Finance Chapter 17 Hybrid and Derivative Securities

Basic EPS

(Net Income - Preferred Dividends)/(Weighted Average of Shares Outstanding) Earnings per share calculated without regard to any contingent securities

EPS formula

(net income - preferred dividends) / average common shares outstanding net income/shares outstanding

straight bond

A bond that is nonconvertible, having no conversion feature.

operating lease

A cancelable contractual arrangement whereby the lessee agrees to make periodic payments to the lessor, often for 5 or fewer years, to obtain an asset's services; generally, the total payments over the term of the lease are less than the lessor's initial cost of the leased asset.

overhanging issue

A convertible security that cannot be forced into conversion by using the call feature.

Review the types of leases, leasing arrangements, the lease-versus-purchase decision, the effects of leasing on future financing, and the advantages and disadvantages of leasing:

A lease enables the firm to make contractual, tax-deductible payments to obtain the use of fixed assets Operating leases are generally 5 or fewer years in term, cancelable, and renewable, and they provide for maintenance by the lessor. Financial leases are longer-term, noncancelable, and not renewable, and they nearly always require the lessee to maintain the asset A lessor can obtain assets to be leased through a direct lease, a sale-leaseback arrangement, or a leveraged lease The lease-versus-purchase decision can be evaluated by calculating the after-tax cash outflows associated with the leasing and purchasing alternatives The more desirable alternative is the one that has the lower present value of after-tax cash outflows.

financial (or capital) lease

A longer-term lease than an operating lease that is noncancelable 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.

derivative security

A security that is neither debt nor equity but derives its value from an underlying asset that is often another security; called "derivatives," for short.

Define options and discuss calls and puts, options markets, options trading, the role of call and put options in fund raising, and hedging foreign-currency exposures with options:

An option provides its holder with an opportunity to purchase or sell a specified asset at a stated price on or before a set expiration date Calls are options to purchase common stock, puts are options to sell common stock Options exchanges provide organized marketplaces in which purchases and sales of call and put options can be made Call and put options do not play a direct role in the fund-raising activities of the financial manager. Currency options can be used to hedge the firm's foreign-currency exposures resulting from international transactions.

conversion feature

An option that is included as part of a bond or a preferred stock issue and allows its holder to change the security into a stated number of shares of common stock.

contingent securities

Convertibles, warrants, and stock options. Their presence affects the reporting of a firm's earnings per share (EPS).

Describe the types of convertible securities, their general features, and financing with convertibles:

Corporate bonds and preferred stock may both be convertible into common stock The conversion ratio indicates the number of shares for which a convertible can be exchanged and determines the conversion price A conversion privilege is nearly always available at any time in the life of the security The conversion value is the value of the convertible measured in terms of the market price of the common stock into which it can be converted The presence of convertibles and other contingent securities (warrants and stock options) often requires the firm to report both basic and diluted earnings per share (EPS). Convertibles are used to obtain deferred common stock financing, to "sweeten" bond issues, to minimize restrictive covenants, and to raise cheap funds temporarily The call feature is sometimes used to encourage or "force" conversion; occasionally, an overhanging issue results.

Differentiate between hybrid and derivative securities and their roles in the corporation:

Hybrid securities are forms of debt or equity financing that possess characteristics of both debt and equity financing Popular hybrid securities include preferred stock, financial leases, convertible securities, and stock purchase warrants. Derivative securities are neither debt nor equity and derive their value from an underlying asset that is often another security Options are a popular derivative security.

Diluted EPS formula

Income available to common stock shareholder + interest on dilutive securities/ Weighted average number of common shares assuming all dilutive securities are converted to common stock

Conversion Ratio Formula

Par Value / Conversion Price

straight preferred stock

Preferred stock that is nonconvertible, having no conversion feature.

maintenance clauses

Provisions normally included in an operating lease that require the lessor to maintain the assets and to make insurance and tax payments.

Explain the key characteristics of stock purchase warrants, the implied price of an attached warrant, and the values of warrants:

Stock purchase warrants enable their holders to purchase a certain number of shares of common stock at the specified exercise price Warrants are often attached to debt issues as "sweeteners," generally have limited lives, are detachable, and may be traded in broker and dealer markets Warrants are similar to convertibles, but exercising them has a less pronounced effect on the firm's leverage and brings in new funds The implied price of an attached warrant can be found by dividing the difference between the bond price with warrants attached and the straight bond value by the number of warrants attached to each bond. The market value of a warrant usually exceeds its theoretical value, creating a warrant premium Investors generally get more leverage from trading warrants than from trading the underlying stock.

Warrant Premium

The difference between the market value and the theoretical value of a warrant.

exercise (or option) price

The price at which holders of warrants can purchase a specified number of shares of common stock.

Demonstrate the procedures for determining the straight bond value, the conversion (or stock) value, and the market value of a convertible bond:

The straight bond value of a convertible is the price at which it would sell in the market without the conversion feature. It typically represents the minimum value at which a convertible bond trades. The conversion value is found by multiplying the conversion ratio by the current market price of the underlying common stock The market value of a convertible generally exceeds both its straight and conversion values, resulting in a market premium The premium is largest when the straight and conversion values are nearly equal.

conversion (or stock) value

The value of a convertible security measured in terms of the market price of the common stock into which it can be converted.

option

an instrument that provides its holder with an opportunity to purchase or sell a specified asset at a stated price on or before a set expiration date

call option

an option to purchase a specified number of shares of stock (typically 100) on or before a specified future date at a stated price

Diluted EPS

earnings per share (EPS) calculated under the assumption that all contingent securities that would have dilutive effects are converted and exercised and are therefore common stock

stock purchase warrants

instruments that give their holders the right to purchase a certain number of shares of the issuer's common stock at a specified price over a certain period of time

hedging

offsetting or protecting against the risk of adverse price movements

put option

option to sell a specified number of shares of a stock (typically 100) on or before a specified future date at a stated price

convertible preferred stock

preferred stock that can be changed into a specified number of shares of common stock

leasing

process by which a firm can obtain the use of certain fixed assets for which it must make a series of contractual periodic tax-deductible payments

renewal options

provisions especially common in operating leases that grant the lessee the right to release assets at the expiration of the lease

purchase options

provisions frequently included in both operating and financial leases that allow the lessee to purchase the leased asset at maturity, typically for a prespecified price

Market Premium

the amount by which the market value exceeds the straight or conversion value of a convertible security

Theoretical Value of a Warrant

the amount one would expect the warrant to sell for in the marketplace

lease-versus-purchase (or lease-versus-buy) decision

the decisions facing firms needing to acquire new fixed assets whether to lease the assets or to purchase them, using borrowed funds or available liquid resources

Lessor

the owner of assets that are being leased

Conversion Price

the per-share price that is effectively paid for common stock as a result of conversion for a convertible security

straight bond value

the price at which a convertible bond would sell in the market without the conversion feature

strike price

the price at which the holder of a call option can buy (or the holder of a put option can sell) a specified amount of stock at any time prior to the option's expiration date

implied price of a warrant

the price effectively paid for each warrant attached to a bond

Lessee

the receiver of the services of the assets under a lease contract

convertible bond

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

capitalized lease

a financial or capital lease that has the present value of all its payments included as an asset and corresponding liability on the firm's balance sheet as required by the Financial Accounting Standards Board in FASB Statement number 13

Hybrid Security

a form of debt or equity financing that possesses characteristics of both debt and equity financing

direct lease

a lease under which a lessor owns or acquires the assets that are leased to a given lessee

sale-leaseback arrangement

a lease under which the lessee sells an asset to a prospective lessor and then leases back the same asset, making fixed periodic payments for its use

leveraged lease

a lease under which the lessor acts as an equity participant, supplying only about 20 percent of the cost of the asset, while a lender supplies the balance

conversion ratio

a ratio at which a convertible can be exchanged for common stock