Chapter 16
Hybrid and
Derivative
Securities
An Overview of Hybrids & Derivatives
• In their simplest form, bonds are pure debt and common
stocks are pure equity.
• Preferred stocks, on the other hand, are a hybrid of the
two. They are like common stocks in that they promise
to pay dividends, are perpetual, and represent
ownership. They are like bonds in that dividends are
fixed like bond interest payments.
• Other hybrid securities include financial leases,
convertible securities, and stock purchase warrants.
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Leasing
• Leasing is the 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.
• The lessee is the receiver of the services of the assets
under a lease contract.
• The lessor is the owner of the assets that are being
leased.
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Leasing: Operating Leases
• An operating lease is a cancelable contractual
arrangement whereby the lessee agrees to make
periodic payments to the lessor, often for 5 or fewer
years, to obtain an assets services.
• Generally, the total payments over the term of the lease
are less than the lessor’s initial cost of the leased asset.
• If the operating lease is held to maturity, the lessee
returns the leased asset over to the lessor, who may
lease it again or sell the asset.
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Leasing: Financial (or Capital) Leases
• A financial lease is a longer-term lease than an
operating lease.
• Financial leases are non-cancelable and obligate the
lessee to make payments for the use of an asset over a
predefined period.
• The total payments over the term of the lease are
greater than the lessor’s cost of the leased asset. In
other words, lessor must receive more than the asset
purchase price to earn its required rate of return.
• Financial leases are commonly used for leasing land,
buildings and expensive pieces of equipment.
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Buy, Lease, rent !!!!
Which one is better ?
• [Link]
Leasing or renting? The small difference
• [Link]
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Leasing: Leasing Arrangements
• A direct lease is a lease under which a lessor owns or
acquires the assets that are leased to a given lessee.
• A sale-leaseback arrangement is a lease under which
the lessee sells an asset for cash to a prospective lessor
and then leases back the same asset.
• A leveraged lease is a lease under which the lessor
acts as an equity participant, supplying about 20 percent
of the cost of the asset with a lender supplying the
balance.
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Leasing: Leasing Arrangements (cont.)
• Operating leases normally require maintenance
clauses requiring the lessor to maintain the assets and
to make insurance and tax payments.
• Renewal options are provisions that grant the lessee
the option to re-lease assets at the expiration of the
lease.
• Finally, purchase options are provisions frequently
included in both operating and financial leases that allow
the lessee to purchase the asset at maturity—usually at
a pre-specified price.
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Leasing: Advantages of Leasing
• A lessee avoids many of the restrictive agreements (Such as
minimum liquidity, mortgage) that are normally included as part of a
long-term loan.
• Leasing—especially operating leases—may provide the firm with
needed financial flexibility.
• Sale-leaseback arrangements may permit the firm to increase its
liquidity by converting an existing asset into cash, which may then
be used as working capital.
• It results in the receipt of service from an asset possibly without
increasing the assets or liabilities on the firm’s balance sheet,
leasing may result in misleading financial ratios.
• Leasing provides 100 percent financing.
• When the firm becomes bankrupt or is reorganized, the maximum
claim of lessors against the corporation is 3 years of lease
payments, and the lessor gets the asset back.
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Leasing: Disadvantages of Leasing
• A lease does not have a stated interest cost.
• At the end of the term of the lease agreement, the
salvage value of an asset, if any, is realized by the
lessor.
• Under a lease, the lessee is generally prohibited from
making improvements on the leased property or asset
without approval of the lessor.
• If a lessee leases an asset that subsequently becomes
out-of-date, it must still make lease payments over the
remaining term of the lease.(Example: Bangladesh
Biman Aircaft)
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The Lease Vs. Purchase
Decision
• The lease-versus-purchase decision is a common
decision faced by firms considering the acquisition of a
new asset.
• This decision involves the application of capital
budgeting techniques as does any other asset
investment acquisition decision.
• The preferred method is the calculation of NPV based
on the incremental cash flows (lease versus purchase).
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