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

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Question 1

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Atlas Anglers Inc.is considering issuing a 16-year convertible bond that will be priced at its $1,000 par value.The bonds have a 7.5% annual coupon rate,and each bond can be converted into 21 shares of common stock.The stock currently sells at $38.00 a share,has an expected dividend in the coming year of $3.80,and has an expected constant growth rate of 5.9%.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 9.8%? Do not round your intermediate calculations.

A) $947.74
B) $758.19
C) $1,184.68
D) $1,089.90
E) $852.97

F) A) and B)
G) C) and D)

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Question 2

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Which of the following statements concerning warrants is 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.

F) None of the above
G) A) and B)

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Question 3

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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 8.0% interest.The firm's tax rate is 35%,and the firm's before-tax cost of debt is 8.0%.Annual maintenance costs associated with ownership are estimated to be $400,000,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. ) Do not round your intermediate calculations.

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

Carolina Trucking Company (CTC) is evaluating a potential lease for a truck with a 4-year life that costs $41,000 and falls into the MACRS 3-year class.If the firm borrows and buys the truck,the loan rate would be 9.6%,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 it will be sold at an estimated residual value of $12,800.If CTC buys the truck,it would purchase a maintenance contract that costs $1,900 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. ) Do not round your intermediate calculations.

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

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.

Herring Inc.is considering issuing 18-year,9.0% 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 11.8%.What is the straight-debt value of each bond at the time of issue? Do not round your intermediate calculations.

Exhibit 20.1 ​ The following data apply to Saunders Corporation's convertible bonds: $\begin{array}{lrlr}\text { Maturity } & 13 & \text { Stock price } & \$ 34.00 \\\text { Par value } & \$ 1,000 & \text { Conversion price } & \$ 43.00 \\\text { Annual coupon } & 5.20 \% & \text { Straight-debt yield } & 9.80 \%\end{array}$ -Refer to Exhibit 20.1.What is the bond's initial conversion value when issued?

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.

Exhibit 20.1 ​ The following data apply to Saunders Corporation's convertible bonds: $\begin{array}{lrlr}\text { Maturity } & 13 & \text { Stock price } & \$ 34.00 \\\text { Par value } & \$ 1,000 & \text { Conversion price } & \$ 43.00 \\\text { Annual coupon } & 5.20 \% & \text { Straight-debt yield } & 9.80 \%\end{array}$ -Refer to Exhibit 20.1.What is the bond's conversion ratio?

Its investment bankers have told Donner Corporation that it can issue a 25-year,7.6% 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 1.3%,which would represent an after-tax risk premium.What coupon rate must be set on the preferred in order to issue it at par? Do not round your intermediate calculations.

Bev's Beverages is negotiating a lease on a new piece of equipment that would cost $87,000 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 $33,000.A maintenance contract on the equipment would cost $2,700 per year,payable at the beginning of each year.Alternatively,the firm could lease the equipment for 3 years for a lease payment of $20,200 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 8.3%.If there is a positive Net Advantage to Leasing,then the firm will lease the equipment.Otherwise,the firm 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. ) Do not round your intermediate calculations.

Which of the following statements about convertibles is CORRECT?

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

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.

Accounting Standards Codification Topic 840 (also known as ASC 840) requires that for an unqualified audit report,financial (or capital) leases must be included in the balance sheet by reporting the

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

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 18 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 $13.90.A similar straight-debt issue would require a 12.0% coupon.What coupon rate should be set on the bonds-with-warrants so that the package would sell for $1,000? Do not round your intermediate calculations.

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 8.8% 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 $1,750,000 each.How much larger or smaller is the bank loan payment than the lease payment? Note: Subtract the loan payment from the lease payment.Do not round your intermediate calculations.