CHAPTER 25: WARRANTS AND CONVERTIBLES

Topics
• 25.1-25.3 Warrants
• 25.4-25.5 Convertibles
• 25.6-25.7 Why Issue Convertibles and Warrants?
• 25.8 Conversion policy

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 Warrants

• A warrant gives its owner the right to buy other securities

issued by the firm (usually stock)
• Quite a bit like call options, except new shares are created
when the warrant is exercised.
– Typically has a longer maturity
– Possibly has a time-varying strike price
– Issued by the firm, not by another investor (unlike option)
– When exercised, results in increase in the # of shares

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 An example
• Ceres Global Ag Corp. news release, Dec. 19, 2007:

An application has been granted for the original listing in the Industrial
category of up to 28,750,000 units (the “Units”) of Ceres Global Ag Corp. (the
“Company”)…The Units will be posted for trading at the opening on Friday,
December 21, 2007. Each Unit consists of one common share of the Company
(the “Common Share”) and one full Common Share purchase warrant (the
“Warrant”). The Units will separate into Common Shares and Warrants on
March 1, 2008. Upon such separation, each Warrant entitles the holder thereof
to purchase one Common Share at a price of $13.50 at any time on or prior to
the close of business on the date that is 36 months from the closing of the
Offering. Upon separation of the Units, the Common Shares and the Warrants
will be listed on Toronto Stock Exchange.

• If all the warrants are exercised, they will increase shares outstanding

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 Dilution Effect of Warrant

• Call options can be valued w/o considering dilution factor,

warrants cannot.
• Black-Scholes price for warrant will be too high
– B/c exercise of warrants increases the # of shares
outstanding…
• B/c of the dilution effect, a lot of warrants are exercised
when stock price is (significantly) above the exercise price.

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 Dilution effect Example
• ABC Inc. has 10 million common shares outstanding and 200,000
warrants. Each warrant can purchase five shares of common
stock at $30 per share. Warrant holders exercised all their
warrants today. ABC’s stock price before the exercise was $33.
What should the new stock price be after the exercise?

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 Valuation of warrants
We can get an approximate estimate for the value of a warrant using
a modified version of Black-Scholes:

1. For a standard call:

firm value net of debt
Payoff from exercising call = ST – X = X
N
where N is the number of shares outstanding

2. For a warrant:
firm value net of debt  X  NW
Payoff from exercising warrant = X
N  NW
N  firm value net of debt  N
=  X * Payoff from exerci sin g call
N  NW  N  N  NW

where NW is the number of shares from exercising the warrants

So to value a warrant, multiply the value of an otherwise-identical

call by a factor of N
N  NW
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 Example
• A stock is currently selling for $30 per share. The stock does not pay
any dividends. A European put option on this stock with an exercise
price of $45 and five years until expiration is currently selling for $5.
The continuously compounded annual risk free interest rate is 10%.
Suppose that the firm has 1,000,000 shares outstanding currently.
There are also 100,000 warrants outstanding. Each warrant entitles its
holder to purchase one additional share. The warrants have an exercise
price of $45 and expire 5 years from now. What is the value of each
warrant? (Assume that the warrants cannot be exercised early)

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 Problems with valuing warrants

• Why is this an approximate value?

– effectively assumes the firm does nothing with the proceeds
from selling the warrant (i.e. pays it out right away to existing
shareholders as a dividend)
– ignores dividends during the life of the warrant and early
exercise
– ignores changing strike price over time
• In practice, it is relatively difficult to accurately determine
the value of a warrant
• However, just as in a standard IPO, it is an important
calculation since overpricing a warrant runs the risk that the
issue may not sell and underpricing it means that the firm is
selling part of itself for less than it is really worth
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 25.4 Convertibles
• A convertible bond gives its owner the right to exchange
bond for stocks issued by the firm
• Terminology
– Conversion ratio: the number of shares which the bond can be
converted into
– Conversion price: The face value of debt surrendered for each
common share received onconversion (par value /number of
shares received)
– Conversion premium: conversion price – stock price
• Conversion price is usually 10-30% above the current
stock price when issued

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 Convertible Basics
• A convertible bond gives its owner the right to exchange
bond for stocks issued by the firm
• Terminology
– Conversion ratio: the number of shares which the bond can be
converted into
– Conversion price: The face value of debt surrendered for each
common share received onconversion (par value /number of
shares received)
– Conversion premium: conversion price – stock price
• Conversion price is usually 10-30% above the current
stock price when issued

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 An Example

In 1999, Amazon raised 1.25 billion by selling convertible

bonds with the following features:
– Coupon rate = 4.75%
– $1000 face value in debt converts at any time to 6.41 shares
– Stock price at the time was around $120

Conversion ratio:
Conversion price:
Conversion premium:

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 Convertibles & Options

• Convertibles are a lot like “bond + call option”

– Except, again, new shares are created
– Bond is forfeited when conversion occurs

• Convertibles are a lot like “bond + warrants”

– Except they are indivisible and cannot trade (or be issued)
separately
– Bond is forfeited when conversion occurs
• the strike price is really the value of the bond, which will be
changing over time

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 Value components of a Convertible Bond

• The value depends on

– its straight bond value – what the convertible bond would sell
for if it could not be converted into common stock

– its conversion value – what the bond would be worth if it

were immediately converted into common stock at current
prices
• Need to consider the dilution factor

– option value = the value of the embedded “warrant”

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 Straight Bond Value

• Consider an issue of zero-coupon debt with a total amount

owed of F at maturity T (and suppose the firm has no other
debt)
• At T the firm is obligated to pay bondholders F, but if it
defaults the bondholders take over the firm and receive VT

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 Conversion Value

• Suppose that there are N existing shares and if all bonds are
converted there will be NC new shares
• Firm value V does not change with conversion, but the
allocation of ownership does
• After conversion, there are ________ shares, so the
convertible owners’ claim is worth __________

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 Convertible Bond Value At Maturity
• Combine the two previous diagrams to obtain the
convertible value at maturity:

• There are two lower bounds for the convertible value: (i) the
straight bond value (since convertible is this plus a call
option); and (ii) the conversion value
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 Value of convertible before maturity

Value of convertible bond = max (straight bond value

or conversion value) + warrant value

• The warrant value is the value of the option to delay

conversion
– The convertible value would be the lower bound if a
conversion decision had to be made immediately

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Assuming no default probability, the Value of a Convertible Bond
is …

Convertible
Bond Value
Convertible bond
values Conversion
Value
floor value

floor Straight bond

value value
Warrant
value
Stock
Price
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 Example
Zero-coupon convertible bond. T = 10 years. Face value = $1,000.
Conversion ratio = 25. Discount rate for the firm’s straight bond =
10%. Current stock price = $12. Current convertible bond price = $400.
(1) What is the value of the embedded warrant in the convertible?

(2) Suppose the conversion date is 10 years from now and it is the only
conversion date. The stock does not pay dividend. The debt has 40 units
outstanding, and current number of shares outstanding is 4,000. What
would be the value of a corresponding call?

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 Problems With Valuing Convertibles

• The following factors make valuing convertibles difficult:

– Dilution (as with warrants)
– Bond value will change randomly over time if interest rates
move randomly (this implies that we have a random strike
price in addition to a random underlying asset value)
– Callability
• The issuing firm usually retains the option to buy back the
convertible bond at a pre-set price (possibly changing over time)
• If a convertible bond is called, the owner of the bond has the
choice of either selling it back to the issuer or converting (this is
called forced conversion)
• With callability, a convertible bond can be viewed as a straight
bond plus a call option (held by the owner on the firm’s equity)
minus a call option (held by the issuer on the bond)
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 Why issue convertibles and warrants?
• Weak argument: “Cheap” debt or equity
– Not if investors pay a fair price (for the embedded option)
– Suppose a firm issues a convertible and the firm
subsequently does poorly, so that holders of the convertible
do no convert ) the firm got the benefit of paying a lower
coupon rate on debt
– If the firm subsequently does well, then the holders of the
convertible will convert, but the conversion price will be
higher than when the convertible was originally issued, so
the firm is better off in this case too
– The problem with this argument is that a comparison is being
made to straight debt if the firm does poorly and to common
shares if the firm does well

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 Good reasons for issuing convertibles and warrants

• Matching cash flows

– young, risky, growth firms often issue convertibles because
they are cash constrained initially (so they benefit from lower
coupon rates) and, if they do well, there will be expensive
dilution due to conversion, but the firm is better able to afford
it then
• Risk synergy (Risk-shifting)
– Useful in cases where it is hard to assess the risk of the issuer
– if the issuer subsequently turns out to be low risk, the straight
bond will have high value (but the call option will not have
much value)
– If it turns out to be high risk, the call option will be valuable
(but the straight bond portion will not be)
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 Good reasons cont’d

• Mitigate agency costs: S/H less prone to take high-risk

projects due to the equity component
• Backdoor equity
– this is an asymmetric information argument
– the basic idea is that young, small, high growth firms often
cannot issue debt without paying high interest due to high risk
of financial distress
– if management knows that current shares are undervalued (e.g.
due to inside information about future prospects), it may be
unwilling to issue equity
– a convertible issue might be a good choice since it reduces
interest costs and avoids selling equity at currently depressed
prices
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Review Q1. Suppose that Maple Aircraft has issued a 4%
convertible bond due December 2003. The face value of
the bond is $1,000. The conversion price is $47.00. The
market price of the convertible is 91% of the face value of
the bond and the price of the common share is $41.50.
Assume the value of the bond in the absence of the
conversion feature would be $650. Suppose that Nc is
sufficiently small relative to N.
a. What is the conversion ratio of the convertible bond?
b. What is the conversion value?
c. How much is a buyer of the convertible paying for the
option to buy one share of the common stock?

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#25.3 A Warrant gives its owner the right to purchase three shares of
common stock at an exercise price of $32 per share. The current
market price of Firm Y is $39 per share. What is the minimum
value of the warrant?

Can you do better if the following is given: The only exercise date
for the warrant is one year from now. The firm pays no dividend.
The riskfree rate is 10%. The outstanding # of warrant is 1. The
outstanding # of shares is 7.

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Assigned Problems # 25.2, 3, 4, 6, 8, 9, 11, 13, 14, 19, 20

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