Chapter 25

Warrants and Convertibles

Slides Prepared By:

Larbi Hammami
Desautels Faculty of Management
McGill University

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Executive Summary

• This chapter describes the basic features of warrants and

convertibles.
• The important questions are:
– How can warrants and convertibles be valued?
– What impact do warrants and convertibles have on firm
value?
– What are the differences between warrants, convertibles, and
call options?
– Under what circumstances are warrants and convertibles
converted into common shares?

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Chapter Outline

25.1 Warrants
25.2 The Difference between Warrants and Call Options
25.3 Warrant Pricing and the Black-Scholes Model
(Advanced)
25.4 Convertible Bonds
25.5 The Value of Convertible Bonds
25.6 Reasons for Issuing Warrants and Convertibles
25.7 Why are Warrants and Convertibles Issued?
25.8 Conversion Policy
25.9 Summary and Conclusions
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25.1 Warrants

• Give the holder the right, but not the obligation, to buy shares
directly from a company at a fixed price for a given period of
time.
• Tend to have longer maturity periods than exchange traded
options.
• Are generally issued with privately placed bonds as an “equity
kicker.”
• Often combined with new issues of common shares and
preferred shares, given to investment bankers as compensation
for underwriting services.
– In this case, they are often referred to as a Green Shoe
Option.
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25.1 Warrants

• Each warrant specifies: the number of shares the holder can buy,
the exercise price and the expiry date.
• The same 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 +
6. Dividends –
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25.2 The Difference Between Warrants
and Call Options
• When a warrant is exercised, a firm must issue new shares.

• This can have the effect of diluting the claims of existing shareholders.
Example - A Call Option Is Sold by Shareholder
• Imagine that Mr. Armstrong and Mr. LeMond are S/Hs 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. Call gives Mercx the option to buy Armstrong’s share for $1,500.
• If this call finishes in-the-money, Mercx will exercise, Armstrong will tender his
share.
• Nothing will change for the firm except the names of the shareholders.

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25.2 The Difference Between Warrants
and Call Options
Example - A Warrant Is Issued by the Company (cont.)
• The balance sheet (market value) of LegStrong, Inc. would
change in the following way:
Balance Sheet Before (Market Value)

Assets Liabilities and Equity

Gold $3,500 Debt 0
Equity(2 shares) $3,500

Total $3,500 Total $3,500

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25.3 Warrant Pricing and the Black-
Scholes Model (Advanced)
• 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 +N w
N = the original number of shares
Nw = the number of warrants

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25.3 Warrant Pricing and the Black-
Scholes Model (Advanced)
• 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− E xercise   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

− E xercise   price
N

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25.3 Warrant Pricing and the Black-
Scholes Model (Advanced)
• The gain from exercising a warrant can be written as:
S hare  price  after   warrant  exercise− E xercise   price
• Note that when N = original # of shares and Nw = the # of warrants,

[ ]
S hare    price Firm ′ s   value   net   of   debt + E xercise   price × N w
after =
N +N w
warrant   exercise

• Thus, the gain from exercising a warrant can be written as:

Firm ′s   value net  of  debt+( Exercise  price×N w ¿ ¿ −E xercise   price

N+N w

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25.3 Warrant Pricing and the Black-
Scholes Model (Advanced)
• The gain from exercising a warrant can be written as:

• The gain from exercising a call can be written as:

Firm ′s   value   net   of  debt

− E xercise   price
N
• So, to value a warrant, multiply the value of an otherwise-identical call by

N
N +N w

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25.4 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.
• Minimum (floor) value of convertible:
– Straight or “intrinsic” bond value
– Conversion value

• The conversion option has value.

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25.5 The Value of Convertible Bonds

• The value of a convertible bond has three components:

1. Straight bond value

2. Conversion value

3. Option value
Example
• Litespeed, Inc., just issued a zero-coupon convertible bond due in 10 years.
• The conversion ratio is 25 shares.
• The interest rate for straight debt is 10%.
• The current share price is $12 per share.
• Each convertible bond is trading at $400 in the market. Face Value is $1,000.
– What is the straight bond value?
– What is the conversion value?
– What is the option value of the bond?
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25.5 The Value of Convertible Bonds

Example (cont.)
• What is the straight bond value?
$ 1,000
SBV =
¿¿
• What is the conversion value?
25 shares × $12/share = $300
• What is the option value of the bond?
= Market value – (greater of the straight bond value & conversion value)
= $400 – $385.54 = $14.46

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25.5 The Value of Convertible Bonds

Figure 25.3: The Value of Convertible Bonds

Convertible
Bond Value Convertible bond Conversion
values Value
Floor value

Straight bond
Floor
value
value = conversion ratio Option
value
Share
Price
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25.6 Reasons for Issuing Warrants and
Convertibles
• Convertible debt carries a lower coupon rate than does otherwise-identical straight
debt due to the conversion option which has value.

• 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.

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25.6 Reasons for Issuing Warrants and
Convertibles
Convertible Debt Vs. Straight Debt
• Convertible debt carries a lower coupon rate than does otherwise-identical straight debt.
• If company subsequently does poorly, conversion finishes out-of-the-money since the share price
will be lower than the conversion price.
• But if the share price does well, firm would have been better off issuing straight debt.
• In an efficient financial market, convertibles will be neither cheaper nor more expensive than
other financial instruments.
• At the time of issuance, investors pay the firm for the fair value of the conversion option.
• If company subsequently does poorly, it will turn out that conversion option finishes out-of-the-
money, but firm would have been even better off selling equity when the price was high.
• But if the share price does well, firm is better off issuing convertibles rather than equity since the
bonds will convert at the higher share price than at the time of issue.
• In an EFM, convertibles will be neither cheaper nor more expensive than other fin. instruments.
• At the time of issuance, investors pay the firm for the fair value of the conversion option.
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25.7 Why Are Warrants and
Convertibles Issued?
• Convertible bonds reduce agency costs, by aligning the incentives of shareholders 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.

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25.8 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 shares at the conversion ratios.
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 share prices during the 30-
day window.

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