Hybrid Financing
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21-02-2011, 09:36 AM

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Hybrid Financing
Preferred Stock, Leasing, Warrants, and Convertibles

 Preferred stock
 Leasing
 Warrants
 Convertibles
 Often referred to as “off balance sheet” financing if a lease is not “capitalized.”
 Leasing is a substitute for debt financing and, thus, uses up a firm’s debt capacity.
 Capital leases are different from operating leases:
 Capital leases do not provide for maintenance service.
 Capital leases are not cancelable.
 Capital leases are fully amortized.
Analysis: Lease vs. Borrow-and-buy Data:
 New computer costs $1,200,000.
 3-year MACRS class life; 4-year economic life.
 Tax rate = 40%.
 kd = 10%.
 Maintenance of $25,000/year, payable at beginning of each year.
 Residual value in Year 4 of $125,000.
 4-year lease includes maintenance.
 Lease payment is $340,000/year, payable at beginning of each year.
Depreciation schedule
In a lease analysis, at what discount rate should cash flows be discounted?

 Since cash flows in a lease analysis are evaluated on an after-tax basis, we should use the after-tax cost of borrowing.
 Previously, we were told the cost of debt, kd, was 10%. Therefore, we should discount cash flows at 6%.
A-T kd = 10%(1 – T) = 10%(1 – 0.4) = 6%.
Cost of Owning Analysis
Notes on Cost of Owning Analysis

1. Depreciation is a tax deductible expense, so it produces a tax savings of T(Depreciation). Year 1 = 0.4($396) = $158.4.
2. Each maintenance payment of $25 is deductible so the after-tax cost of the lease is (1 – T)($25) = $15.
3. The ending book value is $0 so the full $125 salvage (residual) value is taxed, (1 - T)($125) = $75.0.
Cost of Leasing Analysis
 Each lease payment of $340 is deductible, so the after-tax cost of the lease is
(1-T)($340) = -$204.
 PV cost of leasing (@6%) = -$749.294.
Net advantage of leasing
 NAL = PV cost of owning – PV cost of leasing
 NAL = $766.948 - $749.294
= $17.654
 Since the cost of owning outweighs the cost of leasing, the firm should lease.

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