Deck 20: Hybrid Financing: Preferred Stock, leasing, warrants, and Convertibles

Question 1

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

Answer 1

False

Question 2

The owner of a convertible bond owns,in effect,both a bond and a call option.

Answer 2

True

Question 3

Preferred stock normally has no voting rights.However,most preferred issues stipulate that the preferred stockholders can elect a minority number of the directors if the preferred dividend is omitted.

Answer 3

True

Question 4

Corporations that invest surplus funds in floating-rate preferred stock benefit from getting a relatively stable price,and they also benefit from the 70% tax exemption on preferred dividends received.

Question 5

Leasing is often referred to as off-balance-sheet financing because lease payments are shown as operating expenses on a firm's income statement and,under certain conditions,leased assets and associated liabilities do not appear on the firm's balance sheet.

Question 6

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

Question 7

Operating leases help to shift the risk of obsolescence from the user to the lessor.

Question 8

Preferred stockholders have priority over common stockholders with respect to dividends,because dividends must be paid on preferred stock before they can be paid on common stock.However,preferred and common stockholders normally have equal priority with respect to liquidating proceeds in the event of bankruptcy.

Question 9

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.

Question 10

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

Question 11

The full amount of a lease payment is tax deductible provided the contract qualifies as a true lease under IRS guidelines.

Question 12

The problem of dilution of stockholders' earnings never results from the sale of call options,but it can arise if warrants are used.

Question 13

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

Question 14

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.

Question 15

Preferred stock typically has a par value,and the dividend is often stated as a percentage of par.The par value is also important in the event of liquidation,as the preferred stockholders are generally entitled to receive the par value before anything is given to the common stockholders.

Question 16

Most convertible securities are bonds or preferred stocks that,under specified terms and conditions,can be exchanged for common stock at the option of the holder.

Question 17

The "preferred" feature of preferred stock means that it normally will provide a higher expected return than will common stock.

Question 18

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.

Question 19

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

Question 20

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

Question 21

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?

A)6.66%
B)6.99%
C)7.34%
D)7.71%
E)8.09%

Question 22

Which of the following statements is most CORRECT?

A)Preferred stock generally has a higher component cost of capital to the firm than does common stock.
B)By law in most states, all preferred stock must be cumulative, meaning that the compounded total of all unpaid preferred dividends must be paid before any dividends can be paid on the firm's common stock.
C)From the issuer's point of view, preferred stock is less risky than bonds.
D)Whereas common stock has an indefinite life, preferred stocks always have a specific maturity date, generally 25 years or less.
E)Unlike bonds, preferred stock cannot have a convertible feature.

Question 23

Sutton Corporation,which has a zero tax rate due to tax loss carry-forwards,is considering a 5-year,$6,000,000 bank loan to finance service equipment.The loan has an interest rate of 10% and would be amortized over 5 years,with 5 end-of-year payments.Sutton can also lease the equipment for 5 end-of-year payments of $1,790,000 each.How much larger or smaller is the bank loan payment than the lease payment? Note: Subtract the loan payment from the lease payment.

A)$177,169
B)$196,854
C)$207,215
D)$217,576
E)$228,455

Question 24

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.

Question 25

Moniker Manufacturing's bonds were recently issued at their $1,000 par value.At any time prior to maturity (20 years from now),a bondholder can exchange a bond for a share of common stock at a conversion price of $40.What is the conversion ratio?

A)22.56
B)23.75
C)25.00
D)26.25
E)27.56

Question 26

Which of the following is most CORRECT?

A)Firms that use "off-balance-sheet" financing, such as leasing, would show lower debt ratios if the effects of their leases were reflected in their financial statements.
B)Capitalizing a lease means that the firm issues equity capital in proportion to its current capital structure, in an amount sufficient to support the lease payment obligation.
C)The fixed charges associated with a lease can be as high as, but never greater than, the fixed payments associated with a loan.
D)Capital, or financial, leases generally provide for maintenance by the lessor.
E)A key difference between a capital lease and an operating lease is that with a capital lease, the lease payments provide the lessor with a return of the funds invested in the asset plus a return on the invested funds, whereas with an operating lease the lessor depends on the residual value to realize a full return of and on the investment.

Question 27

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

A)because it has no effect on the firm's ability to borrow to make other investments.
B)because, generally, no down payment is required, and there are no indirect interest costs.
C)because lease obligations do not affect the firm's risk as seen by investors.
D)because the lessee owns the property at the end of the lease term.
E)because the lessee may have greater flexibility in abandoning the project in which the leased property is used than if the lessee bought and owned the asset.

Question 28

From the lessee viewpoint,the riskiness of the cash flows,with the possible exception of the residual value,is about the same as the riskiness of the lessee's

A)equity cash flows.
B)capital budgeting project cash flows.
C)debt cash flows.
D)pension fund cash flows.
E)sales.

Question 29

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?

A)$110,285
B)$116,090
C)$122,199
D)$128,631
E)$135,401

Question 30

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.

Question 31

Heavy use of off-balance-sheet lease financing will tend to

A)make a company appear more risky than it actually is because its stated debt ratio will be increased.
B)make a company appear less risky than it actually is because its stated debt ratio will appear lower.
C)affect a company's cash flows but not its degree of risk.
D)have no effect on either cash flows or risk because the cash flows are already reflected in the income statement.
E)affect the lessee's cash flows but only due to tax effects.

Question 32

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?

A)$707.33
B)$744.56
C)$783.75
D)$825.00
E)$866.25

Question 33

Which of the following statements about convertibles is most CORRECT?

A)The coupon interest rate on a firm's convertibles is generally set higher than the market yield on its otherwise similar straight debt.
B)One advantage of convertibles over warrants is that the issuer receives additional cash money when convertibles are converted.
C)Investors are willing to accept a lower interest rate on a convertible than on otherwise similar straight debt because convertibles are less risky than straight debt.
D)At the time it is issued, a convertible's conversion (or exercise) price is generally set equal to or below the underlying stock's price.
E)For equilibrium to exist, the expected return on a convertible bond must normally be between the expected return on the firm's otherwise similar straight debt and the expected return on its common stock.

Question 34

Operating leases often have terms that include

A)maintenance of the equipment by the lessor.
B)full amortization over the life of the lease.
C)very high penalties if the lease is cancelled.
D)restrictions on how much the leased property can be used.
E)much longer lease periods than for most financial leases.

Question 35

Which of the following statements is most CORRECT?

A)Warrants have an option feature but convertibles do not.
B)One important difference between warrants and convertibles is that convertibles bring in additional funds when they are converted, but exercising warrants does not bring in any additional funds.
C)The coupon rate on convertible debt is normally set below the coupon rate that would be set on otherwise similar straight debt even though investing in convertibles is more risky than investing in straight debt.
D)The value of a warrant to buy a safe, stable stock should exceed the value of a warrant to buy a risky, volatile stock, other things held constant.
E)Warrants can sometimes be detached and traded separately from the security with which they were issued, but this is unusual.

Question 36

A lease-versus-purchase analysis should compare the cost of leasing to the cost of owning,assuming that the asset purchased

A)is financed with short-term debt.
B)is financed with long-term debt.
C)is financed with debt whose maturity matches the term of the lease.
D)is financed with a mix of debt and equity based on the firm's target capital structure, i.e., at the WACC.
E)is financed with retained earnings.

Question 37

Which of the following statements concerning warrants is most CORRECT?

A)Bonds with warrants and convertible bonds both have option features that their holders can exercise if the underlying stock's price increases. However, if the option is exercised, the issuing company's debt declines if warrants are used but remains the same if convertibles are used.
B)Warrants are long-term put options that have value because holders can sell the firm's common stock at the exercise price regardless of how low the market price drops.
C)Warrants are long-term call options that have value because holders can buy the firm's common stock at the exercise price regardless of how high the stock's price has risen.
D)A firm's investors would generally prefer to see it issue bonds with warrants than straight bonds because the warrants dilute the value of new shareholders, and that value is transferred to existing shareholders.
E)A drawback to using warrants is that if the firm is very successful, investors will be less likely to exercise the warrants, and this will deprive the firm of receiving any new capital.

Question 38

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.

Question 39

FAS 13 requires that for an unqualified audit report,financial (or capital)leases must be included in the balance sheet by reporting the

A)residual value as a fixed asset.
B)residual value as a liability.
C)present value of future lease payments as an asset and also showing this same amount as an offsetting liability.
D)undiscounted sum of future lease payments as an asset and as an offsetting liability.
E)undiscounted sum of future lease payments, less the residual value, as an asset and as an offsetting liability.

Question 40

Chocolate Factory's convertible debentures were issued at their $1,000 par value in 2011.At any time prior to maturity on February 1,2031,a debenture holder can exchange a bond for 25 shares of common stock.What is the conversion price,P_c?

A)$40.00
B)$42.00
C)$44.10
D)$46.31
E)$48.62

Question 41

Kohers Inc.is considering a leasing arrangement to finance some manufacturing tools that it needs for the next 3 years.The tools will be obsolete and worthless after 3 years.The firm will depreciate the cost of the tools on a straight-line basis over their 3-year life.It can borrow $4,800,000,the purchase price,at 10% and buy the tools,or it can make 3 equal end-of-year lease payments of $2,100,000 each and lease them.The loan obtained from the bank is a 3-year simple interest loan,with interest paid at the end of the year.The firm's tax rate is 40%.Annual maintenance costs associated with ownership are estimated at $240,000 payable at the end of the year,but this cost would be borne by the lessor if the equipment is leased.What is the net advantage to leasing (NAL),in thousands? (Suggestion: Delete 3 zeros from dollars and work in thousands.)

A)$ 96
B)$106
C)$112
D)$117
E)$123

Question 42

Cannon Manufacturing is considering issuing 15-year,8% annual coupon,$1,000 face value convertible bonds at a price of $1,000 each.Each bond would be convertible into 25 shares of common stock.If the bonds were not convertible,investors would require an annual yield of 10%.The stock's current price is $25.00,its expected dividend is $2.50,and its expected growth rate is 5%.The bonds are noncallable for 10 years.What is the bond's conversion value in Year 5?

A)$719.90
B)$757.79
C)$797.68
D)$837.56
E)$879.44

Question 43

Valdes Enterprises is considering issuing a 10-year convertible bond that would be priced at its $1,000 par value.The bonds would have an 8.00% annual coupon,and each bond could be converted into 20 shares of common stock.The required rate of return on an otherwise similar nonconvertible bond is 10.00%.The stock currently sells for $40.00 a share,has an expected dividend in the coming year of $2.00,and has an expected constant growth rate of 5.00%.What is the estimated floor price of the convertible at the end of Year 4?

A)$901.28
B)$924.39
C)$948.09
D)$972.41
E)$996.72

Question 44

The next 4 problems must be kept together; all use the data in Exhibit 20.1.
​Exhibit 20.1

Refer to Exhibit 20.1.What is the bond's initial conversion value when issued?

A)$698.15
B)$734.89
C)$773.57
D)$814.29
E)$857.14

Question 45

Bev's Beverages is negotiating a lease on a new piece of equipment that would cost $80,000 if purchased.The equipment falls into the MACRS 3-year class,and it would be used for 3 years and then sold,because the firm plans to move to a new facility at that time.The estimated value of the equipment after 3 years is $25,000.A maintenance contract on the equipment would cost $2,500 per year,payable at the beginning of each year.Alternatively,the firm could lease the equipment for 3 years for a lease payment of $23,000 per year,payable at the beginning of each year.The lease would include maintenance.The firm is in the 20% tax bracket,and it could obtain a 3-year simple interest loan,interest payable at the end of the year,to purchase the equipment at a before-tax cost of 8%.If there is a positive Net Advantage to Leasing the firm will lease the equipment.Otherwise,it will buy it.What is the NAL? (Note: MACRS rates for Years 1 to 4 are 0.33,0.45,0.15,and 0.07.)

A)$2,852
B)$2,994
C)$3,144
D)$3,301
E)$3,466

Question 46

Ellis Enterprises is considering whether to lease or buy some necessary equipment it needs for a project that will last the next 3 years.If the firm buys the equipment,it will borrow $4,800,000 at 8% interest.The firm's tax rate is 35% and the firm's before-tax cost of debt is 8%.Annual maintenance costs associated with ownership are estimated to be $300,000 and the equipment will be depreciated on a straight-line basis over 3 years.What is the annual end-of-year lease payment (in thousands of dollars)for a 3-year lease that would make the firm indifferent between buying or leasing the equipment? (Suggestion: Delete 3 zeros from dollars and work in thousands.)

A)$1,950
B)$2,052
C)$2,160
D)$2,268
E)$2,382

Question 47

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?

A)$8.00
B)$8.42
C)$8.84
D)$9.28
E)$9.75

Question 48

Herring Inc.is considering issuing 15-year,8% semiannual coupon,$1,000 face value convertible bonds at a price of $1,000 each.Each bond would be convertible into 25 shares of common stock.If the bonds were not convertible,investors would require an annual nominal yield of 10%.What is the straight-debt value of each bond at the time of issue?

A)$725.58
B)$763.76
C)$803.96
D)$846.28
E)$888.59

Question 49

Curry Corporation is setting the terms on a new issue of bonds with warrants.The bonds will have a 30-year maturity and annual interest payments.Each bond will come with 20 warrants that give the holder the right to purchase one share of stock per warrant.The investment bankers estimate that each warrant will have a value of $10.00.A similar straight-debt issue would require a 10% coupon.What coupon rate should be set on the bonds-with-warrants so that the package would sell for $1,000?

A)6.75%
B)7.11%
C)7.48%
D)7.88%
E)8.27%

Question 50

Carolina Trucking Company (CTC)is evaluating a potential lease for a truck with a 4-year life that costs $40,000 and falls into the MACRS 3-year class.If the firm borrows and buys the truck,the loan rate would be 9%,and the loan would be amortized over the truck's 4-year life.The loan payments would be made at the end of each year.The truck will be used for 4 years,at the end of which time it will be sold at an estimated residual value of $12,000.If CTC buys the truck,it would purchase a maintenance contract that costs $1,500 per year,payable at the end of each year.The lease terms,which include maintenance,call for a $10,000 lease payment (4 payments total)at the beginning of each year.CTC's tax rate is 35%.What is the net advantage to leasing? (Note: MACRS rates for Years 1 to 4 are 0.33,0.45,0.15,and 0.07.)

A)$609
B)$642
C)$678
D)$715
E)$751

Question 51

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)10.64%
B)11.20%
C)11.79%
D)12.38%
E)13.00%

Question 52

The next 4 problems must be kept together; all use the data in Exhibit 20.1.
​Exhibit 20.1

Refer to Exhibit 20.1.What is the bond's conversion ratio?

A)27.14
B)28.57
C)30.00
D)31.50
E)33.08

Question 53

Quaid Co.'s common stock sells for $28.00,pays a dividend of $2.10,and has an expected long-term growth rate of 6%.The firm's straight-debt bonds yield a 10.8% return.Quaid is planning a convertible bond issue.The bonds will have a 20-year maturity,pay a 10% annual coupon,have a par value of $1,000,and a conversion ratio of 25 shares per bond.The bonds will sell for $1,000 and will be callable after 10 years.Assuming that the bonds will be converted at Year 10,when they become callable,what will be the expected return on the convertible when it is issued?

A)10.36%
B)10.91%
C)11.48%
D)12.06%
E)12.66%

Question 54

Atlas Anglers Inc.is considering issuing a 15-year convertible bond that will be priced at its $1,000 par value.The bonds have a 6.5% annual coupon rate,and each bond can be converted into 20 shares of common stock.The stock currently sells at $30 a share,has an expected dividend in the coming year of $3,and has an expected constant growth rate of 5.5%.What is the estimated floor price of the convertible at the end of Year 3 if the required rate of return on a similar straight-debt issue is 9.5%?

A)$790.48
B)$830.01
C)$871.51
D)$915.08
E)$960.84

Question 55

Herbert Engineering is issuing new 15-year bonds that have warrants attached.If not for the attached warrants,the bonds would carry a 9% annual interest rate.However,with the warrants attached the bonds will pay a 6% annual coupon.There are 30 warrants attached to each bond,which has a par value of $1,000.What is the value of the straight-debt portion of the bonds?

A)$720.27
B)$758.18
C)$796.09
D)$835.89
E)$877.69

Question 56

The next 4 problems must be kept together; all use the data in Exhibit 20.1.
​Exhibit 20.1

Refer to Exhibit 20.1.What is the minimum price (or "floor" price)at which the Saunders' bonds should sell?

A)$698.15
B)$734.89
C)$773.57
D)$814.29
E)$857.14

Question 57

Upstate Water Company just sold a bond with 50 warrants attached.The bonds have a 20-year maturity and an annual coupon of 12%,and they were issued at their $1,000 par value.The current yield on similar straight bonds is 15%.What is the implied value of each warrant?

A)$3.76
B)$3.94
C)$4.14
D)$4.35
E)$4.56

Question 58

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)$652.55
B)$686.89
C)$723.05
D)$761.10
E)$799.16

Question 59

Warren Corporation's stock sells for $42 per share.The company wants to sell some 20-year,annual interest,$1,000 par value bonds.Each bond would have 75 warrants attached to it,each exercisable into one share of stock at an exercise price of $47.The firm's straight bonds yield 10%.Each warrant is expected to have a market value of $2.00 given that the stock sells for $42.What coupon interest rate must the company set on the bonds in order to sell the bonds-with-warrants at par?

A)7.83%
B)8.24%
C)8.65%
D)9.08%
E)9.54%

Question 60

The next 4 problems must be kept together; all use the data in Exhibit 20.1.
​Exhibit 20.1

Refer to Exhibit 20.1.What is the bond's straight-debt value at the time of issue?

A)$684.78
B)$720.82
C)$758.76
D)$798.70
E)$838.63