CHAPTER

Warrants and
24 Convertibles Bond

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 Slide 2

Key Concepts and Skills

• Understand how warrants and convertible
bonds are similar to call options
• Understand how warrants and convertible
bonds differ from call options
• Understand why corporations would issue
either warrants or convertible bonds

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 Slide 3

Chapter Outline
24.1 Warrants
24.2 The Difference between Warrants and Call
Options
24.3 Warrant Pricing and the Black-Scholes Model
24.4 Convertible Bonds
24.5 The Value of Convertible Bonds
24.6 Reasons for Issuing Warrants and
Convertibles
24.7 Why are Warrants and Convertibles Issued?
24.8 Conversion Policy

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24.1 Warrants
• Warrants are call options that give the holder the right,
but not the obligation, to buy shares of common stock
directly from a company at a fixed price for a given
period of time.
• Warrants tend to have longer maturity periods than
exchange traded options.
• Warrants are generally issued with privately placed
bonds as an “equity kicker.”
• Warrants are also combined with new issues of
common stock and preferred stock and/or given to
investment bankers as compensation for underwriting
services.
– In this case, they are often referred to as a Green Shoe
Option.
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 Slide 5

Warrants
• The factors that affect call option value
affect warrant value in the same ways.

1. Stock price +
2. Exercise price –
3. Interest rate +
4. Volatility in the stock price +
5. Expiration date +
6. Dividends –

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 Slide 6

24.2 The Difference between

Warrants and Call Options
• When a warrant is exercised, a firm
must issue new shares of stock.
• This can have the effect of diluting the
claims of existing shareholders.

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 Slide 7

Dilution Example
• Imagine that Mr. Armstrong and Mr. LeMond are shareholders
in a firm whose only asset is 10 ounces of gold.
• When they incorporated, each man contributed 5 ounces of
gold, then valued at $300 per ounce. They printed up two
stock certificates and named the firm LegStrong, Inc..
• Suppose that Mr. Armstrong decides to sell Mr. Mercx a call
option issued on Mr. Armstrong’s share. The call gives Mr.
Mercx the option to buy Mr. Armstong’s share for $1,500.
• If this call finishes in-the-money, Mr. Mercx will exercise, Mr.
Armstrong will tender his share.
• Nothing will change for the firm except the names of the
shareholders.

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 Slide 8

Dilution Example
• Suppose that Mr. Armstrong and Mr.
LeMond meet as the board of directors of
LegStrong. The board decides to sell Mr.
Mercx a warrant. The warrant gives Mr.
Mercx the option to buy one share for
$1,500.
• Suppose the warrant finishes in-the-
money, (gold increased to $350 per
ounce). Mr. Mercx will exercise. The firm
will print up one new share.

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 Slide 9

Dilution Example
• The balance sheet of LegStrong Inc.
would change in the following way:
Balance Sheet Before
(Book Value)
Assets Liabilities and
Equity
Gold: $3,000 Debt 0
Equity (2 shares) $3,000

Total Assets $3,000 Total

$3,000
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Dilution Example
Balance Sheet Before
(Market Value)
Assets Liabilities and Equity

Gold: $3,500 Debt 0

Cash: $1,500 Equity (3 $5,000
shares)
Total Assets $5,000 Total
$3,000
Note that Mr. Armstrong’s claim falls in value from
$1,750 = $3,500 ÷ 2 to $1,666.67 = $5,000 ÷ 3
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 Slide 11

24.3 Warrant Pricing and the Black-

Scholes Model
• Warrants are worth a bit less than calls due to
the dilution.
• To value a warrant, value an otherwise-identical
call and multiply the call price by:

n
Where
n  nw
n = the original number of shares
nw = the number of warrants
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 Slide 12

Warrant Pricing and the Black-

Scholes Model
To see why, compare the gains from exercising a call
with the gains from exercising a warrant.
The gain from exercising a call can be written as:

share price  exercise price

Note that when n = the number of shares, share price is:
Firm' s value net of debt
n
Thus, the gain from exercising a call can be written as:
Firm' s value net of debt
 exercise price
n
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 Slide 13

Warrant Pricing and the Black-

Scholes Model
The gain from exercising a warrant =
share price after warrant exercise  exercise price
Note that when # = the original number of shares
and #w = the number of warrants,
 share price 
  Firm' s value net of debt  exercise price# w
 after  # # w
 warrant exercise

Thus, the gain from exercising a warrant can be written as:

Firm' s value net of debt  exercise price# w

 exercise price
# # w
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 Slide 14

Warrant Pricing and the Black-

Scholes Model
The gain from exercising a call can be written as:
Firm' s value net of debt
 exercise price
#
The gain from exercising a warrant can be written as:

Firm' s value net of debt  exercise price# w

 exercise price
# # w
A bit of algebra shows that these #
equations differ by a factor of # # w
So to value a warrant, multiply the value
of an otherwise-identical call by #
# # w
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 Slide 15

24.4 Convertible Bonds

• A convertible bond is similar to a bond with
warrants.
• The most important difference is that a bond with
warrants can be separated into different
securities and a convertible bond cannot.
• Recall that the minimum (floor) value of
convertible:
– Straight or “intrinsic” bond value
– Conversion value
• The conversion option has value.

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 Slide 16

24.5 The Value of Convertible

Bonds
The value of a convertible bond has
three components:
1. Straight bond value
2. Conversion value
3. Option value

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Convertible Bond Example

• Litespeed, Inc., just issued a zero coupon
convertible bond due in 10 years.
• The conversion ratio is 25 shares.
• The appropriate interest rate is 10%.
• The current stock price is $12 per share.
• Each convertible is trading at $400 in the market.
– What is the straight bond value?
– What is the conversion value?
– What is the option value of the bond?

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 Slide 18

Convertible Bond Example

– What is the straight bond value?
$1,000
SBV  10
 $385.54
(1.10)

–What is the conversion value?

25 shares × $12/share = $300

–What is the option value of the bond?

$400 – 385.54 = $14.46

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 Slide 19

The Value of Convertible Bonds

Convertible
Bond Value
Convertible bond
values Conversion
Value
floor value

floor Straight bond

value value
= conversion ratio Option
value
Stock
Price
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 Slide 20

24.6 Reasons for Issuing Warrants

and Convertibles
• A reasonable place to start is to compare a hybrid like
convertible debt to both straight debt and straight equity.
• Convertible debt carries a lower coupon rate than does
otherwise-identical straight debt.
• Since convertible debt is originally issued with an out-of-
the-money call option, one can argue that convertible
debt allows the firm to sell equity at a higher price than is
available at the time of issuance. However, the same
argument can be used to say that it forces the firm to sell
equity at a lower price than is available at the time of
exercise.

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 Slide 21

Convertible Debt vs. Straight Debt

• Convertible debt carries a lower coupon rate than does
otherwise-identical straight debt.
• If the company subsequently does poorly, it will turn out
that the conversion option finishes out-of-the-money.
• But if the stock price does well, the firm would have
been better off issuing straight debt.
• In an efficient financial market, convertible bonds will be
neither cheaper or more expensive than other financial
instruments.
• At the time of issuance, investors pay the firm for the
fair value of the conversion option.

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 Slide 22

Convertible Debt vs. Straight Equity

• If the company subsequently does poorly, it will
turn out that the conversion option finishes out-of-
the-money, but the firm would have been even
better off selling equity when the price was high.
• But if the stock price does well, the firm is better off
issuing convertible debt rather than equity.
• In an efficient financial market, convertible bonds
will be neither cheaper or more expensive than
other financial instruments.
• At the time of issuance, investors pay the firm for
the fair value of the conversion option.

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 Slide 23

24.7 Why Are Warrants and Convertibles

Issued?
• Convertible bonds reduce agency costs by aligning
the incentives of stockholders and bondholders.
• Convertible bonds also allow young firms to delay
expensive interest costs until they can afford them.
• Support for these assertions is found in the fact that
firms that issue convertible bonds are different from
other firms:
– The bond ratings of firms using convertibles are lower.
– Convertibles tend to be used by smaller firms with high growth
rates and more financial leverage.
– Convertibles are usually subordinated and unsecured.

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 Slide 24

24.8 Conversion Policy

• Most convertible bonds are also callable.
• When the bond is called, bondholders have about
30 days to choose between:
1. Converting the bond to common stock at the
conversion ratio.
2. Surrendering the bond and receiving the call price in
cash.
• From the shareholder’s perspective, the optimal
call policy is to call the bond when its value is equal
to the call price.
• In the real world, most firms wait to call until the
bond value is substantially above the call price.
Perhaps the firm is afraid of the risk of a sharp drop
in stock prices during the 30-day window.
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 Slide 25

Quick Quiz
• Explain how convertible bonds and
warrants are similar to call options.
• Explain how convertible bonds and
warrants are different from call options.
• Identify possible corporation benefits from
issuing convertible bonds and/or warrants.

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