1 / 28

Chapter Fourteen

Chapter Fourteen. Convertible Securities and Warrants. Learning Objectives. 1. Understand why investors are attracted to convertible securities. 2. Explain how convertible securities values are determined

skyler-mcdowell
Download Presentation

Chapter Fourteen

An Image/Link below is provided (as is) to download presentation Download Policy: Content on the Website is provided to you AS IS for your information and personal use and may not be sold / licensed / shared on other websites without getting consent from its author. Content is provided to you AS IS for your information and personal use only. Download presentation by click this link. While downloading, if for some reason you are not able to download a presentation, the publisher may have deleted the file from their server. During download, if you can't get a presentation, the file might be deleted by the publisher.

E N D

Presentation Transcript

  1. Chapter Fourteen Convertible Securities and Warrants

  2. Learning Objectives 1. Understand why investors are attracted to convertible securities. 2. Explain how convertible securities values are determined 3. Describe how investors may be forced to convert bonds or preferred stock into common stock. 4. Explain the advantages and disadvantages of convertible securities to the corporate issuer. 5. Describe the accounting requirements associated with convertibles. 6. Explain why warrants represent highly speculative investments.

  3. Convertible Securities and Warrants • Convertible security: a bond or share of preferred stock that can be converted into common stock at the option of the holder. • Used as financing alternative in periods of high interest rates or tight money. • Convertible securities provide trade-offs between the investor and the corporation.

  4. $1,000 26.75 = 37.38 Shares/Bond The Texlon Convertible Security • A 25-year long-term bond. • Subordinated bond with sinking fund • Due date: June 1, 2012 • Conversion price: $26.75 per share • conversion ratio = Face Value eConversion Price Texlon conversion = ratio

  5. Conversion Value • The value of the bond at the point in time when it is converted to common stock • = (Price common stock) x Conversion ratio • Assume stock price = $22.00/share • Conversion value = $22 x 37.38 = $822.36 • $822.36 = pure bond value and also Floor Value • Note: The Floor Value depends upon current stock price.

  6. Bond price ($) 1,600 1,400 1,200 1,000 800 $596 600 400 200 0 0 5 10 15 20 25 30 35 40 22 Common stock prices ($) Figure 14-1 Telxon 7-1/2% Convertible Bond on Day of Issue (June 1, 1987) Market priceof bond (conversion value + conversion premium) Conversionvalue of bond (function of stock price) Pure bond value

  7. Bond Price and Premiums

  8. Bond price ($) 1,600 1,400 1,200 1,000 800 $596 600 400 200 0 0 5 10 15 20 25 30 35 40 Common stock prices ($)(a) Figure 14-2. Telxon Convertible Bond - 7.5 %, 2012 Maturity - Convertible into 37.38 Shares of Common Stock Conversion premium Market price of bond Conversion value line Pure bond value

  9. 1,600 1,400 1,200 1,000 Figure 14-2. Telxon Convertible Bond - 7.5 %, 2012 Maturity - Convertible into 37.38 Shares of Common Stock Market price of bond Conversion value line 800 $596 600 400 Downside Risk 200 Pure bond value 0 0 5 10 15 20 25 30 35 40 Common stock prices ($)(b)

  10. Merger of Telxon and Symbol • Initial effect of merger • Symbol share = 2 Telxon shares • Telxon bond conversion price doubled to $53.50 and conversion ration = 18.69 • Symbol declared 3 for 2 stock split • adjusted conversion price = $35.67 • Telxon bond now equals 28.04 Symbol shares

  11. Convertible bond or Common stock?

  12. Table 14-4, Part 1 (top left)

  13. Table 14-4, Part 2 (top right)

  14. Table 14-4, (Lower section) Conversion

  15. Features of Convertible Bonds • Convertible bonds can be profitable or unprofitable depending upon investment strategy. • Convertible bonds generally have lower ratings. They are subordinated debentures. • Downside risk protection is generally superficial, especially if interest rate rises which causes the pure bond value to drop.

  16. Features of Convertible Bonds (cont’d) • Coupon rates are normally 1/3 lower on convertible bonds than on similar risk class bonds. • Investor pays for conversion premium: e.g., $1000 can buy 35.71 shares at $28 as opposed to 31.25 shares through a convertible bond. • Convertible securities suffer from the problem of infrequent trading

  17. Conversion Price Conversion Ratio First five years 40 25.0 shares Next three years 45 22.2 shares Next two years 50 20.0 shares Next five years 55 18.2 shares When to Convert into Common Stock • Firms could also encourage conversion by using progressively higher conversion prices over time.

  18. When to Convert into Common Stock (cont’d) • Convertible securities usually have a call feature which gives the issuing corporation the right to retire the issue at the call price prior to maturity. • When a firm calls the issue, the conversion value is usually greater than the call price. The firm effectively forces the conversion. • Voluntary conversion will only take place if dividend income is greater than bond interest income.

  19. Accounting Considerations = Diluted earnings per share = Adjusted earnings after taxes s Shares outstanding + All convertible securities = $1,50,000 + $270000 s 1,000,000 + 400,000 = $1.26

  20. Speculating Through Warrants • A warrant is an option to buy a stated number of shares (usually 1 share) at a specified price over a given period. • Warrants are issued in conjunction with a bond as a sweetener. • Warrants help a firm issue debt it could not otherwise.

  21. Reflects stock splits

  22. Valuation of Warrants (example) • I = (M - OP) x N, where (14-7) • I = The intrinsic value of the warrant • M = Market value of common stock • OP = the option or exercise price • N = number of shares the warrant entitles • Stock Price of ACB Corp is $28 • Warrant entitles 1 share @ $25 for next 3 years • The McGraw-Hill Companies, Inc.,1999

  23. Valuation of Warrants (example) Intrinsic Value = (Market Stock Price - Option Price) x N = ($28 - $25) x 1 = $3.00 BUT: A warrant with 3 years to expiration would be worth more than $3.00. In this case, perhaps $7.25. Speculative Premium = Market Price of the Warrant - Intrinsic value $ 4.25 = 7.25 - $ 3.00

  24. Valuation of Warrants (example) • We can calculate a negative intrinsic value, but the warrant can still have a positive speculative premium. • What if Market price of ACB Corp. is $23.50? Intrinsic Value = ($23.50 - $25.00) x 1 = -$1.50 • But in this case intrinsic value is zero. • Assume the speculative premium is $2.50 • Warrant Breakeven = = Speculative Premium + Exercise Price = $2.50 + $25 = $27.50

  25. Accounting considerations Assume warrants to purchase 10,000 shares at $20 are outstanding and current stock price = $50. Earnings = $100,000

  26. Figure 14-3 Market Price Relationship for a Warrant Market value of warrant Bond price ($) 40 30 20 10 0 -10 -20 -30 Premium Intrinsic value of warrant 10 20 30 40 50 60 Intrinsic value of warrant 0 Price of common stock

More Related