ Should it be a before tax or after tax rate?

Valuing a Lease

You are considering the purchase of a $10 million piece of equipment. ◦ It would be depreciated using 5 year MACRS.◦ The asset would have zero residual value at the

end of the five years.◦ The pre-tax cost of debt is 10%.◦ The firm’s effective marginal tax rate is 20%

What constant lease payment over the same five years would be equivalent to purchasing the asset?

Leasing Example

5 year MACRS Schedule:

What are the annual incremental cash flows?

Leasing Example

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

20% 32% 19.2% 11.52% 11.52% 5.76%

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

Asset Purchase

Depreciation

Depreciation Tax Shield

Incremental Cash Flow

What is the present value of the cash flows?

What annual payment would have an equivalent present value?

Is this annual payment amount before taxes or after taxes?

Leasing Example

What if the lessee and lessor have different tax rates?◦ What if the lessee had a low tax rate (20%) but the

lessor had a 35% tax rate?

◦ There is $113K to split between the lessor and lessee

Who captures the tax differential?◦ Bargaining power between lessee and lessor

◦ Is there a shortage of potential lessees or lessors?

Leasing Example

What if the lessee and lessor have different depreciation schedules?◦ In an effort to cut the budget deficit, some

lawmakers have called for longer depreciation schedules for large oil companies.

If the depreciation schedule were firm-dependent rather than asset-specific,◦ What change in ownership structure of these assets

would we observe?

◦ Would the deficit reduction be realized?

Leasing Example

Transactions costs / convenience

Lower cost of repossession

Differential maintenance costs

Obsolescence risk

Differential sources of capital

Accounting / capital budgeting differences

Other Reasons to Lease