CHAPTER25:WARRANTSANDCONVERTIBLES

Topics
25.125.3 Warrants
25.425.5 Convertibles
25.625.7 WhyIssueConvertiblesandWarrants?
25.8 Conversionpolicy

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 Warrants
Awarrantgivesitsownertherighttobuyothersecurities
issuedbythefirm(usuallystock)
Quiteabitlikecalloptions,exceptnewsharesarecreated
whenthewarrantisexercised.
Typicallyhasalongermaturity
Possiblyhasatimevaryingstrikeprice
Issuedbythefirm,notbyanotherinvestor(unlikeoption)
Whenexercised,resultsinincreaseinthe#ofshares

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 Anexample
CeresGlobalAgCorp.newsrelease,Dec.19,2007:

AnapplicationhasbeengrantedfortheoriginallistingintheIndustrial
categoryofupto28,750,000units(theUnits)ofCeresGlobalAgCorp.
(theCompany)TheUnitswillbepostedfortradingattheopeningon
Friday,December21,2007.EachUnitconsistsofonecommonshareofthe
Company(theCommonShare)andonefullCommonSharepurchase
warrant(theWarrant).TheUnitswillseparateintoCommonSharesand
WarrantsonMarch1,2008.Uponsuchseparation,eachWarrantentitlesthe
holderthereoftopurchaseoneCommonShareatapriceof$13.50atanytime
onorpriortothecloseofbusinessonthedatethatis36monthsfromthe
closingoftheOffering.UponseparationoftheUnits,theCommonSharesand
theWarrantswillbelistedonTorontoStockExchange.

Ifallthewarrantsareexercised,theywillincreasesharesoutstanding

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 DilutionEffectofWarrant
Calloptionscanbevaluedw/oconsideringdilutionfactor,
warrantscannot.
BlackScholespriceforwarrantwillbetoohigh
B/cexerciseofwarrantsincreasesthe#ofshares
outstanding
B/cofthedilutioneffect,alotofwarrantsareexercised
whenstockpriceis(significantly)abovetheexerciseprice.

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 DilutioneffectExample
ABCInc.has10millioncommonsharesoutstandingand200,000
warrants.Eachwarrantcanpurchasefivesharesofcommon
stockat$30pershare.Warrantholdersexercisedalltheir
warrantstoday.ABCsstockpricebeforetheexercisewas$33.
Whatshouldthenewstockpricebeaftertheexercise?

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 Valuationofwarrants
Wecangetanapproximateestimateforthevalueofawarrantusing
amodifiedversionofBlackScholes:

1.Forastandardcall:
Payofffromexercisingcall=STX= firm value net of debt
X
N
whereNisthenumberofsharesoutstanding

2.Forawarrant: firm value net of debt X N W

Payofffromexercisingwarrant= X
NN W

N firm value net of debt N

= N NW

N
X
N NW
* Payoff from exerci sin g call

whereNWisthenumberofsharesfromexercisingthewarrants

Sotovalueawarrant,multiplythevalueofanotherwiseidentical
N
callbyafactorof
N NW
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 Example
Astockiscurrentlysellingfor$30pershare.Thestockdoesnotpay
anydividends.AEuropeanputoptiononthisstockwithanexercise
priceof$45andfiveyearsuntilexpirationiscurrentlysellingfor$5.
Thecontinuouslycompoundedannualriskfreeinterestrateis10%.
Supposethatthefirmhas1,000,000sharesoutstandingcurrently.
Therearealso100,000warrantsoutstanding.Eachwarrantentitlesits
holdertopurchaseoneadditionalshare.Thewarrantshaveanexercise
priceof$45andexpire5yearsfromnow.Whatisthevalueofeach
warrant?(Assumethatthewarrantscannotbeexercisedearly)

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 Problemswithvaluingwarrants
Whyisthisanapproximatevalue?
effectivelyassumesthefirmdoesnothingwiththeproceeds
fromsellingthewarrant(i.e.paysitoutrightawaytoexisting
shareholdersasadividend)
ignoresdividendsduringthelifeofthewarrantandearly
exercise
ignoreschangingstrikepriceovertime
Inpractice,itisrelativelydifficulttoaccuratelydetermine
thevalueofawarrant
However,justasinastandardIPO,itisanimportant
calculationsinceoverpricingawarrantrunstheriskthatthe
issuemaynotsellandunderpricingitmeansthatthefirmis
sellingpartofitselfforlessthanitisreallyworth
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 25.4Convertibles
Aconvertiblebondgivesitsownertherighttoexchange
bondforstocksissuedbythefirm
Terminology
Conversionratio:thenumberofshareswhichthebondcanbe
convertedinto
Conversionprice:Thefacevalueofdebtsurrenderedforeach
commonsharereceivedonconversion(parvalue/numberof
sharesreceived)
Conversionpremium:conversionpricestockprice
Conversionpriceisusually1030%abovethecurrent
stockpricewhenissued

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 ConvertibleBasics
Aconvertiblebondgivesitsownertherighttoexchange
bondforstocksissuedbythefirm
Terminology
Conversionratio:thenumberofshareswhichthebondcanbe
convertedinto
Conversionprice:Thefacevalueofdebtsurrenderedforeach
commonsharereceivedonconversion(parvalue/numberof
sharesreceived)
Conversionpremium:conversionpricestockprice
Conversionpriceisusually1030%abovethecurrent
stockpricewhenissued

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 AnExample

In1999,Amazonraised1.25billionbysellingconvertible
bondswiththefollowingfeatures:
Couponrate=4.75%
$1000facevalueindebtconvertsatanytimeto6.41shares
Stockpriceatthetimewasaround$120

Conversionratio:
Conversionprice:
Conversionpremium:

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 Convertibles&Options
Convertiblesarealotlikebond+calloption
Except,again,newsharesarecreated
Bondisforfeitedwhenconversionoccurs

Convertiblesarealotlikebond+warrants
Excepttheyareindivisibleandcannottrade(orbeissued)
separately
Bondisforfeitedwhenconversionoccurs
thestrikepriceisreallythevalueofthebond,whichwillbe
changingovertime

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 ValuecomponentsofaConvertibleBond
Thevaluedependson
itsstraightbondvaluewhattheconvertiblebondwouldsell
forifitcouldnotbeconvertedintocommonstock

itsconversionvaluewhatthebondwouldbeworthifit
wereimmediatelyconvertedintocommonstockatcurrent
prices
Needtoconsiderthedilutionfactor

optionvalue=thevalueoftheembeddedwarrant

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 StraightBondValue
Consideranissueofzerocoupondebtwithatotalamount
owedofFatmaturityT(andsupposethefirmhasnoother
debt)
AtTthefirmisobligatedtopaybondholdersF,butifit
defaultsthebondholderstakeoverthefirmandreceiveVT

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 ConversionValue
SupposethatthereareNexistingsharesandifallbondsare
convertedtherewillbeNCnewshares
FirmvalueVdoesnotchangewithconversion,butthe
allocationofownershipdoes
Afterconversion,thereare________shares,sothe
convertibleownersclaimisworth__________

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 ConvertibleBondValueAtMaturity
Combinethetwopreviousdiagramstoobtaintheconvertible
valueatmaturity:

Therearetwolowerboundsfortheconvertiblevalue:(i)the
straightbondvalue(sinceconvertibleisthisplusacall
option);and(ii)theconversionvalue
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 Valueofconvertiblebeforematurity

Valueofconvertiblebond=max(straightbondvalue
orconversionvalue)+warrantvalue

Thewarrantvalueisthevalueoftheoptiontodelay
conversion
Theconvertiblevaluewouldbethelowerboundifa
conversiondecisionhadtobemadeimmediately

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Assumingnodefaultprobability,theValueofaConvertibleBond
is

Convertible
Bond Value
Convertible bond
values Conversion
Value
floor value

floor Straight bond

value value
Warrant
value
Stock
Price
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 Example
Zerocouponconvertiblebond.T=10years.Facevalue=$1,000.
Conversionratio=25.Discountrateforthefirmsstraightbond=
10%.Currentstockprice=$12.Currentconvertiblebondprice=$400.
(1)Whatisthevalueoftheembeddedwarrantintheconvertible?

(2)Supposetheconversiondateis10yearsfromnowanditistheonly
conversiondate.Thestockdoesnotpaydividend.Thedebthas40units
outstanding,andcurrentnumberofsharesoutstandingis4,000.What
wouldbethevalueofacorrespondingcall?

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 ProblemsWithValuingConvertibles
Thefollowingfactorsmakevaluingconvertiblesdifficult:
Dilution(aswithwarrants)
Bondvaluewillchangerandomlyovertimeifinterestrates
moverandomly(thisimpliesthatwehavearandomstrike
priceinadditiontoarandomunderlyingassetvalue)
Callability
Theissuingfirmusuallyretainstheoptiontobuybackthe
convertiblebondatapresetprice(possiblychangingovertime)
Ifaconvertiblebondiscalled,theownerofthebondhasthe
choiceofeithersellingitbacktotheissuerorconverting(thisis
calledforcedconversion)
Withcallability,aconvertiblebondcanbeviewedasastraight
bondplusacalloption(heldbytheowneronthefirmsequity)
minusacalloption(heldbytheissueronthebond)
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 Whyissueconvertiblesandwarrants?
Weakargument:Cheapdebtorequity
Notifinvestorspayafairprice(fortheembeddedoption)
Supposeafirmissuesaconvertibleandthefirm
subsequentlydoespoorly,sothatholdersoftheconvertible
donoconvert)thefirmgotthebenefitofpayingalower
couponrateondebt
Ifthefirmsubsequentlydoeswell,thentheholdersofthe
convertiblewillconvert,buttheconversionpricewillbe
higherthanwhentheconvertiblewasoriginallyissued,so
thefirmisbetteroffinthiscasetoo
Theproblemwiththisargumentisthatacomparisonisbeing
madetostraightdebtifthefirmdoespoorlyandtocommon
sharesifthefirmdoeswell

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 Goodreasonsforissuingconvertiblesandwarrants
Matchingcashflows
young,risky,growthfirmsoftenissueconvertiblesbecause
theyarecashconstrainedinitially(sotheybenefitfromlower
couponrates)and,iftheydowell,therewillbeexpensive
dilutionduetoconversion,butthefirmisbetterabletoafford
itthen
Risksynergy(Riskshifting)
Usefulincaseswhereitishardtoassesstheriskoftheissuer
iftheissuersubsequentlyturnsouttobelowrisk,thestraight
bondwillhavehighvalue(butthecalloptionwillnothave
muchvalue)
Ifitturnsouttobehighrisk,thecalloptionwillbevaluable
(butthestraightbondportionwillnotbe)
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 Goodreasonscontd
Mitigateagencycosts:S/Hlesspronetotakehighrisk
projectsduetotheequitycomponent
Backdoorequity
thisisanasymmetricinformationargument
thebasicideaisthatyoung,small,highgrowthfirmsoften
cannotissuedebtwithoutpayinghighinterestduetohighrisk
offinancialdistress
ifmanagementknowsthatcurrentsharesareundervalued(e.g.
duetoinsideinformationaboutfutureprospects),itmaybe
unwillingtoissueequity
aconvertibleissuemightbeagoodchoicesinceitreduces
interestcostsandavoidssellingequityatcurrentlydepressed
prices
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ReviewQ1.SupposethatMapleAircrafthasissueda4%
convertiblebonddueDecember2003.Thefacevalueof
thebondis$1,000.Theconversionpriceis$47.00.The
marketpriceoftheconvertibleis91%ofthefacevalueof
thebondandthepriceofthecommonshareis$41.50.
Assumethevalueofthebondintheabsenceofthe
conversionfeaturewouldbe$650.SupposethatNcis
sufficientlysmallrelativetoN.
a.Whatistheconversionratiooftheconvertiblebond?
b.Whatistheconversionvalue?
c.Howmuchisabuyeroftheconvertiblepayingforthe
optiontobuyoneshareofthecommonstock?

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#25.3AWarrantgivesitsownertherighttopurchasethreesharesof
commonstockatanexercisepriceof$32pershare.Thecurrent
marketpriceofFirmYis$39pershare.Whatistheminimum
valueofthewarrant?

Canyoudobetterifthefollowingisgiven:Theonlyexercisedate
forthewarrantisoneyearfromnow.Thefirmpaysnodividend.
Theriskfreerateis10%.Theoutstanding#ofwarrantis1.The
outstanding#ofsharesis7.

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AssignedProblems#25.2,3,4,6,8,9,11,13,14,19,20

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