Chapter 24

Warrants and Convertibles

Copyright © 2015 by the McGraw-Hill Education (Asia). All rights reserved.

Key Concepts and Skills
 Understand how warrants and convertible
bonds are similar to call options
 Understand how warrants and convertible
bonds differ from call options
 Understand why corporations would issue
either warrants or convertible bonds

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Chapter Outline
24.1 Warrants
24.2 The Difference between Warrants and Call Options
24.3 Warrant Pricing and the Black-Scholes Model
24.4 Convertible Bonds
24.5 The Value of Convertible Bonds
24.6 Reasons for Issuing Warrants and Convertibles
24.7 Why are Warrants and Convertibles Issued?
24.8 Conversion Policy

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24.1 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 and/or given to investment bankers
as compensation for underwriting services.
 In this case, they are often referred to as a Green Shoe Option.

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Warrants
 The factors that affect call option value affect
warrant value in the same ways.
1. Stock price +
2. Exercise price –
3. Interest rate +
4. Volatility in the stock price +
5. Expiration date +
6. Dividends –

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24.2 The Difference between Warrants
and Call Options
 When a warrant is exercised, a firm must
issue new shares of stock.
 This can have the effect of diluting the
claims of existing shareholders.

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Dilution Example
 Imagine that Mr. Armstrong and Mr. LeMond are shareholders
in a firm whose only asset is 100 ounces of silver.
 When they incorporated, each man contributed 50 ounces of
silver, then valued at $30 per ounce. They printed up two stock
certificates and named the firm LegStrong, Inc..
 Suppose that Mr. Armstrong decides to sell Mr. Mercx a call
option issued on Mr. Armstrong’s share. The call gives Mr.
Mercx the option to buy Mr. Armstong’s share for $1,500.
 If this call finishes in-the-money, Mr. Mercx will exercise, Mr.
Armstrong will tender his share.
 Nothing will change for the firm except the names of the
shareholders.
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Dilution Example
 Suppose that Mr. Armstrong and Mr. LeMond
meet as the board of directors of LegStrong.
The board decides to sell Mr. Mercx a warrant.
The warrant gives Mr. Mercx the option to buy
one share for $1,500.
 Suppose the warrant finishes in-the-money,
(silver increased to $35 per ounce). Mr. Mercx
will exercise. The firm will print up one new
share.
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 Dilution Example
 The balance sheet of LegStrong Inc.
would change in the following way:
Balance Sheet Before
(Book Value)
Assets Liabilities and
Equity
Silver: $3,000 Debt 0
Equity (2 $3,000
shares)
Total Assets $3,000 Total $3,000
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 Dilution Example
Balance Sheet Before
(Market Value)
Assets Liabilities and Equity

Silver: $3,500 Debt 0

Cash: $1,500 Equity (3 $5,000
shares)
Total Assets $5,000 Total $5,000

Note that Mr. Armstrong’s claim falls in value from

$1,750 = $3,500 ÷ 2 to $1,666.67 = $5,000 ÷ 3
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24.3 Warrant Pricing and the Black-
Scholes Model
 Warrants are worth a bit less than calls
due to the dilution.
 To value a warrant, value an otherwise-
identical call and multiply the call price
by: n
Where
nn w
n = the original number of shares
nw = the number of warrants
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Warrant Pricing and the Black-Scholes
Model
To see why, compare the gains from exercising a call
with the gains from exercising a warrant.
The gain from exercising a call can be written as:
share price  exercise price
Note that when n = the number of shares, share price is:
Firm' s value net of debt
n
Thus, the gain from exercising a call can be written as:
Firm' s value net of debt
 exercise price
n
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Warrant Pricing and the Black-Scholes
Model
The gain from exercising a warrant =
share price after warr ant exercise  exercise price
Note that when # = the original number of shares
and #w = the number of warrants,
 share price 
  Firm' s value net of debt  exercise price # w
 after  # # w
 warrant exercise 

Thus, the gain from exercising a warrant can be written as:

Firm' s value net of debt  exercise price # w

 exercise price
# # w 24-12
Warrant Pricing and the Black-Scholes
Model
The gain from exercising a call can be written as:
Firm' s value net of debt
 exercise price
#
The gain from exercising a warrant can be written as:
Firm' s value net of debt  exercise price # w
 exercise price
# # w
A bit of algebra shows that these #
equations differ by a factor of # # w
So to value a warrant, multiply the value
of an otherwise-identical call by #
# # w
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24.4 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 a convertible
is the maximum of:
 Straight or “intrinsic” bond value
 Conversion value
 The conversion option has value.

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24.5 The Value of Convertible Bonds
The value of a convertible bond has three
components:
1. Straight bond value
2. Conversion value
3. Option value

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Convertible Bond Example
 Litespeed, Inc., 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?

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Convertible Bond Example
 What is the straight bond value?
$1,000
SBV  10
 $385.54
(1.10)
–What is the conversion value?

25 shares × $12/share = $300

–What is the option value of the bond?

$400 – 385.54 = $14.46

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The Value of Convertible Bonds
Convertible
Bond Value
Convertible bond
values Conversion
Value
floor value

floor Straight bond

value value
= conversion ratio Option
value
Stock
Price 24-18
24.6 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.
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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.
 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.
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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.
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24.7 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. 24-22
24.8 Conversion Policy
 Most convertible bonds are also callable.
 When the bond is called, bondholders have about 30
days to choose between:
1. Converting the bond to common stock at the conversion
ratio.
2. Surrendering the bond and receiving the call price in cash.
 From the shareholder’s 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. 24-23
Quick Quiz
 Explain how convertible bonds and warrants
are similar to call options.
 Explain how convertible bonds and warrants
are different from call options.
 Identify possible corporation benefits from
issuing convertible bonds and/or warrants.

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