2-2Convertibles, Exchangables,Convertibles, Exchangables,and Warrantsand WarrantsConvertible SecuritiesUse of ConvertiblesValue of ConvertibleSecuritiesExchangeable BondsWarrants
2-3Derivative SecurityDerivative Security -- A financial contractwhose value derives in part from the value andcharacteristics of one or more underlyingassets (e.g., securities, commodities), interestrates, exchange rates, or indices.Derivative SecurityDerivative SecurityStraight debt or equity cannot be exchanged foranother asset, but options are exchangeable.An option is part of the broader category ofderivative securities.We examine the convertible security, exchangeablebond, and warrant in this chapter.
2-4Convertible SecurityConvertible Security -- A bond or apreferred stock that is convertible into aspecified number of shares of commonstock at the option of the holder.Convertible SecurityConvertible SecurityThis provides the convertible holder a fixed return(interest or dividend) andand the option to exchange abond or preferred stock for common stock.The option allows the company to sell convertiblesecurities at a lower yieldlower yield than it would have to payon a straight bond or preferred stock issue.
2-5Conversion PriceConversion Price -- The price per share atwhich common stock will be exchanged for aconvertible security. It is equal to the facevalue of the convertible security divided bythe conversion ratioconversion ratio.Convertible SecurityConvertible SecurityConversion RatioConversion Ratio -- The number of shares ofcommon stock into which a convertiblesecurity can be converted. It is equal to theface value of the convertible security dividedby the conversion price.
2-6FunFinMan, Inc., has an issue of 8%,$100 par value$100 par value preferred stockoutstanding. The security has aconversion price of $30conversion price of $30 per share.What is the conversion ratio?What is the conversion ratio?Conversion ExampleConversion ExampleConversion RatioConversion Ratio= $100 par value$100 par value / $30 conversion price$30 conversion price= 3.33 shares3.33 shares
2-7Antidilution and theAntidilution and theConvertible SecurityConvertible SecurityConversion terms are not necessarily constantover time.Example: The conversion price on 20-yearconvertible-debt might “step-up” over time from $30during the first 5 years, $35 the next 5 years, and $40for the remaining 10 years until maturity.The conversion price is usually adjusted forany stock splits or stock dividends to protectthe convertible bondholder from antidilution(known as the antidilution clauseantidilution clause).
2-8Conversion ValueConversion Value -- The value of theconvertible security in terms of the commonstock into which the security can beconverted. It is equal to the conversion ratiotimes the current market price per share of thecommon stock.Conversion ValueConversion ValueFor example, if the market value per share of commonstock in FunFinMan, Inc., were trading at $42 per$42 pershareshare, then the conversion valueconversion value is:3.33 shares3.33 shares x $42$42 = $140 per share of preferred stock$140 per share of preferred stock
2-9Premium Over Conversion ValuePremium Over Conversion Value -- Themarket price of a convertible securityminus its conversion value; also calledconversion premium.Premium OverPremium OverConversion ValueConversion ValueFor example, if the market value per share ofpreferred stock in FunFinMan, Inc., weretrading at $154 per share$154 per share, then the conversionconversionpremiumpremium is:$154$154 - $140 =$140 = $14 premium per share of$14 premium per share ofpreferred stock (or a 10% premium).preferred stock (or a 10% premium).
2-10Other Issues withOther Issues withConvertible SecuritiesConvertible SecuritiesVirtually all convertible securities provide for a callcallpriceprice, which allows the company to forceconversion when the security market value issignificantly above the call price.Almost all convertible bond issuesconvertible bond issues are subordinatedto other creditors, which allows a lender to treatconvertibles as a part of the equity base whenevaluating the financial condition of the issuer.The potential dilution effect is recognized byinvestors who evaluate earnings based on a diluteddilutedearnings per shareearnings per share.
2-11Use ofUse ofConvertible SecuritiesConvertible SecuritiesIn many cases, convertible securities are employedIn many cases, convertible securities are employedasas “deferred”“deferred” common stock financing.common stock financing.Does not immediately dilute earnings.Securities are converted at a higher price than if theywould have been directly issued. This has theimpact of reducing the dilution effect.The interest or dividend rateThe interest or dividend rate is likely to be lessis likely to be less thanthanthat of straight debt or preferred stock.that of straight debt or preferred stock. The greaterthe growth prospects of the firm’s common stock,the lower the stated rate the firm will need to pay.
2-12Forcing orForcing orStimulating ConversionStimulating ConversionInvestors can exercise their option to convert toInvestors can exercise their option to convert tocommon stock at any time.common stock at any time.Companies can force conversion by calling theCompanies can force conversion by calling theissue.issue.The company has an incentive to call only whenthe conversion price exceeds the call price byaround 15% and when the common dividend rate isless than the interest or preferred. dividend rateinvestors are earning.Firms attempt to stimulate conversion byFirms attempt to stimulate conversion byincluding the “step-up” feature to the conversionincluding the “step-up” feature to the conversionprice or increasing the common dividend.price or increasing the common dividend.
2-13Convertible Bond ValueConvertible Bond Value = Straight BondValue + Option ValueConvertible ValueConvertible ValueVolatility in cash flows of firmDecreasesDecreases straight bond valueIncreasesIncreases option valueSuggests that convertibles are usefulwhen a company’s future is highlyuncertain
2-14Straight Bond ValueStraight Bond ValueThe value of a nonconvertible bond withthe same coupon rate, maturity, anddefault risk as the convertible bond.The value of a nonconvertible bond withthe same coupon rate, maturity, anddefault risk as the convertible bond.(1 + i/2)1(1 + i/2)2(1 + i/2) 2*nnVSB = + + ... +I / 2 I / 2 + F= Σ2*nnt=1(1 + i/2)t= (I / 2)(PVIFA i/2, nn) + F (PVIF i/2, nn)(1 + i/2)2*nn+FI / 2I / 2
2-15Straight Bond ValueStraight Bond Valueof the Convertibleof the ConvertibleCompany C has a convertible debenture outstandingthat provides an 8% coupon (interest is paidsemiannually) and continues exactly 20 years until finalmaturity. A similar nonconvertible bond will currentlyprovide a 5% semiannual yield to maturity5% semiannual yield to maturity. What is theWhat is thestraight bond value of Company C’s convertible bond?straight bond value of Company C’s convertible bond?VV = $40 (PVIFA5%, 20x2) + $1,000 (PVIF5%, 20x2)= $40 (17.159) + $1,000 (.142)= $686.36 + $142= $828.36$828.36
2-16Why Care AboutWhy Care About“Straight Bond Value?”“Straight Bond Value?”The convertible bond valueconvertible bond value equals straightstraightbond valuebond value plus conversion option valueconversion option value.The $828.36$828.36 represents a floor (minimum)below which the convertible value will notfall. This occurs when the conversion optionconversion optionvaluevalue is essentially worthless.The straight bond value is subject to changeas interest rates, firm risk, and time change.This, in turn, is likely to impact theconvertible bond value.
2-17RelationshipsRelationshipsAmong PremiumsAmong PremiumsThe leftmost portionof the graphrepresents a firmthat is in financialdistress.The stronger thefinancial health ofthe firm the greaterthe straight bondstraight bondvaluevalue until it reachesa ceiling level.ValueofConvertibleSecurityMarket Value of Common StockMarketMarketvalue linevalue linePremiumPremiumStraightStraightbond valuebond valueConvertibleConvertiblesecuritysecurityvaluevalue
2-18Relationships AmongRelationships AmongPremiums -- SummaryPremiums -- SummaryA convertible security offers holders partialprotection on the downside (similar to thestraight bond) based on the going-concernand liquidation values of the firm.A convertible security also providesholders with the ability to participate in theupward movement in common stock prices.The greater the volatility of common stockprice, the greater the potential gain and themore valuable the option.
2-19Exchangeable BondExchangeable Bond -- A bond that allows theholder to exchange the security for commonstock of another companyof another company -- generally, one inwhich the bond issuer has an ownershipinterest.Exchangeable BondExchangeable BondThese issues usually occur when the issuer ownscommon stock in the company in which the bondscan be exchanged.Exchange requests are satisfied either by openmarket purchases or directly using the firm’sinvestment holdings of the other company’s stock.
2-20Valuation ofValuation ofan Exchangeablean ExchangeableInvestors may realize diversification benefits sincethe bond and the common stock are from differentcompanies.Potentially, diversification leads to a highervaluation for the exchangeable versus theconvertible.A major disadvantage is that the difference betweenthe cost of the bond and the market value of theexchanged common stock, at the time of exchange,is treated as a capital gain. A convertible gain isnot recognized until the common stock is sold.
2-21WarrantWarrant -- A relatively long-term option topurchase common stock at a specifiedexercise price over a specified period of time.WarrantsWarrantsTo obtain a lower interest rate.To raise funds when the firm isconsidered a marginal credit risk.To compensate underwriters and venturecapitalists when founding a company.Warrants are employed as “sweeteners”:Warrants are employed as “sweeteners”:
2-22Warrant FeaturesWarrant FeaturesThe warrant contains provisions forThe warrant contains provisions for::the number of shares that can be purchased perwarrant.the price at which the warrant can be exercised.the warrant expiration date.Warrant holders areWarrant holders are notnot entitled to anyentitled to anydividends nor do they have any voting power.dividends nor do they have any voting power.The exercise price is generally adjusted forThe exercise price is generally adjusted forany common stock dividends and splits.any common stock dividends and splits.
2-23Example ofExample ofExercise of WarrantsExercise of WarrantsFunFinMan, Inc., is currently financed entirelywith common stock. The firm is composedof $10 million in common stock ($5 parvalue) and $20 million in retained earnings.The company is considering issuing $20million of 8%, 20-year debentures including 1warrant per bond that can be converted into5 shares of common stock at an exerciseprice of $40 per share. How will this impactHow will this impactthe capitalization of the firm?the capitalization of the firm?
2-24Example of ExerciseExample of Exerciseof Warrants (in millions)of Warrants (in millions)DebenturesDebentures $ 0$ 0 $ 10$ 10Common stock ($5 par) 10 10Additional paid-in capital 0 0Retained earnings 20 20Shareholders’ equityShareholders’ equity $ 30 $ 30$ 30 $ 30Total CapitalizationTotal Capitalization $ 30 $ 40$ 30 $ 40Before After*Financing Financing
2-25Example of ExerciseExample of Exerciseof Warrants (in millions)of Warrants (in millions)DebenturesDebentures $ 0$ 0 $ 10$ 10Common stock ($5 par) 10 10.5Additional paid-in capital 0 3.5Retained earnings 20 20Shareholders’ equityShareholders’ equity $ 30 $ 34$ 30 $ 34Total CapitalizationTotal Capitalization $ 30 $ 44$ 30 $ 44Before After*Financing Exercise
2-26Valuation of a WarrantValuation of a WarrantTheoretical value of aTheoretical value of awarrant:warrant:maxmax [ (NN)(PPss) - EE, 00]N = number of shares perN = number of shares perwarrantwarrantPPss = market price of one= market price of oneshare of stockshare of stockE = exercise priceE = exercise priceassociated with theassociated with thepurchase of N sharespurchase of N sharesWarrantValueAssociated Common Stock PriceTheoreticalTheoreticalvalue linevalue line45oMarketMarketvalue linevalue lineExerciseExercisepriceprice
2-27Example of theExample of theValuation of a WarrantValuation of a WarrantTheoretical value of aTheoretical value of awarrant:warrant:maxmax [ (NN)(PPss) - EE, 00]N = 1N = 1, PPss = $10= $10 , E = $5E = $5maxmax[(11)($10$10)-$5$5, 00] = $5$5N = 1N = 1, PPss = $15= $15 , E = $5E = $5maxmax[(11)($15$15)-$5$5, 00] =$10$10WarrantValueAssociated Common Stock Price$5$5$10$10Stock appreciates 50%Stock appreciates 50%Theoretical warrantTheoretical warrantvalue appreciates 100%value appreciates 100%MinimumMinimumvalue is 0.value is 0.
2-28Summary of the ExampleSummary of the Exampleof Warrant Valuationof Warrant ValuationThe market value of a warrant equals orexceeds the theoretical value of the warrant.The greater market value is generated by theunlimited upside potential of the stock pricecombined with the limited downside risk tothe warrant holder (minimum value is 0).The greater the time to expiration, thegreater the opportunity of the upsidepotential of the stock and the greater themarket value of the warrant.