LO5
Warrants 25.6
• A security that gives the holder the right to
purchase shares of stock at a fixed price
over a given period of time
• It is basically a call option issued by
corporations in conjunction with other
securities to reduce the yield
• Usually included with a new debt or
preferred shares issue as a sweetener or
equity kicker
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Differences between warrants and
traditional call options
• Warrants are generally very long term
• They are written by the company and
exercise results in additional shares
outstanding
• The exercise price is paid to the company
and generates cash for the firm
• Warrants can be detached from the original
securities and sold separately
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LO5
Convertible Bonds 25.7
• Convertible bonds (or preferred stock) may
be converted into a specified number of
common shares at the option of the
security holder
• The conversion price is the effective price
paid for the stock. It is the dollar amount of
a bond’s par value that is exchangeable for
one share of stock
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Convertibles – continued
• The conversion ratio is the number of
shares received when the bond is
converted
• Conversion Premium – The difference
between the conversion price and the
current stock price divided by the current
stock price
• Straight Bond Value – The value of a
convertible bond if it could not be
converted into common stock
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Convertibles – continued
• Floor Value – Either the straight bond
value or the conversion value
• Convertible bonds will be worth at least as
much as the straight bond value or the
conversion value, whichever is greater
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Figure 25.5 – Minimum value of a convertible
bond versus the value of the stock for a given
interest rate
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Figure 25.6 – Value of a convertible bond versus
value of the stock for a given interest rate
25-6
Valuing Convertibles
LO5
• Suppose you have a 10% bond that pays semiannual coupons and will mature in 15 years. The
face value is $1,000 and the yield to maturity on
similar bonds is 9%. The bond is also convertible
with a conversion price of $100. The stock is
currently selling for $110. What is the minimum
price of the bond?
•
•
•
•
Straight bond value = 1081.44
Conversion ratio = 1000/100 = 10
Conversion value = 10*110 = 1100
Minimum price = $1100
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Reasons for Issuing Warrants and
Convertibles 25.8
• They allow companies to issue cheap
bonds by attaching sweeteners to the new
bond issue. Coupon rates can then be set
at below market rate for straight bonds
• They give companies the chance to issue
common stock in the future at a premium
over current prices
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Table 25.3 – The case for and
against convertibles
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Other Options 25.9
• Call provision on a bond
• Allows the company to repurchase the bond
prior to maturity at a specified price that is
generally higher than the face value
• Increases the required yield on the bond – this
is effectively how the company pays for the
option
• Put bond
• Gives the bondholder the right to require the
company to repurchase the bond prior to
maturity at a fixed price
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Other Options continued
• Over allotment option
• Underwriters have the right to purchase
additional shares from a firm in an IPO
(chapter 15)
• Insurance and Loan Guarantees
• These are essentially put options
• Managerial options
25-11