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•Suppose call protection ends with price at level C. Then the financial manager should call immediately, forcing the convertible value down to the call price.16

•What if call protection ends with price at level B, barely above the call price? In this case the financial manager will probably wait. Remember, if a call is announced, bondholders have a 30-day period in which to decide whether to convert or redeem. The stock price could easily fall below the call price during this period, forcing the company to redeem for cash. Usually calls are not

announced until the stock price is about 20 percent above the call price. This provides a safety margin to ensure conversion.17

Do companies follow these simple guidelines? On the surface they don’t, for there are many instances of convertible bonds selling well above the call price. But the explanation seems to lie in the call-protection period, during which companies are not allowed to call their bonds. Paul Asquith found that most convertible bonds that are worth calling are called as soon as possible after this period ends.18 The typical delay for bonds that can be called is slightly less than four months after the conversion value first exceeds the call price.

23 . 3 THE DIFFERENCE BETWEEN WARRANTS AND CONVERTIBLES

We have dwelt on the basic similarity between warrants and convertibles. Now let us look at some of the differences:

1.Warrants are usually issued privately. Packages of bonds with warrants or preferred stock with warrants tend to be more common in private placements. By contrast most convertible bonds are issued publicly.

2.Warrants can be detached. When you buy a convertible, the bond and the option are bundled up together. You cannot sell them separately. This may be inconvenient. If your tax position or attitude to risk inclines you to bonds, you may not want to hold options as well. Sometimes warrants are also “nondetachable,” but usually you can keep the bond and sell the warrant.

3.Warrants may be issued on their own. Warrants do not have to be issued in conjunction with other securities. Often they are used to compensate investment bankers for underwriting services. Many companies also give their executives long-term options to buy stock. These executive stock options are not usually called warrants, but that is exactly what they are. Companies can also sell warrants on their own directly to investors, though they rarely do so.

16 The financial manager might delay calling for a time at price C if interest payments on the convertible debt are less than the extra dividends that would be paid after conversion. This delay would reduce cash payments to bondholders. Nothing is lost if the financial manager always calls “on the way down” if stock price subsequently falls toward level B. Note that investors may convert voluntarily if dividends after conversion exceed interest on the convertible bond.

17See P. Asquith and D. Mullins, “Convertible Debt: Corporate Call Policy,” Journal of Finance 46 (September 1991), pp. 1273–1290.

18 See P. Asquith, “Convertible Bonds Are Not Called Late,” Journal of Finance 50 (September 1995), pp. 1275–1289.

4.Warrants are exercised for cash. When you convert a bond, you simply exchange your bond for common stock. When you exercise warrants, you generally put up extra cash, though occasionally you have to surrender the bond or can choose to do so. This means that bond–warrant packages and convertible bonds usually have different effects on the company’s cash flow and on its capital structure.

5.A package of bonds and warrants may be taxed differently. There are some tax differences between warrants and convertibles. Suppose that you are wondering whether to issue a convertible bond at 100. You can think of this convertible as a package of a straight bond worth, say, 90 and an option worth 10. If you issue the bond and option separately, the IRS will note that the bond is issued at a discount and that its price will rise by 10 points over its life. The IRS will allow you, the issuer, to spread this prospective price appreciation over the life of the bond and deduct it from your taxable profits. The IRS will also allocate the prospective price appreciation to the taxable income of the bondholder. Thus, by issuing a package of bonds and warrants

rather than a convertible, you may reduce the tax paid by the issuing company and increase the tax paid by the investor.19

23 . 4 WHY DO COMPANIES ISSUE WARRANTS AND CONVERTIBLES?

You are approached by an investment banker who is anxious to persuade you that your company should issue warrants. She points out that the exercise price of the warrants could be set at 20 percent above the current stock price, so that you would effectively be selling stock at a hefty premium. And, if it turns out that the warrants are never exercised, the proceeds from their sale would become a clear profit to the company. Are you convinced?

You hear many similar arguments for issuing warrants and convertibles, but you should always be suspicious of any “Heads I win, tails you lose” argument. If the shareholder inevitably wins, the warrant holder must lose. But that doesn’t make sense. Surely there must be some price at which it makes sense to buy warrants.20

Suppose that your company’s stock is priced at $100 and that you are considering an issue of warrants exercisable at $120. You believe that you can sell these warrants at $10. If the stock price subsequently fails to reach $120, the warrants will not be exercised. You will have sold warrants for $10 each, which with the benefit of hindsight proved to be worthless to the buyer. If the stock price reaches $130, say, the warrants will be exercised. Your firm will have received the initial payment of $10 plus the exercise price of $120. On the other hand, it will have issued to the warrant holders stock worth $130 per share. The net result is a standoff. You have received a payment of $130 in exchange for a liability worth $130.

19See J. D. Finnerty, “The Case for Issuing Synthetic Convertible Bonds,” Midland Corporate Finance Journal 4 (Fall 1986), pp. 73–82.

20 Here is another “Heads I win, tails you lose” argument. You are an investor. Your broker calls you with an offer of ABC company warrants. ABC’s share price is $10; the warrants expire in one year, have an exercise price of $10, and are selling at $1. Your broker points out that you are likely to make much larger percentage gains from buying the warrants rather than the shares. For example, if over the next year the share price rises by 20 percent to $12, the warrants will be worth $2, a gain of 100 percent. On the other hand, if the share price falls, the most that you can lose as a warrant holder is $1. How do you respond?

Think now what happens if the stock price rises above $130. Perhaps it goes to $200. In this case the warrant issue will end up producing a loss of $70. This is not a cash outflow but an opportunity loss. The firm receives $130, but in this case it could have sold stock for $200. On the other hand, the warrant holders gain $70: They invest $130 in cash to acquire stock that they can sell, if they like, for $200.

Our example is oversimplified—for instance, we have kept quiet about the time value of money and risk—but we hope it has made the basic point. When you sell warrants, you are selling options and getting cash in exchange. Options are valuable securities. If they are properly priced, this is a fair trade; in other words, it is a zero-NPV transaction.

Some managers look on convertibles as “cheap debt.” Others regard them as a deferred sale of stock at an attractive price. These arguments also are misleading. We have seen that a convertible is like a package of a straight bond and an option. The difference between the market value of the convertible and that of the straight bond is therefore the price investors place on the call option. The convertible is “cheap” only if this price overvalues the option.

What then of the other managers—those who regard the issue as a deferred sale of common stock? A convertible bond gives you the right to buy stock by giving up a bond.21 Bondholders may decide to do this, but then again they may not. Thus issue of a convertible bond may amount to a deferred stock issue. But if the firm needs equity capital, a convertible issue is an unreliable way of getting it.

Taken at their face value the motives of these managers are irrational. Convertibles are not just cheap debt, nor are they a deferred sale of stock. But we suspect that these simple phrases encapsulate some more complex and rational motives.

Notice that convertibles tend to be issued by the smaller and more speculative firms. They are almost invariably unsecured and generally subordinated. Now put yourself in the position of a potential investor. You are approached by a small firm with an untried product line that wants to issue some junior unsecured debt. You know that if things go well, you will get your money back, but if they do not, you could easily be left with nothing. Since the firm is in a new line of business, it is difficult to assess the chances of trouble. Therefore you don’t know what the fair rate of interest is. Also, you may be worried that once you have made the loan, management will be tempted to run extra risks. It may take on additional senior debt, or it may decide to expand its operations and go for broke on your money. In fact, if you charge a very high rate of interest, you could be encouraging this to happen.

What can management do to protect you against a wrong estimate of the risk and to assure you that its intentions are honorable? In crude terms, it can give you a piece of the action. You don’t mind the company running unanticipated risks as long as you share in the gains as well as the losses.22

21That is much the same as already having the stock together with the right to sell it for the convertible’s bond value. In other words, instead of thinking of a convertible as a bond plus a call option, you could think of it as the stock plus a put option. Now you see why it is wrong to think of a convertible as equivalent to the sale of stock; it is equivalent to the sale of both stock and a put option. If there is any possibility that investors will want to hold onto their bond, the put option will have some value.

22See M. J. Brennan and E. S. Schwartz, “The Case for Convertibles,” Journal of Applied Corporate Finance 1 (Summer 1988), pp. 55–64.

Convertible securities and warrants make sense whenever it is unusually costly to assess the risk of debt or whenever investors are worried that management may not act in the bondholders’ interest.23

You can also think of a convertible issue as a contingent issue of equity. If a company’s investment opportunities expand, its stock price is likely to increase, allowing the financial manager to call and force conversion of a convertible bond into equity. Thus the company gets fresh equity when it is most needed for expansion. Of course, it is also stuck with debt if the company does not prosper.24

The relatively low coupon rate on convertible bonds may also be a convenience for rapidly growing firms facing heavy capital expenditures. They may be willing to give up the conversion option to reduce immediate cash requirements for debt service. Without the conversion option, lenders might demand extremely high (promised) interest rates to compensate for the probability of default. This would not only force the firm to raise still more capital for debt service but also increase the risk of financial distress. Paradoxically, lenders’ attempts to protect themselves against default may actually increase the probability of financial distress by increasing the burden of debt service on the firm.25

23Changes in risk ought to be more likely when the firm is small and its debt is low-grade. If so, we should find that the convertible bonds of such firms offer their owners a larger potential ownership share. This is indeed the case. See C. M. Lewis, R. J. Rogalski, and J. K. Seward, “Understanding the Design of Convertible Debt,” Journal of Applied Corporate Finance 11 (Spring 1998), pp. 45–53.

24Jeremy Stein points out that an issue of a convertible sends a better signal to investors than a straight equity issue. As we explained in Chapter 15, announcement of a common stock issue prompts worries of overvaluation and usually depresses stock price. Convertibles are hybrids of debt and equity and send a less negative signal. If the company is likely to need equity, its willingness to issue a convertible, and to take the chance that stock price will rise enough to allow forced conversion, also signals management’s confidence. See J. Stein, “Convertible Bonds as Backdoor Equity Financing,” Journal of Financial Economics 32 (1992), pp. 3–21.

25 This fact led to an extensive body of literature on “credit rationing.” A lender rations credit if it is irrational to lend more to a firm regardless of the interest rate the firm is willing to promise to pay. Whether this can happen in efficient, competitive capital markets is controversial. We discussed credit rationing in Chapter 18. For a review of this literature, see E. Baltensperger, “Credit Rationing: Issues and Questions,” Journal of Money, Credit and Banking 10 (May 1978), pp. 170–183.

a.What is the “theoretical” value of the warrant if the stock price is: (i) $20? (ii) $30? (iii) $40? (iv) $50? (v) $60?

b.Plot the theoretical value of the warrant against the stock price.

c.Suppose the stock price is $60 and the warrant price is $5. What would you do?

2.In 1994 Viacom made a typical issue of warrants. Each warrant could be exercised before 1999 at a price of $70 per share. In September 1998 the stock price was $57 per share.

a.Did the warrant holder have a vote?

b.Did the warrant holder receive dividends?

c.If the stock was split 3 for 1, how would the exercise price be adjusted?

d.Suppose that instead of adjusting the exercise price after a 3-for-1 split, the company gives each warrant holder the right to buy three shares at $70 apiece. Would this have the same effect? Would it make the warrant holder better or worse off?

e.What is the “theoretical” value of the warrant?

f.Before maturity is the warrant worth more or less than the “theoretical” value?

g.Other things equal, would the warrant be more or less valuable if:

i.The company increased its rate of dividend payout?

ii.The interest rate declined?

iii.The stock became riskier?

iv.The company extended the exercise period?

v.The company reduced the exercise price?

h.A few companies issue perpetual warrants that have no final exercise date. Suppose that Viacom warrants were perpetual. In what circumstances might it make sense for investors to exercise their warrants?

i.If the stock price rises 5 percent, would you expect the price of a warrant to rise by more or less than 5 percent?

3.Company X has outstanding 1,000 shares and 200 warrants. Each warrant can be converted into one share at an exercise price of $20. What will be the total market value of X’s shares after the warrants mature if the share price on that date is (a) $15,

(b) $25?

4.Maple Aircraft has issued a 4 3⁄4 percent convertible subordinated debenture due 2008. The conversion price is $47.00 and the debenture is callable at $102.75 percent of face value. The market price of the convertible is 91 percent of face value, and the price of the common is $41.50. Assume that the value of the bond in the absence of a conversion feature is about 65 percent of face value.

a.What is the conversion ratio of the debenture?

b.If the conversion ratio were 50, what would be the conversion price?

c.What is the conversion value?

d.At what stock price is the conversion value equal to the bond value?

e.Can the market price be less than the conversion value?

f.How much is the convertible holder paying for the option to buy one share of common stock?

g.By how much does the common have to rise by 2008 to justify conversion?

h.When should Maple call the debenture?

5.a. Pi, Inc., has 30 million shares outstanding and has a net income of $210 million. Calculate Pi’s earnings per share.

b.Pi has also issued $50 million of 5 percent convertible bonds with a face value of $1,000 each and a conversion ratio of 3.142. How will earnings per share change if the bonds are converted?

6.True or false?

a.Convertible bonds are usually senior claims on the firm.

b.The higher the conversion ratio, the more valuable the convertible.

2.Here is a question about dilution. The Electric Bassoon Company has outstanding 2,000 shares with a total market value of $20,000 plus 1,000 warrants with a total market value of $5,000. Each warrant gives its holder the option to buy one share at $20.

a.To value the warrants, you first need to value a call option on an alternative share. How might you calculate its standard deviation?

b.Suppose that the value of a call option on this alternative share was $6. Calculate whether the Electric Bassoon warrants were undervalued or overvalued.

3.This question illustrates that when there is scope for the firm to vary its risk, lenders may be more prepared to lend if they are offered a piece of the action through the issue of a convertible bond.

Ms. Blavatsky is proposing to form a new start-up firm with initial assets of $10 million. She can invest this money in one of two projects. Each has the same expected payoff, but one has more risk than the other. The relatively safe project offers a 40 percent chance of a $12.5 million payoff and a 60 percent chance of an $8 million payoff. The risky project offers a 40 percent chance of a $20 million payoff and a 60 percent chance of a $5 million payoff.

Ms. Blavatsky initially proposes to finance the firm by an issue of straight debt with a promised payoff of $7 million. Ms. Blavatsky will receive any remaining payoff. Show the possible payoffs to the lender and to Ms. Blavatsky if (a) she chooses the safe project and (b) she chooses the risky project. Which project is Ms. Blavatsky likely to choose? Which will the lender want her to choose?

Suppose now that Ms. Blavatsky offers to make the debt convertible into 50 percent of the value of the firm. Show that in this case the lender receives the same expected payoff from the two projects.

4.Occasionally it is said that issuing convertible bonds is better than issuing stock when the firm’s shares are undervalued. Suppose that the financial manager of the Butternut Furniture Company does have inside information indicating that the Butternut stock price is too low. Butternut’s future earnings will in fact be higher than investors expect. Suppose further that the inside information cannot be released without giving away a valuable competitive secret. Clearly, selling shares at the present low price would harm Butternut’s existing shareholders. Will they also lose if convertible bonds are issued? If they do lose in this case, is the loss more or less than it would be if common stock were issued?

Now suppose that investors forecast earnings accurately, but still undervalue the stock because they overestimate Butternut’s actual business risk. Does this change your answers to the questions posed in the preceding paragraph? Explain.

MINI-CASE

The Shocking Demise of Mr. Thorndike

It was one of Morse’s most puzzling cases. That morning Rupert Thorndike, the autocratic CEO of Thorndike Oil, was found dead in a pool of blood on his bedroom floor. He had been shot through the head, but the door and windows were bolted on the inside and there was no sign of the murder weapon.

Morse looked in vain for clues in Thorndike’s office. He had to take another tack. He decided to investigate the financial circumstances surrounding Thorndike’s demise.

The company’s capital structure was as follows:

•Debt: $200 million face value. The bonds had a coupon of 5 percent, matured in 10 years, and offered a yield of 12 percent (the risk-free interest rate was 6 percent).