Learning Objectives Calculate the conversion value of a convertible security. (LO5) Describe warrants and compare them to convertible securities. (LO6)

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Learning Objectives Calculate the conversion value of a convertible security. (LO5) Describe warrants and compare them to convertible securities. (LO6) Calculate the intrinsic value and the speculative premium on a warrant. (LO7) Show how convertible securities and warrants affect earnings per share as reported on the income statement. (LO8)

Valuation of Warrants Intrinsic value of a warrant: I = (M – E) x N LO7 Valuation of Warrants Intrinsic value of a warrant: I = (M – E) x N Where I = intrinsic value of a warrant M = market value of common stock E = Exercise price (or strike price) of a warrant N = Number of shares each warrant entitles the holder to purchase The speculative premium: S = W – I S = Speculative premium W = Warrant price I = Intrinsic value

Figure 19-5 Market price relationships for a warrant LO7 Figure 19-5 Market price relationships for a warrant Value of warrant ($) 40 30 Market value of warrant 20 Intrinsic value of warrant Speculative premium 10 10 20 30 40 50 60 -10 Price of common stock -20

Table 19-3 Leverage in valuing warrants LO7 Table 19-3 Leverage in valuing warrants Low Stock Price High Stock Price Stock price, $25; warrant price, Stock price, $50; warrant price, $5* +$10 movement in stock price $30 + $10 movement in stock price New warrant price, $15 ($10 gain) New warrant price, $40 ($10 gain) Percentage gain $10 Percentage gain $10 in warrant $5 in warrant $30 *The warrant price would be greater than $5 because of the speculative premium. Nevertheless, we use $5 for ease of computation. = x 100 = 200% = x 100 = 33%

Use of Warrants in Corporate Finance LO7 Use of Warrants in Corporate Finance May make a debt or preferred share issue more attractive May be included as an add-on in a merger or acquisition agreement Can be issued in a corporate reorganization or bankruptcy to offer shareholders a chance to recover some of their investment Traditionally has been associated with speculative real estate companies, airlines, and conglomerates Popular with young companies, companies in financial difficulties, chartered banks

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