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WARRANTS AND CONVERTIBLES

This part provides an opportunity to apply our newly acquired knowledge of option pricing to two
important corporate securities. It describes the characteristics of warrants and convertibles and
goes through the following points:
1. The effects of exercising warrants on the firm and on shareholders.
2. Applying the Black-Scholes Option Pricing Model to value warrants.
3. Valuing Convertible Bonds.
4. Reasons for and against issuing warrants and convertibles.
Warrants

Warrants are call options that give the holder the right, but not the obligation, to buy
shares of common stock directly from a company at a fixed price for a given period of
time.
Warrants tend to have longer maturity periods than exchange traded options.
Warrants are generally issued with privately placed bonds as an equity kicker.
Warrants are also combined with new issues of common stock and preferred stock, given
to investment bankers as compensation for underwriting services. In this case, they are
often referred to as a Green Shoe Option.

The same factors that affect call option value affect warrant value in the same ways.
Stock price +
Exercise price
Interest rate +
Volatility in the stock price +
Expiration date +
Dividends
Similarities between warrants and options:
1. Both are American call options on the equity of the firm.
2. Both are usually protected against stock dividends and stock splits.
3. Neither is protected against cash dividends.
Differences between warrants and options:
1. Exercise period of a warrant is usually several years.
2. Warrants are issued by the firm. Options are issued by individuals.
3. When a warrant is exercised the firm receives the exercise price from the investor and the
firm simultaneously issues new shares.
4. When a warrant is exercised, a firm must issue new shares of stock.
5. This can have the effect of diluting the claims of existing shareholders.
The Effects Exercising Warrants on the Firm and on Shareholders
Base Case
Suppose two investors form a corporation. Each puts up $75 and each receives 5 shares of stock
($15 per share). The firm bought 10 barrels of oil currently selling for $15/barrel. At this point,
one share represents one barrel of oil. In one year, the firm will sell its oil inventory and liquidate.
The estimated oil prices in one year are:
Value of Profit of Shares Stock
Probability Oil Price the Firm the Firm Outstanding Price
0.2 $15 per barrel $150 $0 10 $15
0.6 $30 per barrel $300 $150 10 $30
0.2 $45 per barrel $450 $300 10 $45
Warrants
Suppose the two investors finance $10 of their initial investment by selling five warrants at $2
each to a new investor. Each warrant allows the holder to purchase one share of the firm with an
exercise price of $30 per share and an expiration date in one year. The remaining $140 needed to
purchase the oil comes from the investors ($70 each).
If stock price is below the exercise price ($30) at the expiration date, new investor will not
exercise the warrants. If stock price is greater than the exercise price ($30), the new investor will
pay $150 to the firm and receives 5 new shares of stock.
Effects of Issuing Warrants on the Firm
Value of Profit of Shares Stock
Probability Oil Price the Firm the Firm Outstanding Price
0.2 $15 per barrel $150 $0 10 $15
0.6 $30 per barrel $300 $150 10 $30
0.2 $45 per barrel $600 $300 15 $40
Effects of Issuing Warrants on Existing Shareholders (original investors)
Initial Claim on Profit of
Probability Oil Price Investment the Firm Investment
0.2 $15 per barrel $70 $75 $5
0.6 $30 per barrel $70 $150 $80
0.2 $45 per barrel $70 $200 $130
Effects of Warrants on the Warrant-holders (new investor)
Total Claim on Profit of
Probability Oil Price Investment the Firm Investment
0.2 $15 per barrel $10 $0 -$10
0.6 $30 per barrel $10 $0 -$10
0.2 $45 per barrel $160 $200 $40
The gain on each warrant held by new investor can also be calculated as :
(Firm value net of debt + E x NW)/ (N + NW) - E
where E is the exercise price, N is the number of shares outstanding before the warrants are
exercised, and NW is the number of shares issued when the warrants are exercised.
= [($450 + $30*5)/15] - $30 = $40 - $30 = $10
The net profit per warrant is $10 - $2 = $8 per warrant, totaling $40 for 5 warrants.
Applying the Black -Scholes Option Pricing Model to Warrants
Price of a warrant=W = N / (N + NW) x Price of a call option or W=1/(1+q) C
The price of a call option (C) is given by the Black-Scholes Option Pricing Model, then:
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Convertible Bonds
A convertible bond is similar to a bond with warrants.
The most important difference is that a bond with warrants can be separated into different
securities and a convertible bond cannot.
Recall that the minimum (floor) value of convertible:
Straight or intrinsic bond value
Conversion value
The conversion option has value.
The Value of Convertible Bonds
The value of a convertible bond has three components:
1. Straight bond value=SBV
2. Conversion value (CV): is the value if converted into common stock at the
current price.
3. Option value: Value of a Convertible bond exceeds both SBV and CV. It is the
value for waiting since the value in the future is greater.
19
The Value of Convertible Bonds
Convertible
Bond Value
Stock
Price
Straight bond
value
Conversion
Value
= conversion ratio
floor value
floor
value
Convertible bond
values
Option
value
Convertible Bond Problem
A company just issued a zero coupon convertible bond due in 10 years.
The conversion ratio is 25 shares.
The appropriate interest rate is 10%.
The current stock price is $12 per share.
Each convertible is trading at $400 in the market.
What is the straight bond value?
What is the conversion value?
What is the option value of the bond?
What is the straight bond value?
What is the conversion value?
25 shares $12/share = $300
What is the option value of the bond?
$400 385.54 = $14.46
Reasons for Issuing Warrants and Convertibles
A reasonable place to start is to compare a hybrid like convertible debt to both straight
debt and straight equity.
Convertible debt carries a lower coupon rate than does otherwise-identical straight debt.
Since convertible debt is originally issued with an out-of-the-money call option, one can
argue that convertible debt allows the firm to sell equity at a higher price than is available
at the time of issuance. However, the same argument can be used to say that it forces the
firm to sell equity at a lower price than is available at the time of exercise.
Convertible Debt vs. Straight Debt
Convertible debt carries a lower coupon rate than does otherwise-identical straight debt.
If the company subsequently does poorly, it will turn out that the conversion option
finishes out-of-the-money.
54 . 385 $
) 10 . 1 (
000 , 1 $
10
SBV
But if the stock price does well, the firm would have been better off issuing straight debt.
In an efficient financial market, convertible bonds will be neither cheaper or more
expensive than other financial instruments.
At the time of issuance, investors pay the firm for the fair value of the conversion option.
Convertible Debt vs. Straight Equity
If the company subsequently does poorly, it will turn out that the conversion option
finishes out-of-the-money, but the firm would have been even better off selling equity
when the price was high.
But if the stock price does well, the firm is better off issuing convertible debt rather than
equity
In an efficient financial market, convertible bonds will be neither cheaper or more
expensive than other financial instruments.
At the time of issuance, investors pay the firm for the fair value of the conversion option
Why are Warrants and Convertibles Issued
Convertible bonds reduce agency costs, by aligning the incentives of stockholders and
bondholders.
Convertible bonds also allow young firms to delay expensive interest costs until they can
afford them.
Support for these assertions is found in the fact that firms that issue convertible bonds are
different from other firms:
The bond ratings of firms using convertibles are lower.
Convertibles tend to be used by smaller firms with high growth rates and more
financial leverage.
Convertibles are usually subordinated and unsecured.
Conversion Policy: Most convertible bonds are also callable.
When the bond is called, bondholders have about 30 days to choose between:
Converting the bond to common stock at the conversion ratios.
Surrendering the bond and receiving the call price in cash.
From the shareholders perspective, the optimal call policy is to call the bond when its
value is equal to the call price.
In the real world, most firms wait to call until the bond value is substantially above the
call price. Perhaps the firm is afraid of the risk of a sharp drop in stock prices during the
30-day window.
Summary and Conclusions
Convertible bonds and warrants are like call options.
However, there are important differences:
Warrants are issued by the firm.
Warrants and convertible bonds have different effects on corporate cash flow and
capital structure.
Warrants and convertibles cause dilution to existing shareholders claims.
Many arguments, both plausible and implausible, are given for issuing convertible
securities.
Convertible bonds give lends the chance to benefit from risks and reduces the
conflicts between bondholders and stockholders concerning risk.

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