1. Convertibles, Warrants, and Derivatives
Chapter 19
Convertibles, Warrants, and Derivatives

2. PPT 19-1
FIGURE 19-1
Price movement pattern for a convertible bond

3. TABLE 19-1
Pricing pattern for convertible bonds outstanding, 2002 year-end prices
PPT 19-2

4. PPT 19-3
TABLE 19-3
Successful convertible bonds not yet called

5. PPT 19-4
TABLE 19-4
XYZ Corporation

6. Adjusted earnings after taxes
PPT 19-4
Adjusted earnings after taxes
Shares outstanding + All convertible securities5
Diluted earnings
Per share
(19-2) =
Reported earnings
Interest savings
$1,500,000 + $270,000
1,000, ,000
$1,770,000
1, 400,000 = = =
$1.26

7. PPT 19-5
TABLE 19-5
Relationships determining warrant prices

8. PPT 19-6
FIGURE 19-2
Market price relationships for a warrant

9. Review of Formulas PPT 19-7 1. Basic Earnings after taxes
per share Shares of Common Stock
2. Diluted Adjusted earnings after taxes
earnings = (19-2)
per share Shares outstanding + All convertibles securities*
*Other types of securities that create common stock, such as warrants and
options, would also be included.

10. Review of Formulas (continued)
PPT 19-7
3. Intrinsic value of a warrant
I = (M — E) X N (19-3)
where
I = Intrinsic value of a warrant
M = Market value of a common stock
E = Exercise price of a warrant
N = Number of shares each warrant entitles
the holder to purchase
4. Speculative premium of a warrant
S = W — I (19-4)
S = Speculative premium
W = Warrant price
I = Intrinsic value

11. Chapter 19 - Outline LT 19-1 Convertible Security
Convertible Terminology
Advantages and Disadvantages of Convertible Securities
Warrant
Use of Warrants in Corporate Finance
Options

12. Convertible Security LT 19-2
–a hybrid security combining features of debt and common equity
– a bond or share of preferred stock that can be converted into common stock at the option of the holder
– goes up in value if the common stock price increases
– the holder receives a fixed rate of return before converting
– represents a fixed income security that is potentially convertible into common stock if desired

13. Convertible Terminology LT 19-3
Conversion Ratio:
– number of shares of common stock into which the security may be converted
Conversion Price:
– par value of the bond / conversion ratio
Conversion Value:
– conversion ratio x market price of common stock
Conversion Premium:
– difference between the market value and the conversion value

14. Advantages and Disadvantages of Convertible Securities LT 19-4
Advantages to the corporation:
– lower interest rate paid than on a straight bond
– may be the only means for a small corporation to gain access to the bond market
– attractive to a corporation that believes its stock is currently undervalued
Disadvantages to the corporation:
– average size of a convertible offering is very small
– accounting considerations regarding convertibles (potential dilution of EPS)

15. Warrant LT 19-5
Warrant:
– an option to buy a stated number of shares of stock at a specified price over a given time period (a long-term option to buy stock)
–“sweetens” a bond offering (a financial sweetener)
– is usually detachable from the bond issue
– is highly speculative, as its value is dependent on the market movement of the stock
– has a large potential for appreciation if the price of the stock goes up

16. Use of Warrants in Corporate Finance LT 19-6
Enhances a debt issue by allowing for the issuance of debt under difficult circumstances
May be included as an add-on in a merger or acquisition agreement
Can be issued in a corporate reorganization or bankruptcy to offer shareholders a chance to recover some of their investment
Traditionally has been associated with speculative real estate companies, airlines, and conglomerates

17. Options LT 19-7
Options give the owner the right, but not the obligation, to buy or sell a security at a set price for a given period of time
An employee stock option is very similar to a warrant
Call option
– an option to buy securities
Put option
– an option to sell securities