Chapter 25 Notes

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Published on 10 Oct 2011
School
UTSC
Department
Management
Course
MGFC10H3
Professor
Chapter 25 Warrants and Convertibles Notes
25.1 Warrants
warrants are securities that give holders the right, but not the obligation, to buy shares of common stock directly from a company
at a fixed price for a given period of time
each warrant specifies the number of shares that the holder can buy, the exercise price, and the expiration date
how far the warrant price lies above the lower limit will depend on (1) the variance of stock returns; (2) the time to the warrant’s
expiration date; (3) the risk-free rate of interest; (4) the stock price; and (5) the exercise price
25.2 The Difference between Warrants and Call Options
from the holder’s point of view, warrants are similar to call options on common stock
a warrant, like a call option, gives its holder the right to buy common stock at a specified price
warrants usually have an expiration date, though in most cases they are issued with longer lives than call options
from the firm’s point of view, however, a warrant is very different from a call option on the company’s common stock
vital difference between call options and warrants is that call options are issued by individuals and warrants are issued by firms
when a warrant is exercised, a firm must issue new shares of stock
each time a warrant is exercised, then, the number of shares outstanding increases
25.4 Convertible Bonds
a convertible bond is similar to a bond with warrants; the most important difference is that a bond with warrants can be separated
into distinct securities, but a convertible bond cannot
gives holder the right to exchange for given number of shares of stock at any time up and including maturity date of the bond
a share of convertible preferred stock is the same as a convertible bond except that it has no maturity date
25.7 Why Are Warrants and Convertibles Issued?
some differences between convertible bonds and warrants are:
1) the bond ratings of firms using convertibles are lower than those of other firms
2) convertibles tend to be used by smaller firms with high growth rates and more financial leverage
3) convertibles are usually subordinated and unsecured
25.9 Summary and Conclusions
1. A warrant gives the holder the right to buy shares of common stock at an exercise price for a given period of time. Typically,
warrants are issued in a package with privately placed bonds. Afterward, they become detached and trade separately.
2. A convertible bond is a combination of a straight bond and a call option. The holder can give up the bond in exchange for shares
of stock.
3. Convertible bonds and warrants are like call options. However, there are some important differences:
a. Warrants and convertible securities are issued by corporations. Call options are traded between individual investors.
1. Warrants are usually issued privately and are combined with a bond. In most cases, the warrants can be detached
immediately after the issue. In some cases, warrants are issued with preferred stock, with common stock, in executive
compensation programs, or as stand-alone issues.
2. Convertibles are bonds that can be converted into common stock.
3. Call options are sold separately by individual investors (called writers of call options).
b. Warrants and call options are exercised for cash. The holder of a warrant gives the company cash and receives new shares
of the company’s stock. The holder of a call option gives another individual cash in exchange for shares of stock. When
someone converts a bond, it is exchanged for common stock. As a consequence, bonds with warrants and convertible
bonds have different effects on corporate cash flow and capital structure.
c. Warrants and convertibles cause dilution to the existing shareholders. When warrants are exercised and convertible bonds
converted, the company must issue new shares of common stock. The percentage ownership of the existing shareholders
will decline. New shares are not issued when call options are exercised.
4. Many arguments, both plausible and implausible, are given for issuing convertible bonds and bonds with warrants. One plausible
rationale for such bonds has to do with risk. Convertibles and bonds with warrants are associated with risky companies. Lenders
can do several things to protect themselves from high-risk companies:
a. They can require high yields.
b. They can lend less or not at all to firms whose risk is difficult to assess.
c. They can impose severe restrictions on such debt.
Another useful way to protect against risk is to issue bonds with equity kickers. This gives the lenders the chance to benefit
from risks and reduces the conflicts between bondholders and shareholders concerning risk.
5. A puzzle particularly vexes financial researchers: Convertible bonds usually have call provisions. Companies appear to delay
calling convertibles until the conversion value greatly exceeds the call price. From the shareholders’ standpoint, the optimal call
policy would be to call the convertibles when the conversion value equals the call price.
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Document Summary

25. 2 the difference between warrants and call options. 25. 7 why are warrants and convertibles issued? some differences between convertible bonds and warrants are: 3) the bond ratings of firms using convertibles are lower than those of other firms convertibles tend to be used by smaller firms with high growth rates and more financial leverage convertibles are usually subordinated and unsecured. 25. 9 summary and conclusions: a warrant gives the holder the right to buy shares of common stock at an exercise price for a given period of time. Typically, warrants are issued in a package with privately placed bonds. Afterward, they become detached and trade separately: a convertible bond is a combination of a straight bond and a call option. The holder can give up the bond in exchange for shares of stock: convertible bonds and warrants are like call options. However, there are some important differences: warrants and convertible securities are issued by corporations.

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