19 Convertibles Warrants and Derivatives Chapter Mc Graw-Hill Irwin

Chapter Outline • Converting convertible securities to common stock. • Convertible securities may move with the value of common stock. • Interest rates on convertible securities. • Warrants. • Accountant requirements of convertibles and warrants. • Derivative securities. 2

Introduction • Convertible securities, a hybrid security combining the features of debt and common equity. • Warrants, a type of derivative security. • Convertible bonds and convertible preferred stock: – Used infrequently to diversify a company’s capital structure. – CFOs and the corporate treasures try to take advantage of interest rate forecasts and lock in low cost debt. 3

Convertible Securities • A bond or share of preferred stock that can be converted, at the option of the holder into common stock. – When a convertible debenture is initially issued, a conversion ratio to common stock is issued. 4

Value of the Convertible Bond • Must evaluate the conversion privileges. • Other values to be considered include: – Conversion value. – Conversion premium. – Pure bond value. – Downside risks. – Floor value. 5

Price Movement Pattern for a Convertible Bond 6

Pricing Pattern for Convertible Bonds Outstanding, 2006 January 7

Is this Fool’s Gold? • Drawbacks: – Once convertible debentures begin to increase in value, the downside protection becomes redundant. – If interest rates in the market rise, the floor value, or the pure bond value, could fall, creating more downside risk. – Purchaser of the convertible bond normally also pays a premium over the conversion value. – The purchaser is always asked to accept belowmarket rates of interest on the debt instrument. – Convertibles may also suffer from the attachment of a call provision. 8

Advantages to the Corporation • Interest rate paid on convertible issues is lower. • May be the only way a small corporation may enter the bond market. • Attractive to a corporation that believes its stock is currently undervalued. – The price of a stock may go up if the issuance of common stock or convertibles is delayed by an appropriate time. 9

Disadvantages to the Corporation • If no stock or convertible bonds are issued currently, and the stock goes up to a level at which new shares can be offered at a net price: – Only a proportional number of shares will be required. • Another matter of concern is the accounting applied to convertibles. – Convertibles are now dilutive. 10

Forcing Conversion • Call provision is used to force conversion when it needs to shift outstanding debt to common stock. – Value of convertible bonds might go up significantly. – Improves composition of company’s balance sheet by decreasing debt-to-asset ratio. 11

Successful Convertible Bonds Not Yet Called 12

Method of Forcing Conversion • If the conversion value is above the call price when the bond is called: – A discerning investor would take the shares of common stock rather than a cash payout. 13

Forcing Conversion Increases Cash Flow • When comparing the current yield to the dividend yield on the common stock: – Investors generally do not want to convert unless the dividend yield is higher than the yield on the bond. 14

Non-Callable Bonds (NCB) • The company does not get the right to call the bonds before maturity. – Company: does not pay dividends on common stock. – Bondholders: have no motivation to convert as they get interest payments by owning it. • In some cases, the company has a noncallable zero-coupon bond. 15

Step-Up in the Conversion Price • When the bond is issued, the contract may specify the conversion provisions. – At the end of each time period, there is a strong inducement to convert rather than accept an adjustment to a higher conversion price and a lower conversion ratio. 16

Accounting Considerations with Convertibles • The full impact of conversion privileges applying to convertible securities, and other dilutive securities: – May generate additional common stock in the future, its potential effects must be considered. • Different measures to earnings per share: – Basic earnings per share. – Diluted earnings per share. 17

Diluted Earnings Per Share • Assume that 400, 000 new shares will be created from potential conversion, while at the same time, allowing for the reduction in interest payments that would occur as a result of the conversion of the debt to common stock. • The before-tax interest payments are $450, 000 the after-tax interest cost of $270, 000 [$450, 000 (1 -. 40) = $270, 000] will be saved and can be added back to the income. Diluted earnings = Adjusted earnings after taxes ; per share Shares outstanding + All convertible securities Reported Interest earnings savings = $1, 500, 000 + $270, 000 = $1, 770, 000 = $1. 26 1, 000 + 400, 000 1, 400, 000 18

XYZ Corporation 19

Financing through Warrants • An option to buy a stated number of shares of common stock at a specified price over a given time period. – Sometimes issued as a financial sweetener in a bond offering. – May enable the firm to issue debt when it might not have been possible due to: • Low quality credit rating. • High interest rate environment. 20

Warrants - Features • • Usually detachable from the bond issue. Have their own market place. Are traded on the NYSE or over-the-counter. Initial debt to which they were attached remains in place as a stand-alone bond. • Highly speculative: – Does not have a security value. – Is dependent on market movement. 21

Relationship Determining Warrant Prices 22

Valuation of Warrants • Intrinsic value of a warrant: I = (M – E) X N • Where, • I = Intrinsic value of a warrant • M = Market value of a common stock (stock price) • E = Exercise price of a warrant • N = Number of shares each warrant entitles the holder to purchase. • Speculative premium: S=W–I • • Where, S = Speculative premium W = Warrant price I = Intrinsic value 23

Expectation of Potential Profit • Bond investors are willing to accept lower interest rates when warrants are attached. – Warrants have a potential value in excess of the higher interest rate on bonds. – Declining premium may be due to the speculator losing ability to use leverage to generate high returns as the price of stock go up. – The speculator may also pay a very low premium at higher stock prices in that there is no downside protection. 24

Market Price Relationships for a Warrant 25

Use of Warrants in Corporate Finance • A straight debt issue may not be acceptable. – May be accepted only at extremely high rates. • The same security may be well received if detachable warrants are include. – May be included as an add-on in a merger or acquisition agreement. – May be issued in a corporate reorganization or bankruptcy to offer the shareholders a chance to recover if restructuring is successful. 26

Use of Warrants in Corporate Finance (cont’d) • Warrants may not be as desirable as convertible securities for creating new common stock. – Forced conversion is not possible with warrants. • The only option: – Step-up exercise price, whereby the warrant holder pays a progressively higher option price if he does not exerciser the right by a given date. 27

Derivative Securities • Values derived from an underlying security. – In the case of equity options, the value is derived by the underlying common stock. – Futures contracts on government bonds and Treasury bills derive their value from: • Those government securities, and futures contracts on gold or wheat have those commodities as determinants of their basic values. • They can be used to hedge almost any type of risk. 28

Options • Gives the owner the right, but not the obligation, to buy or sell an underlying security at a set price for a given time period. – An employee stock option is similar to a warrant. – Motivates employees to focus on stockholder value. 29

Call Option • An option to buy securities at a set price for a specified period of time. – It is usually traded between individual investors and not exercisable from the firm. • Standardized call option: – Writer of the call option guarantees the sale of 100 shares of stock at a set price. – The buyer of the call option pays the call writer a premium. 30

Put Option • An option to sell securities to the option writer at a set price for a specified time period. – Put writer guarantees to buy the shares from the owner at a set price. – Buyer may hedge the risk of loss by giving the put writer a premium for the guarantee. 31

Futures • Gives the owner the right but not the obligation to buy or sell the underlying security or commodity at a future date. – Requires a very small down payment to control the futures contract. • Guarantees the price for both the farmer who might sell the futures contract and the manufacturer who buys. • Other futures contracts used to hedge corporate financial strategies are interest rate futures or foreign currency features 32

Futures (cont’d) • One common financial futures strategy is to hedge against interest rate movements. – Treasurer can use a financial futures contract to either lock in a rate or profit from an increase in rates. – If rates go up, treasurer can take the profit on the financial futures contract and use the profit to offset higher interest costs. 33

Review of Formulas 34