26.WARRANTS AND CONVERTIBLES

CHAPTER 26 WARRANTS AND CONVERTIBLES Warrants and convertibles are unique compared to other types of securities because they may be converted into common stock. The CFO needs to have a good under- standing of warrants and convertibles along with their valuation, their advantages and disadvantages, and when their issuance is recommended. WARRANTS A warrant is the o ption given holders to buy a predeter- mined number of shares of stock at a given price. Warrants may be detachable or nondetachable. A detachable warrant may be sold separately from the bond with which it is associated. Thus, the holder may exercise the warrant but not redeem the bond. Your company may issue bonds with detachable warrants to purchase additional bonds so as to hedge the risk of adverse future interest rate movements since the warrant is convertible into a bond at a fixed interest rate. If interest rates increase, the warrant will be worthless, and the issue price of the warrant will partially offset the higher interest cost of the future debt issue. A nondetachable warrant is sold with its bond to be exercised by the bond owner simultaneously with the convertible bond. Your company may sell warrants separately (e.g., American Express) or in combination with other securities (e.g., MGM). To obtain common stock, the warrant must be given up along with the payment of cash called the exercise price. Although warrants usually mature on a specified date, some are perpetual. A holder of a warrant may exercise it by purchasing the stock, sell it on the market to other investors, or continue to hold it. The company cannot force the exercise of a warrant. If desired, the company may have the exercise price of the warrant change over time (e.g., increase each year). 504 Warrants 505 If a stock split or stock dividend is issued before the warrant is exercised, the option price of the warrant will be adjusted for it. Warrants may be issued to obtain a dditional funds. When a bond is issued with a warrant, the warrant price is usually established between 10 and 20 percent above the stock’s market price. If the company’s stock price increases above the option price, the warrants will be exercised at the option price. The closer the warrants are to their maturity date, the greater is the likelihood that they will be exercised. What is a warrant worth? The theoretical value of a warrant is computed by a for- mula. The formula value is typically less than the market price of the warrant because the speculative appeal of a warrant allows the investor to obtain personal leverage: Value of a Warrant =  Market price per share − Exercise price  × Number of shares that may be bought EXAMPLE 26.1 A warrant for XYZ Company’s stock gives the owner the right to buy o ne share of common stock at $25 a share. Themarket priceofthe commonstock is$53.The formula price of the warrant is $28 (($53 − $25) ×1). If the owner had the right to buy three shares of common stock with one warrant, the theoretical value of the warrant would be $84 ($53 − $25) × 3). If the stock is selling for an amount below the option price, there will be a negative value. Since this is illogical, a zero value is assigned. EXAMPLE 26.2 Assume the same facts as in Example 26.1, except that the stock is selling at $21 a share. The formula amount is − $4(($21 − $25) × 1). However, zero will be assigned. Warrants do not have an investment value because there are no interest, dividends, or voting rights. Therefore, the market value of a warrant is only attributable to its convertibility feature into common stock. However, 506 Warrants and Convertibles the market price of a warrant is typically more than its theoretical value, which is referred to as the premium on the warrant. The lowest amount that a warrant will sell for is its theoretical value. The value of a w arrant depends on the remaining life of the option, dividend payments on the common stock, the fluctuation in price of the common stock, whether the warrant is listed on the exchange, and the investor’s opportunity. There is a higher price for a warrant when its life is long, the dividend payment on common stock is small, the stock price is volatile, it is listed on the exchange, and the value of funds to the investor is great (because the warrant requires a lesser investment). EXAMPLE 26.3 ABC stock has a market value of $50. The exercise price of the warrant is also $50. Thus, the theoretical value of the warrant is $0. However, the warrant will sell at a premium (positive price) if there is the possibility that the market price of the common stock will exceed $50 prior to the expiration date of the warrant. The more distant the expiration date, the greater will be the premium, since there is a longer period for possible price appreciation. The lower the market price relative to the exercise p rice, the less the premium will be. EXAMPLE 26.4 Assume the same facts as in Example 26.3, except that the current market price of the stock is $35. In this case, the warrant’s premium will be much lower since it would take longer for the stock’s price to increase above $50 a share. If investors expect that the stock price would not increase above $50 at a later date, the value of the warrant would be $0. If the market price of ABC stock rises above $50, the market price of the warrant will increase and the pre- mium will decrease. In other words, when the stock price exceeds the exercise price, the market price of the warrant approximately equals the theoretical value so the premium disappears. The reduction in the pre- mium arises because of the lessening of the advantage of owning the warrant compared to exercising it. Convertible Securities 507 Should you issue a warrant? The advantages of issuing warrants are: ❍ They serve as ‘‘sweetener’’ for an issue of debt or preferred stock. ❍ They permit the issuance of debt at a low interest rate. ❍ They allow for balanced financing between debt and equity. ❍ Funds are received when the warrants are exercised. The disadvantages of issuing warrants are: ❍ When exercised they will result in a dilution of commonstockwhichinturnlowersthemarket price of stock. ❍ They may b e exercised when the business has no need for additional capital. CONVERTIBLE SECURITIES What is a convertible security and when should it be issued? A convertible security can be exchanged for common stock by the holder, and in some cases the issuer, according to specified terms. Examples are convertible bonds a nd con- vertible preferred stock. Common shares are issued when the convertible security is exchanged. The conversion ratio equals: Conversion ratio = Par value of convertible security Conversion price The conversion price is the price the holder pays for the common stock when the conversion is made. The con- version price and the conversion ratio are established at the date the convertible security is issued. The conversion price should be tied t o the growth prospects of the com- pany. The greater the potential, the greater the conversion price. A convertible bond is a quasi-equity security because its market value is keyed to its value if converted instead of as a bond. The convertible bond may be deemed a delayed issue of common stock at a price above the current level. EXAMPLE 26.5 A $1,000 bond is convertible into 3 0 shares of stock. The conversion price is $33.33 ($1,000/30 shares). 508 Warrants and Convertibles EXAMPLE 26.6 A share of convertible preferred stock with a par value of $50 is convertible into four shares of common stock. The conversion price is $12.50 ($50/4). EXAMPLE 26.7 A $1,000 convertible bond is issued that allows the holder to convert the bond into 10 shares of common stock. Thus, the conversion ratio is 10 shares for 1 bond. Since the face value of the b ond is $1,000, the holder is tendering this amount upon conversion. The conversion price equals $100 per share ($1,000/10 shares). EXAMPLE 26.8 Y Company issued a $1,000 convertible bond at par. The conversion price is $40. The conversion ratio is: Conversion ratio = Par value of convertible security Conversion price = $1,000 $40 = 25 The conversion value of a security is computed as: Conversion value = Common stock price × Conversion ratio When a convertible security is issued, it is priced higher than its conversion value. The difference is the conversion premium. The percentage conversion premium is computed as: Percentage conversion premium = Market value − Conversion value Conversion value EXAMPLE 26.9 LA Corporation issued a $1,000 convertible b ond at par. The market price of the common stock at the date of issue was $48. The conversion p rice is $55. Convertible Securities 509 EXAMPLE 26.9 (continued) Conversion ratio = Par value of Convertible security Conversion price = $1,000 $55 = 18.18 Conversion value of t he bond equals: Common stock price × Conversion ratio = $48 × 18.18 = $872 The difference between the conversion value of $872 and the issue price of $1,000 is the conversion premium of $128. The conversion premium may also be expressed as a percentage of the conversion value. The percent in this case is: Percentage conversion premium equals: Market value − Conversion value Conversion value = $1,000 −$872 $872 = $128 $872 = 14.7% The conversion terms may increase in steps over spec- ified time periods. As time elapses, fewer common shares are exchanged for the bond. In some cases, after a specified time period the conversion option may expire. A convertible security usually includes a clause that protects it from dilution caused by stock dividends, stock splits, and stock rights. The clause typically prevents the issuance of common stock at a price lower than the conversion price. The conversion price is adjusted for a stock split or stock dividend, enabling the common shareholder to retain his or her percentage interest. EXAMPLE 26.10 A 3-for-1 stock split requires a tripling of the conver- sion ratio. A 20 percent stock dividend necessitates a 20 percent increase in the conversion ratio. The voluntary conversion of a security by the holder depends on the relationship of the interest on the bond compared to the dividend on the stock, the risk preference of the holder (stock has a greater risk than a bond), a nd the current and expected market price of the stock. 510 Warrants and Convertibles What is the value of a convertible security? A convertible security is a hybrid security because it has attributes similar to common stock and bonds. It is expected that the holder will eventually receive both interest yield and capital gain. Interest yield is the coupon interest relative to the amount invested. The capital gain yield applies to the difference between the conversion price and the stock price at the issuance date and the expected growth rate in stock price. The investment value of a convertible security is the value of the security, assuming it was not convertible but had all other attributes. For a convertible bond, its investment value equals the present value of future interest payments plus the present value of the maturity amount. For preferred stock the investment value equals the present value of future dividend payments plus the present value of expected selling price. Conversion value is the value of the stock received upon converting the bond. As the price of the stock increases, so will its conversion value. EXAMPLE 26.11 A $1,000 bond is convertible into 18 shares of com- mon stock with a market value of $52 per share. The conversion value of the bond equals: $52 × 18 shares = $936 EXAMPLE 26.12 At the date a $100,000 convertible bond is issued, the market price of the stock is $18 a share. Each $1,000 bond is convertible into 50 shares of stock. The conversion ratio is thus 50. The number of shares the bond is convertible into is: 100 bonds ($100,000/$1,000) × 50 shares = 5,000 shares Theconversion valueis $90,000($18 ×5,000shares). If the stock price is anticipated to grow at 6 percent per year, the conversion value at the end of the first year is: Convertible Securities 511 EXAMPLE 26.12 (continued) Shares 5,000 Stock price ($18 × 1.06) $ 19.08 Conversion value $95,400 A convertible security will not sell at less than its value as straight debt (nonconvertiblesecurity).Thisisbecause the conversion privilege has to have some value in terms of its potential convertibility to common stock and in terms of reducing the holder’s risk exposure to a declining bond price. (Convertible bonds fall off less in price than straight debt issues.) Market value will equal investment value only when the conversion privilege is worthless because of a low market price of the common stock relative to the conversion price. When convertible bonds are issued, the business ex- pects that the value of common stock will appreciate and that the bonds will eventually be converted. If conver- sion does occur, the company could t hen issue another convertible bond referred to as leapfrog financing. If the market price of common stock decreases instead of increasing, the holder will not convert the debt into equity. In this case, the convertible security remains as debtandistermeda‘‘hung’’convertible. A convertible security holder may prefer to hold the security rather than converting it even though the conver- sion value exceeds the investment cost. First, as the price of the common stock increases, so will the price of the convertible security. Second, the holder receives regular interest payments or preferred dividends. T o force con- version, companies issuing convertibles often have a call price. The call price is above the face value of the bond (about 10 to 20 percent higher). This forces the conversion of stock, provided the stock price exceeds the conversion price. The holder would prefer a higher-value common stock than a lower call price for the bond. The issuing company may force conversion of its con- vertible bond to common stock when financially advan- tageous, such as when the market price of the stock has declined, or when the interest rate on the convertible debt is currently higher than the going market interest rates. An example of a company that has in the past had a conversion of its convertible bond when the market price of its stock was low was United Technologies. 512 Warrants and Convertibles EXAMPLE 26.13 The conversion price on a $1,000 debenture is $40, and the call price is $1,100. In order for the conversion value of the bond to equal the call price, the market price of the stock would have to be $44 ($1,100/25). If the conversion value of the bond is 15 percent higher than the call price, the approximate market price of common stock would be $51 (1.15 × $44). At a $51 price, conversion is assured because if the investor did not convert he or she would experience an opportunity loss. EXAMPLE 26.14 ABC Company’s convertible bond has a conversion price of $80. The conversion ratio is 10. The market price o f the stock is $140. The call price is $1,100. The bondholder would prefer to convert to common stock with a market value of $1,400 ($140 × 10) than have his or her convertible bond redeemed at $1,100. In this situation, the call provision forces the conversion when the bondholder might be inclined to wait longer. Does it pay to issue a convertible security? The advantages of issuing convertible securities are: ❍ It is a ‘‘sweetener’’ in a debt offering by giving the investor an opportunity to share in the price appreciation of common stock. ❍ The issuance of convertible debt allows for a lower interest rate on the financing compared to issuing straight debt. ❍ There are fewer financing restrictions with a con- vertible security. ❍ Convertibles provide a means of issuing equity at prices higher than current market prices. ❍ A convertible security may be issued in a tight money market, when it is difficult for a creditworthy com- pany to issue a straight bond or preferred stock. ❍ The call provision enables the company to force conversion whenever the market price of the stock exceeds the conversion price. ❍ If the company issued straight debt now and com- mon stock later to meet the debt, it would incur Convertible Securities 513 flotation costs twice, whereas with convertible debt, flotation costs would occur only once, with the initial issuance of the convertible bonds. The disadvantages of issuing convertible securities are: ❍ If the company’s stock price appreciably increases, it would have been better o ff financing through a regular issuance of common stock by waiting to issue it at the higher price rather than allowing conversion at the lower price. ❍ The company has to pay the convertible debt if the stock price does not appreciate. What should be the financing policy? When a company’s stock price is depressed, convertible debt rather than common stock issuance may be advisable if the price of stock is expected to increase. A conversion price above the current market price of stock will involve the issuance of less shares when the bonds are converted relative to selling the shares at a current lower price. Furthermore, there is less share dilution. The conversion will take place only if the price of the stock rises above the conversion price. The drawback is that if the stock price does not increase and conversion does not occur, an additional debt burden is placed upon the firm. The issuance of convertible debt is recommended when the company wants to leverage itself in the short term but desires not to pay interest and principal on the convertible debt in the long term (due to its conversion). A convertible issue is a good financing instrument for a growth company with a low dividend yield on stock. The higher the growth rate, the earlier the conversion. For example, a convertible bond may be a temporary source of funds in a construction period. It is a relatively inexpensive source for financing growth. A convertible issuance is not recommended for a company with a modest growth rate since it would take a long time to force conversion. During such a time the company will not be able to issue additional financing easily. A long conversion period may imply to investors that the stock has not done as well as expected. The growth rate of the firm is an important factor in determining whether convertibles should be issued. Your company can also issue bonds exchangeable for the common stock of other companies. Your company may do this if it owns a sizable stake in another company’s stock and it wants to raise cash. There is an intention to sell shares at a later date because of an expectation of share price appreciation. [...]... convertible preferred stock exchangeable at the option of the company (i.e., when it becomes a taxpayer) into convertible debt of the company How do convertibles compare with warrants? The differences between convertibles and warrants are: ❍ ❍ ❍ Exercising convertibles does not usually generate additional funds to the company, whereas the exercise of warrants does When conversion takes place, the debt...514 Warrants and Convertibles In conclusion, a convertible bond is a delayed common equity financing The issuer expects stock price to rise in the future (e.g., two to four years) to stimulate conversion Convertible bonds... reduced However, the exercise of warrants adds to the equity position with debt still remaining Because of the call feature, the company has more control over the timing of the capital structure with convertibles than with warrants . CHAPTER 26 WARRANTS AND CONVERTIBLES Warrants and convertibles are unique compared to other types of securities because they. needs to have a good under- standing of warrants and convertibles along with their valuation, their advantages and disadvantages, and when their issuance is recommended. WARRANTS A warrant is the. into convertible debt of the company. How do convertibles compare with warrants? The differences between convertibles and warrants are: ❍ Exercising convertibles does not usually generate additional