Warrent and Convertible

WARRANTS AND CONVERTIBLES

Warrants

A warrant is a long-term option issued by a company which gives the holder the right to purchase a specific number of shares of common stock at a stated price during a specified time period. The stated price is called exercise price and the final date on which warrant can be used is called expiration date. Similarly, number of shares that can be purchased using a warrant is known as exercise ratio. Generally, warrants are issued along with bond or preferred stock. They are used to induce investors to buy a firm's long-term debt and preferred stock at a lower rate than otherwise would be required. In other words, warrants are often used as "sweetener" to make the company easier to sell the associated security.  Warrants also help to reduce flotation costs. [pic 1]

Warrant holders may buy the stated number of shares for exercise price. This activity of firm is called exercise of warrant. There are three conditions which encourage holder to exercise their warrants:

1.         Warrant holders will exercise the warrant and buy the stock if the warrants are about to expire and market price of the stock is above the exercise price. This means that if a firm wants its warrants exercised soon in order to raise capital, it should set a relatively short expiration date. But company should ensure that price of stock during the period exceeds the exercise price.

2.         Warrant holders will tend to exercise voluntarily and buy the stock if the company raises the dividend on the common stock by a sufficient amount. Because no dividend is paid on the warrant, it provides no current income. However, if the common stock pays a high dividend, it provides an attractive dividend yield which motivates the holder to exercise the warrant.

3.        In general, exercise price remains the same throughout the warrant period. But sometimes, exercise price may increase after a designated date. Such exercise price is called stepped-up exercise price. In such a case, warrant holders exercise their warrants before the time when stepped-up price takes effect. For example, Delta Company has warrants outstanding with an exercise price of Rs 20 until December 31, 2009, at which time exercise price will rise to Rs 25. If the price of common stock is over Rs 20 just before December 31, 2009, many warrant holders will exercise their options before the steeped-up price takes effect.

Features of Warrants

Some important features of warrant are as follows:

Exercise price (E): It is the price at which shares can be purchased using warrant. The warrant exercise price, generally, is set at 10 percent to 30 percent above the prevailing market price of the common stock on the date the bond is issued. For example, if the stock sells for Rs 200, the exercise price will probably be set in the Rs 220 to Rs 260 range. In some cases, there can also be step-up exercise price, where the warrant's exercise price changes over time.[pic 2]

Exercise ratio (#): Exercise ratio is the number of shares each warrant entitles the holder to purchase. If the exercise ratio on a warrant were 4, one warrant would entitle its owner to purchase 4 shares of common stock at its exercise price.

Expiration date: Although some warrants are issued without specified expiration date, most warrants are set to expire after specific number of years. [pic 3]

Detachability: Warrant may be detachable or non-detachable from the security they accompany. But most of the warrants are detachable warrants. A detachable warrant can be detached and traded separately from the security, whereas non-detachable warrant cannot be separated from the security to which it is attached.

Right to claim on income and assets: Since a warrant is an option to buy common stock, it does not carry the rights of common stockholders until it is exercised. Thus, warrant holders cannot claim on cash dividends paid and on the assets at the time of liquidation of the firm. Further, warrants do not have voting power.

Reporting requirement: For accounting reporting purposes, a company with warrants outstanding is required to report the number of warrant outstanding and earnings per share in such a way that those who read the financial statement can visualize the potential dilution. More specifically, it must report primary earnings per share and diluted earnings per share. Primary earnings per share are based on only outstanding common stock. But a diluted earnings per share is calculated as if all potentially dilutive securities were converted or exercised.

Reasons for Issuing Warrants

1.        Warrant attached to debt offerings provide a feature whereby investors can participate in capital gains. Hence, demand for the security with warrant can be increased. In other words, warrant can be used as "sweetener".

2.        Warrant increases the marketability of the security to which it is attached. Thus, it helps to reduce coupon interest and flotation costs.

3.        Warrant can permit a company to sell common stock at a price above the price prevailing at the time of original issue.

4.        Warrant ensures regular cash in flows in future. When market price of a common stock exceeds exercise price, warrant holders start to exercise their warrant and purchase new shares.

5.        Warrants also allow a company to sell common stock in the future without incurring significant issuance costs at the time of sale.

Valuation of Warrants

Since a warrant is an option to purchase a specified number of shares of stock at a specified price within the stipulated time, value of warrants primarily depends upon common stock price. Warrants have two types of values: Theoretical value (or formula value) and actual market value. Theoretical market value of warrants can be determined by the equation:

TVw = max [(P0 − E) #, 0]         ... (6.1)

Where,

TVw         = theoretical value of a warrant

P0         = current market price of the stock

E         = exercise price per share

#         = exercise ratio

max         = maximum

At the time of issue, a warrant's exercise price is normally greater than the common stock price. Even though the calculated formula value or theoretical value may be negative, it is considered to be zero because in such a case warrant holders do not exercise the warrant. Considering this fact, equation 6.1 can be rearranged as