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Finance Problem Set: Leasing, Warrants and Convertibles

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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.

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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.

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Finance Issues

A few problems related to business finance.

Problem Set 3:

Ross: Chapter 3 - Problems: 3.2, 3.4
3.2 Cheryl Colby, the CFO of Charming Florist Ltd., has created the firm's pro forma balance sheet for the next fiscal year. Sales are projected to grow at 10 percent to the level of $330 million. Current assets, fixed assets, short-term debt, and long-term debt are 25 percent, 150 percent, 40 percent, and 45 percent of the total sales, respectively. Charming Florist pays out 40 percent of net income. The value of common stock is constant at $50 million. The profit margin on sales is 12 percent.
a. Based on Ms. Colby's forecast, how much external fund does Charming Florist need?
b. Reconstruct the current balance sheet based on the projected figures.
c. Lay out the firm's pro forma balance sheet for the next fiscal year.

Chapter 13 - Problems: 13.3, 13.17
13.3 Which of the following statements are true about the efficient-market hypothesis?
1. It implies perfect forecasting ability.
2. It implies that prices reflect all available information.
3. It implies an irrational market.
4. It implies that prices do not fluctuate.
5. It results from keen competition among investors.
13.7 Newtech Corp. is going to adopt a new chip-testing device that can greatly improve its production efficiency. Do you think the lead engineer can profit from purchasing the firm's stock before the news release on the device? After reading the announcement in The Wall Street Journal, should you be able to earn an abnormal return from purchasing the stock? Assume market.

Chapter 14 - Problems: 14.3, 14.11

14.3 Ulrich Inc.'s articles of incorporation authorize the firm to issue 500,000 shares of $5 per value common stock, of which 325,000 shares have been issued. Those shares were sold at an average of 12 percent over par. In the quarter that ended last week, Ulrich earned $260,000 net income; 4 percent of that income was paid as a dividend. Prior to the close of the books, Ulrich had $3,545,000 in retained earnings. The company owns no treasury stock.
1. Create the equity statement for Ulrich.
2. Create a new equity statement that reflects the sale of 25,000 authorized but unissued shares at the price of $4 per share.
14.11 The Cable Company has $1 million of positive NPV projects it would like to take advantage of. If Cable's managers follow the historical pattern of long-term financing for U.S. industrial firms, what will their financing strategy be?

Chapter 15 - Problems: 15.2, 15.4,
Acetate, Inc., has equity with a market value of $20 million and debt with a market value of $10 million. The cost of the debt is 14 percent per annum. Treasury bills that mature in one year yield 8 percent per annum, and the expected return on the market portfolio over the next year is 18 percent. The beta of Acetate's equity is 0.9. The firm pays no taxes.
1. What is Acetate's debt-equity ratio?
2. What is the firm's weighted average cost of capital?
3. What is the cost of capital for an otherwise identical all-equity firm?
The Veblen Company and the Knight Company are identical in every respect except that Veblen is not levered. The market value of Knight Company's 6-percent bonds is $1 million. Financial information for the two firms appears below. All earnings streams are perpetuities. Neither firm pays taxes. Both firms distribute all earnings available to common stockholders immediately.
Veblen Knight
Projected operating income $ 300,000 $ 300,000
Year-end interest on debt ? 60,000
Projected earnings available to common stock $ 300,000 $ 240,000
Required return on equity (rS) 0.125 0.140
Market value of stock $2,400,000 $1,714,000
stock $2,400,000 $1,714,000
Market value of debt ? 1,000,000
Value of the firm $2,400,000 $2,714,000
Weighted average cost of capital(rWACC) 0.125 0.110
Debt-equity ratio 0 0.584
1. An investor who is able to borrow at 6 percent per annum wishes to purchase 5 percent of Knight's equity. Can he increase his dollar return by purchasing 5 percent of Veblen's equity if he borrows so that the initial net cost of the two options are the same?
2. Given the two investment strategies in (a), which will investors choose? When will this process cease?

Chapter 16 - Problems: 16.2, 16.6

Steinberg Corporation and Dietrich Corporation are identical firms except that Dietrich is more levered. Both companies will remain in business for one more year. The companies' economists agree that the probability of a recession next year is 20 percent and the probability of a continuation of the current expansion is 80 percent. If the expansion continues, each firm will generate earnings before interest and taxes (EBIT) of $2 million. If a recession occurs, each firm will generate earnings before interest and taxes (EBIT) of $0.8 million. Steinberg's debt obligation requires the firm to pay $750,000 at the end of the year. Dietrich's debt obligation requires the firm to pay $1 million at the end of the year. Neither firm pays taxes. Assume a one-period model, risk neutrality, and an annual discount rate of 15 percent.
1. Assuming there are no costs of bankruptcy, what is the market value of each firm's debt and equity?
2. What is the value of each firm?
3. Steinberg's CEO recently stated that Steinberg's value should be higher than Dietrich's since the firm has less debt, and, therefore, less bankruptcy risk. Do you agree or disagree with this statement?
16.6 Fountain Corporation economists estimate that a good business environment and a bad business environment are equally likely for the coming year. The managers of Fountain must choose between two mutually exclusive projects. Assume that the project Fountain chooses will be the firm's only activity and that the firm will close one year from today. Fountain is obligated to make a $500 payment to bondholders at the end of the year. Assume the firm's stockholders are risk-neutral. Consider the following information pertaining to the two projects:
Economy Probability Project Payoff Value of Firm Value of Equity Value of Debt
Bad 0.5 $500 $500 = $ 0 $500
Good 0.5 700 700 = 200 500
Economy Probability Project Payoff Value of Firm Value of Equity Value of Debt
Bad 0.5 $100 $100 = $ 0 $100
Good 0.5 800 800 = 300 500

1. What is the expected value of the firm if the low-risk project is undertaken? What if the high-risk project is undertaken? Which of the two strategies maximizes the expected value of the firm?
2. What is the expected value of the firm's equity if the low-risk project is undertaken? What if the high-risk project is undertaken?
3. Which project do Fountain's stockholders prefer? Explain. Suppose bondholders are fully aware that stockholders might choose to maximize equity value rather than total firm value and opt for the high-risk project. To minimize this agency cost, the firm's bondholders decide to use a bond covenant to stipulate that the bondholders can demand a higher payment if Fountainhead chooses to take on the high-risk project. By how much would bondholders need to raise the debt payment so that stockholders would be indifferent between the two projects?

Chapter 21 - Problems: 21.1, 21.3
Discuss the validity of each of the following statements.
1. Leasing reduces risk and can reduce a firm's cost of capital.
2. Leasing provides 100-percent financing.
3. Firms that do a large amount of leasing will not do much borrowing. If the tax advantages of leasing were eliminated, leasing would disappear.
21.3 Super Sonics Entertainment is considering borrowing money at 11 percent and purchasing a machine that costs $350,000. The machine will be depreciated over five years by the straightline method and will be worthless in five years. Super Sonics can lease the machine with the year-end payments of $94,200. The corporate tax rate is 35 percent. Should Super Sonics buy or lease?

Chapter 24 - Problems: 24.2, 24.14

24.2 Explain the following limits on the prices of warrants:
1. If the stock price is below the exercise price of the warrant, the lower bound on the price of a warrant is zero.
2. If the stock price is above the exercise price of the warrant, the lower bound on the price of a warrant is the difference between the the current value of the firm's stock.
3. 24.14 Hannon Home Products, Inc., recently issued $430,000 worth of 8 percent convertible debentures. Each convertible bond has a face value of $1,000. Each convertible bond can be converted into 28 shares of the firm's common stock anytime before maturity. The current price of Hannon's common stock is $31.25 per share, and the market value of each of Hannon's convertible bonds is $1,180. Answer the following questions related to Hannon's convertible bonds: What is the conversion ratio?
4. What is the conversion price?
5. What is the conversion premium?
6. What is the conversion value?
7. If the value of Hannon's common stock increases by $2, what will the conversion value be?

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