Beruflich Dokumente
Kultur Dokumente
and Warrants
Convertible Securities
Use of Convertibles
Value of Convertible
Securities
Exchangeable Bonds
Warrants
22-1
Derivative Security
Derivative Security -- A financial contract
whose value derives in part from the value and
characteristics of one or more underlying
assets (e.g., securities, commodities), interest
rates, exchange rates, or indices.
Straight debt or equity cannot be exchanged for
another asset, but options are exchangeable.
An option is part of the broader category of
derivative securities.
We examine the convertible security, exchangeable
bond, and warrant in this chapter.
22-2
Convertible Security
Convertible Security -- A bond or a
preferred stock that is convertible into a
specified number of shares of common
stock at the option of the holder.
This provides the convertible holder a fixed return
(interest or dividend) and the option to exchange a
bond or preferred stock for common stock.
The option allows the company to sell convertible
securities at a lower yield than it would have to pay
on a straight bond or preferred stock issue.
22-3
Convertible Security
Conversion Price -- The price per share at
which common stock will be exchanged for a
convertible security. It is equal to the face
value of the convertible security divided by
the conversion ratio.
Conversion Ratio -- The number of shares of
common stock into which a convertible
security can be converted. It is equal to the
face value of the convertible security
divided by the conversion price.
22-4
Conversion Example
FunFinMan, Inc., has an issue of 8%,
$100 par value preferred stock
outstanding. The security has a
conversion price of $30 per share.
What is the conversion ratio?
Conversion Ratio
= $100 par value / $30 conversion price
= 3.33 shares
22-5
Antidilution and the
Convertible Security
Conversion terms are not necessarily constant
over time.
Example: The conversion price on 20-year
convertible-debt might “step-up” over time from $30
during the first 5 years, $35 the next 5 years, and $40
for the remaining 10 years until maturity.
The conversion price is usually adjusted for
any stock splits or stock dividends to protect
the convertible bondholder from antidilution
(known as the antidilution clause).
22-6
Conversion Value
Conversion Value -- The value of the
convertible security in terms of the common
stock into which the security can be
converted. It is equal to the conversion ratio
times the current market price per share of the
common stock.
For example, if the market value per share of common
stock in FunFinMan, Inc., were trading at $42 per
share, then the conversion value is:
3.33 shares x $42 = $140 per share of preferred stock
22-7
Premium Over
Conversion Value
Premium Over Conversion Value -- The
market price of a convertible security
minus its conversion value; also called
conversion premium.
22-16
Relationships Among
Premiums -- Summary
A convertible security offers holders partial
protection on the downside (similar to the
straight bond) based on the going-concern
and liquidation values of the firm.
A convertible security also provides
holders with the ability to participate in the
upward movement in common stock prices.
The greater the volatility of common stock
price, the greater the potential gain and the
more valuable the option.
22-17
Exchangeable Bond
Exchangeable Bond -- A bond that allows the
holder to exchange the security for common
stock of another company -- generally, one in
which the bond issuer has an ownership
interest.
These issues usually occur when the issuer owns
common stock in the company in which the bonds
can be exchanged.
Exchange requests are satisfied either by open
market purchases or directly using the firm’s
investment holdings of the other company’s stock.
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Valuation of
an Exchangeable
Investors may realize diversification benefits since
the bond and the common stock are from different
companies.
Potentially, diversification leads to a higher
valuation for the exchangeable versus the
convertible.
A major disadvantage is that the difference between
the cost of the bond and the market value of the
exchanged common stock, at the time of exchange,
is treated as a capital gain. A convertible gain is not
recognized until the common stock is sold.
22-19
Warrants
Warrant -- A relatively long-term option to
purchase common stock at a specified
exercise price over a specified period of time.
Warrant Value
N = number of shares per value line
warrant
Ps = market price of one
share of stock Exercise
E = exercise price price
associated with the 45o
purchase of N shares
Associated Common Stock Price
22-25
Example of the
Valuation of a Warrant
Theoretical value of a
warrant: Stock appreciates 50%
max [ (N)(Ps) - E, 0]
Warrant Value
Theoretical warrant
value appreciates 100%
N = 1, Ps = $10 , E = $5 $10
max[(1)($10)-$5, 0] = $5
Minimum
value is 0. $5
N = 1, Ps = $15 , E = $5
max[(1)($15)-$5, 0] =$10
Associated Common Stock Price
22-26
Summary of the Example
of Warrant Valuation
The market value of a warrant equals or
exceeds the theoretical value of the warrant.
The greater market value is generated by the
unlimited upside potential of the stock price
combined with the limited downside risk to
the warrant holder (minimum value is 0).
The greater the time to expiration, the
greater the opportunity of the upside
potential of the stock and the greater the
market value of the warrant.
22-27