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Chapter 22

Convertibles,
Exchangeables,
and Warrants
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Pearson Education Limited 2004


Fundamentals of Financial Management, 12/e
Created by: Gregory A. Kuhlemeyer, Ph.D.
Carroll College, Waukesha, WI

After studying Chapter 22,


you should be able to:

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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.
Understand why these securities may be attractive
for a firm's long-term financing needs.
Explain the different terms used to express value for
convertible securities - conversion value, market
value, and straight-bond value.
Calculate the value of convertible securities,
exchangeable bonds, and warrants and explain why
premiums over different values occur.
Understand the relationship between an option
instrument and its underlying security.

Convertibles, Exchangeables,
and Warrants

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Convertible Securities
Value of Convertible
Securities
Exchangeable Bonds
Warrants

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.
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).
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,
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,
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,
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

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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.

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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.

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

in cash flows of firm

Decreases
Increases
Suggests

straight bond value

option value

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.

VSB =

I/2
(1 + i/2)1
2*n

t=1

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I/2
(1 + i/2)

I/2
(1 + i/2)2

+ ... +

I/2+F
(1 + i/2) 2*n

F
(1 + i/2)2*n

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

i/2, n

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?

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


= $40 (17.159) + $1,000 (.142)
= $686.36 + $142
= $828.36

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.

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Relationships
Among 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
value until it reaches
a ceiling level.

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Market
value line
Value of Convertible Security

Convertible
security
value

Premium

Straight
bond value

Market Value of Common Stock

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:

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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.

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

$ 10
10
0
20
$ 30
$ 40

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

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

$ 10
10.5
3.5
20
$ 34
$ 44

Valuation 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

Warrant Value

Theoretical value of a
warrant:
Market
value line

Exercise
price

Theoretical
value line

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Associated Common Stock Price


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Example of the
Valuation of a Warrant
Theoretical value of a
warrant:

N = 1,
1 Ps = $10 , E = $5
max[(
max 1)($10)$10 $5,
$5 0] = $5
N = 1,
1 Ps = $15 , E = $5
max[(
max 1)($15)$15 $5,
$5 0] =$10

Warrant Value

max [ (N)(Ps) - E, 0]

Stock appreciates 50%


Theoretical warrant
value appreciates 100%
Minimum
value is 0.

$5

Associated Common Stock Price


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$10

Summary of the Example


of Warrant Valuation

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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.