AFM 371 Winter 2008 Chapter 25 - Warrants and Convertibles 1 / 20
Outline Background Warrants Convertibles Why Do Firms Issue Warrants And Convertibles? 2 / 20
Background when firms issue debt, they sometimes attach option-like features to the bond contract a warrant gives its owner the right to buy other securities issued by the firm (typically stock) a convertible gives its owner the right to exchange a security for a different one issued by the firm the general idea is to issue debt with a low coupon but also to give investors some kind of option as compensation there are variations on the above e.g. preferred shares are sometimes convertible into common, IPOs may contain shares plus warrants to buy new shares, some convertibles may also include warrants, etc. ackground 3 / 20
Background (Cont d) a security that is issued with a warrant packaged with it is sometimes called a unit offering example: Ceres Global Ag Corp. news release, Dec. 19, 2007: An application has been granted for the original listing in the Industrial category of up to 28,750,000 units (the Units ) of Ceres Global Ag Corp. (the Company ), of which up to 25,000,000 Units will be issued and outstanding and up to 3,750,000 Units will be reserved for issuance upon completion of an initial public offering (the Offering. Listing of the Units will become effective at 5:01 p.m. on Thursday, December 20, 2007 in anticipation of the Offering closing on Friday, December 21, 2007. The Units will be posted for trading at the opening on Friday, December 21, 2007. Each Unit consists of one common share of the Company (the Common Share ) and one full Common Share purchase warrant (the Warrant ). The Units will separate into Common Shares and Warrants on March 1, 2008. Upon such separation, each Warrant entitles the holder thereof to purchase one Common Share at a price of $13.50 at any time on or prior to the close of business on the date that is 36 months from the closing of the Offering. Until such separation, the Common Shares and Warrants comprising the Units will not be separately transferable. Upon separation of the Units, the Common Shares and the Warrants will be listed on Toronto Stock Exchange. ackground 4 / 20
Features of Warrants warrants are generally detachable from the security issue (i.e. investors can keep the security and sell off the warrant separately) a warrant is basically a call option but: typically has a longer maturity (often 5-10 years, some are perpetual) often has a strike price that increases over time issued by the firm, not by another investor leads to complications due to dilution: when a warrant is exercised, new shares are issued, so there can be an effect on the underlying stock price example: ABC Inc. has 10 million common shares outstanding. The share price is $33. There are also 200,000 warrants outstanding. Each warrant can be used to purchase 5 more common shares at $30 per share. If all warrant holders exercise today, what should we expect ABC s share price to be? arrants 5 / 20
Valuing Warrants we can get an approximate estimate for the value of a warrant by using a modified version of Black-Scholes for a standard call option: payoff from exercise = S X firm value net of debt = X N where N is the number of shares outstanding assuming all warrants are exercised and each warrant is for one share, for a warrant: payoff from exercise = S X where N W is the number of warrants = firm value net of debt + X N W X N + N ( W ) N firm value net of debt = X N + N W N arrants 6 / 20
Valuing Warrants (Cont d) from the previous slide, to value a warrant, we should multiply the value of an otherwise identical call option by a factor of N/(N + N W ) example: a stock is currently selling for $30 per share. The stock does not pay any dividends. A European put option on this stock with a strike price of $45 and five years until expiry is currently selling for $5. The continuously compounded annual risk free rate is 10%. The firm has 1 million shares outstanding, and 100,000 warrants outstanding. Each warrant can be used to purchase one additional share. The warrants have a strike price of $45 and expire 5 years from now. What is the value of each warrant? (Assume that the warrants cannot be exercised early.) arrants 7 / 20
Valuing Warrants (Cont d) why is this an approximate value? effectively assumes the firm does nothing with the proceeds from selling the warrant (i.e. pays it out right away to existing shareholders as a dividend) ignores dividends during the life of the warrant and early exercise ignores changing strike price over time ignores strategic exercise : e.g. suppose one investor owns a large block of warrants. If this investor exercises, the stock price may decrease a lot. This implies that other investors will try to anticipate when a large investor will exercise and exercise their own warrants beforehand. in practice, it is relatively difficult to accurately determine the value of a warrant however, just as in a standard IPO, it is an important calculation since overpricing a warrant runs the risk that the issue may not sell and underpricing it means that the firm is selling part of itself for less than it is really worth Warrants 8 / 20
Features of Convertibles we will deal with convertible bonds, but the same basic issues arise with preferred stock which also often has a conversion option (into common shares) terminology: conversion ratio: the number of shares which the bond can be converted into conversion price: the par value of bond divided by the number of shares received upon conversion conversion premium: conversion price less stock price example: a firm which has stock currently selling for $40 per share issues a $1,000 par value bond which can be exchanged for 20 shares of common stock any time before the bond matures: conversion ratio: 20 conversion price: $1,000 20 = $50 conversion premium: $50 $40 = $10 onvertibles 9 / 20
Features of Convertibles (Cont d) the conversion price is usually set 10%-30% above the stock price when issued, and it may vary over time according to the contract as with a bond-warrant package, a convertible gives its owner a bond plus a call option, but: the option is not detachable with a convertible the strike price is paid in cash with a warrant, but the bond must be given up with a convertible (i.e. the strike price is really the value of the bond, which will be changing over time) the value of a convertible depends on its straight bond value (i.e. what the bond would sell for without the conversion option and on its conversion value (i.e. what the bond would sell for if it had to be converted immediately) onvertibles 10 / 20
Straight Bond Value consider an issue of zero-coupon debt with a total amount owed of F at maturity T (and suppose the firm has no other debt) at T the firm is obligated to pay bondholders F, but if it defaults the bondholders take over the firm and receive V T $ Straight Bond Value at T F default bonds repaid min(f, V T ) 0 F V T onvertibles 11 / 20
Conversion Value suppose that there are N existing shares and if all bonds are converted there will be N C new shares firm value V does not change with conversion, but the allocation of ownership does after conversion, there are N + N C shares, so the convertible owners claim is worth [N C /(N + N C )] V $ Conversion Value slope= N C < 1 N+N C 0 V onvertibles 12 / 20
Convertible Bond Value At Maturity combine the two previous diagrams to obtain the convertible value at maturity: $ Convertible Bond Value at T convertible bond value F default converted bonds repaid straight bond value conversion value 0 F there are two lower bounds for the convertible value: (i) the straight bond value (since convertible is this plus a call option); and (ii) the conversion value (if convertible value < conversion value, then buying the convertible, converting, and selling shares is an arbitrage opportunity) V T onvertibles 13 / 20
Straight Bond Value Prior To Maturity the straight bond value prior to maturity will look something like: $ Straight Bond Value Before T little chance of default, but time value matters F 0 F V onvertibles 14 / 20
Convertible Bond Value Prior To Maturity the convertible bond value prior to maturity will look something like: $ Convertible Bond Value Before T convertible bond value conversion value F straight bond value 0 F lower bound for convertible bond value V the convertible bond value will be above the lower bound, the difference being the value of the option to delay conversion (it would be the lower bound if a conversion decision had to be made immediately) onvertibles 15 / 20
Problems With Valuing Convertibles the following factors make valuing convertibles difficult: dilution (as with warrants) bond value will change randomly over time if interest rates move randomly (this implies that we have a random strike price in addition to a random underlying asset value) callability the issuing firm usually retains the option to buy back the convertible bond at a pre-set price (possibly changing over time) if a convertible bond is called, the owner of the bond has the choice of either selling it back to the issuer or converting (this is called forced conversion) with callability, a convertible bond can be viewed as a straight bond plus a call option (held by the owner on the firm s equity) minus a call option (held by the issuer on the bond) onvertibles 16 / 20
When Should The Issuer Force Conversion? when should the issuing firm exercise its call and force the owners of convertible bonds to convert or sell back the bond to the issuer? think of firm value V = B + S if management is acting in the shareholders interest, then it wants to minimize B, so it should not let the bond value rise above the call price also, management should never exercise if the bond value is less than the call price, because it would be just giving money away to the convertible bondholders therefore, in principle management should call as soon as the convertible bond value equals the call price in practice, managers usually wait until the convertible bond value is well above the call price before doing so one possible reason for this is the notice period the firm must provide something like 30 days advance notice of a call (and so calling runs the risk of the value of the debt falling in the interim and thus having the firm overpay) onvertibles 17 / 20
Why Do Firms Issue Warrants And Convertibles? one (weak) argument is cheap financing this won t be true if investors pay a fair price for the embedded option suppose a firm issues a convertible and the firm subsequently does poorly, so that holders of the convertible do no convert the firm got the benefit of paying a lower coupon rate on debt if the firm subsequently does well, then the holders of the convertible will convert, but the conversion price will be higher than when the convertible was originally issued, so the firm is better off in this case too the problem with this argument is that a comparison is being made to straight debt if the firm does poorly and to common shares if the firm does well if the firm subsequently does poorly, one could argue that it would have been better off issuing stock rather than the convertible since the stock was overvalued at that time if the firm does well later on, one could argue that the firm would have been better off issuing straight debt originally rather than being obligated to sell more equity as a result of conversion hy Do Firms Issue Warrants And Convertibles? 18 / 20
Good Reasons To Issue Warrants And Convertibles matching cash flows: with costly financing, a sensible approach is to issue securities with cash flows that match those of the firm young, risky, growth firms often issue convertibles because they are cash constrained initially (so they benefit from lower coupon rates) and, if they do well, there will be expensive dilution due to conversion, but the firm is better able to afford it then risk synergy: convertibles and bond-warrant packages are useful in cases where it is hard to assess the risk of the issuer if the issuer subsequently turns out to be low risk, the straight bond will have high value (but the call option will not have much value), whereas if it turns out to be high risk, the call option will be valuable (but the straight bond portion will not be) hy Do Firms Issue Warrants And Convertibles? 19 / 20
Good Reasons To Issue (Cont d) mitigate agency costs: in chapter 23, we showed how a (risky) straight bond can be seen as a risk free bond minus a put option, and how equity can be viewed as a call option this gives incentives for creditors to try to make the firm take low risk projects, and for shareholders to take risky projects convertibles reduce the ability of shareholders to appropriate wealth from bondholders because of the equity component of the convertible consistent with this, convertibles tend to have fewer restrictive covenants than straight corporate debt backdoor equity: this is an asymmetric information argument the basic idea is that young, small, high growth firms often cannot issue debt without paying high interest due to high risk of financial distress if management knows that current shares are undervalued (e.g. due to inside information about future prospects), it may be unwilling to issue equity a convertible issue might be a good choice since it reduces interest costs and avoids selling equity at currently depressed prices hy Do Firms Issue Warrants And Convertibles? 20 / 20