Chapter 22

1. Chapter 22 Convertibles, Exchangeables, and Warrants

2. After Studying Chapter 22, you should be able to: • 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 with option features 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.

3. Convertibles, Exchangables, and Warrants • Convertible Securities • Use of Convertibles • Value of Convertible Securities • Exchangeable Bonds • Warrants

4. 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.

5. Convertible Security • 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. 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.

6. 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. 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.

7. 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

8. 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).

9. Conversion Value For example, if the market value per share of common stock in FunFinMan, Inc., were trading at $42 per share, then the conversion value is: 3.33 shares x $42 = $140 per share of preferred stock 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.

10. 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, then the conversion premium is: $154 – $140 = $14 premium per share of preferred stock (or a 10% premium).

11. Other Issues with Convertible Securities • Virtually all convertible securities provide for a call 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.

12. 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 firm’s common stock, the lower the stated rate the firm will need to pay.

13. 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. • 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.

14. Convertible Value • Volatility in cash flows of firm • Decreases straight bond value • Increases option value • Suggests that convertibles are useful when a company’s future is highly uncertain Convertible Bond Value = Straight Bond Value + Option Value

15. Straight Bond Value The value of a nonconvertible bond with the same coupon rate, maturity, and default risk as the convertible bond. I / 2 I / 2 I / 2+ F VSB = + + ... + (1 +i/2)1 (1 + i/2)2 (1 + i/2) 2*n I / 2 F 2*n + = S (1 + i/2)t (1 + i/2)2*n t=1 = (I / 2)(PVIFA i/2, n) + F (PVIFi/2, n)

16. Straight Bond Value of the Convertible Company C has a convertible debenture outstanding that provides an 8% coupon (interest is paid semiannually) and continues exactly20 years until final maturity. A similar nonconvertible bond will currently provide a 5% semiannual yield to maturity. What is the straight bond value of Company C’s convertible bond? V = $40 (PVIFA5%, 20 x 2) + $1,000 (PVIF5%, 20 x 2) =$40(17.159) + $1,000 (0.142) = $686.36 + $142 = $828.36

17. Why Care About “Straight Bond Value?” • The convertible bond value equals straight bond value plus conversion option 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.

18. Relationships Among Premiums Market value line • 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. Convertible security value Premium Value of Convertible Security Straight bond value Market Value of Common Stock

19. 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.

20. 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 firm’s investment holdings of the other company’s stock.

21. 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.

22. Warrants Warrant – A relatively long-term option to purchase common stock at a specified exercise price over a specified period of time. • 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. Warrants are employed as “sweeteners”:

23. 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.

24. 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?

25. Example of Exercise of Warrants (in millions) Before After FinancingFinancing Debentures $ 0 $ 10 Common stock ($5 par) 10 10 Additional paid-in capital 0 0 Retained earnings 20 20 Shareholders’ equity $ 30 $ 30 Total Capitalization $ 30 $ 40

26. Example of Exercise of Warrants (in millions) Before After FinancingExercise Debentures $ 0 $ 10 Common stock ($5 par) 10 10.5 Additional paid-in capital 0 3.5 Retained earnings 20 20 Shareholders’ equity $ 30 $ 34 Total Capitalization $ 30 $ 44

27. Valuation of a Warrant Theoretical value 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 Theoretical value line Market value line Warrant Value Exercise price 45o Associated Common Stock Price

28. Example of the Valuation of a Warrant Theoretical value of a warrant: max [ (N)(Ps) – E, 0] N = 1, Ps = $10 , E = $5 max[(1)($10) – $5, 0] = $5 N = 1, Ps = $15 , E = $5 max[(1)($15) – $5, 0] =$10 Stock appreciates 50% Theoretical warrant value appreciates 100% $10 Warrant Value Minimum value is 0. $5 Associated Common Stock Price

29. Summary of the Example of Warrant Valuation • 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.