ACST252 Lecture Notes - Lecture 12: Finance Lease, Preferred Stock, Income Statement
11 May 2018
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Week 12
Hybrids and Derivative securities
Hybrids blend the characteristics of both debt and equity. For example, preference shares are a form
of equity that promises to pay fixed periodic dividends that are similar to the fixed contractual
interest payments on bonds. Other popular hybrid securities include financial leases, convertible
securities and warrants.
Derivatives, for example options, are not used by firms to raise funds but, rather, serve as a useful
tool for managing certain aspects of the firs risk ad to proide, here appropriate, profit in their
trade.
Leases
Leasing enables the firm to obtain the use of certain non-current assets for which it must make a
series of contractual, periodic, tax deductible payments.
Types Of Leases
• Operating Lease: contractual arrangement whereby the lessee agrees to make periodic
paets to the lessor, ofte for fie or feer ears, to otai a assets series.
o Cancellable
o Useful life of the asset > Lease period
▪ however, assets would become less efficient and technologically obsolete if
leased for a longer period. E.g. computers
o Ownership remains with the lessor, who may lease it again or sell the asset.
▪ Normally, the asset still has a positive market value at the termination of the
lease.
▪ the lease contract might give the lessee the opportunity to purchase the
leased asset
o Total lease payments < Initial cost of leased asset
o Full payment deductible??
• Finance Lease:
o Longer term
▪ E.g. for land, buildings and larger pieces of equipment.
o Non-cancellable
▪ obligate the lessee to make fixed, tax deductible payments for the use of an
asset over a predefined period of time
• Payments made up of principal (non deductible) and interest
(deductible) components
▪ this makes it similar to certain types of long term debt
o Total lease payments > Initial cost of leased asset.
o Ownership generally transfers to lessee
Techniques for obtaining assets to be leased:
• Direct Lease: Where the lessor owns or acquires the asset under lease.
• Sale-Leaseback: Where the lessee sells the asset to the lessor and then leases the asset back.
• Leveraged Lease: Where the lessor is an equity participant, supplying 15 – 30% of the cost of
the asset, and a lender supplying the balance. These have become especially popular in
structuring leases of very expensive assets.
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Features Of Leasing Arrangements
• Maintenance Clauses: Stipulate who is responsible for the maintenance of the leased asset.
Usually for financial leases, this is the lessee.
• Renewal Options: Allow the lessee the option to re-lease the asset at the expiration of the
lease. These are common for operating leases, because their term is generally shorter than
the usable life of the leased assets.
• Purchase Options: Allow the lessee to purchase the leased asset at the expiration of the
lease, generally for a prespecified price. These are frequently included in both operating and
financial leases.
When you want a new non-current asset, you have 3 options:
• Lease the asset
• Purchase the asset using borrowed funds
• Purchase the asset using available liquid resources.
To choose which option is best:
1. Find the after tax cash outflows for each year under the lease alternative.
a. Usually simply tax adjustment + cost of exercising a purchase option in the final year
of the lease.
2. Find the after tax cash outflows for each year under the purchase alternative.
a. Consider tax deductions from maintenance, depreciation and interest, and how this
impacts the loan payments and maintenance costs
3. Find the present value of the cash outflows from steps 1 and 2 using the after tax cost of
debt as the discount rate.
4. Choose the alternative with the lower present value of cash outflows.
Effects of Leasing on Future Financing
• Because leasing is considered a type of financing, Finance lease commitments will impact on
the firs det ratios and may impact on the ability to access other finance.
• Lease payments are sho as a ta dedutile epese o the firs ioe stateet.
• All finance leases must be capitalised, with the present value of all lease payments included
as a asset ad orrespodig liailit o the firs alae sheet.
Advantages of Leasing
• May avoid the cost of obsolescence
• Avoids many of the restrictive covenants
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• Provides financing flexibility
• May increase liquidity
• Provides 100% financing
• Allows depreciation of land
• May result in misleading financial ratios – making the firm appear better than it otherwise is.
Disadvantages of Leasing
• High returs to lessors
• Terminal value realised by the lessor (operating leases)
• Payments will attract GST (operating leases)
• Lessee is prohiited fro akig iproeets to the leased asset ithout the lessors
approval.
• Lessee may end up paying for an asset that has subsequently becomes obsolete, even if it is
unusable to the lessee.
Basic convertible securities (mainly bonds)
Convertible Securities: Convertible securities are almost always convertible any time during the life
of the security. Occasionally, conversion is permitted only for a limited number of years—say, for
five years after issuance of the convertible.
• Convertible Bonds: Because the conversion feature provides the purchaser with the
possibility of becoming a shareholder on favourable terms, convertibles are generally a less
expensive form of financing than similar-risk non-convertible or straight bonds. The
conversion feature adds a degree of speculation to a bond issue, although the issue still
maintains its value as a bond.
• Convertible Preference Shares: It can normally be sold with a lower stated dividend than
similar-risk non-convertible or straight preference shares. The reason is that the convertible
holder is assured of the fixed dividend payment associated with a preference share and also
may receive the appreciation resulting from increases in the market price of the underlying
ordinary shares. Convertible preference shares behave much like convertible bonds.
General Features Of Convertibles
• Conversion Ratio: The ratio at which a convertible security can be exchanged for ordinary
shares.
• Conversion Price: The per share price that is effectively paid as the result of conversion of a
convertible security.
• Conversion Value: The value of a convertible security measured in terms of the market price
of the ordinary shares into which it can be converted.
Effect of Convertibles On Earnings
• Firms with contingent securities (convertibles, warrants and share options) that if converted
or exercised would dilute EPS are required to report earnings in two ways:
• Earnings Per Share:
o Basic EPS: Calculated without regard to any contingent securities. Basic EPS =
earnings / shares
o Diluted EPS: Calculated under the assumption that all contingent securities that
would have dilutive effects are converted and exercised, and are therefore ordinary
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Document Summary
Hybrids blend the characteristics of both debt and equity. For example, preference shares are a form of equity that promises to pay fixed periodic dividends that are similar to the fixed contractual interest payments on bonds. Other popular hybrid securities include financial leases, convertible securities and warrants. Derivatives, for example options, are not used by firms to raise funds but, rather, serve as a useful tool for managing certain aspects of the fir(cid:373)(cid:859)s risk a(cid:374)d to pro(cid:448)ide, (cid:449)here appropriate, profit in their trade. Leasing enables the firm to obtain the use of certain non-current assets for which it must make a series of contractual, periodic, tax deductible payments. Techniques for obtaining assets to be leased: direct lease: where the lessor owns or acquires the asset under lease, sale-leaseback: where the lessee sells the asset to the lessor and then leases the asset back.
