19-1
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.
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.
LO3. Convertible bonds have a pure bond value based on interest paid and the market-demanded
rate of return.
LO5. Accountants require that the potential effect of convertibles and warrants on earnings per
share be reported on the income statement.
19
19-2
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
B. Value of the convertible bond
1. Conversion value: conversion ratio times the market price per share of
common stock
3. Pure bond value: the value of the convertible bond as a straight bond
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.
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 conversion
PPT Pricing Pattern for Convertible Bonds Outstanding, Prices on January 22,
2018 (Table 19-1)
19-3
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
C. Is this fool’s gold? Disadvantages to the investor
2. The pure bond value will fall if interest rates rise.
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
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
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
PPT Successful Convertible Bonds and Preferred Stock Not Yet Called
(Table 19-3)
19-4
Perspective 19-4: Use Table 19-3 to show that companies do not always force conversion even
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 XYZ Corporation (Table 19-4)
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
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
Earnings after taxes
Basic earnings per share = Shares of common stock
Diluted earnings per share = Adjusted earnings after taxes
Shares outstanding + All convertible securities
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 prearranged 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
N = number of shares each share entitles the holder to purchase
3. Table 19-6 demonstrates the speculative use of warrants to magnify a
change in the stock price.
PPT Market Price Relationships for a Warrant (Figure 19-2)
PPT Leverage in Valuing Warrants (Table 19-6)
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.
3. Cannot be forced with a call, but option price is sometimes “stepped–up.”
4. Equity base expands when warrants are exercised but the underlying debt
remains.
D. Accounting considerations with warrants—Potential dilution of earnings per share
upon exercise of warrants must be disclosed in financial reports. There is a
III. Derivative Securities
A. Call options are similar to employer stock options in that they are 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
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 33, Security Software, Inc. (Convertibles)