a. Under the debt with warrants, find the following:
(1) Straight debt value.
(2) Implied price of alt warrants.
(3) Implied price of each warrant.
(4) Theoretical value of a warrant.
b. On the basis of your findings in part a, do you think the price of the debt with warrants is too high or too low? Explain.
c. Assuming that the firm can raise the needed funds under the specified terms, which debt financing alternative-debt or debt with warrants-would you recommend in view of your findings above? Explain.
d. For the purchase alternative, financed as recommended in part c, calculate the following:
(1) The annual interest expense deductible for tax purposes for each of the next 3 years.
(2) The after-tax cash outflow for each of the next 3 years.
(3) The present value of the cash outflows using the appropriate discount rate.
e. For the lease alternative, calculate the following:
(1) The after-tax cash outflow for each of the next 3 years.
(2) The present value of the cash outflows using the appropriate discount rate applied in pan d(3).
f. Compare the present values of the cash outflow streams for the purchase (in part d(3)] and lease [in part e(2)] alternatives, and determine which would be preferable. Explain and discuss your recommendation.
L. Rashid Company, a rapidly growing chemical processor, needs to raise $3 million in external funds to finance the acquisition of a new chemical waste disposal system4 After carefully analyzing alternative financing sources, Denise McMahon, the firm's vice president of finance, reduced the financing possibilities to three alternatives:
(1) Debt,
(2) Debt with warrants, and
(3) A financial lease.
The key terms of each of these financing alternatives follow.
Debt. The firm can borrow the full $3 million from First Shreveport Bank. The bank will charge 12% annual interest and require annual end-of-year payments of $1,249,050 over the next 3 years. The disposal system will be depreciated under MACRS using a 3-year recovery period. The firm will pay $45,000 at the end of each 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 3-year recovery period.
Debt with Warrants. The firm can borrow the full $3 million from Southern National Bank. The bank will charge 10% annual interest and will, in addition, require a grant of 50,000 warrants, each allowing the purchase of two shares of the firm's stock for $30 per share at any time during the next 10 years. The stock is currently selling for $28 per share, and the warrants are estimated to have a market value of $1 each. The price (market value) of the debt with the warrants attached is estimated to equal the $3 million initial loan principal. The annual end-of-year payments on this loan will be $1,206,345 over the next 3 years. Depreciation, maintenance, insurance, and other costs will have the same costs and treatments under this alternative as those described before for the straight debt financing alternative.
Financial Lease. The waste disposal system can be leased from First International Capital. The lease will require annual end-of-year payments of $1,200,000 over the next 3 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 system for $220,000 at termination of the lease at the end of 3 years.
Denise decided first to determine which of the debt financing alternatives-debt or debt with warrants-would least burden the firm's cash flows over the next 3 years. In this regard, she felt that very few, if any, warrants would be exercised during this period. Once the better debt financing alternative was found, Denise planned to use lease-versus-purchase analysis to evaluate it in light of the lease alternative. Assume the firm is in the 40% tax bracket, and its after-tax cost of debt is 7% under the debt alternative and 6% under the debt with warrants alternative.