1. 25-0 Warrants 25.6 A security that gives the holder the right to purchase shares of stock at a fixed price over a given period of time It is basically a call option issued by corporations in conjunction with other securities to reduce the yield Usually included with a new debt or preferred shares issue as a sweetener or equity kicker LO5

2. 25-1 Differences between warrants and traditional call options Warrants are generally very long term They are written by the company and exercise results in additional shares outstanding The exercise price is paid to the company and generates cash for the firm Warrants can be detached from the original securities and sold separately LO5

3. 25-2 Convertible Bonds 25.7 Convertible bonds (or preferred stock) may be converted into a specified number of common shares at the option of the security holder The conversion price is the effective price paid for the stock. It is the dollar amount of a bond’s par value that is exchangeable for one share of stock LO5

4. 25-3 Convertibles – continued The conversion ratio is the number of shares received when the bond is converted Conversion Premium – The difference between the conversion price and the current stock price divided by the current stock price Straight Bond Value – The value of a convertible bond if it could not be converted into common stock LO5

5. 25-4 Convertibles – continued Floor Value – Either the straight bond value or the conversion value Convertible bonds will be worth at least as much as the straight bond value or the conversion value, whichever is greater LO5

6. 25-5 Figure 25.5 – Minimum value of a convertible bond versus the value of the stock for a given interest rate LO5

7. 25-6 Figure 25.6 – Value of a convertible bond versus value of the stock for a given interest rate LO5

8. 25-7 Valuing Convertibles Suppose you have a 10% bond that pays semi- annual coupons and will mature in 15 years. The face value is $1,000 and the yield to maturity on similar bonds is 9%. The bond is also convertible with a conversion price of $100. The stock is currently selling for $110. What is the minimum price of the bond? Straight bond value = 1081.44 Conversion ratio = 1000/100 = 10 Conversion value = 10*110 = 1100 Minimum price = $1100 LO5

9. 25-8 Reasons for Issuing Warrants and Convertibles 25.8 They allow companies to issue cheap bonds by attaching sweeteners to the new bond issue. Coupon rates can then be set at below market rate for straight bonds They give companies the chance to issue common stock in the future at a premium over current prices LO5

10. 25-9 Table 25.3 – The case for and against convertibles LO5

11. 25-10 Other Options 25.9 Call provision on a bond Allows the company to repurchase the bond prior to maturity at a specified price that is generally higher than the face value Increases the required yield on the bond – this is effectively how the company pays for the option Put bond Gives the bondholder the right to require the company to repurchase the bond prior to maturity at a fixed price LO5

12. 25-11 Other Options continued Over allotment option Underwriters have the right to purchase additional shares from a firm in an IPO (chapter 15) Insurance and Loan Guarantees These are essentially put options Managerial options LO5