Convertibles, Warrants, and Derivatives
Convertibles, Warrants, and Derivatives,19,1-2,Chapter Outline,Converting convertible securities to common stockConvertible securities may move with the value of common stockInterest rates on convertible securitiesWarrantsAccountant requirements of convertibles and warrantsDerivative securities,1-3,Convertible Securities,A bond or share of preferred stock that can be converted, at the option of the holder, into common stockWhen a convertible debenture is initially issued, a conversion ratio to common stock is specifiedRatio indicates the number of common stock shares of converted debenturesTo get the conversion price, the par value of the bond is divided by the conversion ratio,1-4,Value of the Convertible Bond,Must evaluate the conversion privilegesOther values to be considered include:Conversion valueConversion premiumPure bond valueDownside risksFloor value,1-5,Price Movement Pattern for a Convertible Bond,1-6,Pricing Pattern for Convertible Bonds Outstanding, January 2008 prices,1-7,Is this Fools Gold?,Drawbacks:Once convertible debentures begin to increase in value, the downside protection becomes redundantIf interest rates in the market rise, the floor value, or the pure bond value, could fall, creating more downside riskPurchaser of the convertible bond normally also pays a premium over the conversion valueThe purchaser is always asked to accept below-market rates of interest on the debt instrumentConvertibles may also suffer from the attachment of a call provision,1-8,Advantages to the Corporation,Interest rate paid on convertible issues is lowerMay be the only way a small corporation may enter the bond marketAttractive to a corporation that believes its stock is currently undervaluedThe price of a stock may go up if the issuance of common stock or convertibles is delayed by an appropriate time,1-9,Disadvantages to the Corporation,Size of convertible bond market is small compared to markets for nonconvertible corporate bonds and common stocksFirms selling convertible securities are generally smaller firms growing faster, having small dividend payout ratios which results in small dividend yieldsWhile a few firms that sell convertible bonds may be high quality firms, most are small companies with low credit ratings and high risk,1-10,Forcing Conversion,Call option provision is used to force conversion when it needs to shift outstanding debt to common stockValue of convertible bonds might go up significantlyImproves composition of companys balance sheet by decreasing debt-to-equity and debt-to-asset ratio,1-11,Successful Convertible Bonds and Preferred Stock Not Yet Called,1-12,Method of Forcing Conversion,If the conversion value is above the call price when the bond is called:A discerning investor would take the shares of common stock rather than a cash payoutForcing conversion increases cash flowWhen comparing the current yield to the dividend yield on the common stock:Investors generally do not want to convert unless the dividend yield is higher than the yield on the bond,1-13,Step-Up in the Conversion Price,When the bond is issued, the contract may specify the conversion provisionsAt the end of each time period, there is a strong inducement to convert rather than accept an adjustment to a higher conversion price and a lower conversion ratio,1-14,Accounting Considerations with Convertibles,The full impact of conversion privileges applying to convertible securities and other dilutive securities:May generate additional common stock in the future, its potential effects must be consideredDifferent measures to earnings per share:Basic earnings per shareDiluted earnings per share,1-15,Diluted Earnings Per Share,Assume 400,000 new shares will be created from potential conversion, while at the same time allowing for reduction in interest payments that would occur as a result of conversion of the debt to common stockThe before-tax interest payments are $450,000, the aftertax interest cost of $270,000 $450,000 (1- .40) = $270,000 will be saved and can be added back to the income Diluted earnings = Adjusted earnings after taxes ; per share Shares outstanding + All convertible securities Reported Interest earnings savings = $1,500,000 + $270,000 = $1,770,000 = $1.26 1,000,000 + 400,000 1,400,000,1-16,XYZ Corporation,1-17,Financing through Warrants,An option to buy a stated number of shares of common stock at a specified price over a given time periodSometimes issued as a financial sweetener in a bond offeringMay enable the firm to issue debt when it might not have been possible due to:Low quality credit ratingHigh interest rate environment,1-18,Warrants - Features,Usually detachable from the bond issueHave their own market priceAre traded on the NYSE or over-the-counterInitial debt to which they were attached remains in place as a stand-alone bondHighly speculative:Does not have a security valueIs dependent on market movement,
