24-1

CHAPTER

24

Warrants and
Convertibles
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24-2

Executive Summary
This chapter describes the basic features of
warrants and convertibles.
The important questions are:
How can warrants and convertibles be valued?
What impact do warrants and convertibles have on firm value?
What are the differences between warrants, convertibles and
call options?
Under what circumstances are warrants and convertibles
converted into common stock?
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24-3

Chapter Outline
24.1 Warrants
24.2 The Difference between Warrants and Call Options
24.3 Warrant Pricing and the Black-Scholes Model (Advanced)
24.4 Convertible Bonds
24.5 The Value of Convertible Bonds
24.6 Reasons for Issuing Warrants and Convertibles
24.7 Why are Warrants and Convertibles Issued?
24.8 Conversion Policy
24.9 Summary and Conclusions
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24-4

24.1 Warrants
Warrants are call options that give the holder the right, but not the
obligation, to buy shares of common stock directly from a
company at a fixed price for a given period of time.
Warrants tend to have longer maturity periods than exchange
traded options.
Warrants are generally issued with privately placed bonds as an
equity kicker.
Warrants are also combined with new issues of common stock and
preferred stock, given to investment bankers as compensation for
underwriting services.
In this case, they are often referred to as a Green Shoe Option.
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24-5

24.1 Warrants
The same factors that affect call option value
affect warrant value in the same ways.
1.
2.
3.
4.
5.
6.

Stock price +
Exercise price

Interest rate +
Volatility in the stock price
Expiration date
+
Dividends

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24-6

24.2 The Difference Between Warrants

and Call Options
When a warrant is exercised, a firm must
issue new shares of stock.
This can have the effect of diluting the
claims of existing shareholders.

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24-7

Dilution Example
Imagine that Mr. Armstrong and Mr. LeMond are shareholders in a
firm whose only asset is 10 ounces of gold.
When they incorporated, each man contributed 5 ounces of gold,
then valued at $300 per ounce. They printed up two stock
certificates, and named the firm LegStrong, Inc..
Suppose that Mr. Armstrong decides to sell Mr. Mercx a call option
issued on Mr. Armstrongs share. The call gives Mr. Mercx the
option to buy Mr. Armstongs share for $1,500.
If this call finishes in-the-money, Mr. Mercx will exercise, Mr.
Armstrong will tender his share.
Nothing will change for the firm except the names of the
shareholders.
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24-8

Dilution Example
Suppose that Mr. Armstrong and Mr. LeMond
meet as the board of directors of LegStrong. The
board decides to sell Mr. Mercx a warrant. The
warrant gives Mr. Mercx the option to buy one
share for $1,500.
Suppose the warrant finishes in-the-money, (gold
increased to $350 per ounce). Mr. Mercx will
exercise. The firm will print up one new share.
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24-9

Dilution Example
The balance sheet of LegStrong Inc. would
change in the following way:
Balance Sheet Before
(Book Value)
Liabilities and
Equity

Assets
Gold:

$3,000 Debt
Equity
(2 shares)

Total Assets $3,000

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Total

0
$3,000
$3,000

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2410

Dilution
The balance sheet of LegStrong Inc. would
change in the following way:
Balance Sheet Before
(Market Value)
Liabilities and
Equity

Assets
Gold:

$3,500 Debt
Equity
(2 shares)

Total Assets $3,500

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Total

0
$3,500
$3,500

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2411

Dilution
The balance sheet of LegStrong Inc. would change in
the following way:
Balance Sheet After
(Market Value)
Liabilities and
Equity

Assets
Gold:
Cash:

$3,500 Debt
$1,500 Equity

Total Assets $5,000

(3 shares)
Total

0
$5,000
$5,000

Note that Mr. Armstrongs claim falls in value from

$1,750 = $3,500 2 to $1,666.67 = $5,000 3
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2412

Warrant Pricing and the Black-Scholes

Model (Advanced)
Warrants are worth a bit less than calls due to the
dilution.
To value a warrant, value an otherwise-identical call and
multiply the call price by:
n
n nw

Where
n = the original number of shares
nw = the number of warrants
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2413

Warrant Pricing and the Black-Scholes

Model (Advanced)

To see why, compare the gains from exercising a call with the
gains from exercising a warrant.
The gain from exercising a call can be written as:

share price exercise price

Note that when n = the number of shares, share price is:

Firm' s value net of debt

n
Thus, the gain from exercising a call can be written as:
Firm's value net of debt
exercise price
n
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2414

Warrant Pricing and the Black-Scholes

Model (Advanced)

The gain from exercising a warrant can be written

as: share price after warrant exercise exercise price

Note that when n = the original number of shares

and nw = the number of warrants,
share price
Firm's value net of debt exercise price nw
after

n nw
warrant exercise
Thus, the gain from exercising a warrant can be written as:
Firm' s value net of debt exercise price nw
exercise price
n nw

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2415

Warrant Pricing and the Black-Scholes

Model (Advanced)

The gain from exercising a warrant can be written

as:
Firm's value net of debt
n

exercise price

Firm' s value net of debt exercise price nw

exercise price
n nw
A bit of algebra shows that these
equations differ by a factor of

n
n nw

So to value a warrant, multiply the value

of an otherwise-identical call by
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n nw

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2416

24.4 Convertible Bonds

A convertible bond is similar to a bond with warrants.
The most important difference is that a bond with
warrants can be separated into different securities and a
convertible bond cannot.
Recall that the minimum (floor) value of convertible:
Straight or intrinsic bond value
Conversion value

The conversion option has value.

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24.5 The Value of Convertible Bonds

The value of a convertible bond has three

components:
1. Straight bond value
2. Conversion value
3. Option value

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Convertible Bond Problem

Litespeed, Inc., just issued a zero coupon convertible
bond due in 10 years.
The conversion ratio is 25 shares.
The appropriate interest rate is 10%.
The current stock price is $12 per share.
Each convertible is trading at $400 in the market.
What is the straight bond value?
What is the conversion value?
What is the option value of the bond?

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2419

Convertible Bond Problem (continued)

What is the straight bond value?
SBV

$1,000
$385.54
10
(1.10)

What is the conversion value?

25 shares $12/share = $300

What is the option value of the bond?

$400 385.54 = $14.46
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2420

24.5 The Value of Convertible Bonds

Convertible
Bond Value
Convertible bond
values

Conversion
Value
floor value
Straight bond
value

floor
value
= conversion ratio

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Option
value Stock
Price

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2421

24.6 Reasons for Issuing Warrants

and Convertibles
A reasonable place to start is to compare a hybrid like
convertible debt to both straight debt and straight equity.
Convertible debt carries a lower coupon rate than does
otherwise-identical straight debt.
Since convertible debt is originally issued with an out-of-themoney call option, one can argue that convertible debt allows
the firm to sell equity at a higher price than is available at the
time of issuance. However, the same argument can be used to
say that it forces the firm to sell equity at a lower price than is
available at the time of exercise.

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Convertible Debt vs. Straight Debt

Convertible debt carries a lower coupon rate than does otherwiseidentical straight debt.
If the company subsequently does poorly, it will turn out that the
conversion option finishes out-of-the-money.
But if the stock price does well, the firm would have been better
off issuing straight debt.
In an efficient financial market, convertible bonds will be neither
cheaper or more expensive than other financial instruments.
At the time of issuance, investors pay the firm for the fair value of
the conversion option.
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2423

Convertible Debt vs. Straight Equity

If the company subsequently does poorly, it will turn out that
the conversion option finishes out-of-the-money, but the firm
would have been even better off selling equity when the price
was high.
But if the stock price does well, the firm is better off issuing
convertible debt rather than equity
In an efficient financial market, convertible bonds will be
neither cheaper or more expensive than other financial
instruments.
At the time of issuance, investors pay the firm for the fair
value of the conversion option
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2424

24.7 Why are Warrants and

Convertibles Issued
Convertible bonds reduce agency costs, by aligning the incentives
of stockholders and bondholders.
Convertible bonds also allow young firms to delay expensive
interest costs until they can afford them.
Support for these assertions is found in the fact that firms that
issue convertible bonds are different from other firms:
The bond ratings of firms using convertibles are lower.
Convertibles tend to be used by smaller firms with high growth rates
and more financial leverage.
Convertibles are usually subordinated and unsecured.

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24.8 Conversion Policy

Most convertible bonds are also callable.
When the bond is called, bondholders have about 30 days to
choose between:
1.
2.

Converting the bond to common stock at the conversion ratios.

Surrendering the bond and receiving the call price in cash.

From the shareholders perspective, the optimal call policy is to

call the bond when its value is equal to the call price.
In the real world, most firms wait to call until the bond value is
substantially above the call price. Perhaps the firm is afraid of
the risk of a sharp drop in stock prices during the 30-day
window.
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24.9 Summary and Conclusions

Convertible bonds and warrants are like call options.
However, there are important differences:
Warrants are issued by the firm.
Warrants and convertible bonds have different effects on corporate cash
flow and capital structure.
Warrants and convertibles cause dilution to existing shareholders claims.

Many arguments, both plausible and implausible, are given for

issuing convertible securities.
Convertible bonds give lends the chance to benefit from risks and reduces
the conflicts between bondholders and stockholders concerning risk.

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