Chapter 22

Convertibles,
Exchangeables,
and Warrants

22.1 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 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.
22.2 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Convertibles, Exchangables,
and Warrants

Convertible Securities
Use of Convertibles
Value of Convertible
Securities
Exchangeable Bonds
Warrants
22.3 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 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.
22.4 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 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.
22.5 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 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.
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.
22.6 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 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

22.7 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 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).
clause
22.8 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 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,
share then the conversion value is:
3.33 shares x $42 = $140 per share of preferred stock
22.9 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 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,
share then the conversion
premium is:
$154 $140 = $14 premium per share of
preferred stock (or a 10% premium).
22.10 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Other Issues with
Convertible Securities
Virtually all convertible securities provide for a call
price,
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.
share
22.11 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 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.

22.12 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 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.
22.13 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 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
22.14 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 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 I/2+F
VSB = (1 + i/2)1 + (1 + i/2)2 + ... + (1 + i/2) 2*n
2*n I/2 F
= (1 + i/2) t
+
t=1 (1 + i/2)2*n

= (I / 2)(PVIFA i/2, n) + F (PVIF i/2, n )

22.15 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 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.
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
22.16 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Why Care About
Straight Bond Value?
The convertible bond value equals straight
bond value plus conversion option value.
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.
22.17 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Relationships
Among Premiums
Market
The leftmost portion value line
of the graph

Value of Convertible Security

represents a firm Convertible
that is in financial security
Premium
distress. value

The stronger the

financial health of Straight
bond value
the firm the greater
the straight bond
value until it reaches
a ceiling level. Market Value of Common Stock

22.18 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 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.
22.19 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 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.
22.20 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 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.

22.21 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 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.
22.22 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 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.

22.23 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 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?

22.24 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 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
22.25 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 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
22.26 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Valuation of a Warrant
Theoretical value of a
warrant: Theoretical
value line
max [ (N)(Ps) E, 0] Market

Warrant Value
N = number of shares per value line
warrant
Ps = market price of one
share of stock Exercise
E = exercise price price
45o
associated with the
purchase of N shares
Associated Common Stock Price

22.27 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 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%
$10
N = 1,
1 Ps = $10 , E = $5
max[(
max 1)($10)
$10 $5,
$5 0] = $5 Minimum
value is 0. $5
N = 1,
1 Ps = $15 , E = $5
max[(
max 1)($15)
$15 $5,
$5 0] =$10
Associated Common Stock Price

22.28 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 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.
22.29 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.