HS

Chapter 19
Hybrid
Securities
Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Learning Goals
1. Differentiate between hybrid and derivative securities

and their roles in the corporation.
2. Review the types of leases, leasing arrangements, the
lease versus purchase decision, the effects of leasing
on future financing, and the advantages and
disadvantages of leasing.
3. Describe the types of convertible securities, their
general features, and financing with convertibles.
Copyright © 2009 Pearson Prentice Hall. All rights reserved. 16-2

Learning Goals (cont.)
4. Demonstrate the procedures for determining the

straight bond value, conversion (or stock) value, and
market value of a convertible bond.
5. Explain the characteristics of stock purchase warrants,
the implied price of an attached warrant, and the
values of warrants.
6. Define the options and discuss calls and puts, options
markets, options trading, the role of call and put
options in fund raising, and hedging foreign currency
exposures with options.

An Overview of Hybrids & Derivatives
• In their simplest form, bonds are pure debt and common stocks
are pure equity.
• Preferred stocks, on the other hand, are a hybrid of the two.
• They are like common stocks in that they promise to pay
dividends, are perpetual, and represent ownership.
• They are like bonds in that dividends are fixed like bond interest
payments.
• Other hybrid securities include financial leases, convertible
securities, and stock purchase warrants.

An Overview of Hybrids
& Derivatives (cont.)
• The latter part of this chapter focuses on derivative

securities
• A derivative is a security that is neither debt nor equity
but derives its value from an underlying asset that is
often another security.
• Derivative securities are not used by corporations to
raise funds.
• Rather, they serve as a useful tool for managing certain
aspects of firm risk.

Leasing
• Leasing is the process by which a firm can

obtain the use of certain fixed assets for which it
must make a series of contractual, periodic, tax-
deductible payments.
• The lessee is the receiver of the services of the
assets under a lease contract.
• The lessor is the owner of the assets that are
being leased.

Leasing: Operating Leases
• An operating lease is a cancelable contractual

arrangement whereby the lessee agrees to make
periodic payments to the lessor, often for 5 or fewer
years, to obtain an assets services.
• Generally, the total payments over the term of the lease
are less than the lessor’s initial cost of the leased asset.
• If the operating lease is held to maturity, the lessee
returns the leased asset over to the lessor, who may
lease it again or sell the asset.

Leasing: Financial (or Capital) Leases
• A financial (or capital) lease is a longer-term lease

than an operating lease.
• Financial leases are non-cancelable and obligate the
lessee to make payments for the use of an asset over a
predefined period of time.
• The total payments over the term of the lease are
greater than the lessor’s initial cost of the leased asset.
• Financial leases are commonly used for leasing land,
buildings, and large pieces of equipment.

Leasing: Leasing Arrangements
• A direct lease is a lease under which a lessor owns or

acquires the assets that are leased to a given lessee.
• A sale-leaseback arrangement is a lease under which
the lessee sells an asset for cash to a prospective lessor
and then leases back the same asset.
• A leveraged lease is a lease under which the lessor acts
as an equity participant, supplying about 20 percent of
the cost of the asset with a lender supplying the
balance.

Leasing: Leasing Arrangements (cont.)
• Operating leases normally require maintenance clauses

requiring the lessor to maintain the assets and to make insurance
and tax payments.
• Renewal options are provisions that grant the lessee the option
to re-lease assets at the expiration of the lease.
• Finally, purchase options are provisions frequently included in
both operating and financial leases that allow the lessee to
purchase the asset at maturity—usually at a pre-specified price.

Leasing: The Lease-Versus-
Purchase Decision
• The lease-versus-purchase decision is a common

decision faced by firms considering the acquisition of a
new asset.
• This decision involves the application of capital
budgeting techniques as does any other asset
investment acquisition decision.
• The preferred method is the calculation of NPV based
on the incremental cash flows (lease versus purchase)
using the following steps:

Purchase Decision (cont.)
• Step 1: Find the after-tax cash outflows for each year

under the lease alternative.
• Step 2: Find the after-tax cash outflows for each year
under the purchase alternative
• Step 3: Calculate the present value of the cash outflows
from Step 1 and Step 2 using the after-tax cost of debt
as the discount rate.
• Step 4: Choose the alternative with the lower present
value of cash outflows.

Roberts Company, a small machine shop, is contemplating acquiring a new

machine tool costing $24,000. Arrangements can be made to lease or
purchase. The firm is in the 40 percent tax bracket.
Lease. The firm would obtain a 5-year lease requiring annual end-of-year
payments of $6,000. All maintenance costs will be borne by the lessor, and
the lessee would exercise the option to purchase the machine for $4,000 at
termination of the lease.

Purchase. The firm would finance the purchase of the machine with a
9%, 5-year loan requiring end -of-year installment payments of $6,170.
It would be depreciated under MACRS using a 5-year recovery period.
The firm would pay $1,500 per year for a service contract that covers
all maintenance costs; insurance and other costs would be borne by
the firm. The firm plans to keep the machine and use it beyond its 5-
year recovery period.

Step 1: Find the after-tax cash outflows for each year under the lease
alternative.
The after-tax cash outflow from the lease payments can be found as
follows:
A-T Outflow from Lease = $6,000 x (1 - t)
= $6,000 x (1 - .40)
= $3,600
In the final year, the $4,000 cost of the purchase option would be added to
the $3,600 lease outflow to get a year 5 outflow of $7,600 ($3,600 +
$4,000).

Step 2: Find the after-tax cash outflows for each year under the purchase
alternative.
First, the annual interest component of each loan payment must be
determined since only interest can be deducted for tax purposes as shown
in Table 16.1 on the following slide.
Second, the A-T outflows must be computed as shown in Table 16.2.

Table 16.1 Determining the Interest and Principal

Components of the Roberts Company Loan Payments

Table 16.2 After-Tax Cash Outflows Associated with

Purchasing for Roberts Company

Step 3: Calculate the present value of the cash outflows from Step 1 and
Step 2 using the after-tax cost as the discount rate. This is shown in Table
16.3 on the following slide.

Table 16.3 Comparison of Cash Outflows Associated with

Leasing versus Purchasing for Roberts Company

STEP 4: Choose the alternate with the smaller present value of cash
outflows.
Because the present value of cash outflows for leasing ($18,151) is lower
than that for purchasing ($19,539), the leasing alternative is preferred—
resulting in an incremental savings of $1,388.

Leasing: Effects of Leasing
on Future Financing
• FASB No. 13 requires explicit disclosure of financial lease

obligations on the firm’s balance sheet.
• It must be show as a capitalized lease, meaning that the present
value of all payments are included as an asset and corresponding
liability.
• An operating lease on the other hand, need not be capitalized,
but must be reported in the footnotes.
• Because the consequences of missing financial lease payments
are the same as that of missing the principal payment on debt, a
financial analyst must view the lease as a long-term debt
payment.

Leasing: Advantages of Leasing
• The firm may avoid the cost of obsolescence if the lessor fails
to accurately anticipate the obsolescence of assets and sets the
lease payment too low.
• A lessee avoids many of the restrictive covenants that are
normally included as part of a long-term loan.
• Leasing—especially operating leases—may provide the firm
with needed financial flexibility.
• Sale-leaseback arrangements may permit the firm to increase its
liquidity by converting an existing asset into cash, which may
then be used as working capital.

Leasing: Advantages of Leasing (cont.)
• Leasing allows the lessee, in effect, to depreciate land, which is

prohibited if the land were purchased.
• Because it results in the receipt of service from an asset possibly
without increasing the assets or liabilities on the firm’s balance
sheet, leasing may result in misleading financial ratios.
• Leasing provides 100 percent financing.
• When the firm becomes bankrupt or is reorganized, the
maximum claim of lessors against the corporation is 3 years of
lease payments, and the lessor gets the
asset back.

Leasing: Disadvantages of Leasing
• A lease does not have a stated interest cost.

• At the end of the term of the lease agreement, the
salvage value of an asset, if any, is realized by the
lessor.
• Under a lease, the lessee is generally prohibited from
making improvements on the leased property or asset
without approval of the lessor.
• If a lessee leases an asset that subsequently becomes
obsolete, it must still make lease payments over the
remaining term of the lease.
Convertible Securities
• A conversion feature is an option that is

included as part of a bond or preferred stock
issue that allows its holder to change the security
into a stated number of shares of common stock.
• The conversion feature typically enhances the
value of the issue.

Convertible Securities:
Types of Convertible Securities
• A convertible bond can be changed into a specified

number of shares of common stock.
• It is almost always a debenture—an unsecured bond—
with a call feature.
• Because the conversion feature provides the purchaser
with the possibility of becoming a shareholder on
favorable terms, convertible bonds are generally less a
expensive form of financing than similar-risk
nonconvertible or straight bonds.

Types of Convertible Securities (cont.)
• A convertible preferred stock is a preferred stock that

can be changed into a specified number of shares of
common stock.
• It can normally be sold with a lower stated dividend
than a similar-risk nonconvertible stock.
• This is because the convertible preferred holder is
assured of the fixed dividend payment and also may
receive the appreciation resulting from increases in the
market price of the underlying common stock.

Convertible Securities: General Features
of Convertibles
• The conversion ratio is the ratio at which a convertible

security can be exchanged for common stock and can
be state in two ways:
– in terms of a given number of shares of common
Western Wear Company, a manufacturer of denim products, has

outstanding a bond with a $1,000 par value and convertible into 25
shares of common stock. The bond’s conversion ratio is 25. The
conversion price for the bond is $40 per share ($1,000 ÷ 25).

of Convertibles (cont.)
• The conversion ratio is the ratio at which a convertible

security can be exchanged for common stock and can
be state in two ways:
– in terms of a given number of shares of common
– by dividing the par value of the convertible by the conversion
price
Mosher Company, a franchisor of seafood restaurants, has

outstanding a convertible 20-year bond with a par value of $1,000.
The bond is convertible at $50 per share into common stock. The
conversion ratio is 20 ($1,000 ÷ $50).

of Convertibles (cont.)
• The conversion or stock value is the value of the convertible

measured in terms of market price of the common stock into
which it can be converted.
McNamara Industries, a petroleum processor, has outstanding a $1,000

bond that is convertible into common stock at $62.50 per share. The
conversion ratio is therefore 16 ($1,000 ÷ $62.50). Because the current
market price of the common stock is $65 per share, the conversion value is
$1,040 (16 x $65). Because the conversion is above the bond value of
$1,000, conversion is a viable option for the owner.

Financing With Convertibles
• Convertible securities can be used as a form of deferred

common stock financing.
• Convertible securities can be used as a sweetener by giving the
purchaser an opportunity to share in the firm’s success by
converting to common stock.
• Convertibles can normally be sold with lower interest rates than
non-convertibles.
• Convertibles can be sold with fewer restrictive covenants than
non-convertibles.
• Convertibles can be used to raise cheap funds temporarily.

Convertible Securities: Determining
the Value of a Convertible Bond
• The straight bond value of a convertible bond is the price at

which it would sell in the market without the conversion feature.
• The straight value is typically the floor, or minimum, price at
which it would be traded.
Duncan Company, a southeastern discount chain, has just sold a

$1,000 par value, 20-year convertible with a 12% coupon rate. Interest
will be paid at the end of each year, and the principal will be repaid at
maturity. A straight bond could have been sold with a 14% coupon but
the conversion feature compensates for the lower rate on the
convertible. The straight value could be calculated as:

the Value of a Convertible Bond (cont.)
• The straight bond value of a convertible bond is the price at which it would
sell in the market without the conversion feature.
• The straight value is typically the floor, or minimum, price at which it would
be traded.

the Value of a Convertible Bond (cont.)
• The straight bond value of a convertible bond

is the price at which it would sell in the market
without the conversion feature.
• The straight value is typically the floor, or
minimum, price at which it would be traded.
• This value, $867.76, is the minimum price at
which the convertible is expected to sell.

Conversion (or Stock) Value
• The conversion value of a convertible is the value of the

convertible measured in terms of the market price of the common
stock into which the security can be converted.
• When the market price of the common stock exceeds the
conversion price, the conversion value exceeds the par value.
Duncan Company’s convertible bond described earlier is convertible at

$50 per share. Each bond can therefore be converted into 20 shares of
common stock. The conversion values of the bond when the stock is
selling at $30, $40, $50, $60, $70, and $80 are shown as follows:
Conversion (or Stock) Value (cont.)

Conversion (or Stock) Value (cont.)
• When the market price of the common stock exceeds

the $50 conversion price, the conversion value exceeds
the $1,000 par value.
• Because the straight bond is $876.76, the bond will
never sell for less than this amount regardless of how
low its conversion value is.
• If the market price were $30, the bond would still sell
for $876,76—not $600—because its value as a bond
would dominate.

Stock Purchase Warrants
• A stock purchase warrant is a security that gives its

holder the right to purchase a certain number of shares
of common stock at a specified price over a certain
period of time.
• They also bear some similarity to convertibles in that
they provide for the injection of additional equity
capital into the firm at some future date.

Stock Purchase Warrants:
Key Characteristics
• Warrants are often attached to debt issues as

“sweeteners” to add to the marketability of the issue
and lower the required interest rate.
• The price at which warrant holders can purchase a
specified number of common shares is normally
referred to as the exercise (or option) price which is
normally set at 10 to 20 percent above the market price
of the common stock at the time of issuance.
• Warrants normally have a life of no more than 10 years
although some have infinite lives.

Key Characteristics (cont.)
• Warrants are usually “detachable” meaning that the

bondholder may sell the warrant without selling the
underlying security and are often listed and actively
traded.

Stock Purchase Warrants: The Implied
Price of an Attached Warrant
When attached to a bond, the implied price of a

warrant can be found by using the following
equation.
• The straight bond value is found in a fashion similar

to that found using convertible bonds.
• Dividing the implied price of all warrants by the
number of warrants attached to each bond results in
the implied price of each warrant.
Price of an Attached Warrant (cont.)
Martin Marine Products, a manufacturer of marine drive shafts and
propellers, just issued a 10.5% coupon, $1,000 par value, 20-year bond
paying annual interest and having 20 warrants attached for the
purchase of common stock. The bonds were initially sold at $1,000,
and when issued, were selling to yield 12%. The straight value of the
bond would be the present value of its payments discounted at the 12%
yield on similar-risk straight bonds.

• Substituting the
$1,000 price of the
bond with warrants
attached and the $888
straight bond value
into equation 18.1, we
get an implied price of
all warrants of $112 as
follows:

Implied price of all warrants = $1,000 - $888 = $112
Dividing the implied price of all warrants by the number of

warrants attached to each bond—20 in this case —we find
the implied price of each warrant.
Implied price of each warrant = $112 ÷ 20 = $5.60

• Therefore, by purchasing Martin Marine Products’
bond with warrants attached for $1,000, one is
effectively paying $5.60 for each warrant.

The Value of Warrants
• Like a convertible, a warrant has both a market value

and theoretical value.
• The difference between these values—the warrant
premium—depends largely on investor expectations
and the ability of investors to get more leverage from
the warrants than from the underlying stock.
• The theoretical value of a warrant is the amount one
would expect the warrant to sell for in the marketplace
as shown in equation 16.2.

The Value of Warrants (cont.)

Dustin Electronics, a major producer of transistors, has outstanding
warrants that are exercisable at $40 per share and entitle holders to
purchase three shares of common stock. The warrants were initially
attached to a bond issue to sweeten the bond. The common stock of
the firm is currently selling for $45 per share. Substituting P0 = $45, E
= $40, and N = 3 into Equation 18.2 yields a theoretical value of $15
[($45 - $40) x 3].

• The market value of a warrant is generally above its

theoretical value.
• Only when the theoretical value is very high, or the warrant is
near its expiration date are the market value and theoretical
values close.
• The warrant premium is the amount by which market value
exceeds theoretical value and results from both positive
expectations and the ability to trade them.

• Stan Buyer has $2,430, which he is interested in investing in

Dustin Electronics. The firm’s stock is currently selling for $45
per share, and its warrants are selling for $18 per warrant. Each
warrant entitles the holder to purchase three shares of Dustin’s
common stock at $40 per share. Mr. Buyer can choose to
purchase underlying stock or trading in warrant.
• How much dollar effect for each alternatives if the stock prices
raises to $48?

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Chapter 19

Copyright © 2009 Pearson Prentice Hall. All rights reserved.

1. Differentiate between hybrid and derivative securities

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 16-2

4. Demonstrate the procedures for determining the

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 16-3

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 16-4

• The latter part of this chapter focuses on derivative

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 16-5

• Leasing is the process by which a firm can

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 16-6

• An operating lease is a cancelable contractual

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 16-7

• A financial (or capital) lease is a longer-term lease

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 16-8

• A direct lease is a lease under which a lessor owns or

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 16-9

• Operating leases normally require maintenance clauses

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 16-10

• The lease-versus-purchase decision is a common

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 16-11

• Step 1: Find the after-tax cash outflows for each year

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 16-12

Roberts Company, a small machine shop, is contemplating acquiring a new

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 16-13

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 16-14

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 16-15

First, the annual interest component of each loan payment must be

in Table 16.1 on the following slide.

Second, the A-T outflows must be computed as shown in Table 16.2.

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 16-16

Table 16.1 Determining the Interest and Principal

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 16-17

Table 16.2 After-Tax Cash Outflows Associated with

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 16-18

16.3 on the following slide.

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 16-19

Table 16.3 Comparison of Cash Outflows Associated with

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 16-20

than that for purchasing ($19,539), the leasing alternative is preferred—

resulting in an incremental savings of $1,388.

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 16-21

• FASB No. 13 requires explicit disclosure of financial lease

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 16-22

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 16-23

• Leasing allows the lessee, in effect, to depreciate land, which is

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 16-24

• A lease does not have a stated interest cost.

• A conversion feature is an option that is

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 16-26

• A convertible bond can be changed into a specified

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 16-27

• A convertible preferred stock is a preferred stock that

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 16-28

• The conversion ratio is the ratio at which a convertible

Western Wear Company, a manufacturer of denim products, has

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 16-29

• The conversion ratio is the ratio at which a convertible

Mosher Company, a franchisor of seafood restaurants, has

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 16-30

• The conversion or stock value is the value of the convertible

McNamara Industries, a petroleum processor, has outstanding a $1,000

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 16-31

• Convertible securities can be used as a form of deferred