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• Preferred stock has non-voting rights

• Preferred stock lies between equity and debt

• Viewpoint of Issuing corporation (tax disadvantage)

Preferred Dividends are non-deductible

• Viewpoint of Corporate Investor (tax advantage)

Preferred dividends are deductible
• Cumulative
Unpaid preferred dividends must be paid before dividends can be
paid on the common stock shareholders.
Arrears do not earn interest

• Non-cumulative
In contrast with cumulative
• Preferred stock can be Callable or Puttable
• Callable – issuing corporation has the option to call the preferred stock

• Puttable – Investor has the option to return the preferred stock

• Other types of Preferred stock

Adjustable Rate Preferred Stock – dividends re tied to the rate on treasury
securities

Market Auction Preferred Stock – interest rates are reset through auctions,
• Advantages (issuers viewpoint)
1. Preferred dividends cannot force a firm to bankruptcy

2. It avoid the dilution of common equity that occurs when common stock is
sold.

3. It reduces the cash flow drain from repayment of principal that occurs with
debt issues.
• Disadvantage
1. Higher cost of capital

2. It increases financial risk and hence the cost of common equity

Leasing

• Types of Leases:
• Sale-and-leaseback arrangements;
• Operating leases;
• Financial, or capital, leases.
• Often called off balance sheet financing.
Lease vs. Borrow-and-purchase Analysis
Data:
• New equipment: cost = $10,000,000, life = 5 years
• Salvage value or purchase option = $715,000.
• Annual maintenance = $500,000
• Tax rate = 40%.
• Loan interest rate = 10%.
• After-tax cost rate=10%(1 – T)=10%(1 – 0.4)= 6%.
• Annual lease payment = $2,800,000
• 5-year MACRS class life, The MACRS depreciation rates are 20%, 32%,
19%, 12%, 11%, and 6%.;
Depreciation schedule

Depreciable basis = $10,000,000

MACRS Depreciation Depreciation
Year Rate Expense Tax Savings
1 0.20 $2,000,000 $ 800,000
2 0.32 3,200,000 1,280,000
3 0.19 1,900,000 760,000
4 0.12 1,200,000 480,000
5 0.11 1,100,000 440,000
6 0.06 600,000 240,000
1.00 $10,000,000 $4,000,000
Cost of Owning Analysis
Cost of Leasing Analysis
Cost Comparison

• Net Advantage to Leasing (NAL) = PV cost of owning – PV cost of

leasing

• NAL = $8,023,000 - $7,611,000

= $412,000

• Since leasing costs less, so lease should be done.

 Other Factors That Affect Leasing Decisions

• Estimated Residual Value

• Increase Credit Availability

– long term option from a company that gives the holder the
right to buy a stated number of shares of the firm’s common
stock at a specified price for a specified length of time.

– generally distributed with debt.

In 2012, Infomatics Corporation
$50 million of 20-year bonds – would require 10% coupon rate
8% coupon rate – 20 warrants with each $1,000 bond

Each warrant having 10-year life and entitling the holder to buy
one share of common stock at an exercise price of $22 per
share at any time during their 10-year life.

Stock was selling $20 per share at the time and warrants would
expire in 2022 if not exercised.

Warrants are long term call options that have value

INITIAL MARKET PRICE OF A BOND WITH WARRANTS
Present Value of Bonds

PV of 1 at 10% for 20 periods is 0.149

PV of ordinary annuity of 1 at 10% for 20 periods is 8.514

PV of principal ($1000 x 0.14864) $148.64

PV of of interest payments ($80 x 8.51356) $681.08
$829. 72
PV = $829.72 ≈ $830
Price paid for bond = Straight-debt Value of
+
with warrants value of bond warrants
$ 1,000 = $830 + $170

Implied value of each warrant $170/20 = $8.50

Detachable warrants – a warrant that can be detached

from a bond and traded independently of the bond.
If bonds and warrants were priced correctly,

Bonds = $830 Warrants = $8.50 Package = $1,000

If bonds and warrants were priced incorrectly,

Bankers can estimate the straight debt value accurately but it

is more difficult to estimate the proper value of warrants.
For example, if estimated value is too low, $6
170/$6 = 28.3333

When it is offered to the public, price will rise from $1,000 to:

Market price of bond = $830 + $8.50 (28.3333) = $1,070.83

Thus, firm would sold for $1,000 instead of $1,070.83

More warrants would be outstanding than necessary;
Ifwhen warrants
the value are exercised,
is overestimated, $10 there would be more
dilution of the original shareholder’s equity than
necessary.
The issue would fail – it could not be sold at the $1,000 offering
price and the firm would not obtain the funds it needed.
Major difference between call option and warrants

 When call option is exercised – stock provided to option

holder comes from secondary market
 When warrants is exercised – stock provided are newly
issued.

As a result, exercise of warrants dilutes value of original

equity, which could cause the value of original warrant
to differ from value of similar call option.
USE OF WARRANTS IN FINANCING

• Small, rapidly growing firms use warrants as “sweeteners”.

• A hybrid security that provides financial manager with an opportunity to
expand the firm’s mix of securities and thus to appeal to a broader group
of investors.

3 conditions which encourages holders to exercise their warrants:

1. If the warrants are about to expire and the market price of the stock
is above the exercise price.
2. If the company raises the dividend on the common stock by a
sufficient amount.
3. Warrants sometimes have stepped-up exercise price.

Stepped-up exercise price – an exercise price that is specified to rise

if a warrant is not exercised before a designated date.
COMPONENT COST OF BONDS WITH WARRANTS

When Infomatics issued its debt with warrants, the firm received $50 million
or $1,000 for each bond. Simultaneously, the company assumed an
obligation to pay $80 interest for 20 years plus $1,000 at the end of 20
years. the pretax cost of the money would have been 10% if no warrants
had been attached; but each Infomatics bond had 20 warrants, each of
which entitled its holder to buy one share of stock for $22. What is the
percentage cost of the $50 million? As we shall see, the cost is well above
the 8% coupon rate on the bonds.
Note when the warrants expire in 10 years from now, stock is expected to
sell for $51.87, given the $20 intial price and the 10% expected growth
rate:

𝑃10 = $20 (1.10)10 = $51.87

Therefore, investors could exercise their warrants and receive one share of
stock worth $51.87 for each warrant exercised.

Thus if investor held the complete package, realized profit in Year 10 would
be = $51.87 - $22 = $29.87 on each warrant.

Since each bond has 20 warrants attached, investors would have a gain of
20 ($29.87) = $597.40 per bond at the end of Year 10.
 0 1 9 10 11 20

-1,000 80 80 80.00 80 80
597.40 1,000
677.40 1,080

IRR = 10.66% which is investor’s overall pretax rate of return on the issue.
This return is 66 basis points higher than the return on straight debt.

The issue is risker to investors..

1. Part of return is expected to come in the form of stock price appreciation.
2. Part of return is riskier than the interest payments on the bonds.
CONVERTIBLES SECURITIES

are bonds or preferred stocks that, under

specified terms and conditions, can be
exchanged for common stock at the
option of the holder.
CONVERSION RATIO AND CONVERSION
PRICE
Conversion Ratio (Cr)
the number of shares of Conversion Price (Pc)
common stock that are
obtained by converting a the number of shares of
convertible bond or share common stock that are
of convertible preferred
obtained by converting a
stock
convertible bond or share
of convertible preferred
stock
Silicon Valley Software Company’s
$1,000 par value convertible
debentures issued in August 2008
where the holder can exchange a CONVERSION
bond for 20 shares of common stocks. RATIO

AND

CONVERSION
PRICE
• Like a warrant’s exercise price, the
conversion price is typically set at from
15% to 30% above the market price of
the common stock at the time the issue
is sold.

For example, the 2008 convertible

debentures for Breedon Industries are
convertible into 12.5 shares until 2018;
into 11.76 shares from 2019 until 2028;
and into 11.11 shares from 2027 until
maturity in 2038.
The conversion price thus
starts at $80, rises to $85, and then goes
to $90.
Other Factor That Cause Change
In Conversion Price And Ratio

-Stock splits
-Stock dividends
-Sale of common stock @ Price
below Conversion price
The Component Cost Of
Convertibles
 Use Of Convertibles In Financing
Two Important Advantages (issuers standpoint):
1) Convertibles, like bonds with warrants, offer
a company the chance to sell debt with a
low interest rate in exchange for a chance
to participate in the company’s success if it
does well.
2) Convertibles provide a way to sell common
stock at prices higher than those currently
prevailing.
Disadvantages (issuers standpoint):
1) If the stock greatly increased in price, the firm
would probably find that it would have been
better off had it used straight debt in spite of its
higher cost and then later sold common stock
and refunded the debt.
2) Convertibles typically have a low coupon
interest rate, and the advantage of this low-cost
debt will be lost when conversion occurs.
3) If the company truly wants to raise equity
capital and if the price of the stock does not rise
sufficiently after the bond is issued, the company
will be stuck with debt.
Convertibles Can Reduce Agency Costs

-Gains to shareholders from taking on high-risk

projects must be shared with convertible
bondholders. this sharing of benefits lowers agency
costs.
 Convertible debt
• Straight debt with non
detachable warrants.
• Conversion of convertibles
results in replacing debt with
equity in firm’s balance sheet.
• Most convertible issues
contain a call provision that
allows issuer to refund the
debt, which could force
conversion if the conversion
value exceeds the call price.
• Typically have much longer
lives.
• Less risky.
• Lower flotation costs.
Warrants
• Straight debt with detachable
warrants.
• Exercise of warrants brings in
new equity capital.
• Most warrants are not
callable, so firms must wait
until maturity for the
warrants to generate new
equity capital.
• Typically have much shorter
lives and typically expires
before accompanying debt
matures.
• Firms that issues bonds with
warrants are smaller and
risker.
• Require higher flotation costs.
Basic EPS - Ebit/outstanding shares

Diluted EPS