CHAPTER 20

HYBRID FINANCING: PREFERENCE

SHARES, LEASING, OPTIONS,
WARRANTS,
AND CONVERTIBLES
Learning
Objectives
 Understand the concept of hybrid financing.
 Explain the nature, advantages and disadvantages of
using preference shares as a source of long-term
financing.
 Know the nature, advantages and disadvantages of
using leases as a means of financing long-term or fixed
asset needs.
 Understand the use of securities such as convertibles,
and option or warrant to raise long-term funds.
 Hybrid Financing
is the financial instrument that partakes some
characteristics of debt and some characteristics of equity.
TYPES OF LONG-TERM CAPITAL
DESCRIBED AS HYBRID FINANCING

1 Preference Share
 A hybrid security that represents a
cross between debt or bonds and
common stock.
2 Lease Financing
 used by financial managers as an
alternative to borrowing to finance
fixed assets.

3 Option Securities

 attractive to investors because they

allow debt holders to acquire ordinary
shares at bargain prices.
Features of Preference Shares
Issues

◉ Priority to assets and earnings

◉ Par Value
◉ Cumulative Dividends
◉ Convertibility to ordinary shares
 ISSUING PREFERENCE SHARES

Advantages Disadvantages

◉ No default risk. ◉ Preferred dividends are

◉ Dividend payment is not tax deductible.
limited to stated ◉ Cummulative feature of
amount. preferred stocks makes
◉ No voting rights. payment of preferred
◉ Inclusion of call features dividends almost
and sinking funds. mandatory.
 Lease Financing

LEASING -provides an alternative to buying an asset in order to

acquire its services.

THREE MAJOR TYPES OF LEASE AGREEMENTS

A. Direct Leasing

B. Sale and Leaseback

C. Leveraged Leasing
Potential Benefits from Leasing

◉ Increased Flexibility
◉ Certain maintenance at known
cost
◉ Lower administrative costs
◉ Offers an economic advantage
 Finance or Capital Lease

◉ non-cancelable, longer-term lease that fully amortizes the lessor's

cost of the asset; service and maintenance are usually provided by
the lessee.

Illustrative Problem.
Jerdan Company plans to aquire equipment with a 5-year life which has a
cost of P10,000,000, delivered and installed. The company can borrow the
required P10,000,000, using a 10% to be amortized over 5 years that will require
annual payments of P2,637,974.81 per year. Alternatively, Jerdan can lease the
equipment for 5 years at a rental charge of P2,800,00 per year, payable at the
beginning of the year. The lessee has the option to purchase the equipment upon
the expiration of the lease. The lease contract stipulates that the lessor win the
equipment .
 Finance or Capital Lease
However, if Jerdan borrows and buys, it
will have to bear the cost of maintenance,
which will be performed by the equipment
manufacturer at a fixed contract of
P500,000 per year, payable at year-end.
The equipment will be depreciated using
the straight line method. Tax rate is 32%.
The equipment will definitely be used for 5
years, at which time its estimated net
salvage value will be P750,000. Jerdan
plans to continue using the equipment so
(1) if it purchases the equipment, the
company will keep it, and (2) if it leases
the equipment, the company will exercise
an option to buy it at its estimated
salvage value.
 Classification of Finance Lease

◉ The lease transfers ownership of the asset to the lessee by

the end of the lease term;
◉ The lessee has the option to purchase asset at a price that is
expected to be sufficiently lower than the fair value at the
date the option becomes exercisable;
◉ The lease term is for the major part of the economic life of
the asset even if title is not transferred;
◉ At the inception of the lease the present value of the
minimum lease payments amounts to at least substantially
all of the fair value of the leased asset; and
◉ The leased assets are of such a specialized nature that only
the lessee can use them without major modifications.
 Operating Lease

◉ Usually short-term and is often cancelable at the

option of the lessee; obligation is not shown in the
balance sheet; maintenance and upkeep of asset is
provided by the lessor; lease payment is treated as
rent expense.
 Convertible Securities

◉ Instruments that are exchangeable at the option of the

holder into ordinary share under specified terms and
conditions.
◉ Conversion price = effective price paid for the ordinary share
when conversion occurs

Example:
A bond is issued at par value of P 1,000 and can be
converted into 40 ordinary shares.

Conversion Price= P1,000 / 40 = P25 per share

 Option

◉ A contract which gives its holder the right to buy (or

sell) stocks at some predetermined price within a
specified period of time. It is created by outsider
rather than the firm itself.

TYPES OF OPTIONS
1. Call options -convey the right right to buy a
share of stock at
a set price called the
exercise , or striking price.
2. Put options -give the holder the right to sell the
 Option

◉ Option = Current stock price - Striking price

The premium of an option's market value over its

formula
value depends on:

1. Time to maturity
2. Stock price variability
Warrants

◉ An option granted by the corporation to

purchase a specified number of ordinary shares
at a stated price exercisable until some time in
the future, called the expiration date. It is a
company-issued call option.

◉ Theoretical Value = current market price per

share x number of shares that can be
purchased with one warrant and the option
price of the warrant
Warrants

◉ Example:
Current price of ordinary share
33
Number of shares that can be purchased
2
Exercise price
30

(2 x 33) - (2 x 30) = 6
End of Presentation
 Our greatest
weakness lies in
giving up. The
most certain way
to succeed is
always to try just
one more time.

H O M A S A. E D I S O N