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proceeds from the contingent value rights sales go to the firm, whereas those from the
Contingent Value Rights: A
sale of listed puts go to private parties. Second, contingent value right (CVR) provides
the holder with the right to sell a share
contingent value rights tend to be much more long
of stock in the underlying company at
term than typical listed puts.
a fixed price during the life of the
There are several reasons why a firm may right.
choose to issue contingent value rights. The most
obvious is that the firm believes it is significantly undervalued by the market. In such a
scenario, the firm may offer contingent value rights to take advantage of its belief and to
provide a signal to the market of the undervaluation. Contingent value rights are also
useful if the market is overestimating volatility and the put price reflects this
misestimated volatility. Finally, the presence of contingent value rights as insurance may
attract new investors to the market for the common stock.

B. Debt
The clear alternative to using equity, which is a residual claim, is to borrow
money. This option both creates a fixed obligation to make cash flow payments and
provides the lender with prior claims if the firm is in financial trouble.

1. Bank Debt

Historically, the primary source of borrowed money for all private firms and
many publicly traded firms has been the local bank, with the interest rates on the debt
based upon the perceived risk of the borrower. Bank debt provides the borrower with
several advantages. First, it can be used for borrowing relatively small amounts of
money; in contrast, bond issues thrive on economies of scale, with larger issues having
lower costs. Second, if the company is neither well known nor widely followed, bank
debt provides a convenient mechanism to convey information to the lender that will help
in both pricing and evaluating the loan. The presence of hundreds of investors in bond
issues makes this both costly and infeasible if bonds are issued as the primary vehicle for
debt. Finally, in order to issue bonds, firms have to submit to being rated by ratings
agencies and provide them with sufficient information to make this rating Dealing with a
rating agency might be much more difficult for many firms, especially smaller firms, than
dealing with a lending bank.

Besides being a source of both long term and short term borrowing for firms,
banks also often offer them a flexible option to meet unanticipated or seasonal financing
needs. This option is a line of credit, which the firm can draw on only if it needs
financing. In most cases, a line of credit specifies an amount the firm can borrow and
links the interest rate on the borrowing to a market rate, such as the prime rate or treasury
rates. The advantage of having a line of credit is that it provides the firm with access to
the funds without having to pay interest costs if the funds remain unused. Thus, it is a
useful type of financing for firms with volatile working capital needs. In many cases,
however, the firm is required to maintain a compensating balance on which it earns either
no interest or below-market rates. For instance, a firm that wants a $ 20 million line of
credit from a bank might need to maintain a compensating balance of $ 2 million, on
which it earns no interest. The opportunity cost of having this compensating balance must
be weighed against the higher interest costs that will be incurred by taking on a more
conventional loan to cover working capital needs.

7.5. ˜: Corporate Bonds and Bank Debt
If a company can issue corporate bonds, it should not use bank debt.
a. True
b. False

2. Bonds

For larger publicly traded firms, an alternative to bank debt is to issue bonds.
Generally speaking, bond issues have several advantages. The first is that bonds usually
carry more favorable financing terms than equivalent bank debt, largely because risk is
shared by a larger number of financial market investors. The second is that bond issues
might provide a chance for the issuer to add on special features that could not be added
on to bank debt. For instance, bonds can be convertible into common stock or be tied to
commodity prices (commodity bonds). In borrowing money, firms have to make a variety
of choices including the maturity of the borrowing (short term or long term), whether the
debtd should have fixed interest payments or an interest rate tied to market rates (fixed

and floating rates), the nature of the security offered to those buying the bonds (secured
versus unsecured) and how the debt will be repaid over time. In chapter 9, we will
examine how best to make these choices.

3. Leases
A firm often borrows money to finance the acquisition of an asset needed for its
operations. An alternative approach that might accomplish the same goal is to lease the
asset. In a lease, the firm commits to making fixed payments to the owner of the asset for
the rights to use the asset. These fixed payments are either fully or partially tax
deductible, depending upon how the lease is categorized for accounting purposes. Failure
to make lease payments initially results in the loss of the leased asset, but can result in
bankruptcy, though the claims of the lessors (owners of the leased assets) may sometimes
be subordinated to the claims of other lenders to the firm.
A lease agreement is usually categorized as either an operating lease or a capital
lease. For operating leases, the term of the lease agreement is shorter than the life of the
asset, and the present value of lease payments is generally much lower than the actual
price of the asset. At the end of the life of the lease, the asset reverts back to the lessor,
who will either offer to sell it to the lessee or lease it to somebody else. The lessee
usually has the right to cancel the lease and return the asset to the lessor. Thus, the
ownership of the asset in an operating lease clearly resides with the lessor, with the lessee
bearing little or no risk if the asset becomes obsolete. Operating leases cover be the store
spaces leased out by specialty retailing firms like the Gap and Ann Taylor, for instance.A
capital lease generally lasts for the life of the asset, with the present value of lease
payments covering the price of the asset. A capital lease generally cannot be canceled,
and the lease can be renewed at the end of its life at a reduced rate or the asset acquired
by the lessee at a favorable price. In many cases, the lessor is not obligated to pay
insurance and taxes on the asset, leaving these obligations up to the lessee; the lessee
consequently reduces the lease payments, leading to what are called net leases. A capital
lease places substantial risk on the shoulders of the lessee, if the asset loses value or
becomes obsolete. While the differences between operating and financial leases are
obvious, some lease arrangements do not fit neatly into one or another of these extremes;

rather, they share some features of both types of leases. These leases are called
combination leases.

7.6. ˜: Debt Maturity and Interest Rates
Assume that long-term interest rates are much higher than short term rates (a steeply
upward sloping term structure), and that your investment banker advises you to issue
short term debt because it is cheaper than long term debt. Is this true?
a. Yes
b. False
Why or why not?

In Practice: Leasing versus Borrowing

If borrowing money to buy an asset and leasing the asset are both variations on
debt, why might a firm choose one over the other? We can think of several factors that
may sway firms in this choice:
1. Service Reasons: In some cases, the lessor of an asset will bundle service agreements
with the lease agreement and offer to provide the lessee with service support during the
life of the lease. If this service is unique, either because of the lessor™s reputation or
because the lessor is also the manufacturer of the asset, and if the cost of obtaining this
service separately is high, the firm may choose to lease rather than buy the asset. IBM,
for instance, has traditionally leased computers to users, with an offer to service them
when needed.
2. Flexibility: Some lease agreements provide the lessee with the option to exchange the
asset for a different or upgraded version during the life of the lease. This flexibility is
particularly valuable when the firm is unsure of its needs and when technology changes
rapidly. Flexibility is also useful when the asset is required for a period much shorter than
the life of the asset, since buying the asset and selling it again is expensive in terms of
transactions time and cost.
3. Tax Reasons: The classic reason provided for leasing is that different entities face
different tax rates. An entity with a high tax rate buys an asset and leases it to one with no

or a low tax rate. By doing so, the lessor obtains the tax benefits, which are greater
because of its higher tax rate. The lessee, in turn, gets the use of the asset and also gains
by sharing in some of the tax benefits.
In addition, if a lease qualifies as an operating lease, it essentially operates as off-balance
sheet debt and may make firms that use it look safer to the careless analyst. If firms
consider leasing as an alternative to borrowing, the choice becomes primarily a financial
one. Operating leases create lease obligations to the firm and these obligations are tax
deductible. The present value of these after-tax lease obligations has to be weighed
against the present value of the after-tax cash flows that would have been generated if the
firm had borrowed the money and bought the asset instead. The after-tax cash flows from
borrowing and buying the asset have to include not only the interest and principal
payments on the debt, but also the tax benefits accruing from depreciation from owning
the asset and the expected value of the asset at the end of operations.

C. Hybrid Securities
Summarizing our analysis thus far, equity represents a residual claim on the cash
flows and assets of the firm and is generally associated with management control. Debt,
on the other hand, represents a fixed claim on the cash flows and assets of the firm and is
usually not associated with management control. There are a number of securities that do
not fall neatly into either of these two categories; rather, they share some characteristics
with equity and some with debt. These securities are called hybrid securities.

1. Convertible Debt

A convertible bond is a bond that can be converted into a pre-determined number
of shares, at the discretion of the bond holder. While it generally does not pay to convert
at the time of the bond issue, conversion becomes a more attractive option as stock prices
increase. Firms generally add conversions options to bonds to lower the interest rate paid
on the bonds.
Convertible Debt: This is debt that
can be converted into equity at a rate that is
specified as part of the debt agreement
(conversion rate).

In a typical convertible bond, the bond holder is given the option to convert the
bond into a specified number of shares of stock. The conversion ratio measures the
number of shares of stock for which each bond may be exchanged. Stated differently, the
market conversion value is the current value of the shares for which the bonds can be
exchanged. The conversion premium is the excess of the bond value over the conversion
value of the bond.
Thus, a convertible bond with a par value of $1,000, which is convertible into 50
shares of stock, has a conversion ratio of 50. The conversion ratio can also be used to
compute a conversion price - the par value divided by the conversion ratio ““ yielding a
conversion price of $20. If the current stock price is $25, the market conversion value is
$1,250 (50 * $25). If the convertible bond is trading at $1,300, the conversion premium is

In Practice: A Simple Approach to Decomposing Debt and Equity

The value of a convertible debt can be decomposed into straight debt and equity
components using a simple approach. Since the price of a convertible bond is the sum of
the straight debt and the call option components, the value of the straight bond
component in conjunction with the market price should be sufficient to estimate the call
option component, which is also the equity component:
Value of Equity Component = Price of Convertible Bond - Value of Straight Bond
The value of the straight bond component can be estimated using the coupon payments
on the convertible bond, the maturity of the bond and the market interest rate the
company would have to pay on a straight debt issue. This last input can be estimated
directly if the company also trades straight bonds in the market place, or it can be based
upon the bond rating, if any, assigned to the company.
For instance, assume that you have a 10-year convertible bond, with a 5% coupon
rate trading at $ 1,050, and that the company has a debt rating of BBB (with a market
interest rate of 8%). The value of the straight bond and equity components can be
estimated as follows:
Straight Bond Component = $ 50 (PVA, 10 years,8%) + 1000/1.0810 = $798.69

Equity Component = $ 1,050 - $ 799 = $ 251

7.7. ˜: Convertible Debt and Yields

The yields on convertible bonds are much lower than the yields on straight bonds issued
by a company. Therefore, convertible debt is cheaper than straight debt.
a. Yes
b. False
Why or why not?

2. Preferred Stock

Preferred stock is another security that shares some characteristics with debt and
some with equity. Like debt, preferred stock has a fixed dollar dividend; if the firm does
not have the cash to pay the dividend, it
Preferred Stock: This is a hybrid security. Like debt,
is cumulated and paid in a period when
it has a promised payment (the preferred dividend) in
there are sufficient earnings. Like debt,
each period. Like equity, its cash flows are not tax
preferred stockholders do not have a deductible and it has an infinite life.
share of control in the firm, and their
voting privileges are strictly restricted to issues that might affect their claims on the
firm™s cash flows or assets. Like equity, payments to preferred stockholders are not tax
deductible and come out of after tax cash. Also like equity, preferred stock does not have
a maturity date when the face value is due. In terms of priority, in the case of bankruptcy,
preferred stockholders have to wait until the debt holders™ claims have been met before
receiving any portion of the assets of the firm.
While accountants and ratings agencies continue to treat preferred stock as equity,
it can be argued that the fixed commitments that preferred stock create are like debt
obligations and have to be dealt with likewise. The obligations created by preferred stock
are generally less onerous than those created by debt; however, since they are generally
cumulated, cannot cause default, and do not have priority over debt claims in the case of

Unlike convertible debt, which can be decomposed into equity and debt
components, preferred stock cannot really be treated as debt because preferred dividends
are not tax deductible and certainly cannot be viewed as the equivalent of equity because
of the differences in cash flow claims and control. Consequently, preferred stock is
treated as a third component of capital, in addition to debt and equity, for purposes of
capital structure analysis and for estimating the cost of capital.

7.8. ˜: Preferred Stock and Equity
Many ratings agencies and regulators treat preferred stock as equity in computing debt
ratios, because it does not have a finite maturity and firms cannot be forced into
bankruptcy if they fail to pay preferred dividends. Do you agree with this categorization?
a. Yes
b. False
Why or why not?


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