HYBRID FORMS OF FINANCING

THE PREFERRED STOCK

The preferred stock represents a type of corporate financing which is somewhat

paradoxical as between its nominal characteristics and its practical application. On the surface, it
appears to provide the corporation with a security coupling the limited obligation of the bond
with the flexibility of the common stock -- a combination that would be unusually attractive to
the issuer. Unfortunately, general experience does not bear out such expectations.

From the purely legal point of view the preferred stock is a type of ownership and thus
takes a classification similar to that of the common stock. Accounting practice recognizes this
by placing preferred stock along with common stock in the equity section of the balance sheet,
and tax laws interpret preferred dividends as a distribution of net profits to the owners rather than
a cost of the business, as in the case of interest on bonds. The preferred stock certificate is
much the same as that for the common stock, stating that the named individual is the owner of a
number of shares of preferred stock. Unlike the bond, the preferred stock does not contain any
promise of repayment of the original investment; and as far as the shareholders are concerned,
this must be considered as a permanent investment for the life of the company. Further, there is
no legal obligation to pay a fixed rate of return on the investment.

The special character of the preferred stock lies in its relationship to the common stock.
When a preferred stock is used as part of the capital structure, the rights and responsibilities of
the owners as residual claimants to the asset values and earning power of the business no longer
apply equally to all shareholders. Specifically, the common shareholders agree that the preferred
stockholders shall have “preference” or first claim in the event that the BOD are able and willing
to pay a dividend. This “preferential” treatment is readily seen if the stocks are said to be
cumulative and participating.

You should note that the prior claim of the preferred stock does not guarantee a fixed
and regular rate of return similar to that of the bond -- it merely establishes an order of priority in
which the board of directors will pay dividends if it decides to do so. At the same time, it
establishes a definite upper limit to the preferred shareholders’ claim on earnings. Whatever is
the profitability level of a given company, the preferred stockholders will only receive up to the
extent of its dividend rate.

In most cases, the “preferential position of the preferred stock also extends to the
disposition of the assets in the event of liquidation. But this preference is only with reference to
the common stock and does not affect the senior position of creditors in any way. It has meaning
and value only if asset values remain after creditors have been fully satisfied -- a condition which
is by no means certain in the event of liquidation following bankruptcy.
 The impression we have created in the foregoing description of the preferred stock issue
as an alternative source of financing is that of a limited commitment on dividends coupled with
considerable freedom in the timing of such payments. In reality, experience with preferred
stock indicates that the flexibility in dividend payments is more apparent than real. The
management of a business which is experiencing normal profitability and growth desires to pay a
regular dividend on both common and preferred stock because of a sense of responsibility to the
corporate owners and/or because of the necessity of having to solicit further equity capital in the
future. The pressure for a regular common dividend in many cases assures the holder of a
preferred stock that that his regular dividend will not be interrupted, even in years when profit
are insufficient to give common shareholders a comparable return, for it is very damaging to
the reputation of a common stock (and therefore its price) if preferred dividend arrearages
stand before it. The fact that most preferred issues are substantially smaller in total amount
than the related common issue means that the cash drain of a preferred dividend is often less
significant than the preservation of the status of the common stock.

The result is that management comes to view the preferred issue much as it would a
bond, establishing the policy that the full preferred dividend must be paid as a matter of course.
The option of passing the dividend still exists, but it is seen as a step to be taken only in case of
unusual financial difficulty. Why then, issue preferred stock as a source of financing? Why not
issue bonds instead? The fact is, the preferred stock dividends can be omitted when the
company is under dire circumstances. Unlike in a bond, the issuing company is legally obliged
to pay fixed interest amounts. Although, the preferred stock dividends do not provide the
company with tax shields that the interest provides yet, there are still a lot of other advantages
to the issuing company, among which are:

1. It has no final maturity; in essence, it is a perpetual loan.

2. It adds to the equity base of the company and thereby strengthens its financial condition.
This enhances the ability of the company to borrow in the future.
3. Preferred stockholders cannot force the company into legal bankruptcy as would the debt
financing. Thus issuance of bonds is a much riskier form of financing.

LEASING

Definition:
A lease is an agreement between one party called the lessor and another party called the
lessee whereby the lessee is granted the right to use the property owned by the lessor for a
specific period of time in consideration of rent payment.

Forms:

1) Sale and Leaseback - this is an agreement whereby one party sells a property to another party
and then immediately leases the property back from its new owner. Thus, the seller becomes a
seller-lessee and the purchaser a purchaser-lessor.

2) Direct Leasing- a company acquires the use of an asset it did not own previously.
3) Leveraged leasing - the lessor acquires the asset in keeping with the terms of the lease
arrangement and finances the acquisition in part by an equity investment. The remaining part is
provided by the lenders. The loan is usually secured by a mortgage on the asset, as well as by
the assignment of the lease and lease payments. The lessor is the borrower. As owner of the
asset, the lessor is entitled to deduct all depreciation charges associated with the asset.

Accounting Treatment:

Operating Lease: Under this concept, the periodic rental is recognized simply as expense on the
part of the lessee and income on the part of the lessor. The leased property remains an asset to
the lessor, consequently, the lessor bears all ownership expenses such as depreciation, taxes,
insurance and maintenance.

Capital Lease: Under this concept, the lease is not a lease as popularly understood but in
substance a purchase of property. It is a lease-purchase. On the part of the lessee, the lease is
conceived as a purchase of an asset and involves the recognition of an asset and the
corresponding liability for the same. Moreover, periodic depreciation to the property is to be
provided, and the periodic lease payment is to be treated as payment for the liability and interest.

Properties of a Capital Lease:

1. The lease is noncancellable.

2. The lease contains any of the following provisions:
a. The lease transfers ownership of the leased asset to the lessee at the end of the
lease term.
b. The lease has a bargain purchase option which means that the lessee has the
right to purchase the leased asset for a price that is sufficiently lower than
the expected fair value of the asset on option exercise date. If the option
price is approximately equal to the expected fair value of the asset on
exercise date, there is no bargain purchase option.
c. The lease term is at least 75% of the useful life of the leased asset.
d. The present value of all rental payments is at least 90% of the fair value of the
leased asset at the inception of the lease.

As a rule, depreciation is based on the life of the asset. However, if the capital lease
qualified under either of the last two criteria and the lease term is shorter than the life of the
asset, the lease term is used for depreciation purposes.

Leasing is often equated with borrowing in terms of financing on the part of the
lessee because just like borrowing, it requires fixed periodic payments.
 To illustrate leasing as a source of financing, consider the following problem:

United Company has decided to acquire an equipment which has a cost of P300,000.00
Lease financing the equipment would require for an annual payment of P56,000.00 per year for
six years. Annual lease payments are to be made at the end of the year prior to each of the six
years. The lessee is responsible for maintenance, insurance and taxes. If the asset is purchased,
United Co., would finance it with a six year term loan at 6% interest. Corporate tax rate is 35%
and United depreciates using the straight-line method. Which option is better for United, to
lease finance the property or to borrow and purchase the property?

A deeper analysis of this problem would involve analyzing the alternatives using the
1)present value method and 2)comparing the relative cost of each alternative.

Implicit cost of leasing:

Present Value of Cost = E lease payments/(1 + R) t

this refers to the
present value of an
5
300,000 (1) = 56,000 (1+R) annuity at n=5
years. This value
can be found in the
annuity table.

300,000/56,000 = 5.3571- 1.0000

=4.3571

In the annuity table, we see that this value is between 4% and 5%.

4% 4.452
.0949
1% X? 4.357
.123
5% 4.329

.0949 X (1%)/.123 = .7715%

This is the
4% + .7715% = 4.7715% implicit cost of
leasing .

Compare this with the explicit cost of borrowing at 6%. It appears that it is much
cheaper to lease than to purchase through borrowing.

But analysis should go beyond this and an NPV method is imperative. Using the NPV method,
the following analysis would enlighten a decision maker.

NPV of Cash Outflow if the company will lease (assuming it is an operating lease).
 Period Cash outflow Tax shield ATCOutflow Factor PV
0 56,000 0 56,000 1.000 56,000
1-5 56,000 19,600 36,400 4.464 162,490
6 19600 (19600) .795 (15,582)
Total 202,908

If the company borrows at an interest rate of 6% for an amount of P300,000, the monthly
amortization of the company would be:

300,000 = 57,559
5.212
this is the factor
at 6% for six
years beginning
with year 0.
(4.212 +1.000)
To anchor the alternatives on the same ground of analysis we assume the same period of cash
outflow between the two alternatives, that is the loan amortization will also start at time 0. The
debt payment schedule would be:

Period Loan Amortization Interest Principal Payment Principal Balance

@ 6% @ EOY
0 57,559 0 57,559 242,441
1 57,559 14,546 43,013 199,428
2 57,559 11,966 45,593 153,835
3 57,559 9,230 48,329 105,506
4 57,559 6,330 51,229 54,277
5 57,534 3,257 54,277 0

The company will have an additional expense in the form of interest and depreciation and as
such will also have an additional tax shield from these expenses. This is summarized below:

Period Interest+Depn Tax shield @ 35%

0 0 0
1 64,546 22,591
2 61,966 21688
3 59,230 20,730
4 56,330 19,715
5 53,257 18,640
6 50,000 17,500
The NPV of the cash outflows related with borrowing is then computed in the table below:

Period Cash outflow Tax shield Net Cash outflow PV Factor Present value
0 57,559 0 57,559 1.000 57,559
1 57,559 22,591 34,968 .9625 33,657
2 57,559 21,688 35,871 .9263 33,227
3 57,559 20,730 36,829 .8916 32,837
4 57,559 19,715 37,844 .8581 32,474
5 57534 18,640 38,894 .8259 32,122
6 0 17,500 (17,500) .7949 (13,911)
207,965

The NPV analysis still shows that leasing is a better alternative than borrowing because the cash
outflow in the latter is higher by P5,057.00. Although this is not much but it shows an objective
means of quantifying a particular alternative as against the other. There are still however, other
factors that should be considered. For one, leasing frees the company from an additional risk of
owning a property plus the burden of additional maintenance cost in the next years. Perhaps, if
figures could be made available regarding the repairs and maintenance cost of owning the
property, the lease alternative would present a better picture in financing.

The same methods of analysis could be made if the assumption on the lease is a capital
lease. Only that, the depreciation would not be based on the cost of 300,000 but on the present
value of the total rental payments which is 56,000 X 5.212 = 291,872. This present value would
be the recorded value of the asset in a capital lease.

Mtgumban