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Convertibles, Exchangeables, and Warrants
You pays your money and you takes your choice.
PUNCH
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ANSWERS TO QUESTIONS
1. The conversion price and the conversion ratio are reciprocals of each other. The conversion
ratio tells how many shares of common stock will be received for each $1,000 debenture.
$1,000 divided by the conversion price equals the conversion ratio. The conversion value of
2. With the advantage of hindsight and on the assumption that the firm did not require any of
the funds until the date of conversion and that equity flotation costs were less than the
3. The company issues straight debt to avoid diluting the EPS and to gain the beneficial effects
4. Warrants allow the investor to obtain a high degree of personal leverage when buying
5. The question is purposely broad to encourage discussion of the relative advantages of
a. Use of convertibles gives the firm greater control over the timing of future capital
b. Upon conversion, convertibles typically expand the equity base more than warrants do.
c. If the price of the firm’s stock rises and then falls prior to the expiration date of the
warrants, the warrants may lose their value and not be exercised. The firm would then
Offsetting these advantages are the increased dilution and possible problems with
6. The bondholder might convert to obtain an attractive common stock dividend, to avoid an
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7. Warrants are used by these firms as “sweeteners” to lower the explicit interest rate on debt
8. It is valued more highly because of its upside potential to the investor. The greater the
potential fluctuation in the market price of the common stock, the more valuable the option.
In essence, the investor puts up less money and participates in upside fluctuations in the
9. This event probably has been discounted in the price of the common stock. Accounting
10. A “step-up” in conversion price will prompt holders of the convertible security to convert
before a “step-up” occurs, assuming that the conversion value is in excess of the
11. For roughly the same amount of upside movement in price, the investor has a lower net
investment than he/she would in the common stock. Because the option requires less net
12. The attractiveness of warrants depends on the exercise price, the time to expiration, and the
potential of the common stock. Again it is the upside potential that is important. If a
13. The investor achieves leverage, so that percentage changes in warrant value exceed
percentage changes in share price, while being protected on the downside. This skewed
14. No. The company must give an option on the common stock that may cause dilution. There
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15. Both the convertible bond and the exchangeable bond are options on common stock and
16. Both securities are hybrids, having valuation features of bonds and common stock options.
There are diversification properties with the exchangeable bonds, because the option is on
SOLUTIONS TO PROBLEMS
1. a.
EPS $ 3.00
b.
Face per bond $1,000.00
e.
Before After
Originally Conversion Conversion
Operating earnings $5,000,000 $6,000,000 $6,000,000
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2.
Operating earnings $6,000,000
Interest 1,200,000
3. a. Premiums:
Observations
1 2 3 4 5
Market Price Per Share $ 40 $ 45 $ 32 $ 23 $ 18
b. At high common stock prices, the convertible debenture sells at a substantial premium
over its straight-bond value, but at only a slight premium over its conversion value.
Here the convertible sells mainly for its common stock attraction, and the bond feature
4. At $10 a share, the conversion value is $250 and the premium-over-conversion-value is
$190. The premium over straight bond value is $30. As the common stock price has
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5. a. (000s omitted)
Capitalization
Convertible Debentures Deb. with Warrants
Before
Financing
Before
Conversion
After
Conversion
Before
Exercise
After
Exercise
Debentures $ 0 $10,000 $ 0 $10,000 $10,000
Com. Stock $ 5,000 5,000 $ 6,000 5,000 5,200
b. Earnings
Net income before int. and taxes $ 6,000 $ 8,000 $ 8,000 $ 8,000 $ 8,400
Less: Interest 0 800 0 1,000 1,000
c. Theoretical value of warrant =
6. The exchange price is $1,000/16.666 = $60
7. TV = (N)(Ps) – E
a. TV = (5)($100) – $400 = $100
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8. a. 34.7 × $43 = $1,492.10. This assumes the bonds sell for their conversion value – i.e.,
there is no premium.
9. a. (3)($18) – $60 = –$6, or zero as the warrant cannot have a negative value.
d. As this amount is positive, we would expect the warrant to sell at some positive price,
10. a.
()
$1 $50 $26
$26
+−
b. Theoretical value now = (2)($26) – $45 = $7
c. The greater leverage associated with the lesser investment in the warrants results in a
substantially higher return in terms of percentage.
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SOLUTIONS TO SELF-CORRECTION PROBLEMS
1. a. Conversion value = Conversion ratio × market price per share
b. Premium over conversion value = $50 – $42 = $8
c. Earnings per share:
Total after-tax earnings ($3 × 500,000 shares) $1,500,000
Preferred stock dividend 140,000
d. Earnings per share after profit increase:
Total after-tax earnings $2,500,000
Preferred stock dividend 140,000
2. a. Conversion price = $36 × 1.12 = $40.32
Call price per share the first 10 years = $40.32 × 1.06 = $42.74
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b. This period is somewhat longer than the two to three years that market participants have
3. Market price of warrant and theoretical value at various common stock prices (in ascending
order):
When plotted, the relationship is of the same pattern as shown in Figure 22.1. The
maximum premium over theoretical value occurs when share price is $24, and the