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

LG 6 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 oppor- tunity to purchase or sell a specified asset at a stated price on or before a set expiration date. Rights, warrants, and calls and puts are all options. Calls are options to purchase common stock, and 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. The options traded on the exchanges are standardized, and the prices at which they trade are determined by the forces of supply and demand. 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.

Opener-in-Review

When you think of airlines, you probably expect that their primary asset is air- planes, yet many airlines primarily lease the aircraft that they fly. In what other industries might you expect to find that the main asset required to operate is

CHAPTER 17

Hybrid and Derivative Securities

Self-Test Problems (Solutions in Appendix)

LG 2 ST17–1 Lease versus purchase The Hot Bagel Shop wishes to evaluate two plans for financing an oven: leasing and borrowing to purchase. The firm is in the 40% tax bracket.

Lease The shop can lease the oven under a 5-year lease requiring annual end-of- year payments of $5,000. All maintenance costs will be paid by the lessor, and insurance and other costs will be borne by the lessee. The lessee will exercise its option to purchase the asset for $4,000 at termination of the lease.

Purchase The oven costs $20,000 and will have a 5-year life. It will be depreci- ated under MACRS using a 5-year recovery period. (See Table 4.2 on page 117 for the applicable depreciation percentages.) The total purchase price will be financed by a 5-year, 15% loan requiring equal annual end-of-year payments of $5,967. The firm will pay $1,000 per year for a service contract that covers all maintenance costs; insurance and other costs will be borne by the firm. The firm plans to keep the equipment and use it beyond its 5-year recovery period.

a. For the leasing plan, calculate the following: (1) The after-tax cash outflow each year. (2) The present value of the cash outflows, using a 9% discount rate.

b. For the purchasing plan, calculate the following:

(1) The annual interest expense deductible for tax purposes for each of the

5 years. (2) The after-tax cash outflow resulting from the purchase for each of the 5 years. (3) The present value of the cash outflows, using a 9% discount rate.

c. Compare the present values of the cash outflow streams for these two plans, and determine which plan would be preferable. Explain your answer.

LG 4 ST17–2 Finding convertible bond values Mountain Mining Company has an outstanding issue of convertible bonds with a $1,000 par value. These bonds are convertible into 40 shares of common stock. They have an 11% annual coupon interest rate and a 25-year maturity. The interest rate on a straight bond of similar risk is currently 13%.

a. Calculate the straight bond value of the bond. b. Calculate the conversion (or stock) value of the bond when the market price of

the common stock is $20, $25, $28, $35, and $50 per share. c. For each of the stock prices given in part b, at what price would you expect the

bond to sell? Why? d. What is the least you would expect the bond to sell for, regardless of the

common stock price behavior?

Warm-Up Exercises All problems are available in

LG 2 E17–1 N and M Corp. is considering leasing a new machine for $25,000 per year. The lease arrangement calls for a 5-year lease with an option to purchase the machine at the end of the lease for $3,500. The firm is in the 34% tax bracket. What is the present value of the lease outflows, including the purchase option, if lease payments are

PART 8

Special Topics in Managerial Finance

LG 3 E17–2 During the past 2 years Meacham Industries issued three separate convertible bonds.

For each of them, calculate the conversion price:

a. A $1,000-par-value bond that is convertible into 10 shares of common stock. b. A $2,000-par-value bond that is convertible into 20 shares of common stock. c. A $1,500-par-value bond that is convertible into 30 shares of common stock.

LG 3 E17–3 Newcomb Company has a bond outstanding with a $1,500 par value and convert- ible at $30 per share. What is the bond’s conversion ratio? If the underlying stock

currently trades at $25 per share, what is the bond’s conversion value? Would it be advisable for a bondholder to exercise the conversion option?

LG 4 E17–4 Crystal Cafes recently sold a $2,000-par-value, 10-year convertible bond with an 8% coupon interest rate. The interest payments will be paid annually at the end of

each year and the principal will be repaid at maturity. A similar bond without a con- version feature would have sold with a 9% coupon interest rate. What is the min- imum price that the Crystal Cafes’ convertible bond should sell for?

LG 6 E17–5 A 6-month call option on 100 shares of SRS Corp. stock is selling for $300. The strike price for the option is $40. The stock is currently selling at $38 per share. Ignoring bro- kerage fees, what price must the stock achieve to just cover the expense of the option? If the stock price rises to $45, what will the net profit on the option contract be?

Problems All problems are available in

LG 2 P17–1 Lease cash flows Given the lease payments and terms shown in the following table, determine the yearly after-tax cash outflows for each firm, assuming that lease pay- ments are made at the end of each year and that the firm is in the 40% tax bracket. Assume that no purchase option exists.

Firm

Annual lease payment

Term of lease

LG 2 P17–2 Loan interest For each of the loan amounts, interest rates, annual payments, and loan terms shown in the following table, calculate the annual interest paid each year over the term of the loan, assuming that the payments are made at the end of each year.

Loan

Amount

Interest rate

Annual payment Term

A $14,000

4 years

B 17,500

C 2,400

D 49,000

E 26,500

CHAPTER 17

Hybrid and Derivative Securities

LG 2 P17–3 Loan payments and interest Schuyler Company wishes to purchase an asset costing $117,000. The full amount needed to finance the asset can be borrowed at 14% interest. The terms of the loan require equal end-of-year payments for the next

6 years. Determine the total annual loan payment, and break it into the amount of interest and the amount of principal paid for each year. ( Hint: Use the techniques presented in Chapter 5 to find the loan payment.)

LG 2 P17–4 Lease versus purchase JLB Corporation is attempting to determine whether to lease or purchase research equipment. The firm is in the 40% tax bracket, and its after-

tax cost of debt is currently 8%. The terms of the lease and of the purchase are as follows:

Lease Annual end-of-year lease payments of $25,200 are required over the 3-year life of the lease. All maintenance costs will be paid by the lessor; insurance and other costs will be borne by the lessee. The lessee will exercise its option to pur- chase the asset for $5,000 at termination of the lease.

Purchase The research equipment, costing $60,000, can be financed entirely with a 14% loan requiring annual end-of-year payments of $25,844 for

3 years. The firm in this case will depreciate the equipment under MACRS using a 3-year recovery period. (See Table 4.2 on page 117 for the applicable depreciation percentages.) The firm will pay $1,800 per year for a service con- tract that covers all maintenance costs; insurance and other costs will be borne by the firm. The firm plans to keep the equipment and use it beyond its 3-year recovery period.

a. Calculate the after-tax cash outflows associated with each alternative. b. Calculate the present value of each cash outflow stream, using the after-tax cost

of debt. c. Which alternative—lease or purchase—would you recommend? Why?

LG 2 P17–5 Lease versus purchase Northwest Lumber Company needs to expand its facilities. To do so, the firm must acquire a machine costing $80,000. The machine can be leased or purchased. The firm is in the 40% tax bracket, and its after-tax cost of debt is 9%. The terms of the lease and purchase plans are as follows:

Lease The leasing arrangement requires end-of-year payments of $19,800 over 5 years. All maintenance costs will be paid by the lessor; insurance and other costs will be borne by the lessee. The lessee will exercise its option to purchase the asset for $24,000 at termination of the lease.

Purchase If the firm purchases the machine, its cost of $80,000 will be financed with a 5-year, 14% loan requiring equal end-of-year payments of $23,302. The machine will be depreciated under MACRS using a 5-year recovery period. (See Table 4.2 on page 117 for the applicable depreciation percentages.) The firm will pay $2,000 per year for a service contract that covers all maintenance costs; insurance and other costs will be borne by the firm. The firm plans to keep the equipment and use it beyond its 5-year recovery period.

a. Determine the after-tax cash outflows of Northwest Lumber under each alternative.

b. Find the present value of each after-tax cash outflow stream, using the after-tax cost of debt.

PART 8

Special Topics in Managerial Finance

Personal Finance Problem

LG 2 P17–6 Lease-versus-purchase decision Joanna Browne is considering either leasing or pur- chasing a new Chrysler Sebring convertible that has a manufacturer’s suggested retail price (MSRP) of $33,000. The dealership offers a 3-year lease that requires a capital payment of $3,300 ($3,000 down payment + $300 security deposit) and monthly payments of $494. Purchasing requires a $2,640 down payment, sales tax of 6.5% ($2,145), and 36 monthly payments of $784. Joanna estimates the value of the car will be $17,000 at the end of 3 years. She can earn 5% annual interest on her savings and is subject to a 6.5% sales tax on purchases.

Make a reasonable recommendation to Joanna using a lease-versus-purchase analysis that, for simplicity, ignores the time value of money.

a. Calculate the total cost of leasing. b. Calculate the total cost of purchasing. c. Which should Joanna do?

LG 2 P17–7 Capitalized lease values Given the lease payments, terms remaining until the leases expire, and discount rates shown in the following table, calculate the capitalized value of each lease, assuming that lease payments are made annually at the end of each year.

Lease

Lease payment

Remaining term

Discount rate

LG 3 P17–8 Conversion price Calculate the conversion price for each of the following convert-

ible bonds:

a. A $1,000-par-value bond that is convertible into 20 shares of common stock. b. A $500-par-value bond that is convertible into 25 shares of common stock. c. A $1,000-par-value bond that is convertible into 50 shares of common stock.

LG 3 P17–9 Conversion ratio What is the conversion ratio for each of the following bonds? a. A $1,000-par-value bond that is convertible into common stock at $43.75 per

share. b. A $1,000-par-value bond that is convertible into common stock at $25

per share. c. A $600-par-value bond that is convertible into common stock at $30 per share.

LG 3 P17–10 Conversion (or stock) value What is the conversion (or stock) value of each of the

following convertible bonds?

a. A $1,000-par-value bond that is convertible into 25 shares of common stock.

The common stock is currently selling for $50 per share. b. A $1,000-par-value bond that is convertible into 12.5 shares of common stock.

The common stock is currently selling for $42 per share. c. A $1,000-par-value bond that is convertible into 100 shares of common stock.

CHAPTER 17

Hybrid and Derivative Securities

LG 3 P17–11 Conversion (or stock) value Find the conversion (or stock) value for each of the $1,000-par-value convertible bonds described in the following table.

Conversion Current market

Convertible

ratio

price of stock

A 25 $42.25 B 16 50.00 C 20 44.00 D 5 19.50

LG 4 P17–12 Straight bond value Calculate the straight bond value for each of the bonds shown in the table below.

Interest rate

on equal-risk Years to Bond

Coupon interest rate

Par value

(paid annually)

straight bond maturity

LG 4 P17–13 Determining values—Convertible bond Eastern Clock Company has an out- standing issue of convertible bonds with a $1,000 par value. These bonds are con- vertible into 50 shares of common stock. They have a 10% annual coupon interest rate and a 20-year maturity. The interest rate on a straight bond of similar risk is currently 12%.

a. Calculate the straight bond value of the bond. b. Calculate the conversion (or stock) value of the bond when the market price of

the common stock is $15, $20, $23, $30, and $45 per share. c. For each of the stock prices given in part b, at what price would you expect the

bond to sell? Why? d. What is the least you would expect the bond to sell for, regardless of the

common stock price behavior? LG 4 P17–14 Determining values—Convertible bond Craig’s Cake Company has an outstanding

issue of 15-year convertible bonds with a $1,000 par value. These bonds are con- vertible into 80 shares of common stock. They have a 13% annual coupon interest rate, whereas the interest rate on straight bonds of similar risk is 16%.

a. Calculate the straight bond value of this bond. b. Calculate the conversion (or stock) value of the bond when the market price is

$9, $12, $13, $15, and $20 per share of common stock. c. For each of the common stock prices given in part b, at what price would you

expect the bond to sell? Why? d. Graph the straight value and conversion value of the bond for each common

stock price given. Plot the per-share common stock prices on the x axis and the bond values on the y axis. Use this graph to indicate the minimum market value

PART 8

Special Topics in Managerial Finance

LG 5 P17–15 Implied prices of attached warrants Calculate the implied price of each warrant for

each of the bonds shown in the following table.

Number with warrants

Price of bond

Coupon

Interest rate

Years to of warrants Bond

interest rate

on equal-risk

attached

Par value

(paid annually)

straight bond

maturity attached to bond

LG 5 P17–16 Evaluation of the implied price of an attached warrant Dinoo Mathur wishes to determine whether the $1,000 price asked for Stanco Manufacturing’s bond is fair in light of the theoretical value of the attached warrants. The $1,000-par-value, 30-year, 11.5%-coupon-interest-rate bond pays annual interest and has 10 warrants attached for purchase of common stock. The theoretical value of each warrant is $12.50. The interest rate on an equal-risk straight bond is currently 13%.

a. Find the straight value of Stanco Manufacturing’s bond. b. Calculate the implied price of all warrants attached to Stanco’s bond.

c. Calculate the implied price of each warrant attached to Stanco’s bond. d. Compare the implied price for each warrant calculated in part c to its theoretical

value. On the basis of this comparison, what assessment would you give Dinoo with respect to the fairness of Stanco’s bond price? Explain.

LG 5 P17–17 Warrant values Kent Hotels has warrants that allow the purchase of three shares of its outstanding common stock at $50 per share. The common stock price per share and the market value of the warrant associated with that stock price are shown in the table.

Common stock

Market value

price per share

of warrant

a. For each of the common stock prices given, calculate the theoretical warrant value. b. Graph the theoretical and market values of the warrant on a set of axes with per-

share common stock price on the x axis and warrant value on the y axis. c. If the warrant value is $12 when the market price of common stock is $50, does

this contradict or support the graph you have constructed? Explain. d. Specify the area of warrant premium. Why does this premium exist? e. If the expiration date of the warrants is quite close, would you expect your graph

CHAPTER 17

Hybrid and Derivative Securities

Personal Finance Problem LG 5 P17–18 Common stock versus warrant investment Susan Michaels is evaluating the Burton Tool Company’s common stock and warrants to choose the better investment. The firm’s stock is currently selling for $50 per share; its warrants to purchase three shares of common stock at $45 per share are selling for $20. Ignoring transaction costs, Ms. Michaels has $8,000 to invest. She is quite optimistic with respect to Burton because she has certain “inside information” about the firm’s prospects with respect to a large government contract.

a. How many shares of stock and how many warrants can Ms. Michaels purchase? b. Suppose Ms. Michaels purchased the stock, held it 1 year, and then sold it for $60

per share. What total gain would she realize, ignoring brokerage fees and taxes? c. Suppose Ms. Michaels purchased warrants and held them for 1 year and the

market price of the stock increased to $60 per share. Ignoring brokerage fees and taxes, what would be her total gain if the market value of the warrants increased to $45 and she sold out?

d. What benefit, if any, would the warrants provide? Are there any differences in the risk of these two alternative investments? Explain.

Personal Finance Problem LG 5 P17–19 Common stock versus warrant investment Tom Baldwin can invest $6,300 in the common stock or the warrants of Lexington Life Insurance. The common stock is currently selling for $30 per share. Its warrants, which provide for the purchase of two shares of common stock at $28 per share, are currently selling for $7. The stock is expected to rise to a market price of $32 within the next year, so the expected theoretical value of a warrant over the next year is $8. The expiration date of the warrant is 1 year from the present.

a. If Mr. Baldwin purchases the stock, holds it for 1 year, and then sells it for $32, what is his total gain? (Ignore brokerage fees and taxes.)

b. If Mr. Baldwin purchases the warrants and converts them to common stock in 1 year, what is his total gain if the market price of common shares is actually $32? (Ignore brokerage fees and taxes.) c. Repeat parts a and b, assuming that the market price of the stock in 1 year is

(1) $30 and (2) $28. d. Discuss the two alternatives and the tradeoffs associated with them.

LG 6 P17–20 Options profits and losses For each of the 100-share options shown in the fol- lowing table, use the underlying stock price at expiration and other information to determine the amount of profit or loss an investor would have had, ignoring bro- kerage fees.

Underlying stock

price per share Option

of option

of option

price per share

at expiration

A Call

B Call

E Call

PART 8

Special Topics in Managerial Finance

Personal Finance Problem

LG 6 P17–21 Call option Carol Krebs is considering buying 100 shares of Sooner Products, Inc., at $62 per share. Because she has read that the firm will probably soon receive cer- tain large orders from abroad, she expects the price of Sooner to increase to $70 per share. As an alternative, Carol is considering purchase of a call option for 100 shares of Sooner at a strike price of $60. The 90-day option will cost $600. Ignore any brokerage fees or dividends.

a. What will Carol’s profit be on the stock transaction if its price does rise to $70

and she sells? b. How much will Carol earn on the option transaction if the underlying stock

price rises to $70? c. How high must the stock price rise for Carol to break even on the option trans-

action? d. Compare, contrast, and discuss the relative profit and risk associated with the

stock and the option transactions. Personal Finance Problem

LG 6 P17–22 Put option Ed Martin, the pension fund manager for Stark Corporation, is consid- ering purchase of a put option in anticipation of a price decline in the stock of Carlisle, Inc. The option to sell 100 shares of Carlisle, Inc., at any time during the next 90 days at a strike price of $45 can be purchased for $380. The stock of Carlisle is currently selling for $46 per share.

a. Ignoring any brokerage fees or dividends, what profit or loss will Ed make if he buys the option and the lowest price of Carlisle stock during the 90 days is $46, $44, $40, and $35?

b. What effect would the fact that the price of Carlisle’s stock slowly rose from its initial $46 level to $55 at the end of 90 days have on Ed’s purchase?

c. In light of your findings, discuss the potential risks and returns from using put options to attempt to profit from an anticipated decline in share price.

LG 6 P17–23 ETHICS PROBLEM

A hedge fund charged with managing part of Harvard University’s endowment purchased more than 1 million put options on Enron stock not long before the company went bankrupt, making tens of millions of dollars in the process. Some members of the university argued that profiting on the collapse of Enron was unethical. What do you say?

Spreadsheet Exercise

Morris Company, a small manufacturing firm, wants to acquire a new machine that costs $30,000. Arrangements can be made to lease or purchase the machine. The firm is in the 40% tax bracket. The firm has gathered the following information about the two alternatives:

Lease Morris would obtain a 5-year lease requiring annual end-of-year lease payments of $10,000. The lessor would pay all maintenance costs; insurance and other costs would be borne by the lessee. Morris would be given the right to exer-

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Hybrid and Derivative Securities

Purchase Morris can finance the purchase of the machine with an 8.5%, 5-year loan requiring annual end-of-year installment payments. The machine would be depreciated under MACRS using a 5-year recovery period. The exact deprecia- tion rates over the next six periods would be 20%, 32%, 19%, 12%, 12%, and 5%, respectively. Morris would pay $1,200 per year for a service contract that covers all maintenance costs. The firm plans to keep the machine and use it beyond its 5-year recovery period.