Hybrid Securities

Chapter 17
Overview of Hybrids and
Derivatives

Hybrid Security – a form of debt and equity financing that
possesses characteristics of both debt and equity
financing

Example: Preferred stock, Financial or Capital Lease,
Convertible securities and Bonds with attached stock
purchase warrants

Derivative Security – A security that is neither debt not
equity but derives its value from an underlying asset that
is often another security

Example: Options
Financial Lease

Financial Lease- a longer-term lease than an operating
lease that is non-cancelable and obligates 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

Techniques for obtaining assets to be leased
1. Direct Lease- lessor owns the assets that are leased
2. Sale-leaseback arrangement- lessee sells the asset then
leases it back
3. Leveraged lease- lessor as equity participant (20% of cost)
and third-party lenders supplies the balance
Financial Lease

Lease vs. purchase decision- the decision facing the firm
needing to acquire new fixed assets: whether to lease
the assets or to purchase them, using borrowed funds or
available liquid resources

Apply Net Present Value in evaluating the leasing and

purchasing alternatives
Leave-Purchase Analysis

STEP 1- Compute for after-tax cash outflows for each
year under lease alternative

STEP 2- Compute for after-tax cash outflows for each

year under purchase alternative

STEP 3- Calculate present value of cash outflows for

both alternatives using after-tax cost of debt

STEP 4- Choose alternative with lower present value of

cash outflows
 Lease vs. Purchase
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% tax bracket and its
after-tax cost of debt is 7%. The estimated after-tax cash
flows for the lease and purchase alternatives are given
below:
End of Year Lease Purchase
1 -64,329 -68,454
2 -64,329 -59,110
3 -64,329 -63,596
4 -64,329 -66,663
5 64,329 30,056
Answer

PV of lease (172,030) or (172,015)

PV purchase- (196,945) or (196,192)

Bessey should lease aircraft
 Advantages and Disadvantages
of Leasing over Purchasing

Advantages
Disadvantages
1. Avoid cost of obsolescence 1. Return to the lessor is high

2. Avoid restrictive covenants 2. Salvage value of the asset

3. Financing flexibility (for low- is realized by lessor

cost assets infrequently 3. Prohibited from making
acquired) improvements without prior
4. Increase liquidity (sale- approval
leaseback) 4. Lease payments are still

5. Lease payment on land is tax due even if the asset

deductible becomes obsolete
6. Better financial ratios (operating
lease)
7. 100% financing

8. Lower claim in case of

bankruptcy
 Convertible Securities

Conversion feature- an option included as part of a
bond or preferred stock that allows its holder to change
the security into a stated number of shares of common
stock

Straight bond- bond without conversion feature

Convertible bond- a bond that can be changed into a
specified number of shares of common stock

Straight preferred stock- preferred stock that is

nonconvertible

Convertible preferred stock- preferred stock that can be
changed in to a specified number of shares of common
stock
 Convertible Securities

General Features
1. Conversion ratio- ratio at which a convertible
security can be exchanged for common stock
2. Conversion price- per-share price paid for
common stock as the result of conversion
3. Conversion (stock) value- value of the convertible
security by multiplying conversion ratio by the
current market price of common stock
Convertible Securities
Marks-Write Pen Company has an outstanding issue of
convertible bonds with a P1,000 par value. These bonds
are convertible into 50 shares of common stock. They
have a 10 percent coupon and a 10-year maturity. The
interest rate on a straight bond of similar risk is 8
percent. The market price of the stock is P30/share.

A firm has outstanding convertible preferred stock with a

P50 par value which is convertible at P16.67 per share
of common stock. The current market price of a share of
common stock is P15.
Answer
Marks-Write Pen Firm
Conversion ratio 50 3
(P50/ 16.67)
Conversion Price P20 P16.67
(P1,000 / 50)
Conversion Value P1,500 P45
(50 x P30) (3 x P15)
Convertible Securities

Motives of convertible financing

Deferred common stock financing

Use as a “sweetener” for financing

Fewer restrictive covenants

Raise cheap funds temporarily

Convertible gives investors the chance to experience
attractive capital gains while taking less risk resulting to
a market premium

Market Premium- the amount by which the market value
exceeds the straight or conversion value
Convertible Securities

Other features
1. Call feature- enables issuer to encourage or
“force” conversion

2. Call price- stated price at which a security may

be repurchased, generally exceed par value
equal to 1 year stated interest

3. Overhanging issue- a convertible security that

cannot be forced to conversion using the call
feature
Value of Convertible Bond

3 values of convertible bond:
1. Straight bond value- price at which it would sell in the
market without the conversion feature; equals present
value of interest and principal discounted using interest
rate of nonconvertible bond
2. Conversion value- market price of common stock into
which the security can be converted
3. Market value- likely to be greater than straight value or
conversion value; market premium is the amount by which
market value exceeds the straight or conversion value
Values and Market Premium
 Stock Purchase Warrants

an instrument that gives its holder the right to purchase
certain number of shares of common stock at a
specified price over a certain period of time

Motives of warrants

Use as a “sweetener” for financing

Lower interest rates or fewer restrictive covenants

Key characteristics
1. Exercise (or option) price- price at which holders can
purchase a specified number of shares of common
stock
2. Detachable- can sell the warrant without selling the
security
Stock Purchase Warrants

Key characteristics
3. Implied price- price effectively paid fro each warrant
attached to a bond; =price of bonds with warrants
less straight bond value
4. Theoretical value (TVW)- expected price of a warrant
TVW = (P0- E) x N

Combination of positive investor expectation and

leverage opportunities results to warrant premium

Warrant premium- difference of market value and
theoretical value
Stock Purchase Warrants
Goldie’s Pet Store has warrants that allow the purchase of
two shares of its outstanding common stock at P30 per
share. The common stock price per share is P34 and
the market value of the warrant is P8. Compute for:
1. Theoretical value of the warrant

2. Market premium of the warrant

3. Goldie’s gain if stock price goes up to P40

4. Goldie’s loss if stock price declines to P28

Answer
1. (34-30) x 2 = 8
2. 8-8 = 0
3. If stock price goes up to P40: (2 x 10)-8 = 12
4. If stock price declines to P28: (2x -2) -8= -12

Warrants have higher return and higher risk than

underlying stock (leverage opportunities)
Options

an instrument that provides holder an
opportunity to purchase or sell a specified asset
at a stated price on or before expiration date;
Different from real options

Three basic forms:
1. (Preemptive) Rights- financial instruments that permit
stockholders to purchase additional shares at a price
below market price, in direct proportion to their
number of owned shares; serves as protection from
dilution of ownership when new shares are issued
2. Warrants (detached)
3. Calls and Puts
Options

Types of options:
1. Call- option to purchase a specified number of shares
of stock (typically 100) on or before a specified future
date at a stated price (striking price)
2. Put- option to sell a specified number of shares of
stock (typically 100) on or before a specified future
date at a stated price (striking price)

Option premium- call option’s market price, price one

must pay to acquire the right to buy the stock at the
strike price
 Options

Role of Call and Put
1. Issued by investors and option exchanges, not by businesses
2. Not a source of financing to the firm
3. Used by investors to earn returns or protect returns already
earned

Currency option- widely used to hedge foreign currency
exposures, right to purchase or sell a specific currency at a
fixed price

Hedging- offsetting or protecting against the risk of adverse
price movements while preserving possibility of profiting
from favorable price movements

Futures or forward exchange contract- a contract to
purchase or sell a currency at a stated price or rate of
another currency at some future, specified date
Effect on EPS

Contingent securities- convertibles, warrants and stock
options

If converted or exercised, would dilute (lower) EPS

Basic EPS-calculated without regard to any contingent

securities

Diluted EPS- calculation under the assumption that ALL
contingent securities are converted and exercised, and
are therefore common stock
Seatwork 4

Identify whether the following characteristics is that of a convertible,
warrant and/or option
1. Lower the required interest rate on debt
2. Enhanced marketability of a security
3. Stabilizes the firm’s share price in the market
4. Detachable
5. Results to new equity capital when used
6. Exercise of which increases CS outstanding
7. Issued by investors (individuals and other firms)
8. Results to fewer restrictive covenants
9. Results to reduction of debt
10. Used for managing certain aspects of the firm’s risk
Answer
1. C, W
2. C, W

3. O

4. W

5. C, W

6. C, W

7. O

8. C, W

9. C

10.O
End of Chapter 17