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Chapter 22Chapter 22

Convertibles, Convertibles, Exchangeables, Exchangeables,

and Warrantsand Warrants

Convertibles, Convertibles, Exchangeables, Exchangeables,

and Warrantsand Warrants© 2001 Prentice-Hall, Inc.

Fundamentals of Financial Management, 11/eCreated by: Gregory A. Kuhlemeyer, Ph.D.

Carroll College, Waukesha, WI

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Convertibles, Exchangables, Convertibles, Exchangables, and Warrantsand 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.

Derivative SecurityDerivative Security

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.

Convertible SecurityConvertible Security

This provides the convertible holder a fixed return (interest or dividend) andand 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 lower yield than it would have to pay on a straight bond or preferred stock issue.

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Conversion Price 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 ratioconversion ratio.

Convertible SecurityConvertible Security

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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FunFinMan, Inc., has an issue of 8%, $100 par value $100 par value preferred stock

outstanding. The security has a conversion price of $30 conversion price of $30 per share.

What is the conversion ratio?What is the conversion ratio?

Conversion ExampleConversion Example

Conversion RatioConversion Ratio = $100 par value$100 par value / $30 conversion price $30 conversion price = 3.33 shares3.33 shares

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Antidilution and the Antidilution and the Convertible SecurityConvertible 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 clauseantidilution 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.

Conversion ValueConversion Value

For example, if the market value per share of common stock in FunFinMan, Inc., were trading at $42 per $42 per

shareshare, then the conversion value conversion value is:

3.33 shares 3.33 shares x $42$42 = $140 per share of preferred stock$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.

Premium Over Premium Over Conversion ValueConversion Value

For example, if the market value per share of preferred stock in FunFinMan, Inc., were

trading at $154 per share$154 per share, then the conversion conversion premium premium is:

$154$154 - $140 = $140 = $14 premium per share of $14 premium per share of preferred stock (or a 10% premium).preferred stock (or a 10% premium).

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Other Issues with Other Issues with Convertible SecuritiesConvertible Securities

Virtually all convertible securities provide for a call call priceprice, which allows the company to force conversion when the security market value is significantly above the call price.

Almost all convertible bond issues 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 diluted earnings per shareearnings per share.

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Use of Use of Convertible SecuritiesConvertible Securities

In many cases, convertible securities are employed In many cases, convertible securities are employed as as “deferred” “deferred” common stock financing.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 The interest or dividend rate is likely to be less is likely to be less than than that of straight debt or preferred stock.that of straight debt or preferred stock. The greater the growth prospects of the firm’s common stock, the lower the stated rate the firm will need to pay.

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Forcing or Forcing or Stimulating ConversionStimulating Conversion

Investors can exercise their option to convert to Investors can exercise their option to convert to common stock at any time.common stock at any time.

Companies can force conversion by calling the Companies can force conversion by calling the issue. 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 Firms attempt to stimulate conversion by including the “step-up” feature to the conversion including the “step-up” feature to the conversion price or increasing the common dividend. price or increasing the common dividend.

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Convertible Bond Value Convertible Bond Value = Straight Bond Value + Option Value

Convertible ValueConvertible Value

Volatility in cash flows of firm

DecreasesDecreases straight bond value

IncreasesIncreases option value

Suggests that convertibles are useful when a company’s future is highly uncertain

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Straight Bond ValueStraight Bond ValueStraight Bond ValueStraight Bond Value

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

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

(1 + i/2)1 (1 + i/2)2 (1 + i/2) 2*nnVSB = + + ... +

I / 2 I / 2 + F

= 2*nn

t=1(1 + i/2)t

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

(1 + i/2)2*nn+ F

I / 2

I / 2

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Straight Bond Value Straight Bond Value of the Convertibleof the ConvertibleStraight Bond Value Straight Bond Value of the Convertibleof 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 maturity5% semiannual yield to maturity. What is the What is the straight bond value of Company C’s convertible bond?straight bond value of Company C’s convertible bond?

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

= $40 (17.159) + $1,000 (.142)

= $686.36 + $142

= $828.36 $828.36

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 maturity5% semiannual yield to maturity. What is the What is the straight bond value of Company C’s convertible bond?straight bond value of Company C’s convertible bond?

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

= $40 (17.159) + $1,000 (.142)

= $686.36 + $142

= $828.36 $828.36

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Why Care About Why Care About “Straight Bond Value?”“Straight Bond Value?”

The convertible bond value convertible bond value equals straight straight bond value bond value plus conversion option valueconversion option value.

The $828.36$828.36 represents a floor (minimum) below which the convertible value will not fall. This occurs when the conversion option conversion option value 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 Relationships Among PremiumsAmong Premiums

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 straight bond value value until it reaches a ceiling level.

Val

ue

of

Co

nve

rtib

le S

ecu

rity

Market Value of Common Stock

MarketMarketvalue linevalue line

PremiumPremium

Straight Straight bond valuebond value

ConvertibleConvertiblesecuritysecurity

valuevalue

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Relationships Among Relationships Among Premiums -- SummaryPremiums -- 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 of another company -- generally, one in

which the bond issuer has an ownership interest.

Exchangeable BondExchangeable Bond

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 Valuation of an Exchangeablean 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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Warrant Warrant -- A relatively long-term option to purchase common stock at a specified

exercise price over a specified period of time.

WarrantsWarrants

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.

Warrants are employed as “sweeteners”:Warrants are employed as “sweeteners”:

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Warrant FeaturesWarrant Features

The warrant contains provisions forThe 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 Warrant holders are notnot entitled to any entitled to any dividends nor do they have any voting power.dividends nor do they have any voting power.

The exercise price is generally adjusted for The exercise price is generally adjusted for any common stock dividends and splits.any common stock dividends and splits.

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Example of Example of Exercise of WarrantsExercise 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 How will this impact

the capitalization of the firm?the capitalization of the firm?

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Example of Exercise Example of Exercise of Warrants (in millions)of Warrants (in millions)

DebenturesDebentures $ 0$ 0 $ 10 $ 10

Common stock ($5 par) 10 10

Additional paid-in capital 0 0

Retained earnings 20 20

Shareholders’ equityShareholders’ equity $ 30 $ 30$ 30 $ 30

Total CapitalizationTotal Capitalization $ 30 $ 40$ 30 $ 40

Before After*Financing Financing

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Example of Exercise Example of Exercise of Warrants (in millions)of Warrants (in millions)

DebenturesDebentures $ 0$ 0 $ 10 $ 10

Common stock ($5 par) 10 10.5

Additional paid-in capital 0 3.5

Retained earnings 20 20

Shareholders’ equityShareholders’ equity $ 30 $ 34$ 30 $ 34

Total CapitalizationTotal Capitalization $ 30 $ 44$ 30 $ 44

Before After*Financing Exercise

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Valuation of a WarrantValuation of a Warrant

Theoretical value of a Theoretical value of a warrant:warrant:

maxmax [ (NN)(PPss) - EE, 00]

N = number of shares per N = number of shares per warrantwarrant

PPss = market price of one = market price of one

share of stockshare of stock

E = exercise price E = exercise price associated with the associated with the purchase of N sharespurchase of N shares

War

ran

t V

alu

e

Associated Common Stock Price

TheoreticalTheoreticalvalue linevalue line

45o

MarketMarketvalue linevalue line

ExerciseExercisepriceprice

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Example of the Example of the Valuation of a WarrantValuation of a Warrant

Theoretical value of a Theoretical value of a warrant:warrant:

maxmax [ (NN)(PPss) - EE, 00]

N = 1N = 1, PPss = $10 = $10 , E = $5E = $5

maxmax[(11)($10$10)-$5$5, 00] = $5$5

N = 1N = 1, PPss = $15 = $15 , E = $5E = $5

maxmax[(11)($15$15)-$5$5, 00] =$10$10

War

ran

t V

alu

e

Associated Common Stock Price

$5$5

$10$10

Stock appreciates 50%Stock appreciates 50%

Theoretical warrantTheoretical warrantvalue appreciates 100%value appreciates 100%

MinimumMinimumvalue is 0.value is 0.

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Summary of the Example Summary of the Example of Warrant Valuationof 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.