LO 5 Warrants 25 6 A security that

LO 5 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 25 -0

LO 5 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 25 -1

LO 5 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 25 -2

LO 5 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 25 -3

LO 5 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 25 -4

LO 5 Figure 25. 5 – Minimum value of a convertible bond versus the value of the stock for a given interest rate 25 -5

LO 5 Figure 25. 6 – Value of a convertible bond versus value of the stock for a given interest rate 25 -6

Valuing Convertibles LO 5 • 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 25 -7

LO 5 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 25 -8

LO 5 Table 25. 3 – The case for and against convertibles 25 -9

LO 5 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 25 -10

LO 5 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