Foundations of Financial Management: An Analysis (part 75)

Timing, perseverance, and 10 years of trying will eventually make you look like an overnight success.

Biz Stone (co-founder of Twitter)

 

Convertibles, Warrants, and Derivatives

(Part C)

by

Charles Lamson

Financing Through Warrants

A warrant is an option to buy a stated number of shares of stock at a specified price (the exercise price) over a given time. 

Warrants are sometimes issued as a financial sweetener in a bond offering, and they may enable the firm to issue debt when this would not be otherwise feasible because of a low quality rating or a high interest rate environment. The warrants are usually detachable from the bond issue, have their own market price, and are generally traded on the New York Stock Exchange or over-the-counter. After warrants are detached, the initial debt to which they were attached remains in existence as a stand-alone bond. Often the bond price will fall and the bond yield will rise once the warrants are detached.

Because a warrant is dependent on the market movement of the underlying common stock and has no "security value" as such, it is highly speculative. If the common stock of the firm is volatile, the value of the warrants may change dramatically.

Valuation of Warrants

Because the value of a warrant is closely tied to the underlying stock price, we can develop a formula for the intrinsic value of a warrant.

I = (M - E) * N (Formula 3)

where

I = Intrinsic value of a warrant

M = Market value of common stock

E = Exercise price of a warrant

N = Number of shares each warrant entitles the holder to purchase

Investors are willing to pay a speculative premium because a small percentage gain in the stock price may generate large percentage increases in the warrant price. Formula 4 demonstrates the calculation of the speculative premium.

S = W - I (Formula 4)

where

S = Speculative premium

 W = Warrant price

 I = Intrinsic value

There is more than enough potential profit to entice speculators to buy a warrant with a zero intrinsic value. It is this potential to participate in the growth of the common stock that makes warrants attractive additions to bond offerings. Bond investors are often willing to accept lower interest rates on bonds that carry warrants because they know the warrants have potential value that could be far in excess of a higher interest rate.

The typical relationship between the warrant price and intrinsic value of a warrant is depicted in Figure 2. We assume the warrant entitles the holder to purchase one new share of common stock at $20. Although the intrinsic value of the warrant is theoretically negative at a common stock price between 0 and 20, the warrant still carries some value in the market. Also observe that the difference between the market price of the warrant and its intrinsic value is diminished at the upper ranges of value. Two reasons may be offered for the declining premium.

Figure 2

First the speculator loses the ability to use leverage to generate high returns as the price of the stock goes up. When the price of the stock is relatively low, say, $25, and the warrant is in the $5 range, a 10 percent movement in the stock could mean a 200 percent gain in the value of the warrant, as indicated in the left-hand panel of Table 6.

Table 6 Leverage in valuing warrants

At the upper levels of stock value, much of this leverage is lost. At a stock value of $50 and a warrant value of approximately $30, a 10-point movement in the stock would produce only a 33% gain in the warrant as indicated in the right-hand panel of Table 6.

Another reason speculators pay a very low premium at higher stock prices is that there is less downside protection. A warrant selling at $30 when the stock price is $50 is more vulnerable to downside movement then is a $5 to $10 warrant when the stock is in the $20.

Use of Warrants in Corporate Finance

Let us examine the suitability of warrants for corporate financing purposes. As previously indicated, warrants may allow for the issuance of debt under difficult circumstances. While a straight debt issue may not be acceptable or may be accepted only at extremely high rates, the same security may be well-received because detachable warrants are included. Warrants may also be included as an add-on in a merger or acquisition agreement. A firm might offer $20 million dollars in cash plus 10,000 warrants in exchange for all the outstanding shares of the acquisition candidate. Warrants may also be issued in a corporate reorganization or bankruptcy to offer the shareholders a chance to recover some of their investment if the restructuring goes well.

The use of warrants has traditionally been associated with such aggressive high-flying firms as speculative real estate companies, airlines, and conglomerates. However, in the 1960s staid and venerable American Telephone and Telegraph came out with a $1.57 billion dollar debt offering, sweetened by the use of warrants (Block & Hirt, p. 569).

As a financing device for creating new common stock, warrants may not be as desirable as convertible securities. A corporation with convertible debentures outstanding may force the conversion of debt to common stock through a call, while no similar device is available to the firm with warrants. The only possible inducement might be a step up in exercise price (price at which the underlying security can be bought or sold)---whereby the warrant holder pays a progressively higher option price if he does not exercise by a given date.

Accounting Considerations with Warrants

As with convertible securities, the potential dilutive effect of warrants must be considered. All warrants are included in computing diluted earnings per share (see Formula 2 from last post and reintroduced below). The accountant must compute the number of shares that could be created by the exercise of all warrants, with the provision that the total can be reduced by the assumed use of the cash proceeds to purchase a partially offsetting amount of shares at the market price. Assume that warrants to purchase 10,000 shares at $20 are outstanding and that the current price of the stock is $50. We show the following:

In computing earnings per share, we will add 6,000 shares to the denominator, with no adjustment to the numerator. this of course will lead to some dilution in earnings per share. It's important must be interpreted by the financial manager and a security analyst. 

*MAIN SOURCE: BLOCK & HIRT, 2005, FOUNDATIONS OF FINANCIAL MANAGEMENT, 11TH ED., PP. 566-570*

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