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1. Describe the features of three common types of options that may be used by firms in their financing– the convertible security, the exchangeable bond, and the warrant.
2. Understand why these securities with option features may be attractive for a firm's long-term financing needs.
3. Explain the different terms used to express value for convertible securities - conversion value, market value, and straight-bond value.
4. Calculate the value of convertible securities, exchangeable bonds, and warrants and explain why premiums over different values occur.
5. Understand the relationship between an option instrument and its underlying security.
After Studying Chapter 22, After Studying Chapter 22, you should be able to:you should be able to:
Convertible Security Convertible Security – A bond or a preferred stock that is convertible into a specified
number of shares of common stock at the option of the holder.
• This provides the convertible holder a fixed return (interest or dividend) andand the option to exchange a bond or preferred stock for common stock.
• The option allows the company to sell convertible securities at a lower yield lower yield than it would have to pay on a straight bond or preferred stock issue.
• Conversion terms are not necessarily constant over time.• Example: The conversion price on 20-year
convertible-debt might “step-up” over time from $30 during the first 5 years, $35 the next 5 years, and $40 for the remaining 10 years until maturity.
• The conversion price is usually adjusted for any stock splits or stock dividends to protect the convertible bondholder from antidilution (known as the antidilution clauseantidilution clause).
Antidilution and the Antidilution and the Convertible SecurityConvertible Security
• Virtually all convertible securities provide for a call call priceprice, which allows the company to force conversion when the security market value is significantly above the call price.
• Almost all convertible bond issues convertible bond issues are subordinated to other creditors, which allows a lender to treat convertibles as a part of the equity base when evaluating the financial condition of the issuer.
• The potential dilution effect is recognized by investors who evaluate earnings based on a diluted diluted earnings per shareearnings per share.
Other Issues with Other Issues with Convertible SecuritiesConvertible Securities
• In many cases, convertible securities are employed In many cases, convertible securities are employed as as “deferred” “deferred” common stock financing.common stock financing.
• Does not immediately dilute earnings.
• Securities are converted at a higher price than if they would have been directly issued. This has the impact of reducing the dilution effect.
• The interest or dividend rate The interest or dividend rate is likely to be less is likely to be less than that of straight debt or preferred stock.than that of straight debt or preferred stock. The greater the growth prospects of the firm’s common stock, the lower the stated rate the firm will need to pay.
Use of Use of Convertible SecuritiesConvertible Securities
• Investors can exercise their option to convert to Investors can exercise their option to convert to common stock at any time.common stock at any time.
• Companies can force conversion by calling the Companies can force conversion by calling the issue.issue. • The company has an incentive to call only when the
conversion price exceeds the call price by around 15% and when the common dividend rate is less than the interest or preferred. dividend rate investors are earning.
• Firms attempt to stimulate conversion by Firms attempt to stimulate conversion by including the “step-up” feature to the conversion including the “step-up” feature to the conversion price or increasing the common dividend. price or increasing the common dividend.
Forcing or Forcing or Stimulating ConversionStimulating Conversion
Company C has a convertible debenture outstanding that provides an 8% coupon (interest is paid
semiannually) and continues exactly 20 years until final maturity. A similar nonconvertible bond will currently provide a 5% semiannual yield to maturity5% semiannual yield to maturity. What is the What is the straight bond value of Company C’s convertible bond?straight bond value of Company C’s convertible bond?
VV = $40 (PVIFA5%, 20 x 2) + $1,000 (PVIF5%, 20 x 2)
= $40 (17.159) + $1,000 (0.142)
= $686.36 + $142
= $828.36 $828.36
Company C has a convertible debenture outstanding that provides an 8% coupon (interest is paid
semiannually) and continues exactly 20 years until final maturity. A similar nonconvertible bond will currently provide a 5% semiannual yield to maturity5% semiannual yield to maturity. What is the What is the straight bond value of Company C’s convertible bond?straight bond value of Company C’s convertible bond?
VV = $40 (PVIFA5%, 20 x 2) + $1,000 (PVIF5%, 20 x 2)
= $40 (17.159) + $1,000 (0.142)
= $686.36 + $142
= $828.36 $828.36
Straight Bond Value Straight Bond Value of the Convertibleof the ConvertibleStraight Bond Value Straight Bond Value of the Convertibleof the Convertible
• The convertible bond value convertible bond value equals straight straight bond value bond value plus conversion option valueconversion option value.
• The $828.36$828.36 represents a floor (minimum) below which the convertible value will not fall. This occurs when the conversion option value conversion option value is essentially worthless.
• The straight bond value is subject to change as interest rates, firm risk, and time change. This, in turn, is likely to impact the convertible bond value.
Why Care About Why Care About “Straight Bond Value?”“Straight Bond Value?”
• A convertible security offers holders partial protection on the downside (similar to the straight bond) based on the going-concern and liquidation values of the firm.
• A convertible security also provides holders with the ability to participate in the upward movement in common stock prices.
• The greater the volatility of common stock price, the greater the potential gain and the more valuable the option.
Relationships Among Relationships Among Premiums – SummaryPremiums – Summary
Exchangeable Bond Exchangeable Bond – A bond that allows the holder to exchange the security for common stock of another company of another company – generally, one in
which the bond issuer has an ownership interest.
• These issues usually occur when the issuer owns common stock in the company in which the bonds can be exchanged.
• Exchange requests are satisfied either by open market purchases or directly using the firm’s investment holdings of the other company’s stock.
• Investors may realize diversification benefits since the bond and the common stock are from different companies.
• Potentially, diversification leads to a higher valuation for the exchangeable versus the convertible.
• A major disadvantage is that the difference between the cost of the bond and the market value of the exchanged common stock, at the time of exchange, is treated as a capital gain. A convertible gain is not recognized until the common stock is sold.
Valuation of Valuation of an Exchangeablean Exchangeable
• The warrant contains provisions forThe warrant contains provisions for::• the number of shares that can be purchased per
warrant.
• the price at which the warrant can be exercised.
• the warrant expiration date.
• Warrant holders are Warrant holders are notnot entitled to any entitled to any dividends nor do they have any voting power.dividends nor do they have any voting power.
• The exercise price is generally adjusted for any The exercise price is generally adjusted for any common stock dividends and splits.common stock dividends and splits.
• The market value of a warrant equals or exceeds the theoretical value of the warrant.
• The greater market value is generated by the unlimited upside potential of the stock price combined with the limited downside risk to the warrant holder (minimum value is 0).
• The greater the time to expiration, the greater the opportunity of the upside potential of the stock and the greater the market value of the warrant.
Summary of the Example Summary of the Example of Warrant Valuationof Warrant Valuation