chapter 22 Convertibles, Exchangeables And Warrants

1. 22.1 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Chapter 22Chapter 22
Convertibles,Convertibles,
Exchangeables,Exchangeables,
and Warrantsand Warrants

2. 22.2 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
1. 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.
2. Understand why these securities with option features
may be attractive for a firm's long-term financing needs.
3. Explain the different terms used to express value for
convertible securities - conversion value, market value,
and straight-bond value.
4. Calculate the value of convertible securities,
exchangeable bonds, and warrants and explain why
premiums over different values occur.
5. Understand the relationship between an option
instrument and its underlying security.
After Studying Chapter 22,After Studying Chapter 22,
you should be able to:you should be able to:

3. 22.3 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
• Convertible Securities
• Use of Convertibles
• Value of Convertible
Securities
• Exchangeable Bonds
• Warrants
Convertibles, Exchangables,Convertibles, Exchangables,
and Warrantsand Warrants

4. 22.4 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Derivative SecurityDerivative 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.
Derivative SecurityDerivative Security

5. 22.5 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Convertible SecurityConvertible 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.
• This provides the convertible holder a fixed return
(interest or dividend) andand the option to exchange a
bond or preferred stock for common stock.
• The option allows the company to sell convertible
securities at a lower yieldlower yield than it would have to pay
on a straight bond or preferred stock issue.
Convertible SecurityConvertible Security

6. 22.6 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Conversion PriceConversion 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 ratioconversion ratio.
Conversion RatioConversion 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.
Convertible SecurityConvertible Security

7. 22.7 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
FunFinMan, Inc., has an issue of 8%,
$100 par value$100 par value preferred stock
outstanding. The security has a
conversion price of $30conversion price of $30 per share.
What is the conversion ratio?What is the conversion ratio?
Conversion RatioConversion Ratio
= $100 par value$100 par value / $30 conversion price$30 conversion price
= 3.33 shares3.33 shares
Conversion ExampleConversion Example

8. 22.8 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
• 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 clauseantidilution clause).
Antidilution and theAntidilution and the
Convertible SecurityConvertible Security

9. 22.9 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Conversion ValueConversion 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.
For example, if the market value per share of common
stock in FunFinMan, Inc., were trading at $42 per$42 per
shareshare, 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
Conversion ValueConversion Value

10. 22.10 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Premium Over Conversion ValuePremium 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$154 per share, then the conversionconversion
premiumpremium is:
$154$154 – $140 =$140 = $14 premium per share of$14 premium per share of
preferred stock (or a 10% premium).preferred stock (or a 10% premium).
Premium OverPremium Over
Conversion ValueConversion Value

11. 22.11 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
• Virtually all convertible securities provide for a callcall
priceprice, which allows the company to force
conversion when the security market value is
significantly above the call price.
• Almost all convertible bond issuesconvertible 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 diluteddiluted
earnings per shareearnings per share.
Other Issues withOther Issues with
Convertible SecuritiesConvertible Securities

12. 22.12 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
• In many cases, convertible securities are employedIn many cases, convertible securities are employed
asas “deferred”“deferred” common stock financing.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 rateThe interest or dividend rate is likely to be lessis likely to be less
than that of straight debt or preferred stock.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.
Use ofUse of
Convertible SecuritiesConvertible Securities

13. 22.13 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
• Investors can exercise their option to convert toInvestors can exercise their option to convert to
common stock at any time.common stock at any time.
• Companies can force conversion by calling theCompanies can force conversion by calling the
issue.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 byFirms attempt to stimulate conversion by
including the “step-up” feature to the conversionincluding the “step-up” feature to the conversion
price or increasing the common dividend.price or increasing the common dividend.
Forcing orForcing or
Stimulating ConversionStimulating Conversion

14. 22.14 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Convertible Bond ValueConvertible Bond Value = Straight Bond
Value + Option Value
• Volatility in cash flows of firm
• DecreasesDecreases straight bond value
• IncreasesIncreases option value
• Suggests that convertibles are useful
when a company’s future is highly
uncertain
Convertible ValueConvertible Value

15. 22.15 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
The value of a nonconvertible bond with
the same coupon rate, maturity, and
default risk as the convertible bond.
The value of a nonconvertible bond with
the same coupon rate, maturity, and
default risk as the convertible bond.
(1 + i/2)1
(1 + i/2)2
(1 + i/2) 2*nn
VSB = + + ... +
I / 2 I / 2 + F
= Σ
2*nn
t=1
(1 + i/2)t
= (I / 2)(PVIFA i/2, nn) + F (PVIF i/2, nn)
(1 + i/2)2*nn
+
F
I / 2
I / 2
Straight Bond ValueStraight Bond Value

16. 22.16 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Company C has a convertible debenture outstanding
that provides an 8% coupon (interest is paid
semiannually) and continues exactly 20 years until final
maturity. A similar nonconvertible bond will currently
provide a 5% semiannual yield to maturity5% semiannual yield to maturity. What is theWhat is the
straight bond value of Company C’s convertible bond?straight bond value of Company C’s convertible bond?
VV = $40 (PVIFA5%, 20 x 2) + $1,000 (PVIF5%, 20 x 2)
= $40 (17.159) + $1,000 (0.142)
= $686.36 + $142
= $828.36$828.36
Straight Bond ValueStraight Bond Value
of the Convertibleof the Convertible

17. 22.17 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
• The convertible bond valueconvertible bond value equals straightstraight
bond valuebond value plus conversion option valueconversion option value.
• The $828.36$828.36 represents a floor (minimum)
below which the convertible value will not fall.
This occurs when the conversion option valueconversion 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.
Why Care AboutWhy Care About
“Straight Bond Value?”“Straight Bond Value?”

18. 22.18 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
• 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 bondstraight bond
valuevalue until it reaches
a ceiling level.
ValueofConvertibleSecurity
Market Value of Common Stock
MarketMarket
value linevalue line
PremiumPremium
StraightStraight
bond valuebond value
ConvertibleConvertible
securitysecurity
valuevalue
RelationshipsRelationships
Among PremiumsAmong Premiums

19. 22.19 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
• 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.
Relationships AmongRelationships Among
Premiums – SummaryPremiums – Summary

20. 22.20 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Exchangeable BondExchangeable Bond – A bond that allows the
holder to exchange the security for common
stock of another companyof 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.
Exchangeable BondExchangeable Bond

21. 22.21 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
• 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.
Valuation ofValuation of
an Exchangeablean Exchangeable

22. 22.22 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
WarrantWarrant – 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”Warrants are employed as “sweeteners”::
WarrantsWarrants

23. 22.23 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
• The warrant contains provisions forThe 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 areWarrant holders are notnot entitled to anyentitled to any
dividends nor do they have any voting power.dividends nor do they have any voting power.
• The exercise price is generally adjusted for anyThe exercise price is generally adjusted for any
common stock dividends and splits.common stock dividends and splits.
Warrant FeaturesWarrant Features

24. 22.24 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
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 willHow will
this impact the capitalization of the firm?this impact the capitalization of the firm?
Example ofExample of
Exercise of WarrantsExercise of Warrants

25. 22.25 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
DebenturesDebentures $ 0$ 0 $ 10$ 10
Common stock ($5 par) 10 10
Additional paid-in capital 0 0
Retained earnings 20 20
Shareholders’ equityShareholders’ equity $ 30 $ 30$ 30 $ 30
Total CapitalizationTotal Capitalization $ 30 $ 40$ 30 $ 40
Before After
Financing Financing
Example of ExerciseExample of Exercise
of Warrants (in millions)of Warrants (in millions)

26. 22.26 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
DebenturesDebentures $ 0$ 0 $ 10$ 10
Common stock ($5 par) 10 10.5
Additional paid-in capital 0 3.5
Retained earnings 20 20
Shareholders’ equityShareholders’ equity $ 30 $ 34$ 30 $ 34
Total CapitalizationTotal Capitalization $ 30 $ 44$ 30 $ 44
Before After
Financing Exercise
Example of ExerciseExample of Exercise
of Warrants (in millions)of Warrants (in millions)

27. 22.27 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Theoretical value of aTheoretical value of a
warrant:warrant:
maxmax [ (NN)(PPss) – EE, 00]
N = number of shares perN = number of shares per
warrantwarrant
PPss = market price of one= market price of one
share of stockshare of stock
E = exercise priceE = exercise price
associated with theassociated with the
purchase of N sharespurchase of N shares
WarrantValue
Associated Common Stock Price
TheoreticalTheoretical
value linevalue line
45o
MarketMarket
value linevalue line
ExerciseExercise
priceprice
Valuation of a WarrantValuation of a Warrant

28. 22.28 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Theoretical value of aTheoretical value of a
warrant:warrant:
maxmax [ (NN)(PPss) – EE, 00]
N = 1N = 1, PPss = $10= $10 , E = $5E = $5
maxmax[(11)($10$10) – $5$5, 00] = $5$5
N = 1N = 1, PPss = $15= $15 , E = $5E = $5
maxmax[(11)($15$15) – $5$5, 00] =$10$10
WarrantValue
Associated Common Stock Price
$5$5
$10$10
Stock appreciates 50%Stock appreciates 50%
Theoretical warrantTheoretical warrant
value appreciates 100%value appreciates 100%
MinimumMinimum
value is 0.value is 0.
Example of theExample of the
Valuation of a WarrantValuation of a Warrant

29. 22.29 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
• 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.
Summary of the ExampleSummary of the Example
of Warrant Valuationof Warrant Valuation