Convertibles, Exchangeables, and Warrants

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Chapter 22

• Convertibles, Exchangeables, and Warrants

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After Studying Chapter 22, you should be able to

1. Describe the features of three common types of
   options that may be used by firms in their
   financing the convertible security, the
   exchangeable bond, and the warrant.
2. Understand why these securities with option
   features may be attractive for a firm's long-term
   financing needs.
3. Explain the different terms used to express value
   for convertible securities - conversion value,
   market value, and straight-bond value.
4. Calculate the value of convertible securities,
   exchangeable bonds, and warrants and explain why
   premiums over different values occur.
5. Understand the relationship between an option
   instrument and its underlying security.

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Convertibles, Exchangables, and Warrants

• Convertible Securities
• Use of Convertibles
• Value of Convertible Securities
• Exchangeable Bonds
• Warrants

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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.

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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.

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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.

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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

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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).

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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

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Premium Over Conversion Value
Premium Over Conversion Value The market price
of a convertible security minus its conversion
value also called conversion premium.

• For example, if the market value per share of
  preferred stock in FunFinMan, Inc., were trading
  at 154 per share, then the conversion premium
  is
• 154 140 14 premium per share of preferred
  stock (or a 10 premium).

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Other Issues with Convertible Securities

• Virtually all convertible securities provide for
  a call price, which allows the company to force
  conversion when the security market value is
  significantly above the call price.
• Almost all convertible bond issues are
  subordinated to other creditors, which allows a
  lender to treat convertibles as a part of the
  equity base when evaluating the financial
  condition of the issuer.
• The potential dilution effect is recognized by
  investors who evaluate earnings based on a
  diluted earnings per share.

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Use of Convertible Securities

• In many cases, convertible securities are
  employed as deferred common stock financing.
• Does not immediately dilute earnings.
• Securities are converted at a higher price than
  if they would have been directly issued. This
  has the impact of reducing the dilution effect.
• The interest or dividend rate is likely to be
  less than that of straight debt or preferred
  stock. The greater the growth prospects of the
  firms common stock, the lower the stated rate
  the firm will need to pay.

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Forcing or Stimulating Conversion

• Investors can exercise their option to convert to
  common stock at any time.
• Companies can force conversion by calling the
  issue.
• The company has an incentive to call only when
  the conversion price exceeds the call price by
  around 15 and when the common dividend rate is
  less than the interest or preferred. dividend
  rate investors are earning.
• Firms attempt to stimulate conversion by
  including the step-up feature to the conversion
  price or increasing the common dividend.

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Convertible Value
Convertible Bond Value Straight Bond Value
Option Value

• Volatility in cash flows of firm
• Decreases straight bond value
• Increases option value
• Suggests that convertibles are useful when a
  companys future is highly uncertain

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Straight Bond Value

• The value of a nonconvertible bond with the same
  coupon rate, maturity, and default risk as the
  convertible bond.

I / 2
I / 2 F
I / 2
VSB

...
(1 i/2)1
(1 i/2)2
(1 i/2) 2n
F
I / 2
2n

S
(1 i/2)t
(1 i/2)2n
t1
(I / 2)(PVIFA i/2, n) F (PVIF i/2, n)
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Straight Bond Value of the Convertible

• Company C has a convertible debenture outstanding
  that provides an 8 coupon (interest is paid
  semiannually) and continues exactly 20 years
  until final maturity. A similar nonconvertible
  bond will currently provide a 5 semiannual yield
  to maturity. What is the straight bond value of
  Company Cs convertible bond?
• V 40 (PVIFA5, 20 x 2) 1,000 (PVIF5, 20 x
  2)
• 40 (17.159) 1,000 (0.142)
• 686.36 142
• 828.36

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Why Care About Straight Bond Value?

• The convertible bond value equals straight bond
  value plus conversion option value.
• The 828.36 represents a floor (minimum) below
  which the convertible value will not fall. This
  occurs when the conversion option value is
  essentially worthless.
• The straight bond value is subject to change as
  interest rates, firm risk, and time change.
  This, in turn, is likely to impact the
  convertible bond value.

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Relationships Among Premiums
Market value line

• The leftmost portion of the graph represents a
  firm that is in financial distress.
• The stronger the financial health of the firm the
  greater the straight bond value until it reaches
  a ceiling level.

Convertible security value
Premium
Value of Convertible Security
Straight bond value
Market Value of Common Stock
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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.

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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 firms
  investment holdings of the other companys 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.

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Warrants
Warrant A relatively long-term option to
purchase common stock at a specified exercise
price over a specified period of time.
Warrants are employed as sweeteners

• To obtain a lower interest rate.
• To raise funds when the firm is considered a
  marginal credit risk.
• To compensate underwriters and venture
  capitalists when founding a company.

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Warrant Features

• The warrant contains provisions for
• the number of shares that can be purchased per
  warrant.
• the price at which the warrant can be exercised.
• the warrant expiration date.
• Warrant holders are not entitled to any dividends
  nor do they have any voting power.
• The exercise price is generally adjusted for any
  common stock dividends and splits.

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Example of Exercise of Warrants

• FunFinMan, Inc., is currently financed entirely
  with common stock. The firm is composed of 10
  million in common stock (5 par value) and 20
  million in retained earnings. The company is
  considering issuing 20 million of 8, 20-year
  debentures including 1 warrant per bond that can
  be converted into 5 shares of common stock at an
  exercise price of 40 per share. How will this
  impact the capitalization of the firm?

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Example of Exercise of Warrants (in millions)
Before After Financing Financing

• Debentures 0 10
• Common stock (5 par) 10 10
• Additional paid-in capital 0 0
• Retained earnings 20 20
• Shareholders equity 30 30
• Total Capitalization 30 40

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Example of Exercise of Warrants (in millions)
Before After Financing Exercise

• Debentures 0 10
• Common stock (5 par) 10 10.5
• Additional paid-in capital 0
  3.5
• Retained earnings 20 20
• Shareholders equity 30 34
• Total Capitalization 30 44

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Valuation of a Warrant

• Theoretical value of a warrant
• max (N)(Ps) E, 0
• N number of shares per warrant
• Ps market price of one share of stock
• E exercise price associated with the purchase
  of N shares

Theoretical value line
Market value line
Warrant Value
Exercise price
45o
Associated Common Stock Price
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Example of the Valuation of a Warrant

• Theoretical value of a warrant
• max (N)(Ps) E, 0
• N 1, Ps 10 , E 5
• max(1)(10) 5, 0 5
• N 1, Ps 15 , E 5
• max(1)(15) 5, 0 10

Stock appreciates 50 Theoretical warrant value
appreciates 100
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Warrant Value
Minimum value is 0.
5
Associated Common Stock Price
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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.