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Understanding Convertible Securities and Warrants: Valuation and Impact on Earnings

This guide aims to enhance your understanding of convertible securities and warrants. Learn to calculate the conversion value of convertible securities and compare them with warrants. Explore how to determine the intrinsic value and speculative premium of warrants, while understanding their speculative nature. Additionally, discover how these financial instruments influence earnings per share as reported on income statements. Equip yourself with key formulas and insights necessary for successful investment decision-making in the realm of equity securities.

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Understanding Convertible Securities and Warrants: Valuation and Impact on Earnings

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  1. Learning Objectives • Calculate the conversion value of a convertible security. (LO5) • Describe warrants and compare them to convertible securities. (LO6) • Calculate the intrinsic value and the speculative premium on a warrant. (LO7) • Show how convertible securities and warrants affect earnings per share as reported on the income statement. (LO8)

  2. LO6 Warrants Warrant: • an option to buy a stated number of shares of common stock at a specified price over a given time period (a long-term option to buy stock) • may be attached to another security issue. Investor can usually detach and sell warrants separately • may be issued “stand-alone” • is highly speculative for the investor, as its value is dependent on the market movement of the stock • has a large potential for appreciation if the price of the stock goes up

  3. LO6 Table 19-2Relationships determining warrant prices, October 2011 Source: www.Canadianwarrants.com

  4. LO6 Review of Formulas (b) 3. Intrinsic value of a warrant I = (M - E) x N (19-3) where I = Intrinsic value of a warrant M = Market value of a common stock E = Exercise price of a warrant N = Number of shares each warrant entitles the holder to purchase 4. Speculative premium of a warrant S = W - I (19-4) where S = Speculative premium W = Warrant price I = Intrinsic value

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