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Lecture Fundamentals of financial management - Chapter 20: Hybrid financing: Preferred stock, leasing, warrants, and convertibles

Chapter 20 - Hybrid financing: Preferred stock, leasing, warrants, and convertibles. This chapter presents the following content: Leasing; analysis: lease vs. borrow-and-buy; depreciation schedule; in a lease analysis, at what discount rate should cash flows be discounted? Cost of owning analysis; notes on cost of owning analysis;. | CHAPTER 20 Hybrid Financing: Preferred Stock, Leasing, Warrants, and Convertibles Preferred stock Leasing Warrants Convertibles Leasing Often referred to as “off balance sheet” financing if a lease is not “capitalized.” Leasing is a substitute for debt financing and, thus, uses up a firm’s debt capacity. Capital leases are different from operating leases: Capital leases do not provide for maintenance service. Capital leases are not cancelable. Capital leases are fully amortized. Analysis: Lease vs. Borrow-and-buy Data: New computer costs $1,200,000. 3-year MACRS class life; 4-year economic life. Tax rate = 40%. kd = 10%. Maintenance of $25,000/year, payable at beginning of each year. Residual value in Year 4 of $125,000. 4-year lease includes maintenance. Lease payment is $340,000/year, payable at beginning of each year. Depreciation schedule Depreciable basis = $1,200,000 MACRS Depreciation End-of-Year Year Rate Expense Book Value 1 0.33 $ 396,000 $804,000 2 0.45 540,000 264,000 3 0.15 180,000 84,000 4 0.07 84,000 0 1.00 $1,200,000 In a lease analysis, at what discount rate should cash flows be discounted? Since cash flows in a lease analysis are evaluated on an after-tax basis, we should use the after-tax cost of borrowing. Previously, we were told the cost of debt, kd, was 10%. Therefore, we should discount cash flows at 6%. A-T kd = 10%(1 – T) = 10%(1 – 0.4) = 6%. 0 1 2 3 4 Cost of Owning Analysis Cost of asset (1,200.0) Dep. tax savings1 158.4 216.0 72.0 33.6 Maint. (AT)2 (15.0) (15.0) (15.0) (15.0) Res. value (AT)3 _ _ _ 75.0 Net cash flow (1,215.0) 143.4 201.0 57.0 108.6 PV cost of owning (@ 6%) = -$766.948. Analysis in thousands: Notes on Cost of Owning Analysis Depreciation is a tax deductible expense, so it produces a tax savings of T(Depreciation). Year 1 = 0.4($396) = $158.4. Each maintenance payment of $25 is deductible so the after-tax cost of the lease is (1 – T)($25) = $15. The ending book value is $0 so the full $125 salvage . | CHAPTER 20 Hybrid Financing: Preferred Stock, Leasing, Warrants, and Convertibles Preferred stock Leasing Warrants Convertibles Leasing Often referred to as “off balance sheet” financing if a lease is not “capitalized.” Leasing is a substitute for debt financing and, thus, uses up a firm’s debt capacity. Capital leases are different from operating leases: Capital leases do not provide for maintenance service. Capital leases are not cancelable. Capital leases are fully amortized. Analysis: Lease vs. Borrow-and-buy Data: New computer costs $1,200,000. 3-year MACRS class life; 4-year economic life. Tax rate = 40%. kd = 10%. Maintenance of $25,000/year, payable at beginning of each year. Residual value in Year 4 of $125,000. 4-year lease includes maintenance. Lease payment is $340,000/year, payable at beginning of each year. Depreciation schedule Depreciable basis = $1,200,000 MACRS Depreciation End-of-Year Year Rate Expense Book Value 1 0.33 $ 396,000 $804,000 2 0.45 540,000 264,000 3 .