Lease analysis Martha Millon, financial manager for Fish & Chips Inc., has been asked to perform a lease-versus-
buy analysis on a new computer system. The computer costs $1,200,000, and, if it is purchased, Fish & Chips could obtain a term loan for the full amount at a 10 percent cost. The loan would be amortized over the 4-year life of the computer, with payments made at the end of each year. The computer is classified as special
purpose, and hence it falls into the MACRS 3-year class. The applicable MACRS rates are 33, 45, 15, and 7 percent. If the computer is purchased, a maintenance contract must be obtained at a cost of $25,000, payable at the
beginning of each year.After 4 years, the computer will be sold, and Millon’s best estimate of its residual value at that time is $125,000. Because technology is changing rapidly, however, the residual value is very uncertain. As an alternative, National Leasing is willing to write a 4-year lease on the computer, including maintenance, for payments of $340,000 at the beginning of each year. Fish & Chips’ marginal federal-plus-state tax rate is 40 percent. Help Millon conduct her analysis by answering the following questions.
a. (1) Why is leasing sometimes referred to as “off balance sheet” financing?
(2) What is the difference between a capital lease and an operating lease?
(3) What effect does leasing have on a firm’s capital structure?
b. (1) What is Fish & Chips’ present value cost of owning the computer? (Hint: Set up a table whose bottom
line is a “time line” that shows the net cash flows over the period t 0 to t 4, and then find the PV of
these net cash flows, or the PV cost of owning.)
(2) Explain the rationale for the discount rate you used to find the PV.
c. (1) What is Fish & Chips’ present value cost of leasing the computer? (Hint: Again, construct a time line.)
(2) What is the net advantage to leasing? Does your analysis indicate that the firm should buy or lease the
computer? Explain.
d. Now assume that Millon believes the computer’s residual value could be as low as $0 or as high as $250,000,
but she stands by $125,000 as her expected value. She concludes that the residual value is riskier than the
other cash flows in the analysis, and she wants to incorporate this differential risk into her analysis. Describe
how this could be accomplished. What effect would it have on the lease decision?
e. Millon knows that her firm has been considering moving its headquarters to a new location for some time,
and she is concerned that these plans may come to fruition prior to the expiration of the lease. If the move
occurs, the company would obtain completely new computers, and hence Millon would like to include a
cancellation clause in the lease contract. What effect would a cancellation clause have on the riskiness of the
lease?
Preferred stock, warrants, and convertibles Martha Millon, financial manager of Fish & Chips Inc., is facing a dilemma. The firm was founded 5 years ago to develop a new fast-food concept, and although Fish & Chips has done well, the firm’s founder and chairman believes that an industry shake-out is imminent. To survive, the firm
must capture market share now, and this requires a large infusion of new capital.
Because the stock price may rise rapidly, Millon does not want to issue new common stock. On the other hand, interest rates are currently very high by historical standards, and, with the firm’s B rating, the interest payments on a new debt issue would be too much to handle if sales took a downturn. Thus, Millon has narrowed her choice to bonds with warrants or convertible bonds. She has asked you to help in the decision process by answering the following questions.
a. How does preferred stock differ from common equity and debt?
b. What is floating-rate preferred?
c. How can a knowledge of call options provide an understanding of warrants and convertibles?
d. One of Millon’s alternatives is to issue a bond with warrants attached. Fish & Chips’ current stock price is $10, and its cost of 20-year, annual coupon debt without warrants is estimated by its investment bankers to be 12 percent. The bankers suggest attaching 50 warrants to each bond, with each warrant having an exercise
price of $12.50. It is estimated that each warrant, when detached and traded separately, will have a value of $1.50.
(1) What coupon rate should be set on the bond with warrants if the total package is to sell for $1,000?
2) Suppose the bonds are issued and the warrants immediately trade for $2.50 each. What does this
imply about the terms of the issue? Did the company “win” or “lose”?
(3) When would you expect the warrants to be exercised?
(4) Will the warrants bring in additional capital when exercised? If so, how much and what type of
capital?
(5) Because warrants lower the cost of the accompanying debt, shouldn’t all debt be issued with war-
rants? What is the expected cost of the bond with warrants if the warrants are expected to be exer-
cised in 5 years, when Fish & Chips’ stock price is expected to be $17.50? How would you expect the cost of the bond with warrants to compare with the cost of straight debt? With the cost of common stock?
e. As an alternative to the bond with warrants, Millon is considering convertible bonds. The firm’s investment bankers estimate that Fish & Chips could sell a 20-year, 10 percent annual coupon, callable convertible bond for its $1,000 par value, whereas a straight-debt issue would require a 12 percent coupon. Fish
& Chips’ current stock price is $10, its last dividend was $0.74, and the dividend is expected to grow at a constant rate of 8 percent. The convertible could be converted into 80 shares of Fish & Chips stock at the owner’s option.
(1) What conversion price, Pc, is implied in the convertible’s terms?
(2) What is the straight-debt value of the convertible? What is the implied value of the convertibility feature?
(3) What is the formula for the bond’s conversion value in any year? Its value at Year 0? At Year 10?
(4) What is meant by the term “floor value” of a convertible? What is the convertible’s expected floor value in Year 0? In Year 10?
(5) Assume that Fish & Chips intends to force conversion by calling the bond when its conversion value is 20 percent above its par value, or at 1.2($1,000) $1,200. When is the issue expected to be called?
Answer to the closest year.
(6) What is the expected cost of the convertible to Fish & Chips? Does this cost appear consistent with the riskiness of the issue? Assume conversion in Year 5 at a conversion value of $1,200.
f. Millon believes that the costs of both the bond with warrants and the convertible bond are essentially equal, so her decision must be based on other factors. What are some of the factors that she should consider in making her decision?
