26.WARRANTS AND CONVERTIBLES

CHAPTER 26
WARRANTS AND CONVERTIBLES
Warrants and convertibles are unique compared to other
types of securities because they may be converted into
common stock. The CFO needs to have a good under-
standing of warrants and convertibles along with their
valuation, their advantages and disadvantages, and when
their issuance is recommended.
WARRANTS
A warrant is the o ption given holders to buy a predeter-
mined number of shares of stock at a given price. Warrants
may be detachable or nondetachable. A detachable warrant
may be sold separately from the bond with which it is
associated. Thus, the holder may exercise the warrant but
not redeem the bond. Your company may issue bonds
with detachable warrants to purchase additional bonds
so as to hedge the risk of adverse future interest rate
movements since the warrant is convertible into a bond at
a fixed interest rate. If interest rates increase, the warrant
will be worthless, and the issue price of the warrant will
partially offset the higher interest cost of the future debt
issue. A nondetachable warrant is sold with its bond to
be exercised by the bond owner simultaneously with the
convertible bond.
Your company may sell warrants separately (e.g.,
American Express) or in combination with other securities
(e.g., MGM).
To obtain common stock, the warrant must be given
up along with the payment of cash called the exercise price.
Although warrants usually mature on a specified date,
some are perpetual. A holder of a warrant may exercise

it by purchasing the stock, sell it on the market to other
investors, or continue to hold it. The company cannot
force the exercise of a warrant.
If desired, the company may have the exercise price of
the warrant change over time (e.g., increase each year).
504
Warrants 505
If a stock split or stock dividend is issued before the
warrant is exercised, the option price of the warrant will
be adjusted for it.
Warrants may be issued to obtain a dditional funds.
When a bond is issued with a warrant, the warrant price
is usually established between 10 and 20 percent above
the stock’s market price. If the company’s stock price
increases above the option price, the warrants will be
exercised at the option price. The closer the warrants are
to their maturity date, the greater is the likelihood that
they will be exercised.
What is a warrant worth?
The theoretical value of a warrant is computed by a for-
mula. The formula value is typically less than the market
price of the warrant because the speculative appeal of a
warrant allows the investor to obtain personal leverage:
Value of a
Warrant
=

Market price
per share
−

Exercise
price

×
Number of shares
that may be bought
EXAMPLE 26.1
A warrant for XYZ Company’s stock gives the owner
the right to buy o ne share of common stock at $25 a
share. Themarket priceofthe commonstock is$53.The
formula price of the warrant is $28 (($53 − $25) ×1).
If the owner had the right to buy three shares of
common stock with one warrant, the theoretical value
of the warrant would be $84 ($53 − $25) × 3).
If the stock is selling for an amount below the
option price, there will be a negative value. Since this
is illogical, a zero value is assigned.
EXAMPLE 26.2
Assume the same facts as in Example 26.1, except
that the stock is selling at $21 a share. The formula
amount is − $4(($21 − $25) × 1). However, zero will
be assigned.
Warrants do not have an investment value because
there are no interest, dividends, or voting rights. Therefore,
the market value of a warrant is only attributable to
its convertibility feature into common stock. However,
506 Warrants and Convertibles
the market price of a warrant is typically more than its
theoretical value, which is referred to as the premium on
the warrant. The lowest amount that a warrant will sell

for is its theoretical value.
The value of a w arrant depends on the remaining life
of the option, dividend payments on the common stock,
the fluctuation in price of the common stock, whether
the warrant is listed on the exchange, and the investor’s
opportunity. There is a higher price for a warrant when
its life is long, the dividend payment on common stock is
small, the stock price is volatile, it is listed on the exchange,
and the value of funds to the investor is great (because the
warrant requires a lesser investment).
EXAMPLE 26.3
ABC stock has a market value of $50. The exercise
price of the warrant is also $50. Thus, the theoretical
value of the warrant is $0. However, the warrant
will sell at a premium (positive price) if there is the
possibility that the market price of the common stock
will exceed $50 prior to the expiration date of the
warrant. The more distant the expiration date, the
greater will be the premium, since there is a longer
period for possible price appreciation. The lower the
market price relative to the exercise p rice, the less the
premium will be.
EXAMPLE 26.4
Assume the same facts as in Example 26.3, except that
the current market price of the stock is $35. In this
case, the warrant’s premium will be much lower since
it would take longer for the stock’s price to increase
above $50 a share. If investors expect that the stock
price would not increase above $50 at a later date, the
value of the warrant would be $0.

If the market price of ABC stock rises above $50, the
market price of the warrant will increase and the pre-
mium will decrease. In other words, when the stock
price exceeds the exercise price, the market price of the
warrant approximately equals the theoretical value so
the premium disappears. The reduction in the pre-
mium arises because of the lessening of the advantage
of owning the warrant compared to exercising it.
Convertible Securities 507
Should you issue a warrant?
The advantages of issuing warrants are:
❍ They serve as ‘‘sweetener’’ for an issue of debt or
preferred stock.
❍ They permit the issuance of debt at a low interest
rate.
❍ They allow for balanced financing between debt and
equity.
❍ Funds are received when the warrants are exercised.
The disadvantages of issuing warrants are:
❍ When exercised they will result in a dilution of
commonstockwhichinturnlowersthemarket
price of stock.
❍ They may b e exercised when the business has no
need for additional capital.
CONVERTIBLE SECURITIES
What is a convertible security and when
should it be issued?
A convertible security can be exchanged for common stock
by the holder, and in some cases the issuer, according to
specified terms. Examples are convertible bonds a nd con-

vertible preferred stock. Common shares are issued when
the convertible security is exchanged. The conversion ratio
equals:
Conversion ratio =
Par value of
convertible security
Conversion price
The conversion price is the price the holder pays for the
common stock when the conversion is made. The con-
version price and the conversion ratio are established at
the date the convertible security is issued. The conversion
price should be tied t o the growth prospects of the com-
pany. The greater the potential, the greater the conversion
price.
A convertible bond is a quasi-equity security because
its market value is keyed to its value if converted instead of
as a bond. The convertible bond may be deemed a delayed
issue of common stock at a price above the current level.
EXAMPLE 26.5
A $1,000 bond is convertible into 3 0 shares of stock.
The conversion price is $33.33 ($1,000/30 shares).
508 Warrants and Convertibles
EXAMPLE 26.6
A share of convertible preferred stock with a par value
of $50 is convertible into four shares of common stock.
The conversion price is $12.50 ($50/4).
EXAMPLE 26.7
A $1,000 convertible bond is issued that allows the
holder to convert the bond into 10 shares of common
stock. Thus, the conversion ratio is 10 shares for 1

bond. Since the face value of the b ond is $1,000, the
holder is tendering this amount upon conversion. The
conversion price equals $100 per share ($1,000/10
shares).
EXAMPLE 26.8
Y Company issued a $1,000 convertible bond at par.
The conversion price is $40. The conversion ratio is:
Conversion ratio =
Par value of
convertible security
Conversion price
=
$1,000
$40
= 25
The conversion value of a security is computed as:
Conversion value = Common stock price
× Conversion ratio
When a convertible security is issued, it is priced
higher than its conversion value. The difference is
the conversion premium. The percentage conversion
premium is computed as:
Percentage conversion
premium
=
Market value −
Conversion value
Conversion value
EXAMPLE 26.9
LA Corporation issued a $1,000 convertible b ond at

par. The market price of the common stock at the date
of issue was $48. The conversion p rice is $55.
Convertible Securities 509
EXAMPLE 26.9 (continued)
Conversion
ratio
=
Par value of
Convertible security
Conversion price
=
$1,000
$55
= 18.18
Conversion value of t he bond equals:
Common
stock price
×
Conversion
ratio
= $48 × 18.18 = $872
The difference between the conversion value of
$872 and the issue price of $1,000 is the conversion
premium of $128. The conversion premium may also
be expressed as a percentage of the conversion value.
The percent in this case is:
Percentage conversion premium equals:
Market value −
Conversion value
Conversion value

=
$1,000 −$872
$872
=
$128
$872
= 14.7%
The conversion terms may increase in steps over spec-
ified time periods. As time elapses, fewer common shares
are exchanged for the bond. In some cases, after a specified
time period the conversion option may expire.
A convertible security usually includes a clause that
protects it from dilution caused by stock dividends, stock
splits, and stock rights. The clause typically prevents
the issuance of common stock at a price lower than the
conversion price. The conversion price is adjusted for
a stock split or stock dividend, enabling the common
shareholder to retain his or her percentage interest.
EXAMPLE 26.10
A 3-for-1 stock split requires a tripling of the conver-
sion ratio. A 20 percent stock dividend necessitates a
20 percent increase in the conversion ratio.
The voluntary conversion of a security by the
holder depends on the relationship of the interest on
the bond compared to the dividend on the stock, the
risk preference of the holder (stock has a greater risk
than a bond), a nd the current and expected market
price of the stock.
510 Warrants and Convertibles
What is the value of a convertible

security?
A convertible security is a hybrid security because it
has attributes similar to common stock and bonds. It
is expected that the holder will eventually receive both
interest yield and capital gain. Interest yield is the coupon
interest relative to the amount invested. The capital gain
yield applies to the difference between the conversion
price and the stock price at the issuance date and the
expected growth rate in stock price.
The investment value of a convertible security is the
value of the security, assuming it was not convertible
but had all other attributes. For a convertible bond,
its investment value equals the present value of future
interest payments plus the present value of the maturity
amount. For preferred stock the investment value equals
the present value of future dividend payments plus the
present value of expected selling price.
Conversion value is the value of the stock received
upon converting the bond. As the price of the stock
increases, so will its conversion value.
EXAMPLE 26.11
A $1,000 bond is convertible into 18 shares of com-
mon stock with a market value of $52 per share. The
conversion value of the bond equals:
$52 × 18 shares = $936
EXAMPLE 26.12
At the date a $100,000 convertible bond is issued,
the market price of the stock is $18 a share. Each
$1,000 bond is convertible into 50 shares of stock. The
conversion ratio is thus 50. The number of shares the

bond is convertible into is:
100 bonds
($100,000/$1,000)
× 50 shares = 5,000 shares
Theconversion valueis $90,000($18 ×5,000shares).
If the stock price is anticipated to grow at 6 percent
per year, the conversion value at the end of the first
year is:
Convertible Securities 511
EXAMPLE 26.12 (continued)
Shares 5,000
Stock price ($18
× 1.06) $ 19.08
Conversion value
$95,400
A convertible security will not sell at less than its value
as straight debt (nonconvertiblesecurity).Thisisbecause
the conversion privilege has to have some value in terms of
its potential convertibility to common stock and in terms
of reducing the holder’s risk exposure to a declining bond
price. (Convertible bonds fall off less in price than straight
debt issues.) Market value will equal investment value
only when the conversion privilege is worthless because
of a low market price of the common stock relative to the
conversion price.
When convertible bonds are issued, the business ex-
pects that the value of common stock will appreciate and
that the bonds will eventually be converted. If conver-
sion does occur, the company could t hen issue another
convertible bond referred to as leapfrog financing.

If the market price of common stock decreases instead
of increasing, the holder will not convert the debt into
equity. In this case, the convertible security remains as
debtandistermeda‘‘hung’’convertible.
A convertible security holder may prefer to hold the
security rather than converting it even though the conver-
sion value exceeds the investment cost. First, as the price
of the common stock increases, so will the price of the
convertible security. Second, the holder receives regular
interest payments or preferred dividends. T o force con-
version, companies issuing convertibles often have a call
price. The call price is above the face value of the bond
(about 10 to 20 percent higher). This forces the conversion
of stock, provided the stock price exceeds the conversion
price. The holder would prefer a higher-value common
stock than a lower call price for the bond.
The issuing company may force conversion of its con-
vertible bond to common stock when financially advan-
tageous, such as when the market price of the stock has
declined, or when the interest rate on the convertible debt
is currently higher than the going market interest rates.
An example of a company that has in the past had a
conversion of its convertible bond when the market price
of its stock was low was United Technologies.
512 Warrants and Convertibles
EXAMPLE 26.13
The conversion price on a $1,000 debenture is $40,
and the call price is $1,100. In order for the conversion
value of the bond to equal the call price, the market
price of the stock would have to be $44 ($1,100/25).

If the conversion value of the bond is 15 percent
higher than the call price, the approximate market
price of common stock would be $51 (1.15 × $44).
At a $51 price, conversion is assured because if the
investor did not convert he or she would experience
an opportunity loss.
EXAMPLE 26.14
ABC Company’s convertible bond has a conversion
price of $80. The conversion ratio is 10. The market
price o f the stock is $140. The call price is $1,100. The
bondholder would prefer to convert to common stock
with a market value of $1,400 ($140 × 10) than have
his or her convertible bond redeemed at $1,100. In
this situation, the call provision forces the conversion
when the bondholder might be inclined to wait longer.
Does it pay to issue a convertible
security?
The advantages of issuing convertible securities are:
❍ It is a ‘‘sweetener’’ in a debt offering by giving
the investor an opportunity to share in the price
appreciation of common stock.
❍ The issuance of convertible debt allows for a lower
interest rate on the financing compared to issuing
straight debt.
❍ There are fewer financing restrictions with a con-
vertible security.
❍ Convertibles provide a means of issuing equity at
prices higher than current market prices.
❍ A convertible security may be issued in a tight money
market, when it is difficult for a creditworthy com-

pany to issue a straight bond or preferred stock.
❍ The call provision enables the company to force
conversion whenever the market price of the stock
exceeds the conversion price.
❍ If the company issued straight debt now and com-
mon stock later to meet the debt, it would incur
Convertible Securities 513
flotation costs twice, whereas with convertible debt,
flotation costs would occur only once, with the initial
issuance of the convertible bonds.
The disadvantages of issuing convertible securities are:
❍ If the company’s stock price appreciably increases,
it would have been better o ff financing through a
regular issuance of common stock by waiting to
issue it at the higher price rather than allowing
conversion at the lower price.
❍ The company has to pay the convertible debt if the
stock price does not appreciate.
What should be the financing policy?
When a company’s stock price is depressed, convertible
debt rather than common stock issuance may be advisable
if the price of stock is expected to increase. A conversion
price above the current market price of stock will involve
the issuance of less shares when the bonds are converted
relative to selling the shares at a current lower price.
Furthermore, there is less share dilution. The conversion
will take place only if the price of the stock rises above
the conversion price. The drawback is that if the stock
price does not increase and conversion does not occur, an
additional debt burden is placed upon the firm.

The issuance of convertible debt is recommended when
the company wants to leverage itself in the short term but
desires not to pay interest and principal on the convertible
debt in the long term (due to its conversion).
A convertible issue is a good financing instrument for
a growth company with a low dividend yield on stock.
The higher the growth rate, the earlier the conversion. For
example, a convertible bond may be a temporary source of
funds in a construction period. It is a relatively inexpensive
source for financing growth. A convertible issuance is
not recommended for a company with a modest growth
rate since it would take a long time to force conversion.
During such a time the company will not be able to issue
additional financing easily. A long conversion period may
imply to investors that the stock has not done as well as
expected. The growth rate of the firm is an important factor
in determining whether convertibles should be issued.
Your company can also issue bonds exchangeable for
the common stock of other companies. Your company
may do this if it owns a sizable stake in another company’s
stock and it wants to raise cash. There is an intention to
sell shares at a later date because of an expectation of
share price appreciation.
514 Warrants and Convertibles
In conclusion, a convertible bond is a delayed common
equity financing. The issuer expects stock price to rise in
the future (e.g., two to four years) to stimulate conver-
sion. Convertible bonds may be appropriate for smaller,
rapidly growing companies.
NOTE

If your company has an uncertain future tax position,
it may issue convertible preferred stock exchangeable
at the option of the company (i.e., when it becomes a
taxpayer) into convertible debt of the company.
How do convertibles compare with
warrants?
The differences between convertibles and warrants are:
❍ Exercising convertibles does not usually generate
additional funds to the company, whereas the ex-
ercise of warrants does.
❍ When conversion takes place, the debt ratio is re-
duced. However, the exercise of warrants adds to
the equity position with debt still remaining.
❍ Because of the call feature, the company has more
control over the timing of the capital structure with
convertibles than with warrants.