Chapter 20 Financing with Derivatives © 2018 Cengage. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Introduction Derivative Short-Term Options Convertible Fixed Income Securities Warrants Rights Offering Swaps © 2018 Cengage. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Options (slide 1 of 8) Call Option Buy a particular asset Put Option Sell a particular asset © 2018 Cengage. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Options (slide 2 of 8) Call Option Valuation Concepts Value of Call Option At Expiration = Stock Price – Exercise Price Prior to Expiration > Stock Price – Exercise Price Maximum Value = Stock Price Minimum Value = 0 © 2018 Cengage. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. What variables impact the value of call option? © 2018 Cengage. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Options (slide 3 of 8) Variables Affecting Call Option Valuation Relationship Between the Exercise Price and the Stock Price The higher the exercise price, given the stock price, the lower the call option value, all other things being equal © 2018 Cengage. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Options (slide 4 of 8) © 2018 Cengage. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Options (slide 5 of 8) Variables Affecting Call Option Valuation Time Remaining Until Expiration Date The longer the time remaining before the option expires, the higher the option value, all other things being equal © 2018 Cengage. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Options (slide 6 of 8) © 2018 Cengage. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Options (slide 7 of 8) Variables Affecting Call Option Valuation Interest Rates The higher the level of interest rates, the higher the call option’s value, all other things being equal Expected Stock Price Volatility The greater the expected stock price volatility, the higher the call option value, all other things being equal © 2018 Cengage. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Options (slide 8 of 8) Call Options on Bonds Common Stock in an Options Framework © 2018 Cengage. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Convertible Securities (slide 1 of 5) Features of Convertible Securities Conversion Price Conversion Ratio Par Value of Security Conversion Ratio = Conversion Price © 2018 Cengage. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Convertible Securities (slide 2 of 5) Managing Long-Term Funding with Convertibles Reasons for Issuing Convertible Securities Reduces agency costs Lower interest payments or dividends Sell common stock at a higher price than the prevailing market price at the time of issue Allows time for investments to pay benefits © 2018 Cengage. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Convertible Securities (slide 3 of 5) Valuation of Convertible Securities Conversion Value Stock Price x Conversion Ratio Straight Bond Value n P0 t 1 Interest 1 kd t Principal 1 kd n Market Value © 2018 Cengage. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Convertible Securities (slide 4 of 5) © 2018 Cengage. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Convertible Securities (slide 5 of 5) Converting Convertible Securities Voluntary Forced Conversion Redemption Convertible Securities and Earnings Dilution © 2018 Cengage. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Warrants (slide 1 of 4) Often “Detachable” Reasons for Issuing Warrants Lower agency costs Permits a company to sell common stock at a price above the price prevailing at the time of original issue Allows a company to sell common stock in the future without incurring significant issuance costs at the time of sale © 2018 Cengage. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Warrants (slide 2 of 4) Valuation of Warrants © 2018 Cengage. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. How are warrants and convertible securities different? © 2018 Cengage. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Warrants (slide 3 of 4) Comparison of Convertible Securities and Warrants Similarities Both tend to reduce agency costs The intention is the deferred issuance of common stock at a price higher than that prevailing at the time of the convertible or warrant issue Both the convertibility option and the attachment of warrants result in interest expense or preferred dividend savings for the issuing company © 2018 Cengage. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Warrants (slide 4 of 4) Comparison of Convertible Securities and Warrants Differences The company receives additional funds at the time warrants are exercised The fixed-income security remains on the company’s books after the exercise of warrants No additional funds are received at the time convertibles are converted With convertibles, the fixed-income security is exchanged for common stock and taken off the company’s books Because of the call feature, convertible securities potentially give the company more control than warrants over when the common stock is issued © 2018 Cengage. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Analysis of Rights Offerings (slide 1 of 3) Rights Offering Preemptive Rights Subscription Price © 2018 Cengage. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Analysis of Rights Offerings (slide 2 of 3) Valuation of Rights Rights-On R= Rights-on market price of the stock S Formula value of the right M0 M0 - S R= N+1 Subscription price of the right N Number of rights necessary to purchase one new share © 2018 Cengage. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Analysis of Rights Offerings (slide 3 of 3) Valuation of Rights Ex-Rights R Ex-rights market price of the stock S Formula value of the right Me Me - S R= N Subscription price of the right N Number of rights necessary to purchase one new share © 2018 Cengage. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Swaps (slide 1 of 2) Interest Rate Swaps Credit Default Swaps © 2018 Cengage. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Swaps (slide 2 of 2) © 2018 Cengage. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Questions? © 2018 Cengage. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
