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Finance Problem Set: Leasing, Warrants and Convertibles

Connors Construction needs a piece of equipment that can be leased or purchased. The equipment costs $100. One option is to borrow $100 from the local bank and use the money to buy the equipment. The other option is to lease the equipment. The company's balance sheet prior to the equipment purchase or lease is shown below.
Current assets $300 Debt $400
Fixed assets 500 Equity 400
Total assets $800 Total liabilities and equity $800
What would be the company's debt ratio if it chose to purchase the equipment? What would be the company's debt ratio if it leased the equipment and it could keep the lease off its balance sheet? Is the company's financial risk any different whether the equipment is leased or purchased? Explain.

Gregg Company recently issued two types of bonds. The first issue consisted of 20-year straight (no warrants attached) bonds with an 8% annual coupon. The second issue consisted of 20-year bonds with a 6% annual coupon with warrants attached. Both bonds were issued at par ($100). What is the value of the warrants that were attached to the second issue?

Petersen Securities recently issued convertible bonds with a $1,000 par value. The bonds have a conversion price of $40 per share. What is the bond's conversion ratio, CR?

Morris-Meyer Mining Company must install $1.5 million of new machinery in its Nevada mine. It can obtain a bank loan for 100% of the required amount. Alternatively, a Nevada invesment banking firm that represents a group of investors believes that it can arrange for a lease financing plan. Assume that the following facts apply:
1. The equipment falls in the MACRS 3-year class. The applicable MACRS rates of 33%, 45%, 15%, and 7%.
2. Estimated maintenance expenses are $75,000 per year.
3. Morris-Meyer's federal-plus-state tax rate is 40%.
4. If the money is borrowed, the bank loan will be at a rate of 15%, amortized in 4 equal installments to be paid at the end of each year.
5. The tentative lease terms call for end-of-year payments of $400,000 per year for 4 years.

Pogue Industries Inc. has warrants outstanding that permits its holders to purchase 1 share of stock per warrant at a price of $21. (Refer to Chapter 18 for Parts a, b, c.).
a. Calculate the exercise value of Pogue's warrants if the common stock sells at each of the following prices: $18, $21, $45, and $70.
b. At hat approximate price do you think the warrants would sell under each condition indicated in Part a? What premium is implied in your price? Your answer will be a guess, but your prices and premiums should bear reasonable relationships to each other.
c. How would each of the following factors affect your estimates of the warrants' prices and premiums in Part b?
1. The life of the warrant is lengthened.
2. The expected variability (sigma_p) in the stock's price decreases.
3. The expected growth rate in the stock's EPS increases.
4. The company announces the following change in dividend policy: Whereas it formerly paid no dividends, henceforth it will pay out all earnings as dividends.
d. Assume that Pogue's stock now sells for $18 per share. The company wants to sell some 20-year, annual interest, $1,000 par value bonds. Each bond will have 50 warrants, each warrant entitles the holder to buy 1 share of stock at a price of $21. Pogue's pure bonds yield 10%. Regardless of your answer to Part b, assume that the warrants will have a market value of $1.50 when the stock sells at $18. What annual coupon interest rate and annual dollar coupon must the company set on the bonds with warrants if the bonds are to clear the market (i.e., the market is in equilibrium)? Round to the nearest dollar or percentage point.

Solution Preview

Please see the attached Excel file for your tutorial. Please note that there is one worksheet per problem for a total of 5 sheets.

Question a:
Selling price Warrant exercise price Higher Value
$18 $21 No ZERO
$21 $21 No ZERO
$25 $21 Yes ($25-$21)=$4
$70 $21 Yes ($70-$21)=$49

Remember that the ...

Solution Summary

The solution discuses leasing, warrants and convertibles in the finance problem set.