Warrent and Convertible

...

TVw = (P0 − E) # ... (6.1 (a)[1]∗)

For example, at a time of issue of debenture with warrant, Delta Company's share price and exercise price were Rs 20 and Rs 25 respectively. Each warrant entitled the holder to two shares; theoretical value of a warrant at the time of issue was zero:

TVw = max [(P0 − E)# , 0]

= max [(Rs 20 − Rs 25)2, 0]

= max [− Rs 10, 0]

= 0

When stock price equals to exercise price, theoretical value of warrant equals to zero

TVW = max [(Rs 25 − Rs 25)2, 0]

= max [0, 0]

= 0

Once the stock price rises above the exercise price of the warrant, the formula value will be greater than zero. For example, when Delta company's stock price increases to Rs 40 before expiration. Theoretical value of warrant equals to Rs 30.

TVW = max [(Rs 40 − Rs 25)2 , 0]

= max [Rs 30, 0]

= Rs 30

Most warrants sell at prices in excess of their theoretical values. The difference between market (actual) value of warrant and theoretical value of warrant is called warrant premium. Symbolically, [pic 4]

Warrant premium = Market value of warrant (MVW) − Theoretical value of warrant (TVW)

Warrant premium is maximized when stock price equals exercise price because at this point a small increase in share price results greater percentage change in value of warrant. But size of premium deceases as stock price increases. The relationship between theoretical value of warrant and market value of warrant is shown in Figure 6.1.

When the market value of the associated stock is less than the exercise price, the theoretical value of warrant is zero and it is said to be trading "out of the money". When the value of the associated common stock is greater than the exercise price, the theoretical value of the warrant is positive, as depicted by the diagonal line in Figure 6.1. Under these circumstances, the warrant is said to be trading "in the money". [pic 5]

[pic 6]

Market value of warrant and warrant premium depends upon various factors:

(i) Current price of stock (ii) exercise price (iii) time left to the warrant expiration date (iv) degree of price volatility on the underlying common stock. Current stock price, maturity period, volatility affect the market price of warrant positively and exercise price have inverse relationship with warrant market price and premium.

Convertible Securities

Convertible securities are bonds or preferred stocks that can be converted into stated number of common stock at the option of the holders within stipulated period in time. Conversion is made under specified terms and conditions. A bond can be converted into preferred stock and common stock while preferred stock can be converted into common stock only. Convertible securities (bonds or preferred stocks) provide stable return. In addition, the investor may enjoy capital gains associated with common stock. As a result, a company is able to sell a convertible security at a lower yield than that it would have to pay on a straight bond or preferred stock issue. In other words, the conversion feature typically enhances the marketability of an issue. But unlike the exercise of warrants, which provides the firm with additional funds, conversion does not bring in additional capital. Amount of debt or preferred stock simply replaced by common stock. [pic 7]

Features of Convertibles

Conversion Ratio (CR)

Conversion ratio is the number of shares of common stock for which the convertible can be exchanged. It is set out when the convertible is initially issued. Conversion ratio can be computed by dividing par value of a convertible by conversion price.[pic 8]

Conversion Price (CP)

The conversion price is the effective price investors pay for the common stock when conversion occurs. Conversion price can be computed by dividing par value of a convertible by conversion ratio. Like warrant's exercise price, conversion price is fixed 20 percent to 30 percent above the market price of the common stock at the time the convertible issue is sold. Generally, conversion price is fixed for the life of the convertible or conversion period. But sometimes, convertible may have the provision of stepped-up conversion price. In this provision, conversion price increases after the designated date.[pic 9]

Conversion Period

The period during which conversion of security is permitted is called conversion period. On some issues, the time period during which the convertible can be exchanged for common stock is limited. But other convertibles may be exchanged at any time during their life. In either case, the conversion period is specified when the convertible is originally issued.

Conversion Value[pic 10]

The conversion value (or stock value) of a convertible security is the total market value of the common stocks that are received upon conversion at given point in time. The conversion value can be determined simply by multiplying the market price of the firm’s common stock by conversion ratio.

Straight Bond Value

Straight bond value (or investment value) of a convertible debt issue is the value it would have if it did not posses the conversion feature (option). Thus, it is equal to the sum of the present value of the coupon interest plus the present value of the principal or maturity value. Discounting rate used is the yield on similar risk non-convertible debt.[pic 11]

Conversion Premium

Conversion premium can be computed at the time of issue and in subsequent years. At the time of issue, conversion premium (Initial premium) is the difference between conversion price and market price of stock. Initial premium in percent is the initial premium divided by stock price. But conversion premium in subsequent years is the difference between the convertibles market price and the higher of its straight