Deck 17: Hybrid and Derivative Securities

Question 1

Leasing is considered a source of financing provided by the lessee to the lessor.

Answer 1

False

Question 2

Derivatives are used by corporations as a useful tool for managing certain aspects of the firm's risk.

Answer 2

True

Question 3

An operating lease is often also referred to as a capital lease.

Answer 3

False

Question 4

A financial lease is often also referred to as a capital lease.

Question 5

The lessor is the receiver of the services of the assets under a lease whereas a lessee is the owner of the assets that are being leased.

Question 6

A direct lease is a lease under which the lessee sells an asset for cash to a prospective lessor and then leases back the same asset, making periodic payments for its use.

Question 7

A financial lease is a cancelable contractual arrangement whereby the lessee agrees to make periodic payments to the lessor, often for five or fewer years, for an asset's services.

Question 8

The following securities are all popular hybrid securities EXCEPT

A) financial leases.
B) convertible securities.
C) options.
D) stock purchase warrants.

Question 9

An operating lease is noncancelable and obligates the lessee to make payments for the use of an asset over a predefined period of time.

Question 10

A form of debt or equity financing that possesses characteristics of both is called a(n)

A) derivative security.
B) hybrid security.
C) option.
D) operating lease.

Question 11

A hybrid security is neither debt nor equity but instead derives its value from an underlying asset.

Question 12

An option is a security that is neither debt nor equity but derives its value from an underlying asset that is often another security.

Question 13

A hybrid security is a form of debt or equity financing that possesses characteristics of both debt and equity.

Question 14

A form of debt or equity financing that possesses characteristics of both debt and equity financing is called

A) hybrid security.
B) convertible security.
C) derivative security.
D) none of the above.

Question 15

Preferred stock is considered a hybrid security because it blends the characteristics of both bond and equity.

Question 16

A security that is neither debt nor equity but derives its value from an underlying asset is called a(n)

A) derivative security.
B) hybrid security.
C) option.
D) operating lease.

Question 17

The lease arrangement has many more restrictive covenants than those normally included as part of a long-term loan.

Question 18

The lessee is the receiver of the services of the assets under a lease whereas a lessor is the owner of the assets that are being leased.

Question 19

A derivative security is neither debt nor equity but instead derives its value from an underlying asset.

Question 20

If a lessee leases (under a financial lease) an asset that subsequently becomes obsolete, it can require the lessor to replace it with an equally productive asset in real term over the remaining term of the lease.

Question 21

A leveraged lease is a lease under which the lessee sells an asset for cash to a prospective lessor and then leases back the same asset, making fixed periodic payments for its use.

Question 22

An operating lease need not be capitalized, but its basic features must be disclosed in a footnote to the financial statements.

Question 23

If a lease meets any of the FASB Standard No. 13 criteria, it should be shown as a capitalized lease, meaning the present value of all its payments should be included as an asset and corresponding liability on the firm's balance sheet.

Question 24

When a firm becomes bankrupt or is reorganized, the maximum claim of lessors against the corporation is three years of lease payments.

Question 25

At the end of the term of the lease agreement, the salvage value of an asset, if any, is realized by the lessee.

Question 26

A ________ is normally initiated by a firm that needs funds for operations. An asset previously owned by a lessee is sold to the lessor.

A) direct lease
B) leveraged lease
C) sale-leaseback
D) capital lease

Question 27

Assets leased under ________ leases generally have a usable life longer than the term of the lease.

A) financial
B) operating
C) capital
D) direct

Question 28

________ lease is a contractual arrangement whereby the lessee agrees to make periodic payments to the lessor for five or fewer years for an asset's services. This type of lease may also be canceled at the option of the lessee.

A) A financial
B) An operating
C) A capital
D) A direct

Question 29

Leasing allows the lessee, in effect, to depreciate land, which is prohibited if the land were purchased.

Question 30

Renewal options are provisions frequently included in both operating and financial leases that allow the lessee to purchase the leased asset at maturity.

Question 31

One disadvantage of leasing is that in many cases, the return to the lessor is quite high so the firm in need of the asset might be better off borrowing to purchase it.

Question 32

A capital or capitalized lease is otherwise known as

A) an operating lease.
B) a financial lease.
C) a direct lease.
D) a leveraged lease.

Question 33

Since operating leases result in the receipt of services from an asset without increasing the assets or liabilities on the firm's balance sheet, leasing may result in misleading financial ratios.

Question 34

Renewal options normally require the lessor to maintain the assets and to make insurance and tax payments.

Question 35

One advantage of leasing is that in many cases, the return to the lessor is quite high so the firm in need of the asset might be better off borrowing to purchase it.

Question 36

A capitalized lease is a financial lease that has the present value of all its payments included as an asset and corresponding liability on the firm's balance sheet.

Question 37

Purchase options are provisions frequently included in both operating and financial leases that allow the lessee to purchase the leased asset at maturity.

Question 38

In a financial lease, the lessor must receive more than the asset's purchase price in order to earn its required return. However, in an operating lease, the total payments made by the lessee to the lessor are generally less than the lessor's initial cost of the leased asset.

Question 39

Maintenance clauses are provisions normally included in an operating lease that require the lessor to maintain the assets and to make insurance and tax payments.

Question 40

Renewal options are provisions normally included in an operating lease that grant the lessee the right to re-lease assets at the expiration of the lease.

Question 41

A cancelable contractual arrangement whereby the lessee agrees to make periodic payments to the lessor, often for 5 or fewer years, to obtain an asset's services is called a(n)

A) operating lease.
B) financial lease.
C) capital lease.
D) direct lease.

Question 42

The consequences of missing a financial lease payment are ________ those of missing an interest or principal payment on debt.

A) less severe than
B) the same as
C) more severe than
D) unrelated to

Question 43

Disadvantages of leasing from the lessee's perspective include all of the following EXCEPT

A) the return to the lessor is quite high.
B) prohibition on leasehold improvements.
C) under a financial lease, an asset may subsequently become obsolete.
D) the maximum claim of the lessor in the event of bankruptcy is three years of lease payments.

Question 44

The conversion ratio is the ratio at which a convertible security can be exchanged for a nonconvertible security.

Question 45

All of the following must be considered when making a lease-versus-purchase decision EXCEPT

A) the after-tax cash flows for each year under the lease alternative.
B) the after-tax cash flows for each year under the purchase alternative.
C) the present value of all cash flows.
D) the depreciation expense under the lease.

Question 46

Dwyer Corporation is determining whether to lease or purchase new equipment. The firm is in the 38% tax bracket, and its after-tax cost of debt is currently 7%. The terms of the lease and the purchase are: Lease: Annual end-of-year lease payments of $31,500 are required over the 3-year life of the lease. All maintenance costs will be paid by the leasor; insurance and other costs will be borne by the lessee. The lessee will exercise it option to purchase the equipment for $6000 at the termination of the lease.
Purchase: The equipment, costing $77,000, can be financed entirely with a 12% loan requiring annual end-of-year payments of $32,059 for 3 years. The firm will depreciated the equipment under MACRS using a 3-year recovery period (33% in year 1, 45% in year 2, 15% in year 3 and 7% in year 4). The firm will pay $2000 per year for a service contract that covers maintenance costs; insurance and other costs will be borne by the firm. The firm plans to keep the equipment and use it beyond its 3-year recovery period.
Calculate the present value of the cash outflow for both the lease and purchasing and recommend one alternative.

A) The present value of the cash outflow for the lease is $56,151 and for purchasing is $56,775, therefore Dwyer should choose the lease.
B) The present value of the cash outflow for the lease is $56,151 and for purchasing is $56,775, therefore Dwyer should choose purchasing.
C) The present value of the cash outflow for the lease is $64,590 and for purchasing is $65,398, therefore Dwyer should choose the lease.
D) The present value of the cash outflow for the lease is $51,178 and for purchasing is $51,703, therefore Dwyer should choose the lease.

Question 47

Bessey Aviation is considering leasing or purchasing a small aircraft to transport executives between manufacturing facilities and the main administrative headquarters. The firm is in the 40 percent tax bracket and its after-tax cost of debt is 7 percent. The estimated after-tax cash flows for the lease and purchase alternatives are given below: (a) Given the above cash outflows for each alternative, calculate the present value of the after-tax cash flows using the after-tax cost of debt for each alternative.
(b) Which alternative do you recommend? Why?

Question 48

The total payments of ________ lease over the lease period are greater than the cost of the leased asset to the lessor.

A) a financial
B) an operating
C) a serial
D) a direct

Question 49

Advantages of leasing from the lessee's perspective include all of the following EXCEPT

A) capability of effectively depreciating land.
B) ability to avoid restrictive covenants that are normally part of a long-term loan.
C) benefit of the salvage value at the end of the term of the lease reverts to the lessor.
D) 100 percent financing.

Question 50

________ leases are noncancelable and are generally used for leasing land, buildings, and large pieces of fixed equipment.

A) Financial
B) Operating
C) Serial
D) Direct

Question 51

A noncancelable arrangement that requires the lessee to make payments for the use of an asset over a relatively long period of time is called a(n)

A) operating lease.
B) financial lease.
C) sale-leaseback arrangement.
D) direct lease.

Question 52

In a ________, the lessor acts as an equity participant supplying part of the necessary capital while a lender supplies the remaining balance.

A) direct lease
B) leveraged lease
C) sale-leaseback
D) capital lease

Question 53

Lisa's Riding Equipment Company has entered into two lease arrangements. One lease is an operating lease on an office copier requiring annual lease payments of $2,000 for the next three years. The other lease is a 15-year financial lease on a building requiring annual lease payments of $150,000. If the firm's discount rate is 10 percent, how should each lease be presented on the firm's balance sheet?

Question 54

The conversion feature permits the firm's capital structure to be changed without increasing the total financing.

Question 55

FASB Standard No. 13 requires explicit disclosure of ________ obligation on the firm's balance sheet. For this type of lease, the present value for all of its payments is shown as an asset and the total lease payment obligation is included as a liability on the firm's balance sheet.

A) an operating lease
B) a leveraged lease
C) a sale-leaseback
D) a capital lease

Question 56

A lease under which a lessor owns or acquires the assets that are leased to a given lessee is called a(n)

A) operating lease.
B) financial lease.
C) sale-leaseback arrangement.
D) direct lease.

Question 57

A lease under which a lessor acts as an equity participant supplying only about 20 percent of the cost of the asset, while a lender supplies the balance is called a(n)

A) operating lease.
B) leveraged lease.
C) sale-leaseback arrangement.
D) direct lease.

Question 58

FASB Standard No. 13 establishes requirements for the explicit disclosure of certain types of lease obligations on the firm's balance sheet. To qualify as a capital lease, any of the following elements may be present EXCEPT

A) the lease transfers ownership of the property to the lessee by the end of the lease.
B) the lease contains an option to purchase the property at a "bargain" price.
C) the lease term is less than 75 percent of the economic life of the property.
D) at the beginning of the lease, the present value of the lease payment is equal to 90 percent or more of the fair market value of the leased property less any investment tax credit received by the lessor.

Question 59

A lease under which a lessee sells an asset for cash to a prospective lessor and then leases back the same asset is called a(n)

A) operating lease.
B) leveraged lease.
C) sale-leaseback arrangement.
D) direct lease.

Question 60

The type of lease in which the lessor acquires or purchases the asset in order to lease to a given lessee is known as

A) a financial lease.
B) a direct lease.
C) an operating lease.
D) a leveraged lease.

Question 61

In case of an overhanging issue, if the firm were to call the issue, the bondholders would accept the call price rather than convert the bonds.

Question 62

Diluted earnings per share (EPS) are found by adjusting basic EPS for the impact of converting all convertibles and exercising all warrants and options that would have diluting effects on the firm's earnings.

Question 63

The conversion price is the value of a convertible security as measured by the market price of the common stock into which it can be converted.

Question 64

Converting a convertible security is beneficial when the market price of the common stock into which it can be converted is greater than its conversion price.

Question 65

By using convertible bonds, the issuing firm can temporarily raise debt, which is typically less expensive than common stock, to finance projects.

Question 66

An overhanging issue is a convertible security that cannot be forced into conversion by using the call feature.

Question 67

Since the purchaser of a convertible security is given an opportunity to become a common stockholder and to share in the firm's future success, convertibles can normally be sold with higher interest rates than nonconvertibles.

Question 68

The conversion ratio can be obtained by dividing the par value of the convertible by the conversion price.

Question 69

Contingent securities such as convertibles, warrants, and stock options affect the reporting of a firm's earnings per share (EPS).

Question 70

The conversion feature, which can be part of either a bond or preferred stock, permits the firm to raise additional funds at some point in the future by selling common stock, thereby shifting the company's capital structure to a less highly levered position.

Question 71

Since the conversion feature provides the purchaser of a convertible bond with the possibility of becoming a stockholder, convertible bonds are generally a less expensive form of financing than similar-risk nonconvertible or straight bonds.

Question 72

When the market price of the common stock exceeds the conversion price, the conversion (or stock) value exceeds the par value of the convertible security.

Question 73

Because a security is first sold with a conversion price above the current market price of the firm's stock, conversion is initially not attractive.

Question 74

Convertibles can be used as a form of deferred common stock financing.

Question 75

Contingent securities such as common stocks and bonds affect the reporting of a firm's earnings per share (EPS).

Question 76

Convertibles can normally be sold with lower interest rates than non-convertibles.

Question 77

A conversion feature is an option that is included as part of a common stock issue that allows its holder to change the stock into a stated number of shares of preferred stock.

Question 78

Common stock equivalents are all contingent securities that derive a major portion of their value from their conversion privileges or common stock characteristics.

Question 79

The presence of contingent securities such as warrants and stock options affects the reporting of the firm's earnings per share.

Question 80

One motive for issuing convertibles is that convertible securities can be issued with far fewer restrictive covenants than nonconvertibles.