Chapter 19: Convertibles, Warrants, and Derivatives
Chapter 19
Convertibles, Warrants, and Derivatives
Discussion Questions
19-1.
What are the basic advantages to the corporation of issuing convertible
securities?
The advantages to the corporation of a convertible security are:
a. The interest rate is lower than on a straight issue.
b. This type of security may be the only device for allowing a small firm access
to the capital markets.
c. The convertible allows the firm to effectively sell stock at a higher price than
that possible when the bond was initially issued (but perhaps at a lower price
than future price potential might provide).
d. If the bond can be called at a price above its conversion price, the bond will
be converted to stock and the debt to asset ratio will decline.
19-2.
Why are investors willing to pay a premium over the theoretical value (pure bond
value or conversion value)?
Investors are willing to pay a premium over the theoretical value for a convertible
bond issue because of the future prospects for the associated common stock.
Thus, if there are many years remaining for the conversion privilege, the investor
will be able to receive a reasonably high interest rate and still have the option of
converting the convertible bond to common stock if circumstances justify.
19-3.
Why is it said that convertible securities have a floor price?
The floor price of a convertible is based on the pure bond value associated with
the interest payments on the bond as shown in Figure 19-1. Regardless of how
low the associated common stock might go, the semiannual interest payments
will set a floor price for the bond.
Chapter 19: Convertibles, Warrants, and Derivatives
19-4.
The price of Haltom Corporation 5 ¼ 2019 convertible bonds is $1,380. For the
Williams Corporation, the 6 ⅛ 2018 convertible bonds are selling at $725.
a. Explain what factors might cause their prices to be different from their par
value of $1,000.
b. What will happen to each bond’s value if long-term interest rates decline?
Convertible bond pricing
a. Haltom bonds are well above par value because its common stock has
probably increased substantially. In the case of Williams, it is reasonable to
assume that its common stock has declined. Also, its interest rate is probably
well below the going market rate because of its low bond price.
b. With the Haltom Corporation, there would be little or no impact. It is clearly
controlled by its common stock value. With the Williams Corporation, its
potential value is somewhat associated with interest rates (rather than just
conversion), so it is likely to go up somewhat in value.
19-5.
How can a company force conversion of a convertible bond?
A firm may force conversion of a bond issue through the use of the call
privilege. If a bond has had a substantial gain in value due to an increase in price
of the underlying common stock, the bondholder may prefer to convert to
common stock rather than trade in the bond at some small premium over par as
stipulated in a call agreement.
19-6.
What is meant by a step-up in the conversion price?
A “step–up” in conversion price will increase with the passage of time and
likewise the conversion ratio will decline. Before each step-up, there is an
inducement for bondholders to convert to common at the more desirable price.
19-7.
Explain the difference between basic earnings per share and diluted earnings per
share.
Basic earnings per share do not consider the potentially dilative effects of
convertibles, warrants, and other securities that can generate new shares of
common stock. Diluted earnings per share consider all dilutive effects regardless
Chapter 19: Convertibles, Warrants, and Derivatives
19-8.
Explain how convertible bonds and warrants are similar and different.
Convertible bonds and warrants are similar in that they give the security holder a
future option on the common stock of the corporation. They are dissimilar in that
a convertible bond represents a debt obligation of the firm as well. When it is
converted to common stock, corporate debt will actually be reduced and the
capitalization of the firm will not increase. A warrant is different in that it is not
a valuable instrument on its own merits, and also its exercise will increase the
overall capitalization of the firm.
19-9.
Explain why warrants are issued. (Why are they used in corporate finance?)
Warrants may be used to sweeten a debt offering or as part of a merger offer or a
bankruptcy proceeding. They also offer the potential of future cash flow to the
corporation if the warrants are used to buy new shares of common stock.
19-10.
What are the reasons that warrants often sell above their intrinsic value?
Warrants may sell above their intrinsic value because the investor views the
associated stock’s prospects optimistically. Also the longer the time to expiration
the higher the speculative premium because the possibility of a rising stock price
increases. Warrants also allow for the use of leveraged investing.
19-11.
What are the differences between a call option and a put option?
A call option is an option to buy at a set price for a given period of time, and a
put option is an option to sell at a set price for a given period of time.
19-12.
Suggest two areas where the use of futures contracts is most common. What
percent of the value of the underlying security is typical as a down payment in a
futures contract?
Futures contracts are most common for commodities and interest rate securities,
especially government bonds.
Five percent is a typical down payment (margin) in a futures contract. This
allows the holder of the contract to control an amount of securities 20 times more
than the down payment. For this reason, futures contracts have very volatile
prices.
Chapter 19: Convertibles, Warrants, and Derivatives
19-13.
You buy a stock option with an exercise price of $50. The cost of the option is
$4. If the stock ends up at $56, indicate whether you have a profit or loss with a
call option? With a put option?
With a call option, you would have a profit of $2. You bought the option for $4
and the market value is $6 over the exercise value. With a put option, you would
have a loss. It is worthless to have the right to sell a stock for $50, when the cost
of the stock is $56. You would lose your $4 investment.
Chapter 19
Problems
1. Value of warrants (LO4) Rockport Shipping Co. has warrants outstanding that allow the
holder to purchase a share of stock for $16 (exercise price). The common stock is currently
selling for $24, while the warrant is selling for $11.75 per share.
a. What is the intrinsic (minimum) value of this warrant?
b. What is the speculative premium on this warrant?
19–1. Solution:
Rockport Shipping Co.
a. I = (M – E) × N
Where: I = Intrinsic value of a warrant
M = Market value of common stock
E = Exercise price of a warrant
N = Number of shares each warrant entitles the
holder to purchase
b. S = W – I
Chapter 19: Convertibles, Warrants, and Derivatives
19-5
S = $11.75 – $8.00 = $3.75
2. Value of warrants (LO4) National Motors, Inc., has warrants outstanding that allow the
holder to purchase 1.5 shares of stock per warrant at $28 per share (exercise price). Thus,
each individual share can be purchased at $28 with the warrant. The common stock is
currently selling for $35. The warrant is selling for $14.
a. What is the intrinsic (minimum) value of this warrant?
b. What is the speculative premium on this warrant?
c. What should happen to the speculative premium as the expiration date approaches?
19–2. Solution:
National Motors, Inc.
a. I = (M – E) × N
Where: I = Intrinsic value of a warrant
M = Market value of common stock
E = Exercise price of a warrant
N = Number of shares each warrant entitles the
holder to purchase
b. S = W – I
Where: S = Speculative premium
W = Warrant price
I = Intrinsic value
c. The speculative premium should decrease and approach $0
as the expiration date nears.
Chapter 19: Convertibles, Warrants, and Derivatives
19-6
3. Breakeven on warrants (LO4) The warrants of Airbus Transportation Corporation allow
the holder to buy a share of stock at $13.25 and are selling for $3.75. The stock price is
currently $10.65. To what price must the stock go for the warrant purchaser to at least be
assured of breaking even?
19–3. Solution:
Airbus Transportation Corporation
The stock price must go to $17.00. At that point, the warrant
will be worth at least the current price of $3.75.
I = (M – E) × N
Where: I = Intrinsic value of a warrant
M = Market value of common stock
E = Exercise price of a warrant
N = Number of shares each warrant entitles the
holder to purchase
4. Breakeven on warrants (LO4) The warrants of Dragon Pet Co. allow the holder to buy a
share of stock at $26.10 and are selling for $7.80. The stock price is currently $21.50. To
even?
19–4. Solution:
Dragon Pet Company
I = (M – E) × N
Where: I = Intrinsic value of a warrant
Chapter 19: Convertibles, Warrants, and Derivatives
19-7
M = Market value of common stock
E = Exercise price of a warrant
N = Number of shares each warrant entitles the
holder to purchase
(Assume all bonds in the following problems have a par value of $1,000.)
5. Features of convertible bond (LO1) DNA Labs, Inc. has a $1,000 convertible bond
outstanding that can be converted into 40 shares of common stock. The common stock is
currently selling for $26.75 a share, and the convertible bond is selling for $1,118.50.
a. What is the conversion value of the bond?
b. What is the conversion premium?
c. What is the conversion price?
19–5. Solution:
DNA Labs, Inc.
a. $26.75 stock price × 40 shares = $1,070 conversion value
6. Features of convertible bond (LO1) O’Reilly Moving Company has a $1,000 par value
convertible bond outstanding that can be converted into 25 shares of common stock. The
common stock is currently selling for $36.25 a share, and the convertible bond is selling
for $970.
a. What is the conversion value of the bond?
b. What is the conversion premium?
c. What is the conversion price?
Chapter 19: Convertibles, Warrants, and Derivatives
19-8
19–6. Solution:
O’Reilly Moving Company
a. $36.25 stock price × 25 shares = $906.25 conversion value
7. Price of a convertible bond (LO2) The bonds of Stein Company have a conversion
premium of $35. Their conversion price is $20. The common stock price is $18.50. What is
the price of the convertible bonds?
19–7. Solution:
Stein Co.
First compute the conversion ratio
the conversion price:
Par value/conversion price = conversion ratio in shares
Multiply the common stock price times the conversion ratio to
get the conversion value:
Common stock price × conversion ratio = conversion value
the convertible bond price:
Chapter 19: Convertibles, Warrants, and Derivatives
19-9
8. Price of a convertible bond (LO2) The bonds of Generic Labs, Inc., have a conversion
premium of $75. Their conversion price is $25. The common stock price is $21.50. What is
the price of the convertible bond?
19–8. Solution:
Generic Labs, Inc.
The conversion ratio is equal to the $1000 par value divided by
the conversion price:
Par value/conversion price = conversion ratio
Common stock price × conversion ratio = conversion value
9. Conversion premium for bond (LO2) Sherwood Forest Products has a convertible bond
quoted on the NYSE bond market at 95. (Bond quotes represent percentage of par value.
Thus, 70 represents $700, 80 represents $800, and so on.) It matures in 10 years and carries
a coupon rate of 6½ percent. The conversion ratio is 25, and the common stock is currently
selling for $35 per share on the NYSE.
a. Compute the conversion premium.
b. At what price does the common stock need to sell for the conversion value to be equal
to the current bond price?
19–9. Solution:
Chapter 19: Convertibles, Warrants, and Derivatives
19-10
Sherwood Forest Products
First calculate the bond price = 95% × $1000 par value
=$950 bond price
10. Conversion value and pure bond value (LO1) Pittsburgh Steel Company has a
convertible bond outstanding, trading in the marketplace at $930. The par value is $1,000,
the coupon rate is 8 percent, and the bond matures in 25 years. The conversion price is $50
and the company’s common stock is selling for $44 per share. Interest is paid
semiannually.
a. What is the conversion value?
b. If similar bonds which are not convertible are currently yielding 10 percent, what is the
pure bond value of this convertible bond? (Use semiannual analysis as described
in Chapter 10.)
19–10. Solution:
Pittsburgh Steel Company
a. Par value/conversion price = conversion ratio
b. Pure bond value where n = 50, i = 5%
11. Pure bond value and change in interest rates (LO3) In problem 10, if the interest rate on
similar bonds which are not convertible goes up from 10 percent to 12 percent, what will
be the new pure bond value of the Pittsburgh Steel Company bonds? Assume the Pittsburgh