Chapter 5

Warrants and
Convertibles

22-1
 Warrants

 A warrant is an option to buy stated number of

shares of common stock at a specified price
(exercise/strike price).
 Warrants are similar to call options but typically
have longer maturities
 Come together with bond or preferred stock
 Used as sweeteners
 Dilution effect on EPS, MPS and in control
 Effect on capital structure

22-2
 Characteristics of warrant
 Exercise/strike price (E) = specified price at which the holder
of warrant can buy the stock of company that issues warrant
 Exercise ratio (#) = the number of share that can be purchased
by the holder of one warrant (one bond = one warrant)
 Time to expiration = it is specified time until which a warrant
can be exercised
 Detachable and non-detachable = some warrant can be
detached from bond and some can not be detached
 Right to claim = No right to claim on income and asset until
exercised
 Reporting = the company should report the potential dilution
effect if warrants are exercised
22-3
 Valuation of warrant
 Theoretical/minimum/formula/floor value
of warrant (TVw) = Max [(P0 – E)#, 0]
 Expected theoretical value of warrant,
E(TVw) =  Max [(P0 – E)#, 0] p
p = probability
Warrant premium, Wp = MVW – TVW
MVW = market value of warrant

22-4
 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.
 Dilution effect
22-5
 Features of Convertible
Conversion Price (CP) - The price per share at which
common stock will be exchanged for a convertible
security.
CP = face value of convertible bond  conversion ratio

Conversion Ratio (CR) - The number of shares of

common stock into which a convertible security can
be converted.
CR = face value of the convertible security the
conversion price.
22-6
 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
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.
Conversion value initially (t= 0) = P0 × CR
Conversion value at time t, Ct = Pt × CR = P0 (1+g)t × CR
Pt= market price of stock at time t.
g = growth rate in stock price

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
22-9
 Straight Bond Value or
investment 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

Bt = (1 + i/2)1 + (1 + i/2)2 + ... + (1 + i/2) 2*n
2*n I/2 F
=S (1 + i/2)t
+ (1 + i/2)2*n
t=1

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

22-10
 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 C’s convertible bond?

V = $40 (PVIFA5%, 20x2) + $1,000 (PVIF5%, 20x2)

= $40 (17.159) + $1,000 (.142)
= $686.36 + $142
= $828.36
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 Minimum price of
convertible
Itis the higher of conversion
value and straight bond value
Minimum price of convertible
= Max (Bt, Ct)

22-12
 Convertible Premiums

Initial conversion premium : it is

the conversion price premium
over current price of stock
= (CP – P0) P0
P0 = market price of stock

22-13
 Convertible Premiums
Premium Over Conversion Value in subsequent years --
The market price of a convertible security minus its
conversion value; also called conversion premium.
= (market price of convertible – higher of Ct or Bt)  higher
of Ct or Bt

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).
22-14
 Convertible Premiums

 Premium over straight bond value

= (market price of convertible – straight bond value)
 straight bond value
 Premium over conversion value
= (market price of convertible – conversion value)
 conversion value
 Conversion parity Price = market price of convertible
 conversion ratio

22-15
 Yield to maturity
Yield to maturity on a straight bond can be found
by solving for i in following equation

I I I+F
Bt = (1 + i)1 + (1 + i)2 + ... + (1 + i) n
n I F
=S (1 + i)t
+ (1 + i)n
t=1

= (I )(PVIFA i, n) + F (PVIF i, n)
22-16
 Expected rate of return on
convertible
Expected return on a convertible bond can be
found by solving for i in following equation
I I I + Cn
Bt = (1 + i)1 + (1 + i)2 + ... + (1 + i) n
n I Cn
=S (1 + i)t
+ (1 + i)n
t=1

= (I )(PVIFA i, n) + Cn (PVIF i, n)
Cn = conversion value or selling price of
22-17 convertible at time t
 Converting Convertible
Securities
 Force conversion
Company can call the bond when the company wants to force the
conversion. 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.
 Stimulated conversion
Company can stimulate the conversion by rising the dividend on
common stock to high enough level the holders of convertible
securities are better of converting to receive higher dividend
rather than receiving coupon interests on bond.

22-18