1. McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 14 Convertible Securities and Securities andWarrants

2. 14-2 Objectives Understand why investors are attracted to convertible securities and warrants. Understand why investors are attracted to convertible securities and warrants. Explain how convertible securities values are determined. Explain how convertible securities values are determined. Describe how investors may be forced to convert bonds or preferred stock into common stock. Describe how investors may be forced to convert bonds or preferred stock into common stock.

3. 14-3 Objectives Explain the advantages and disadvantages of convertible securities to the corporate issuer. Explain the advantages and disadvantages of convertible securities to the corporate issuer. Describe the accounting requirements associated with convertibles. Describe the accounting requirements associated with convertibles. Explain why warrants represent highly speculative investments. Explain why warrants represent highly speculative investments.

4. 14-4 Convertible Securities and Warrants Convertible Securities Convertible Securities Conversion Price and Conversion Ratio Conversion Price and Conversion Ratio Advantages and Disadvantages to the Issuing Corporation Advantages and Disadvantages to the Issuing Corporation Accounting Considerations with Convertibles Accounting Considerations with Convertibles Speculating through Warrants Speculating through Warrants Accounting Considerations with Warrants Accounting Considerations with Warrants

5. 14-5 Definition - Convertible Securities Bond or preferred stock that can be converted into common stock at the option of the holder (owner) Bond or preferred stock that can be converted into common stock at the option of the holder (owner) Best time to buy convertible securities when: Best time to buy convertible securities when: Interest rates are highInterest rates are high Bond and preferred prices depressed Bond and preferred prices depressed Stock prices are relatively lowStock prices are relatively low

6. 14-6 Convertibles Securities Rising stock prices or falling interest rates exert upward pressure on convertible securities’ prices Rising stock prices or falling interest rates exert upward pressure on convertible securities’ prices

7. 14-7 Conversion Price & Conversion Ratio

8. 14-8 Amazon.com 4.75% Convertible Subordinated Notes: Due February 1, 2009

9. 14-9 Value of the Convertible Bond Pure bond value Pure bond value Value of bond without conversion featuresValue of bond without conversion features Floor value = minimum price of the bondFloor value = minimum price of the bond Conversion Value Conversion Value Value of bond based on common stock price and number of shares received upon conversionValue of bond based on common stock price and number of shares received upon conversion Parity Price The point where conversion value and pure bond value are equalThe point where conversion value and pure bond value are equal

10. 14-10

11. 14-11 Application Example Amazon.com $742.50 indicates the value of the underlying shares of common stock each bond represents on the day of the offering

12. 14-12 Bond Price & Premiums Conversion premium amount investors are willing to pay above and beyond the value of the shares of common stock they would receive upon conversion Conversion premium amount investors are willing to pay above and beyond the value of the shares of common stock they would receive upon conversion

13. 14-13 Bond Price & Premiums Bond is less risky than stocks because it has a higher claim on assets and income Bond is less risky than stocks because it has a higher claim on assets and income Claim on income is a legal contractual agreement Claim on income is a legal contractual agreement Bond price will rise as stock price rises because of the option of converting the bond to shares of stock Bond price will rise as stock price rises because of the option of converting the bond to shares of stock

14. 14-14 Bond Price & Premiums Downside Limit Downside Limit Difference between market price of bond and pure bond valueDifference between market price of bond and pure bond value Downside Risk Downside Risk Difference between market price of bond and pure bond value as percentage of bond market priceDifference between market price of bond and pure bond value as percentage of bond market price

15. 14-15 Application Example Amazon.com

16. 14-16 Bond Price & Premiums Market price will slowly approach pure bond value as the common stock price falls Market price will slowly approach pure bond value as the common stock price falls Market price will slowly approach conversion value as the common stock price rises Market price will slowly approach conversion value as the common stock price rises Conversion premium is largest at parity price Conversion premium is largest at parity price Price at which risk-return trade-offs to investor is highestPrice at which risk-return trade-offs to investor is highest At parity point, there is no downside risk if the stock price should fall, investor will benefit if stock price rises At parity point, there is no downside risk if the stock price should fall, investor will benefit if stock price rises

17. 14-17 Amazon.com Convertible Bond — Conversion Premium and Downside Risk

18. 14-18 Amazon.com Bond Prices, Stock Prices, Conversion Values, and Conversion Premiums

19. 14-19 Bond Price & Premiums Factors affecting conversion: The more volatile the stock price, the higher the conversion premium The more volatile the stock price, the higher the conversion premium The longer the term to maturity, the higher the premium The longer the term to maturity, the higher the premium

20. 14-20 Bond Price & Premiums Forced conversion Forced conversion When company calls the convertible security knowing that the owners will take the stock and thus convert the debt to equityWhen company calls the convertible security knowing that the owners will take the stock and thus convert the debt to equity Advantages to corporation of forced conversion: Advantages to corporation of forced conversion: 1. Company doesn’t pay off the debt with cash 2. Reduce cash outflows for interest expense

21. 14-21 Comparing the Convertible Bond with Common Stock Purchases Would you have been better of buying common stock or convertible bond? Would you have been better of buying common stock or convertible bond? Depends on whether common stock went up in price, and whether it went up fast enough to outpace income you may have received from the bond Depends on whether common stock went up in price, and whether it went up fast enough to outpace income you may have received from the bond

22. 14-22 Decision showing a trade-off by Investors DecisionStock Convertiblebond More shares Fewer shares Lower cash flow Higher Buy Buy Don’t buy either Opportunitycost? ? ? ?

23. 14-23 Comparing Returns between Purchasing Amazon.com Common Stock or Convertible Bond

24. 14-24 Comparing the Convertible Bond with Common Stock Purchases Generalizations… Bonds selling at discount to par have higher conversion premiums than bonds selling at a premium Bonds selling at discount to par have higher conversion premiums than bonds selling at a premium Bonds selling at a premium are so far past parity price that advantages to investors have evaporated as so has the premium Bonds selling at a premium are so far past parity price that advantages to investors have evaporated as so has the premium Bonds selling close to par are priced close to their pure bond values Bonds selling close to par are priced close to their pure bond values

25. 14-25 Selected Convertible Bonds

26. 14-26 Comparing the Convertible Bond with Common Stock Purchases continued Generalizations… Preferred shares exhibit same type of characteristics as convertible bonds except: Preferred shares exhibit same type of characteristics as convertible bonds except: Most issued at $50 per share instead of $1,000Most issued at $50 per share instead of $1,000 Dividend yield for preferred stock is higher than current yield on bondsDividend yield for preferred stock is higher than current yield on bonds

27. 14-27 Selected Convertible Preferred Stocks

28. 14-28 Disadvantages of Convertibles Wrong bond price can eliminate advantages Wrong bond price can eliminate advantages Pure bond value can decline substantially due to higher interest rates Pure bond value can decline substantially due to higher interest rates Bonds bought at a premium have no downside protection Bonds bought at a premium have no downside protection Stockpricedeclines Bondpricedeclinestoo

29. 14-29 Disadvantages of Convertibles Pays lower yields than “straight” nonconvertible bonds in similar class Pays lower yields than “straight” nonconvertible bonds in similar class Lack liquidity due to small trading volume or small dollar size Lack liquidity due to small trading volume or small dollar size

30. 14-30 When to convert into Common Stock Convertible securities generally have a call provision Convertible securities generally have a call provision Gives corporation option of redeeming bond at specified price before maturityGives corporation option of redeeming bond at specified price before maturity Call price usually at a premium over par value of bond in early years of callability Call price usually at a premium over par value of bond in early years of callability Declines over time to par valueDeclines over time to par value

31. 14-31 When to convert into Common Stock Companies usually force conversion when the conversion value is well above the call price Companies usually force conversion when the conversion value is well above the call price Investors will take shares rather then call price since shares are worth moreInvestors will take shares rather then call price since shares are worth more Companies encourage voluntary conversion by using a step-up in conversion price over time Companies encourage voluntary conversion by using a step-up in conversion price over time Only reason for voluntarily converting is if the dividend income on the common stock is greater than the interest income on the bond Only reason for voluntarily converting is if the dividend income on the common stock is greater than the interest income on the bond

32. 14-32 Step-up in Conversion Price

33. 14-33 When to convert into Common Stock Only reason for voluntarily converting: Only reason for voluntarily converting: If dividend income on common stock is greater than interest income on bondIf dividend income on common stock is greater than interest income on bond

34. 14-34 Advantages and Disadvantages to the Issuing Corporation Interest on convertible issues is lower than “straight” debt instrument Interest on convertible issues is lower than “straight” debt instrument Might be only way for smaller corporations to access the bond market Might be only way for smaller corporations to access the bond market Attractive to corporation that believes its stock is undervalued Attractive to corporation that believes its stock is undervalued

35. 14-35 Accounting Considerations with Convertibles Dilution – the addition of new shares to the capital structure Dilution – the addition of new shares to the capital structure Basic earnings per shareBasic earnings per share Diluted earnings per shareDiluted earnings per share

36. 14-36 Accounting Considerations with Convertibles Diluted earnings per share adjusts for all potential dilution from the issuance of any new shares of common stock arising from: Diluted earnings per share adjusts for all potential dilution from the issuance of any new shares of common stock arising from: Convertible bonds Convertible bonds Convertible preferred stocks Convertible preferred stocks Warrants Warrants Other options outstanding Other options outstanding

37. 14-37 Accounting Considerations with Convertibles

38. 14-38 Accounting Considerations with Convertibles Basic earnings per share Basic earnings per share Earnings per share unadjusted for dilutionEarnings per share unadjusted for dilution

39. 14-39 XYZ Corporation

40. 14-40 Speculation through Warrants Warrant - an option to buy a stated number of shares of stock from the issuing company at a specified price over a given time period Warrant - an option to buy a stated number of shares of stock from the issuing company at a specified price over a given time period Warrants can trade in the open market, the final owner decides whether to exercise the option or to let it expire Warrants can trade in the open market, the final owner decides whether to exercise the option or to let it expire

41. 14-41 Selected Warrants as of November 13, 2006

42. 14-42 Speculation through Warrants Warrants allow holder to buy one share of common stock per warrant on the date of issue Warrants allow holder to buy one share of common stock per warrant on the date of issue Adjusted for stock splitsAdjusted for stock splits Usually issued as a sweetener to a bond offering Usually issued as a sweetener to a bond offering May enable firm to issue debt when otherwise would not be feasibleMay enable firm to issue debt when otherwise would not be feasible Allow bond issue to carry lower coupon rate and are usually detachable from bond after issue date Allow bond issue to carry lower coupon rate and are usually detachable from bond after issue date

43. 14-43 Speculation through Warrants continued After being separated from bond, warrants have their own market price and may trade on a different market from the common stock After being separated from bond, warrants have their own market price and may trade on a different market from the common stock After warrants are exercised, initial debt remains in existence After warrants are exercised, initial debt remains in existence Highly speculative Highly speculative

44. 14-44 Valuation of Warrants Warrant’s value is tied to underlying stock price Warrant’s value is tied to underlying stock price Minimum or intrinsic value of a warrant: Minimum or intrinsic value of a warrant: I = (M – EP) * N I = (M – EP) * N I = Intrinsic or minimum value of the warrant M = Market value of common stock EP = Option or exercise price of warrant N = # of share each warrant entitles holder to purchase

45. 14-45 Valuation of Warrants continued Option or Exercise price Option or Exercise price Purchase price stipulated in warrantPurchase price stipulated in warrant Intrinsic value Intrinsic value Market price of common stock minus option price of warrant times number of shares each warrant receivesMarket price of common stock minus option price of warrant times number of shares each warrant receives Speculative premium Speculative premium Price of warrant minus intrinsic value when warrant entitles holder to purchase one sharePrice of warrant minus intrinsic value when warrant entitles holder to purchase one share

46. 14-46 Valuation of Warrants SP = (EP – M) * N SP = Speculative premium EP = Exercise price of the warrant M = Market value of the common stock N = # of shares each warrant represents

47. 14-47 Valuation of Warrants Speculative premium represents amount stock price must rise by expiration date to break even on purchase of warrant Speculative premium represents amount stock price must rise by expiration date to break even on purchase of warrant As long as there is time left to expiration - investors gamble on stock price increases and are willing to pay a speculative premium As long as there is time left to expiration - investors gamble on stock price increases and are willing to pay a speculative premium

48. 14-48 Further Explanation of Intrinsic Value The difference between market price of warrant and its intrinsic value is diminished as stock price increases The difference between market price of warrant and its intrinsic value is diminished as stock price increases Speculator loses ability to use leverage to generate high returnsSpeculator loses ability to use leverage to generate high returns Less downside protectionLess downside protection

49. 14-49 Assume warrant entitles holder purchase one new share of common stock at $20

50. 14-50 Leverage in Valuing Warrants

51. 14-51 Further Explanation of Intrinsic Value continued Higher price volatility for common stocks Higher price volatility for common stocks Higher warrant price (premium)Higher warrant price (premium) Longer the time to expiration Longer the time to expiration Higher warrant price (premium)Higher warrant price (premium)

52. 14-52 Use of Warrants by Corporations Warrants allow issuance of debt under difficult circumstances Warrants allow issuance of debt under difficult circumstances Straight debt may not be acceptable or may be at extremely high rates. security sells because detachable warrants are included Straight debt may not be acceptable or may be at extremely high rates. security sells because detachable warrants are included

53. 14-53 Use of Warrants by Corporations May be included as add-on in merger or acquisition agreement May be included as add-on in merger or acquisition agreement Traditionally associated with aggressive, “high-flying” firms Traditionally associated with aggressive, “high-flying” firms BiotechsBiotechs AirlinesAirlines ConglomeratesConglomerates

54. 14-54 Use of Warrants by Corporations As a financing device for creating new common stock, warrants may not be as desirable as convertible securities As a financing device for creating new common stock, warrants may not be as desirable as convertible securities No call featureNo call feature Original debt outstanding remains in existence after detachable warrant is exercised.Original debt outstanding remains in existence after detachable warrant is exercised.

55. 14-55 Accounting Considerations with Warrants Potential dilutive effect must be considered Potential dilutive effect must be considered Use treasury stock method to calculate EPS Use treasury stock method to calculate EPS Compute total number of new shares that could be created by exercise of all warrants Compute total number of new shares that could be created by exercise of all warrants

56. 14-56 WebsitesComments www.convertbond.com Fee-based source of information on convertible bond issues www.numa.com Provides calculator for convertible bonds cbs.marketwatch.com Personal finance section contains general information on convertible bonds www.bondsonline.com Provides information about convertible bonds