19.4: Warrants and Convertible Securities

Question 1

What are warrants in corporate finance?

Answer 1

Warrants are the corporate finance equivalent of call options, issued by firms to raise capital.

When they are exercised, more shares are created, typically with long maturities, making them valuable for companies seeking primary financing.

Question 2

What is the primary difference between warrants and call options?

Answer 2

Warrants are issued by companies to raise capital, while call options are transactions between external investors with no impact on the firm’s capital. Warrants also generally have longer maturities than call options.

Question 3

Explain the significance of warrants for junior resource companies.

Answer 3

Warrants provide junior resource companies with a means of raising capital. They offer initial financing, and if the company’s projects succeed, the exercise of warrants results in additional equity funding and potential share price increases.

Question 4

How is the payoff to warrant holders calculated?

Answer 4

The payoff to warrant holders is calculated as:
Payoff = (m / (n + m)) * (V - nX)
Where:
- m is the number of warrants
- n is the number of shares
- V is the firm’s value
- X is the exercise price

Question 5

What is the dilution factor in the context of warrants?

Answer 5

The dilution factor is calculated as:

Dilution Factor = m / (n + m)

It represents the impact of additional shares issued when warrants are exercised, reducing the ownership percentage of existing shareholders.

Question 6

What are convertible securities?

Answer 6

Convertible securities are bonds or preferred shares that can be converted into a specified number of common shares at the bondholder’s discretion. They offer flexibility and can alter the firm’s capital structure upon conversion.

Question 7

Define the conversion ratio (CR) and conversion price (CP) in convertible bonds.

Answer 7

• Conversion Ratio (CR): The number of shares a convertible security can be exchanged for.
• Conversion Price (CP): The price at which a convertible security can be converted into common shares, based on its conversion ratio.

Question 8

How is the conversion value (CV) of a convertible bond calculated?

Answer 8

The conversion value (CV) is calculated as:
CV = CR * P
Where:
- CR is the conversion ratio
- P is the market price of the stock

Question 9

How is the conversion premium calculated for a convertible bond?

Answer 9

The conversion premium is calculated as:
Conversion Premium = (Market Value - CV) / CV
This premium reflects the percentage by which the bond’s price exceeds its conversion value.

Question 10

What is the straight bond value (SBV) in convertible bonds?

Answer 10

The straight bond value (SBV) is the price a convertible bond would sell for if it could not be converted into common stock. It is calculated using the formula:

SBV = I * [(1 - 1/(1 + k_b)^n) / k_b] + F / (1 + k_b)^n

Where:
- I is the interest or coupon payments
- k_b is the yield on similar non-callable bonds
- n is the term to maturity
- F is the face (par) value of the bond

Question 11

What is the floor value (FV) of a convertible bond?

Answer 11

The floor value (FV) is calculated as:
FV = Max(SBV, CV)
It is the lowest price a convertible bond will sell for, which is equal to the larger of its straight bond value (SBV) or its conversion value (CV).

Question 12

What is the straight bond value (SBV) in convertible bonds?

Answer 12

The straight bond value (SBV) is the price a convertible bond would sell for if it could not be converted into common stock, calculated using the standard bond pricing equation.

Question 13

What is the floor value (FV) of a convertible bond?

Answer 13

The floor value (FV) is the lowest price a convertible bond will sell for, which is equal to the larger of its straight bond value or its conversion value.

Question 14

How do companies use warrants as “sweeteners” in financing?

Answer 14

Companies use warrants as “sweeteners” to make securities more attractive, enhancing financing by offering potential upside through additional equity if exercised.

This can help firms with high risk or limited cash flow access capital.

Question 15

Explain the difference in risk between convertible bonds and straight bonds.

Answer 15

Convertible bonds offer the option to convert to equity, potentially reducing risk if the company’s stock performs well, while straight bonds offer fixed income with no conversion option, relying solely on the issuer’s creditworthiness.

Question 16

Why are convertible bonds considered “out-of-the-money” or “in-the-money”?

Answer 16

Convertible bonds are “out-of-the-money” when the conversion price is higher than the current stock price, making conversion unattractive. They are “in-the-money” when the stock price exceeds the conversion price, encouraging conversion for potential profit.

Question 17

How is the conversion price (CP) for a convertible bond calculated?

Answer 17

The conversion price (CP) is calculated as:
CP = Par Value / Conversion Ratio
Example: For a bond with a par value of $1,000 and a conversion ratio of 50, CP = $1,000 / 50 = $20.

Question 18

How do you calculate the straight bond value (SBV) for a convertible bond?

Answer 18

The straight bond value (SBV) is calculated using the formula:
SBV = I * [(1 - (1/(1 + k_b)^n)) / k_b] + F / (1 + k_b)^n
Where:
- I = interest or coupon payments ($100 in this example)
- k_b = yield on similar non-callable bonds (0.08 or 8% in this example)
- n = term to maturity (10 years in this example)
- F = face (par) value of the bond ($1,000 in this example)

 Example: SBV = $100 * [(1 - (1/(1 + 0.08)^10)) / 0.08] + $1,000 / (1 + 0.08)^10 = $1,134.20

Question 19

What are the keystrokes for calculating SBV on a financial calculator?

Answer 19

Keystrokes for calculating SBV:
-100 PMT
10 N
-1,000 FV
8 I/Y
CPT PV
Result: $1,134.20

Question 20

How is the conversion value (CV) of a convertible bond determined?

Answer 20

The conversion value (CV) is calculated as:
CV = Conversion Ratio * Price per Share

Example: For a conversion ratio of 50 shares and a share price of $25, CV = 50 * $25 = $1,250.

Question 21

How do you calculate the floor value (FV) of a convertible bond?

Answer 21

The floor value (FV) is the greater of the straight bond value (SBV) or the conversion value (CV):
FV = Max(SBV, CV)
Example: If SBV = $1,134.20 and CV = $1,250, then FV = $1,250.

Question 22

What is the conversion premium and how is it calculated?

Answer 22

The conversion premium is the percentage by which the market price of a convertible bond exceeds its conversion value. It is calculated as:

Conversion Premium = ((Market Price - CV) / CV) * 100%

Example: If the market price is $1,350 and CV = $1,250,

 Conversion Premium = (($1,350 - $1,250) / $1,250) * 100% = 8%

Question 23

Explain why issuing debt or preferred shares with warrants attached, or issuing convertible bonds or convertible preferred shares, may represent attractive sources of financing for higher-risk firms.

Answer 23

These instruments provide flexibility and potentially lower costs compared to traditional debt.

They offer upside potential through conversion or exercise of warrants, which can attract investors even for higher-risk firms.

The added equity feature can reduce immediate cash flow burdens, making financing more feasible for companies with uncertain prospects.

Question 24

Define and explain how to determine the following for a convertible: conversion price, conversion value, straight bond value, floor value, and convertible premium.

Answer 24

• Conversion Price: Price at which a bond can be converted into shares, calculated as Par/Conversion Ratio.
• Conversion Value: Value if converted into shares, calculated as Conversion Ratio * Share Price.
• Straight Bond Value: Value as a non-convertible bond, using standard bond valuation.
• Floor Value: Higher of SBV or CV, setting a minimum price.
• Convertible Premium: Percentage difference between market price and CV, calculated as ((Market Price - CV) / CV) * 100%.