ACS310: Finance

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ACS310 Finance

• Hybrid and Derivative Securities
• (Lecture 15)

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Hybrids and Derivatives

• Hybrid debt or equity that shares
  characteristics of both forms of security.

Example Warrants

• Derivative neither debt nor equity, but derives
  value from an underlying asset that is generally
  another security.

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Derivatives (Contd)

• Not used to raise funds
• Useful tool for managing certain aspects of
  firms risk
• Can hedge risk of a portfolio of securities
• Alternative investment strategy

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Leasing
Lessee control of And use of assets
Lessor owner of asset
Contractual, Periodic, Tax deductible Pmts for
use of fixed asset

• Operating Leases
• Short term, cancellable.

5 yrs or less
May be a fee to cancel
NOTE Generally, total pmts over lease lt Total
Initial Cost of Asset
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Leasing (contd)

• Financial (Capital) Leases
• Long term, non-cancelable.
• Regulation 3065 Lease
• Transfers ownership at end of lease period.
• Lessee has option to purchase below fair value.
• Lease term generally more than 75 economic life.
• Start of lease Present Value 90 fair value.

CICA defines Fin. Lease As having one Or more
of These elements
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Leasing Arrangements
Lessor owns or acquire assets that are leased to
a given lessee

• Direct Lease
• Sale-leaseback arrangement
• Leveraged Leases

• Common with Op. Leases
• Lessor maintains the asset
• Lessor pays taxes and insurance

Three techniques for lessors to obtain assets to
be leased
Lessee sells lessor asset for cash and then
leases back same asset

• Common with Op leases
• Grant lessee option to re-lease assets at
  expiration of lease

One or more third party lenders lessor acts as
equity participant

• Maintenance clauses
• Renewal Options
• Purchase Options

• Common with Op and fin. Leases
• lessee able to purchase asset at maturity
• price is usually specified

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Lease vs. Purchase Decision

• Alternatives lease asset, borrow to purchase
  asset, purchase asset with available liquid
  resources.
• Decision can be made using NPV.
• Cash flows and Discount Rate Issues
• Cost of asset
• Yearly lease payments
• Tax shield from CCA
• Salvage value
• Tax shield from CCA upon salvage
• Investment tax credits available on asset

Relationship to earlier Chapters
Chapter 12 and 13
NPV gt or 0
Accept (acquire asset)
Assumption value of asset is in use, not
ownership
Purchase or Lease?
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Table 16.1 Example

• NPVL Incremental Cost 56,000
• - PV (tax shield from CCA) -18,138
• - PV (salvage) - 4,467
• PV (tax shield loss from salvage) 1,489
• - PV (after tax lease payments) -34,171
• NPVL 713

NOTE Lease pmts are required at the beginning of
the lease
Annuity due analysis is used
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Pros and Cons of Leasing

• Advantages
• Total cost of lease less than purchase
• Avoid obsolescence cost
• Avoid loan covenants
• Increase liquidity
• Allows land depreciation
• Provides 100 financing

• Disadvantages
• Lessor return high
• Lessor retains salvage value
• Restrictions on improvements
• Obsolescence may occur before end of lease

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Types of Convertible Securities
Usually sell with lower stated dividend than
straight preferred shares of comparable risk

• Convertibility normally implies having a call
  feature that allows the asset to be changed from
  debt instrument to equity.
• Convertible Bonds debentures, convert to
  equity.
• Convertible Preferred Shares, convert to common
  shares.

WHY?
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General Features of Convertibles

• Conversion Ratio
• Number of shares into which the security may be
  converted.
• Conversion price gives the par value of the
  conversion ratio. (i.e. per share price)
• Conversion (or Share) Value, measured in market
  price.

Of the CSs into which it can be converted
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General Features (continued)
Stock options
All Contingent securities are treated as CS

• Contingent securities
• Basic Earnings Per Share, do not account for the
  number of contingent shares.
• Diluted EPS, accounts for the number of
  contingent shares converted into common shares.

warrants
convertibles
Lowers EPS
WHY?
EPS EAC / CS Outstanding
Therefore, EPS reporting is same as before, for
this part
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Financing with Convertibles

• Effectively a form of deferred common share
  financing.
• Convertibles can normally be sold with lower
  interest rates than non-convertibles.
• Convertible securities can be issued with fewer
  restrictive covenants than non-convertibles.
• Overhanging issue, may cause firm to repay bond
  at its par value (more than the call premium).

NOTE Can raise cheap funds temporarily, since
debt is less exp. than CS
Thereby decreasing coupon rate of debt for firm
Investors view convs as equity
Therefore, covenants arent as important to them
Conv. Sec. that cannot be forced into conversion
using a call feature
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Determining Value of a Convertible Bond

• Straight Bond Value (as if non-convertible).
• Conversion (or Share) Value.
• Market Value or premium, amount by which straight
  or converted value exceeded in the share market.

Chapter 8
Check out Figure 16.1 for relationships between
above
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Figure 16.1 Values and Market Premium
Convertible Bond
Stock price is high enough to cause conversion
value gt straight bond value
Benefit greatest to investors at this point
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Warrants Basic Characteristics

• An instrument giving the right to purchase shares
  at specified price, within specified time.
• Exercise price.
• Warrant Tradinglisted on TSX.
• Like convertibles, warrants result in new equity
  capital when exercised.

Attached to debt issues as sweeteners

• 10-20 above mtk price
• price at which CS can be purchased by warrant
  holder

Reduction in leverage
WHY?
Increase in equity
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Warrants (continued)

• Implied price of a warrant is the effective price
  paid for a warrant attached to a bond.
• Warrant premium is the difference between market
  value and theoretic value of warrant.
• Intrinsic Value of a Warrant is the difference
  between Market Price of shares and Exercise Price
  of warrant.
• (16.2) IVW P0 - E

Have both a mkt value and intrinsic value like
that of convertibles
WP PW - IVW
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Figure 16.2 Values and Warrant Premium
Always above the intrinsic value except at pt of
expiry
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Options
Type of derivative security

• Options are contracts giving right to buy or sell
  an asset at stated price before expiration date.
• Call Option an option to buy.
• Put Option an option to sell.
• Strike Price Price at which the option can be
  executed.

BASIC FORMS
Ch. 6

• Rights
• Warrants
• Puts and Calls

Set close to market price
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Option Trading

• Canadian Derivatives Clearing Corporation (CDCC)
  issues, guarantees and clears all options
  contracts in Canada.
• Options Contracts trade on the TSX and ME.
• Option Contracts serve as hedges against market
  price movements these are not a source of
  funding for the firm.

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Options (contd)

• NOTE Premium for an option is based on 7 factors

3) Time to expiry
1) Exercise Price
6) Interest rate level
5) Dividend history
2) Current mkt price
4) Volatility of CS
7) Supply and demand factors