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Exam 20: Hybrid Financing

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Question 1

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Leasing is typically a financing decision and not a capital budgeting decision. The decision to acquire the asset is a "done deal" before the lease analysis begins. Therefore, in a lease analysis, we are concerned simply with whether to finance the asset with a lease or with a loan.

A) True
B) False

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Question 2

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Under a sale and leaseback arrangement, the seller of the leased property is the lessee and the buyer is the lessor.

A) True
B) False

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Question 3

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Which of the following is most CORRECT?

If a leased asset has a negative residual value, for example, as a result of a statutory requirement to dispose of an asset in an environmentally sound manner, the lessee of the asset could reasonably expect to pay a lower lease rate because the asset does not have a positive residual value.

A detachable warrant is a warrant that can be removed from the security with which it was issued and traded separately from it. Most traded warrants are originally attached to bonds or preferred stocks.

In the lease-versus-buy decision, leasing is often preferable

A convertible debenture can never sell for more than its conversion value or less than its bond value.

Its investment bankers have told Donner Corporation that it can issue a 25-year, 8.1% annual payment bond at par. They also stated that the company can sell an issue of annual payment preferred stock to corporate investors who are in the 40% tax bracket. The corporate investors require an after-tax return on the preferred that exceeds their after-tax return on the bonds by 1.0%, which would represent an after-tax risk premium. What coupon rate must be set on the preferred in order to issue it at par?

Firms generally do not call their convertibles unless the conversion value is greater than the call price.

Preferred stock can provide a financing alternative for some firms when market conditions are such that they cannot issue either pure debt or common stock at any reasonable cost.

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?

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.

Emerson Electrical Engineering Inc. is issuing new 20-year bonds that have warrants attached. If not for the attached warrants, the bonds would carry an 11% interest rate. However, with the warrants attached the bonds will pay a 9% annual coupon. There are 25 warrants attached to each bond, which have a par value of $1,000. The exercise price of the warrants is $25.00 and the expected stock price 10 years from now (when the warrants may be exercised) is $50.77. What is the investor's expected overall pre-tax rate of return for this bond-with-warrants issue?

A warrant is an option, and as such it cannot be used as a "sweetener."

A warrant holder is not entitled to vote, but he or she does receive any cash dividends paid on the underlying stock.

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.

Thomson Engineering is issuing new 20-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 value of the straight-debt portion of the bonds?

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

Orient Airlines' common stock currently sells for $33, and its 8% convertible debentures (issued at par, or $1,000) sell for $850. Each debenture can be converted into 25 shares of common stock at any time before 2022. What is the conversion value of the bond?

Ballentine Inc., which has a zero tax rate due to tax loss carry-forwards, is considering a 6-year, $5,000,000 bank loan in order to buy a new piece of equipment. The loan will be amortized over 6 years with end-of-year payments and has an interest rate of 9%. Alternatively, Ballentine can also lease the equipment for an end-of-year payment of $1,250,000. By how much does the lease payment exceed the loan payment?