Warrants 25.6

1. Warrants 25.6 LO5 • A security that gives the holder the right to purchase shares of stock at a fixed price over a given period of time • It is basically a call option issued by corporations in conjunction with other securities to reduce the yield • Usually included with a new debt or preferred shares issue as a sweetener or equity kicker

2. Differences between warrants and traditional call options LO5 • Warrants are generally very long term • They are written by the company and exercise results in additional shares outstanding • The exercise price is paid to the company and generates cash for the firm • Warrants can be detached from the original securities and sold separately

3. Convertible Bonds 25.7 LO5 • Convertible bonds (or preferred stock) may be converted into a specified number of common shares at the option of the security holder • The conversion price is the effective price paid for the stock. It is the dollar amount of a bond’s par value that is exchangeable for one share of stock

4. Convertibles – continued LO5 • The conversion ratio is the number of shares received when the bond is converted • Conversion Premium – The difference between the conversion price and the current stock price divided by the current stock price • Straight Bond Value – The value of a convertible bond if it could not be converted into common stock

5. Convertibles – continued LO5 • Floor Value – Either the straight bond value or the conversion value • Convertible bonds will be worth at least as much as the straight bond value or the conversion value, whichever is greater

6. Figure 25.5 – Minimum value of a convertible bond versus the value of the stock for a given interest rate LO5

7. Figure 25.6 – Value of a convertible bond versus value of the stock for a given interest rate LO5

8. Valuing Convertibles LO5 • Suppose you have a 10% bond that pays semi-annual coupons and will mature in 15 years. The face value is $1,000 and the yield to maturity on similar bonds is 9%. The bond is also convertible with a conversion price of $100. The stock is currently selling for $110. What is the minimum price of the bond? • Straight bond value = 1081.44 • Conversion ratio = 1000/100 = 10 • Conversion value = 10*110 = 1100 • Minimum price = $1100

9. Reasons for Issuing Warrants and Convertibles 25.8 LO5 • They allow companies to issue cheap bonds by attaching sweeteners to the new bond issue. Coupon rates can then be set at below market rate for straight bonds • They give companies the chance to issue common stock in the future at a premium over current prices

10. Table 25.3 – The case for and against convertibles LO5

11. Other Options 25.9 LO5 • Call provision on a bond • Allows the company to repurchase the bond prior to maturity at a specified price that is generally higher than the face value • Increases the required yield on the bond – this is effectively how the company pays for the option • Put bond • Gives the bondholder the right to require the company to repurchase the bond prior to maturity at a fixed price

12. Other Options continued LO5 • Over allotment option • Underwriters have the right to purchase additional shares from a firm in an IPO (chapter 15) • Insurance and Loan Guarantees • These are essentially put options • Managerial options