CHAPTER 21

CONVERTIBLE DEBENTURES AND WARRANTS

Q.1.
A.1.

Q.2.
A.2.

Q.3.

A.3.

Q.4.
A.4.

Define the following terms: (a) conversion price, (b) conversion value, and (c)
conversion premium.
A convertible debenture is a debenture that can be changed into a specified
number of ordinary shares at the option of the owner. It is also called hybrid
security. The conversion price is the price paid for ordinary share at the time of
conversion. The conversion ratio is the number of ordinary shares that an investor
can receive when he/she exchanges his convertible debenture.
The conversion value of a convertible debenture is equal to the conversion
ratio multiplied by the ordinary shares market price. The difference between the
convertible debentures market value and higher of the conversion or NCD value
(i.e., investment value of non-convertible debenture) is called the conversion
premium.
What are the important features of a convertible security? What reasons are
generally given for issuing convertible securities?
Convertible security is either a debenture or a preference share that can be
exchanged for a stated number of ordinary shares at the option of the investor.
The most notable feature of convertible security is that it promises a fixed income
associated with security as well as chance of capital gains associated with equity
shares after the owner has exercised his conversion option.
Companies offer convertible securities to sweeten the debt and thereby
make it attractive. It is a form of deferred equity financing, and provides low cost
funds during the early stage of investment project. Investors generally prefer fixed
interest convertible securities to earn a definite, fixed income with the chance of
making capital gains. The convertible securities avoid immediate dilution of the
earnings for share.
Convertible debentures generally carry lower rates of interest than the nonconvertible debentures. If this is true, does it mean that the cost of capital on
convertible debentures is lower than on non-convertibles? Why or why not?
Yes, the cost of capital on convertible debenture is lower on non-convertible
debentures. The company offers lower rate on convertibles because of the value
of the conversion feature as compared to non-convertibles. Investors generally
prefer fixed-income convertibles. After the project is complete and the companys
earnings rise, the share is likely to increase. With an in-built option to convert, the
investor are likely to make capital gains This chance of making capital gains,
tempts investors to accept lower rate of interest today.
How is a convertible security valued? Explain your answer with the help of a
graph.
The convertible security are traded (bought and sold) in the stock market until
they are converted into equity shares. The price at which the convertible security

sells is called its market value. A convertible security market value depends on
both investment and the conversion value. The difference between the convertible
debentures market value and the higher of the conversion or the NCD value
(investment value) is called conversion premium.

Conversion premium =

Market
Conversion or
Value
Investment value
--------------------------------Conversion or Investment Value

Above graph shows the relationship between the convertible debentures

market, investment and conversion value, and the ordinary share price. The
conversion value, on the other hand, is related to the ordinary share price. It
increases as the ordinary share price increases. Typically, the market value is
higher than both the investment and conversion value. The difference between
investment and conversion value lines is known as conversion premium.
Q.5.
A.5.

What is a warrant? What are its characteristic features? Why are warrants issued?
A warrant is an option to buy a specified number of ordinary shares at an
indicated price during a specified period. Warrants are used by large, profitable
companies as a part of a major financing package. Warrants may also be used in
conjunction with ordinary or preference shares. The purpose is to improve the
marketability of issue.
Warrants have a number of features; few of them are explained hereunder.
1) The exercise price of a warrant is the price at which its holder can
purchase the issuing firms ordinary shares.
2) Exercise ratio states the number of ordinary shares that can be purchased
at the exercise price per warrant.
3) The expiration date is the date when the option to buy ordinary shares in
exchange for warrants expires.
4) A warrant can be either detachable (sold separately from the security to
which it was originally attached) or non-detachable (cannot be sold
separately).

5) Warrants entitle to purchase ordinary shares.

Generally, following are the reasons for issuing warrants.
1) Warrants help to make the issue of equity and debentures attractive.
2) Warrants are used to sweeten the debenture issue by giving the investors
an opportunity to participate in capital gains when the share price
appreciates.
3) Warrants also provide a company an opportunity for deferred equity
financing. The company sells its ordinary shares in future at a premium by
setting exercise price higher than the prevailing share price.
4) The company to some extent is sure to obtain cash inflows in future when
investors exercise their warrants.
Q.6.
A.6.

Explain the difference between a convertible security and a warrant.

A convertible security and a warrant are used by large, profitable companies as a
part of a major financing package.
In the case of a convertible security and a warrant, the conversion
price/exercise price, conversion ratio/exercise ratio and conversion date/expiration
date is decided at the time of issue, to make the issue more attractive.
A convertible security is converted into equity shares on the conversion
date, and no cash inflows for the company occur at that time.
In the case of warrant, the buyer, i.e., investor has an option to exercise his
right for equity or preference shares holding, and company have cash inflows on
that date.
Both a convertible security and a warrant can be used as deferred equity
financing tool, and they help in the beginning of the project, to avail the benefits
of trading on equity.

Q.7.
A.7.

Explain the valuation of warrants with the help of a graph.

A warrant is an option to buy a stated number of companys ordinary shares t a
given price on or before a specified maturity date.
The theoretical value of a warrant can be found out by knowing the
ordinary shares market price, and warrants exercise price and exercise ratio.
Warrants theoretical value = (Share price Exercise price) Exercise ratio
If the share price is less than the exercise price, then the warrants
theoretical value will be negative.
The difference between the warrants market value and its theoretical
value is called the premium.
Premium can be calculated as:

Premium =

Warrants market value Warrants theoretical value

----------------------------------------------------------------Warrants theoretical value

Q.8.
A.8.

What is meant by zero-interest debentures and deep-discount debentures? How is

their cost determined? Illustrate your answer.
Zero-interest debentures (ZID) or Zero-coupon bonds do not carry an explicit rate
of interest. The difference between the face value of the bond and its purchase
price is the return of the investor. For example, a company may issue a ZID of
face value Rs 100 for Rs 52 today for a period of 5 years. Then, the rate of interest
is 13%, calculated as under:
FV = PV (1+i)n
100 = 52 (1+i)5
By trial and error method, i = 13%.
Deep-discount bond (DDB) or deep-discount debentures or zero-interest
bond are issued at a price much lower than the face value. Thus, there is an
implicit rate of interest. For example, a bond issued at a price of Rs 12,750 to be
redeemed after 30 years at its face value of Rs 5,00,000. The implied annual rate
of interest is 13%, calculated as under:
FV = PV (1+i)n
5,00,000 = 12,750 (1+i)30
By trial and error method, i = 13%.