Warrants and Rights Chapter 12 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company1 What is it? Warrants and rights.

Warrants and Rights Chapter 12Tools & Techniques of

Investment Planning

Copyright 2007, The National Underwriter Company 1

What is it?

• Warrants and rights are essentially long-term and short-term call options, respectively, to purchase shares of the stock of the corporation issuing the warrants or rights.– They give the owner the right for a specified period of time to purchase

a specified number of the company’s shares of stock at a specified price

• This price is known as the exercise, subscription, or strike price.

– Each right gives the owner an option to buy a fraction of a single share of the company’s stock

• Generally, several rights are required to purchase one additional share of stock.

– Warrants may give the owner the right to buy one or some other number of shares.


Investment Planning


What is it?

• In some cases, the exercise price may not remain level throughout the term until expiration.– It may increase at scheduled times and in scheduled amounts

throughout the term until it expires.

• In-the-money warrants may be callable.– Corporations may sometimes call the warrants to force their

exercise before the end of the specified term.


Investment Planning


When is the use of this tool indicated?

• Corporations typically issue rights when they plan to raise funds by selling additional shares of common stock to the public– Every current stockholder is given one right for each one share of stock

they own.• Each right may only allow the purchase of a new partial share.• The opportunity to buy the shares is often at a predetermined price (“in the

money” or below the subscription price to the public) and lasts for a very short period of time (a few weeks).

• Shareholders who wish to maintain their proportional ownership of the firm can exercise their rights and purchase new shares at the price specified by the rights.– Shareholders who do not wish to do so may sell them for cash before

they expire if an open market exists for them.– Once expired, they are worthless.


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• Warrants are issued by corporations in conjunction with new bond issues or preferred stock issues. – Provides an “equity kicker,” allowing the owner the opportunity to

someday exercise the warrant and enjoy the potential appreciation of the underlying stock

– Generally lowers the interest rate or dividend rate necessary to sell the issue

– They are usually issued with an out-of-the-money exercise price and an expiration date ranging from 3 to 5 years

• Corporations will sometimes issue warrants in lieu of cash payments for investment banking, legal, or other services.– Often applies to young, start-up firms or fast-growing firms– Potential equity financing in the long run


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• Warrants have virtually all the same characteristics and may serve most of the same objectives as call options or Long-Term Equity Anticipation Securities (LEAPS: options with expiration terms as long as 2 years and 8 months):– When the investor wishes to speculate on an upward movement in the

value of the stock

– When the investor wishes to create a leveraged situation• The price of the warrant will virtually always be less than the current value of

the stock into which it can be converted

– When the investor has limited funds, but still wishes to participate in the potential gains in a firm’s stock

– When the investor has sold the stock short, but wishes to hedge his position in the event the stock appreciates in value


Investment Planning


Advantages

• Rights provide current shareholders with the opportunity to retain their proportionate ownership and control of a firm.

• Rights help to increase the likelihood for the corporation that the new issue of stock will be fully subscribed.

• Warrants provide the owner with the opportunity to participate in the potential appreciation of the stock with a small investment relative to the cost of purchasing the number of shares into which it may be converted.

• The low unit cost of warrants, relative to the price of the firm’s stock, creates leverage and enables an investor to magnify potential gains for a given level of investment.

• Warrants can be sold short to take advantage of an anticipated decline in the value of the underlying stock.


Investment Planning


Disadvantages

• The administration of the rights offering may slightly increase the corporation’s cost for a new stock issuance.

• Warrants offer no current income; they pay no dividends.• Warrants carry no voting rights until they are exercised and the

underlying stock is acquired.• If the warrant has an expiration date, the risk of being stuck with a

valueless asset increases as that date approaches.• Downside moves by the stock price will result in a more than

proportional percentage downward move in the value of the warrant.– Particularly if a warrant is “in-the-money”

• In-the-money warrants may be called by the company to force exercise before the scheduled end of the term of the warrant.


Investment Planning


Tax Implications: Stock Rights

• An investor is generally not required to recognize the receipt of stock rights as a taxable event.

• If the stock rights are exercised or sold, the investor must refigure his tax basis in the stock by allocating part of the basis in the existing stock to the stock rights (providing cost basis of the rights themselves are sold).

• The allocated basis of the stock rights is in turn added to the cost of the stock acquired at exercise (if the investor chooses to exercise the rights).

• The allocation is based on the relative FMV of the stock and the stock rights at the time the stock rights are distributed.

• The basis of the stock rights is increased, and the basis of the existing stock is decreased.

– By the proportional value of the stock rights to the total value of the existing stock and the stock rights


Investment Planning


Example

• An investor owns stock in a company and receives a distribution of stock rights to purchase additional shares at $36 per share. At the time of distribution, the fair market value of the stock is $36 and the fair market value of the rights is $9.

– The basis allocation is determined by examining the relative value of the rights ($9) to the total value of the existing stock and the rights ($9+$36=$45).

– Therefore, the basis allocation ratio for the stock rights is $9/$45=20%, and the remaining 80% of the basis would be allocated to the existing stock.

– Thus, if the existing stock had a basis of $20, it would be reduced to $16 ($20x80%=$16). The basis of the rights would be $4 ($20x20%).

– If the rights were exercised, the cost basis of the rights would be added to the delivered new shares, for a total cost basis of $40 ($36+$4=$40).


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• If the FMV of the rights is less than 15% of the FMV of the underlying stock on the date of distribution, investors do not make any basis allocation.– The basis of the stock rights if $0.

• Investors can take action on this and make an irrevocable IRC Sec. 307(b)(2) election.– This election must be filed with their tax returns for the

year of the stock rights distribution.


Investment Planning


Example

• An investor owns stock in a company and receives a distribution of stock rights to purchase additional shares at $36 per share. At the time of the distribution, the fair market value of the stock is $36 and the fair market value of the right is $4. – There is no basis allocation because the value of the right

($4) is less than 15% of $36 ($5.40).– The cost basis of the rights will be $0.


Investment Planning


Example

• Continuing the previous example, the investor makes an irrevocable 307(b)(2) election to allocate part of his stock basis to the stock rights. Assume the investor’s stock basis is $20 per share.– The investor allocates 10% or $2 ($4/($4+$36)) per share

to the stock rights and 90% or $18 per share to the existing stock.

– The investor’s total basis in each share of stock acquired through the exercise of the stock right will be $38 per share.


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• Long-term or short-term capital-gains treatment depends on the holding period.– If investors sell their rights, the holding period for

that gain begins with the date they acquired the original stock.

– If investors exercise their rights and then sell the new stock they acquire, they have a short-term gain.

• The holding period for the stock begins on the date of the exercise of the rights and the acquisition of the new shares.


Investment Planning


Example

• An investor owns stock purchased in June 1998. In June 2004, the investor receives stock rights to purchase additional shares.– If the investor sells the rights two weeks later, she has a long-

term gain or loss based on a holding period of six years (and based upon the cost basis determination).

– If she exercises the rights and then sells the stock she acquired from the exercise a month later, she has a short-term capital gain or loss based on a holding period for the new stock of one month.


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• If stock rights expire unexercised, no gain or loss is recognized.

• Investors have two choices if they possess a right that is about to expire out-of-the-money:– Sell them and allocate the basis away from the stock to the

right• Take a loss on the sale of the right immediately

– Allow the right to expire worthless • Maintain a higher basis in the existing stock

• If the existing stock had already been held for more than one year, a sale of the worthless right for a loss will be a long-term capital loss, subject to the capital loss restrictions.


Investment Planning


Tax Implications: Warrants

• Warrants are taxed under the same general rules as options.– When acquired other than as employment compensation or as

compensation for services

• No gain or loss is recognized when a warrant is acquired.

• The warrant holder recognizes gain or loss when:– The warrant period ends and the warrant expires unexercised, or– When the option is sold.

• If the warrant is exercised, usually there is no taxable event.

• When a warrant is sold or expires, the character of gain or loss is generally as a capital asset.


Investment Planning


Tax Implications: Warrants

• When warrants are issued in conjunction with a bond offering, the investors who purchase the bonds generally must allocate their basis in the bonds and the warrants in proportion to their respective market values when purchased or received– Applies similarly to warrants issued with a preferred stock offering

• When exercised, the stock basis is the exercise price increased by the premium paid (or basis allocated) for the warrant, if any, plus transaction / commission costs.– The stock’s holding period begins on the date of acquisition.

• Warrants received as compensation for employment or as compensation for services for the company are taxable as ordinary income at their fair market value on the date of receipt.– This FMV becomes the basis.


Investment Planning


Alternatives

• Call options– Shorter in duration than warrants– Enable the owner to purchase a certain number of shares of stock at a

fixed price for a given period of time

• LEAPS (Long-Term Equity Participation Securities– Long-term listed options with expiration terms up to 2 years and 8

months• Single-Stock Futures (SSFs)

– Certain combinations of long and short positions in SSFs, straddles, or spreads, permit investors to create a “package” or “synthetic” investment with the risk, return, and leverage characteristics comparable to that of options or warrants on individual stocks.

• Purchase of the underlying stock


Investment Planning


Where and How do I get it?

• Rights are originally issued to the current shareholders of the company planning to raise new funds through a new stock offering.– The investment banker or underwriting syndicate usually makes a

secondary market for the rights to permit existing shareholders who prefer not to exercise their rights to sell them to other current shareholders or outside investors.

• Warrants are originally issued along with new issues of bonds or preferred stock.– They may be listed on organized stock exchanges or traded over the

counter, depending on the size and strength of the issuing company, where its stock is listed or traded, and the number of the specific warrants in the market place.


Investment Planning


What fees or other costs are involved?

• Rights are given to existing shareholders at no direct cost.– No commission is paid upon the exercise of rights to purchase new

shares of stock.

– A relatively small commission is paid to sell or buy the rights in the secondary market created by the investment banker or syndicate handling the new issue of stock.

• Warrants received along with a purchase of new bonds or preferred stock have no additional cost.– They are simply acquired as an attachment to the purchased bonds or

stock.

– Warrants bought or sold on listed exchanges or over the counter are subject to the same type of commissions as other securities.


Investment Planning


How do I select the best of its type?

• Warrants for stocks of companies with strong growth potential and low dividend payout ratios offer the most promising returns.– Similar to long-term call options

– For trading purposes, warrants with longer terms until expiration and for companies whose stocks are more volatile offer a greater chance of significant movements in the value of the warrant.


Investment Planning


How do I select the best of its type?

• Rights purchased in the secondary market are usually purchased as a leveraged mechanism to speculate in the short-term movements of a stock.

• Rights originally distributed directly to an investor might be sold to enjoy a slight premium for the speculative value of the rights.– Over and above the in-the-money exercise value, if they can be sold at a

higher after-expenses/after-commission cost.

• The rights can also be exercised at any point to acquire the underlying stock for its future growth potential, or to receive the stock for immediate sale.


Investment Planning


Where can I find out more about it?

• There is generally much less information available regarding warrants than options and other types of securities– They are somewhat of a niche area of specialization within the

investment community.– Large brokerage firms have specialists who concentrate on

warrants.• They occasionally publish reports on warrants.

• Stockwarrants.com (www.stockwarrants.com)– Advertises on its home page that it “is the internet’s only

coverage/analysis service for American warrants. In fact, you won’t find better overall coverage of the stock warrant universe in any media.”

Warrants and Rights Chapter 12 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company1 What is it? Warrants and rights.

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