ExecutiveSummary Thischapterdescribesthebasicfeaturesofwarrantsandconvertibles Theimportantquestionsare Howcanwarrantsandconvertiblesbevalued Whatimpactdowarrantsandconvertibleshaveonfirmvalue Whatarethedifferencesbetweenwarrants convertiblesandcalloptions Underwhatcircumstancesarewarrantsandconvertiblesconvertedintocommonstock ChapterOutline 24 1Warrants24 2TheDifferencebetweenWarrantsandCallOptions24 3WarrantPricingandtheBlack ScholesModel Advanced 24 4ConvertibleBonds24 5TheValueofConvertibleBonds24 6ReasonsforIssuingWarrantsandConvertibles24 7WhyareWarrantsandConvertiblesIssued24 8ConversionPolicy24 9SummaryandConclusions 24 1Warrants Warrantsarecalloptionsthatgivetheholdertheright butnottheobligation tobuysharesofcommonstockdirectlyfromacompanyatafixedpriceforagivenperiodoftime Warrantstendtohavelongermaturityperiodsthanexchangetradedoptions Warrantsaregenerallyissuedwithprivatelyplacedbondsasan equitykicker Warrantsarealsocombinedwithnewissuesofcommonstockandpreferredstock giventoinvestmentbankersascompensationforunderwritingservices Inthiscase theyareoftenreferredtoasaGreenShoeOption 24 1Warrants Thesamefactorsthataffectcalloptionvalueaffectwarrantvalueinthesameways Stockprice Exerciseprice Interestrate Volatilityinthestockprice Expirationdate Dividends 24 2TheDifferenceBetweenWarrantsandCallOptions Whenawarrantisexercised afirmmustissuenewsharesofstock Thiscanhavetheeffectofdilutingtheclaimsofexistingshareholders DilutionExample ImaginethatMr ArmstrongandMr LeMondareshareholdersinafirmwhoseonlyassetis10ouncesofgold Whentheyincorporated eachmancontributed5ouncesofgold thenvaluedat 300perounce Theyprinteduptwostockcertificates andnamedthefirmLegStrong Inc SupposethatMr ArmstrongdecidestosellMr MercxacalloptionissuedonMr Armstrong sshare ThecallgivesMr MercxtheoptiontobuyMr Armstong ssharefor 1 500 Ifthiscallfinishesin the money Mr Mercxwillexercise Mr Armstrongwilltenderhisshare Nothingwillchangeforthefirmexceptthenamesoftheshareholders DilutionExample SupposethatMr ArmstrongandMr LeMondmeetastheboardofdirectorsofLegStrong TheboarddecidestosellMr Mercxawarrant ThewarrantgivesMr Mercxtheoptiontobuyonesharefor 1 500 Supposethewarrantfinishesin the money goldincreasedto 350perounce Mr Mercxwillexercise Thefirmwillprintuponenewshare DilutionExample ThebalancesheetofLegStrongInc wouldchangeinthefollowingway Dilution ThebalancesheetofLegStrongInc wouldchangeinthefollowingway Dilution ThebalancesheetofLegStrongInc wouldchangeinthefollowingway NotethatMr Armstrong sclaimfallsinvaluefrom 1 750 3 500 2to 1 666 67 5 000 3 WarrantPricingandtheBlack ScholesModel Advanced Warrantsareworthabitlessthancallsduetothedilution Tovalueawarrant valueanotherwise identicalcallandmultiplythecallpriceby Wheren theoriginalnumberofsharesnw thenumberofwarrants WarrantPricingandtheBlack ScholesModel Advanced Toseewhy comparethegainsfromexercisingacallwiththegainsfromexercisingawarrant Thegainfromexercisingacallcanbewrittenas Notethatwhenn thenumberofshares sharepriceis Thus thegainfromexercisingacallcanbewrittenas WarrantPricingandtheBlack ScholesModel Advanced Notethatwhenn theoriginalnumberofsharesandnw thenumberofwarrants Thegainfromexercisingawarrantcanbewrittenas Thus thegainfromexercisingawarrantcanbewrittenas WarrantPricingandtheBlack ScholesModel Advanced Thegainfromexercisingawarrantcanbewrittenas Thegainfromexercisingacallcanbewrittenas Abitofalgebrashowsthattheseequationsdifferbyafactorof Sotovalueawarrant multiplythevalueofanotherwise identicalcallby 24 4ConvertibleBonds Aconvertiblebondissimilartoabondwithwarrants Themostimportantdifferenceisthatabondwithwarrantscanbeseparatedintodifferentsecuritiesandaconvertiblebondcannot Recallthattheminimum floor valueofconvertible Straightor intrinsic bondvalueConversionvalueTheconversionoptionhasvalue 24 5TheValueofConvertibleBonds Thevalueofaconvertiblebondhasthreecomponents StraightbondvalueConversionvalueOptionvalue ConvertibleBondProblem Litespeed Inc justissuedazerocouponconvertiblebondduein10years Theconversionratiois25shares Theappropriateinterestrateis10 Thecurrentstockpriceis 12pershare Eachconvertibleistradingat 400inthemarket Whatisthestraightbondvalue Whatistheconversionvalue Whatistheoptionvalueofthebond ConvertibleBondProblem continued Whatisthestraightbondvalue Whatistheconversionvalue 25shares 12 share 300Whatistheoptionvalueofthebond 400 385 54 14 46 24 5TheValueofConvertibleBonds ConvertibleBondValue StockPrice ConversionValue 24 6ReasonsforIssuingWarrantsandConvertibles Areasonableplacetostartistocompareahybridlikeconvertibledebttobothstraightdebtandstraightequity Convertibledebtcarriesalowercouponratethandoesotherwise identicalstraightdebt Sinceconvertibledebtisoriginallyissuedwithanout of the moneycalloption onecanarguethatconvertibledebtallowsthefirmtosellequityatahigherpricethanisavailableatthetimeofissuance However thesameargumentcanbeusedtosaythatitforcesthefirmtosellequityatalowerpricethanisavailableatthetimeofexercise ConvertibleDebtvs StraightDebt Con