978-1259277160 Chapter 19 Lecture Note

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Convertibles, Warrants, and Derivatives

Author’s Overview

Because the material in the chapter can be viewed from both a corporate finance and

investments perspective, the student’s interest in the chapter is usually quite high. The student

is given an in depth exposure to convertibles, with primary attention devoted to valuation

procedures. There is also material on the usefulness, advantages, and disadvantages of

convertibles to the corporation. Of course the advantage to the corporation is usually a

disadvantage to the investor and the disadvantage to the corporation is an advantage to the

investor. Many real world examples are included in the text and can be woven into the lecture.

Accounting considerations related to SFAS #128 are covered using step-by-step procedures for

computing basic and diluted earnings per share.

The discussion of warrants parallels many of the points considered under convertibles. The

topic of leverage, as it applies to warrants, also is appropriately introduced at this point and

provides valuable background material for the student who progresses to subsequent courses in

investments.

We provide a brief introduction to options and futures in a corporate finance context. We

discuss put and call options and focus on employee stock options, which may be of interest to

those students entering the job market. Futures are presented in combination with corporate

hedging activities using oil and currency futures.

Chapter Concepts

LO1. Convertible securities can be converted to common stock at the option of the owner.

LO2. Because these securities can be converted to common stock, their value may move with

the value of common stock.

LO3. Convertible bonds have a pure bond value based on interest paid and the market

demanded rate of return.

LO4. Warrants are similar to convertibles in that they give the warrant holder the right to

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acquire common stock.

LO5. Accountants require that the potential effect of convertibles and warrants on earnings

per share be reported on the income statement.

LO6. Derivative securities such as options and futures can be used by corporate financial

managers for hedging activities.

Annotated Outline and Strategy

I. Convertible Securities

A. A convertible is a fixed income security, bond, or preferred stock that can be

converted at the option of the holder into common stock. (The chapter focuses on

convertible bonds.)

1. Conversion ratio: number of shares of common stock into which the

security may be converted

2. Conversion price: face value of bond divided by the conversion ratio

B. Value of the Convertible Bond

1. Conversion value: conversion ratio times the market price per share of

common stock

2. Conversion premium: market value of convertible bond minus the

conversion value

3. Pure bond value: the value of the convertible bond as a straight bond

(non- convertible bond); the present value of the annual interest payment

and maturity payment discounted at the market rate of interest

4. Investors pay a conversion premium if the price of the convertible

security exceeds the value if the conversion were exercised.

5. If the market price of the common stock exceeds the conversion price, the

market value of the bond will rise above its par value to the conversion

value or higher.

6 The convertible bond’s value is limited on the downside by its pure bond

value, which is considered the “floor value.”

PPT Price Movement Pattern for a Convertible Bond (Figure 19-1)

Perspective 19-1: Students often get confused about where the data come from for plotting

these lines. The instructor should emphasize the relationship between common stock value and

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conversion value and the meaning of pure bond value. The conversion value line is easy to

draw; you start at zero and pick any stock price then multiply by the conversion ratio and

connect the two points. The pure bond value is a horizontal line representing the bond value

without conversion features.

PPT Pricing Pattern for Convertible Bonds Outstanding, Prices – February 6,

2015 (Table 19-1)

Perspective 19-2: Use Table 19-1 to discuss discounts and premium to the pure bond value

when the convertible bond is selling at a premium to par value, close to par value, and at a

discount to par value. Comparisons can also be made between coupon rates and yields to

maturity. Additionally you can use the table to examine the concept of downside risk if the

stock price should fall to the pure bond value.

C. Is this Fool’s Gold? Disadvantages to the Investor

1. All downside risk is not eliminated. When the conversion value is very

high, the investor is subject to significant downward price movement.

2. The pure bond value will fall if interest rates rise.

3. Interest rates on convertibles are less than on nonconvertible straight

bonds of the same risk.

4. Convertibles are usually subject to the call provision.

D. Advantages and Disadvantages to the Corporation

1. Lower interest rate than a straight bond

2. May be only means for the company to gain access to the capital market

3. Enables the sale of stock at higher than market price

4. The size of the convertible bond market is relatively small.

5. Firms that use convertibles are usually smaller companies experiencing

rapid growth and low dividend yields with low credit ratings and high

risk

PPT Characteristics of Convertible Bonds, February 6, 2015 (Table 19-2)

E. Forcing Conversion

1. Conversion may be forced if the company calls the convertible when the

conversion value exceeds the call price.

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2. Conversion is encouraged by a “step-up” provision in the conversion

price.

Perspective 19-3: After covering the advantages and disadvantages of convertibles from

both the investor and the corporate viewpoint, examine the trade-offs that are made by both

parties. Probe students’ understanding of why a security like this exists and how it affects the

capital structure and the cost of capital.

PPT Successful Convertible Bonds and Preferred Stock not yet Called,

February 6, 2015 (Table19-3)

Perspective 19-4: Use Table 19-3 to show that companies do not always force conversion

even when they could do so. The reasons usually focus on the fact that interest is tax deductible

while dividends are not. So the company will consider whether the increased dividend

payments that would occur with conversion are more costly than paying the interest on the

bond.

F. Accounting Considerations with Convertibles

1. Prior to 1969 the possible dilution effect of convertible securities on

earnings per share was not required to be reflected in financial reports.

2. Currently earnings per share must be reported in two ways:

PPT Diluted Earnings per Share, XYZ Corporation (Table 19-4)

where convertible securities include warrants, other options and any

convertible securities that create common stock.

PPT Diluted Earnings per Share Equation

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Earnings after taxes

Basic earnings per share = Shares of common stock

Reported earnings plus interest savings after taxes

Diluted earnings = Shares outstanding + All convertible securities

II. Financing Through Warrants

A. A warrant is an option to buy a stated number of shares of stock at a specified

price over a given period.

1. Sweetens a debt issue by lowering the interest rate on the bond

2. Usually detachable from the bond

3. Speculative: the value is dependent on the market movement of the stock

PPT Relationships Determining Warrant Prices (Table 19-5)

Finance in Action: Enticing Investors through Convertibles and Warrants

Convertibles and warrants are features used by a company to provide incentives above and

beyond the rate of return. This article discusses how one company overcame low demand for

its common stock by sweetening the deal through a warrants offering. This way the investors

can avoid the risk of full ownership if the stock value declines, but have the option to jump on

board at pre-arranged prices if the company does well.

B. Valuation of Warrants

1. Applying this formula, the minimum value of a warrant may be found

where:

I = intrinsic value of a warrant

M = market value of a common stock

E = exercise price of a warrant

N = number of shares each share entitles the holder to purchase

2. The actual price of the warrant may substantially exceed the formula

value due to the speculative nature of warrants.

3. Table 19-6 demonstrates the speculative use of warrants to magnify a

change in the stock price.

C. Use of Warrants in Corporate Finance

1. Enhances a debt issue by giving the bondholder an option to buy the

company’s stock at a set price.

2. Add-on in a merger or acquisition

3. Cannot be forced with a call, but option price is sometimes “stepped-up.”

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( ) I M E N= – ´

4. Equity base expands when warrants are exercised but the underlying debt

remains.

PPT Market Price Relationships for a Warrant (Figure 19-2)

D. Accounting Considerations with Warrants – Potential dilution of earnings per

share upon exercise of warrants must be disclosed in financial reports. There is a

required calculation to compute the dilution and it involves using the proceeds of

the cash inflow to retire and equal dollars worth of common stock shares.

III. Derivative Securities

A. Call options are similar to employer stock options in that it is an option to buy

securities at a set price for a specified period of time.

B. A put option is the opposite of a call option. A put allows the put holder to sell

shares to the put writer at a set price for a specified period of time.

C. Futures contracts give the owner the right but not the obligation to buy or sell

the underlying security or commodity at a future date.

D. Derivatives can be used for speculation as well as hedging. Corporations

generally use derivatives to hedge risk.

Perspective 19-5: The instructor should emphasize that the use of derivatives is one of the

most important developments in finance and that they can be used to hedge almost any type of

risk.

Other Chapter Supplements

Cases for Use with Foundations of Financial Management

Case 30, Hamilton Products (Convertibles)

Case 33, Security Software, Inc. (Convertibles)

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