Chapter 24

Warrants and Convertibles

McGraw-Hill/Irwin Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights

 Key Concepts and Skills
• Understand how warrants and convertible
bonds are similar to call options
• Understand how warrants and convertible
bonds differ from call options
• Understand why corporations would issue
either warrants or convertible bonds
 Chapter Outline
24.1 Warrants
24.2 The Difference between Warrants and Call Options
24.3 Warrant Pricing and the Black-Scholes Model
24.4 Convertible Bonds
24.5 The Value of Convertible Bonds
24.6 Reasons for Issuing Warrants and Convertibles
24.7 Why are Warrants and Convertibles Issued?
24.8 Conversion Policy
 24.1 Warrants
• Warrants are call options that give the holder 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.
• Warrants tend to have longer maturity periods than
exchange traded options.
• Warrants are generally issued with privately placed bonds as
an “equity kicker.”
• Warrants are also combined with new issues of common
stock and preferred stock and/or given to investment
bankers as compensation for underwriting services.
– In this case, they are often referred to as a Green Shoe Option.
 Warrants
• The factors that affect call option value affect
warrant value in the same ways.
1. Stock price +

2. Exercise price –

3. Interest rate +

4. Volatility in the stock price +

5. Expiration date +
 24.2 The Difference between Warrants and
Call Options
• When a warrant is exercised, a firm must
issue new shares of stock.
• This can have the effect of diluting the
claims of existing shareholders.
 Dilution Example
• Imagine that Mr. Armstrong and Mr. LeMond are shareholders in
a firm whose only asset is 10 ounces of gold.
• When they incorporated, each man contributed 5 ounces of gold,
then valued at $300 per ounce. They printed up two stock
certificates and named the firm LegStrong, Inc..
• Suppose that Mr. Armstrong decides to sell Mr. Mercx a call
option issued on Mr. Armstrong’s share. The call gives Mr. Mercx
the option to buy Mr. Armstong’s share for $1,500.
• If this call finishes in-the-money, Mr. Mercx will exercise, Mr.
Armstrong will tender his share.
• Nothing will change for the firm except the names of the
shareholders.
 Dilution Example
• Suppose that Mr. Armstrong and Mr. LeMond meet as the board of
directors of LegStrong. The board decides to sell Mr. Mercx a
warrant. The warrant gives Mr. Mercx the option to buy one share
for $1,500.
• Suppose the warrant finishes in-the-money, (gold increased to
$350 per ounce). Mr. Mercx will exercise. The firm will print up one
new share.
 Dilution Example
• The balance sheet of LegStrong Inc. would change in the
following way:

Balance Sheet Before

(Book Value)

Assets Liabilities and

Equity

Gold: $3,000 Debt 0

Equity (2 shares) $3,000

Total Assets $3,000 Total $3,000

 Dilution Example
Balance Sheet Before
(Market Value)

Assets Liabilities and Equity

Gold: $3,500 Debt 0

Cash: $1,500 Equity (3 shares) $5,000

Total Assets $5,000 Total $3,000

Note that Mr. Armstrong’s claim falls in value from

$1,750 = $3,500 ÷ 2 to $1,666.67 = $5,000 ÷ 3
 Warrant Pricing and the Black-Scholes
Model
To see why, compare the gains from exercising a call with the
gains from exercising a warrant.
The gain from exercising a call can be written as:
share price  exercise price
Note that when n = the number of shares, share
price is: Firm' s value net of debt
n
Thus, the gain from exercising a call can be written
as:
Firm' s value net of debt
 exercise price
n
Warrant Pricing and the Black-Scholes Model
The gain from
shareexercising a warrant
price after warr ant=exercise  exercise price
Note that when # = the original number of
shares and #w = the number of warrants,
 share price 
  Firm' s value net of debt  exercise price # w
 after  # # w
 warrant exercise 

Thus, the gain from exercising a warrant can be

written as:
Firm' s value net of debt  exercise price # w
 exercise price
# # w
 Warrant Pricing and the Black-Scholes Model
The gain from exercising a call can be written as:
Firm' s value net of debt
 exercise price
#
The gain from exercising a warrant can be written as:
Firm' s value net of debt  exercise price # w
 exercise price
# # w
A bit of algebra shows that these #
equations differ by a factor of # # w
So to value a warrant, multiply the
#
value of an otherwise-identical call
by # # w
24.3 Warrant Pricing and the Black-Scholes
Model
• Warrants are worth a bit less than calls due to the
dilution.
• To value a warrant, value an otherwise-identical call and
multiply the call price by:

n
Where
n  nw
n = the original number of shares
nw = the number of warrants
24.4 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 different securities and
a convertible bond cannot.
• Recall that the minimum (floor) value of a convertible
is the maximum of:
– Straight or “intrinsic” bond value
– Conversion value
• The conversion option has value.
24.5 The Value of Convertible Bonds
The value of a convertible bond has three
components:
1. Straight bond value
2. Conversion value
3. Option value
 Convertible Bond Example
• Litespeed, Inc., just issued a zero coupon convertible
bond due in 10 years.
• The conversion ratio is 25 shares.
• The appropriate interest rate is 10%.
• The current stock price is $12 per share.
• Each convertible is trading at $400 in the market.
– What is the straight bond value?
– What is the conversion value?
– What is the option value of the bond?
 Convertible Bond Example
– What is the straight bond value?
$1,000
SBV  10
 $385.54
(1.10)
– What is the conversion value?

25 shares × $12/share = $300

– What is the option value of the bond?

$400 – 385.54 = $14.46

The Value of Convertible Bonds
Convertible
Bond Value
Convertible bond
values Conversion
Value
floor value

floor Straight bond

value value
= conversion ratio Option
value
Stock
Price
 24.6 Reasons for Issuing Warrants and
Convertibles
• A reasonable place to start is to compare a hybrid like
convertible debt to both straight debt and straight equity.
• Convertible debt carries a lower coupon rate than does
otherwise-identical straight debt.
• Since convertible debt is originally issued with an out-of-the-
money call option, one can argue that convertible debt allows
the firm to sell equity at a higher price than is available at the
time of issuance. However, the same argument can be used to
say that it forces the firm to sell equity at a lower price than is
available at the time of exercise.
Convertible Debt vs. Straight Debt
• Convertible debt carries a lower coupon rate than does
otherwise-identical straight debt.
• If the company subsequently does poorly, it will turn out that
the conversion option finishes out-of-the-money.
• But if the stock price does well, the firm would have been better
off issuing straight debt.
• In an efficient financial market, convertible bonds will be neither
cheaper or more expensive than other financial instruments.
• At the time of issuance, investors pay the firm for the fair value
of the conversion option.
Convertible Debt vs. Straight Equity
• If the company subsequently does poorly, it will turn out that
the conversion option finishes out-of-the-money, but the firm
would have been even better off selling equity when the price
was high.
• But if the stock price does well, the firm is better off issuing
convertible debt rather than equity.
• In an efficient financial market, convertible bonds will be
neither cheaper or more expensive than other financial
instruments.
• At the time of issuance, investors pay the firm for the fair
value of the conversion option.
 24.7 Why Are Warrants and Convertibles
Issued?
• Convertible bonds reduce agency costs by aligning the
incentives of stockholders and bondholders.
• Convertible bonds also allow young firms to delay
expensive interest costs until they can afford them.
• Support for these assertions is found in the fact that firms
that issue convertible bonds are different from other
firms:
– The bond ratings of firms using convertibles are lower.
– Convertibles tend to be used by smaller firms with high growth
rates and more financial leverage.
– Convertibles are usually subordinated and unsecured.
24.8 Conversion Policy
• Most convertible bonds are also callable.
• When the bond is called, bondholders have about 30 days
to choose between:
1. Converting the bond to common stock at the conversion
ratio.
2. Surrendering the bond and receiving the call price in cash.
• From the shareholder’s perspective, the optimal call policy
is to call the bond when its value is equal to the call price.
• In the real world, most firms wait to call until the bond
value is substantially above the call price. Perhaps the firm
is afraid of the risk of a sharp drop in stock prices during
the 30-day window.
Quick Quiz
• Explain how convertible bonds and warrants
are similar to call options.
• Explain how convertible bonds and warrants
are different from call options.
• Identify possible corporation benefits from
issuing convertible bonds and/or warrants.