Chapter McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. Convertibles, Warrants, and Derivatives 19

19-2 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.

19-3 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.

19-4 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.

19-5 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.

19-6 Price Movement Pattern for a Convertible Bond

19-7 Pricing Pattern for Convertible Bonds Outstanding, 2006 January

19-8 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 below- market rates of interest on the debt instrument. –Convertibles may also suffer from the attachment of a call provision.

19-9 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.

19-10 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.

19-11 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.

19-12 Successful Convertible Bonds Not Yet Called

19-13 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.

19-14 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.

19-15 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 non- callable zero-coupon bond.

19-16 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.

19-17 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.

19-18 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, ,000 1,400,000

19-19 XYZ Corporation

19-20 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.

19-21 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.

19-22 Relationship Determining Warrant Prices

19-23 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

19-24 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.

19-25 Market Price Relationships for a Warrant

19-26 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.

19-27 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.

19-28 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.

19-29 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.

19-30 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.

19-31 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.

19-32 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

19-33 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.

19-34 Review of Formulas