Convertibles, Warrants, and Derivatives Chapter 19 Convertibles, Warrants, and Derivatives

PPT 19-1 FIGURE 19-1 Price movement pattern for a convertible bond

TABLE 19-1 Pricing pattern for convertible bonds outstanding, 2002 year-end prices PPT 19-2

PPT 19-3 TABLE 19-3 Successful convertible bonds not yet called

PPT 19-4 TABLE 19-4 XYZ Corporation

Adjusted earnings after taxes PPT 19-4 Adjusted earnings after taxes Shares outstanding + All convertible securities5 Diluted earnings Per share (19-2) = Reported earnings Interest savings $1,500,000 + $270,000 1,000,000 + 400,000 $1,770,000 1, 400,000 = = = $1.26

PPT 19-5 TABLE 19-5 Relationships determining warrant prices

PPT 19-6 FIGURE 19-2 Market price relationships for a warrant

Review of Formulas PPT 19-7 1. Basic Earnings after taxes per share Shares of Common Stock 2. Diluted Adjusted earnings after taxes earnings = (19-2) per share Shares outstanding + All convertibles securities* *Other types of securities that create common stock, such as warrants and options, would also be included.

Review of Formulas (continued) PPT 19-7 3. Intrinsic value of a warrant I = (M — E) X N (19-3) where I = Intrinsic value of a warrant M = Market value of a common stock E = Exercise price of a warrant N = Number of shares each warrant entitles the holder to purchase 4. Speculative premium of a warrant S = W — I (19-4) S = Speculative premium W = Warrant price I = Intrinsic value

Chapter 19 - Outline LT 19-1 Convertible Security Convertible Terminology Advantages and Disadvantages of Convertible Securities Warrant Use of Warrants in Corporate Finance Options

Convertible Security LT 19-2 –a hybrid security combining features of debt and common equity – a bond or share of preferred stock that can be converted into common stock at the option of the holder – goes up in value if the common stock price increases – the holder receives a fixed rate of return before converting – represents a fixed income security that is potentially convertible into common stock if desired

Convertible Terminology LT 19-3 Conversion Ratio: – number of shares of common stock into which the security may be converted Conversion Price: – par value of the bond / conversion ratio Conversion Value: – conversion ratio x market price of common stock Conversion Premium: – difference between the market value and the conversion value

Advantages and Disadvantages of Convertible Securities LT 19-4 Advantages to the corporation: – lower interest rate paid than on a straight bond – may be the only means for a small corporation to gain access to the bond market – attractive to a corporation that believes its stock is currently undervalued Disadvantages to the corporation: – average size of a convertible offering is very small – accounting considerations regarding convertibles (potential dilution of EPS)

Warrant LT 19-5 Warrant: – an option to buy a stated number of shares of stock at a specified price over a given time period (a long-term option to buy stock) –“sweetens” a bond offering (a financial sweetener) – is usually detachable from the bond issue – is highly speculative, as its value is dependent on the market movement of the stock – has a large potential for appreciation if the price of the stock goes up

Use of Warrants in Corporate Finance LT 19-6 Enhances a debt issue by allowing for the issuance of debt under difficult circumstances 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

Options LT 19-7 Options give the owner the right, but not the obligation, to buy or sell a security at a set price for a given period of time An employee stock option is very similar to a warrant Call option – an option to buy securities Put option – an option to sell securities