17.4 Stock Purchase Warrants

LG 5 17.4 Stock Purchase Warrants

Stock purchase warrants are similar to stock rights, which were briefly described stock purchase warrants

in Chapter 7. Stock purchase warrants give their holders the right to purchase a

Instruments that give their

certain number of shares of the issuer’s common stock at a specified price over a

holders the right to purchase a

certain period of time. (Of course, holders of warrants earn no income until the certain number of shares of the warrants are exercised or sold.) Warrants also bear some similarity to convert-

issuer’s common stock at a specified price over a certain

ibles in that they provide for the injection of additional equity capital into the

period of time.

firm at some future date. KEY CHARACTERISTICS

Warrants are often attached to debt issues as “sweeteners.” When a firm makes a large bond issue, the attachment of stock purchase warrants may add to the mar- ketability of the issue and lower the required interest rate. As sweeteners, war- rants are similar to conversion features. Often, when a new firm is raising its initial capital, suppliers of debt will require warrants to permit them to share in whatever success the firm achieves. In addition, established companies sometimes offer warrants with debt to compensate for risk and thereby lower the interest rate and/or provide for fewer restrictive covenants.

exercise (or option) price

Exercise Prices

The price at which holders of warrants can purchase a

The price at which holders of warrants can purchase a specified number of shares

specified number of shares of

of common stock is normally referred to as the exercise (or option) price. This

PART 8

Special Topics in Managerial Finance

at the time of issuance. Until the market price of the stock exceeds the exercise price, holders of warrants will not exercise them because they can purchase the stock more inexpensively in the marketplace.

Warrants normally have a life of no more than 10 years, although some have infinite lives. Unlike convertible securities, warrants cannot be called, but their limited life stimulates holders to exercise their warrants when the exercise price is below the market price of the firm’s stock.

Warrant Trading

A warrant is usually detachable, which means that the bondholder may sell the warrant without selling the security to which it is attached. Many detachable warrants are actively traded in both broker and dealer markets. Many actively traded warrants are listed on the American Stock Exchange. Warrants often pro- vide investors with better opportunities for gain (with increased risk) than the underlying common stock.

Comparison of Warrants to Rights and Convertibles The similarity between a warrant and a right should be clear. Both result in new

equity capital, although the warrant provides for deferred equity financing. The life of a right is typically not more than a few months; a warrant is generally exer- cisable for a period of years. Rights are issued at a subscription price below the prevailing market price of the stock; warrants are generally issued at an exercise price 10 to 20 percent above the prevailing market price.

Warrants and convertibles also have similarities. The exercise of a warrant shifts the firm’s capital structure to a less highly leveraged position because new common stock is issued without any change in debt. If a convertible bond were converted, the reduction in leverage would be even more pronounced because common stock would be issued in exchange for a reduction in debt. In addition, the exercise of a warrant provides an influx of new capital; with convertibles, the new capital is raised when the securities are originally issued rather than when they are converted. The influx of new equity capital resulting from the exercise of

a warrant does not occur until the firm has achieved a certain degree of success that is reflected in an increased price for its stock. In this case, the firm conve- niently obtains needed funds.

IMPLIED PRICE OF AN ATTACHED WARRANT implied price of a warrant

When warrants are attached to a bond, the implied price of a warrant—the price

The price effectively paid for

that is effectively paid for each attached warrant—can be found by first using

each warrant attached to a

Equation 17.1:

bond.

Implied price of = Price of bond with -

Straight bond value

all warrants

warrants attached

The straight bond value is found in a fashion similar to that used in valuing con- vertible bonds. Dividing the implied price of all warrants by the number of war-

rants attached to each bond results in the implied price of each warrant.

695 Example 17.9 3 Martin Marine Products, a manufacturer of marine drive shafts and propellers,

CHAPTER 17

Hybrid and Derivative Securities

just issued a 10.5%-coupon-interest-rate, $1,000-par, 20-year bond paying annual interest and having 20 warrants attached for the purchase of the firm’s stock. The bonds were initially sold for their $1,000 par value. When issued, similar- risk straight bonds were selling to yield a 12% rate of return. The straight value of the bond would be the present value of its payments discounted at the 12% yield on similar-risk straight bonds:

Year(s)

Payments

Present value

Straight bond value $887.96 a $1,000 at 10.5% = $105 interest per year.

Substituting the $1,000 price of the bond with warrants attached and the $887.96 straight bond value into Equation 17.1, we get an implied price of all warrants of $112.04:

Implied price of all warrants = $1,000 - $887.96 = $112.04 Dividing the implied price of all warrants by the number of warrants attached to

each bond—20 in this case—we find the implied price of each warrant: Implied price of each warrant = $112.04 , 20 = $5.60 Therefore, by purchasing Martin Marine Products’ bond with warrants attached

for $1,000, one is effectively paying $5.60 for each warrant.

The implied price of each warrant is meaningful only when compared to the specific features of the warrant—the number of shares that can be purchased and the specified exercise price. These features can be analyzed in light of the pre- vailing common stock price to estimate the true market value of each warrant. Clearly, if the implied price is above the estimated market value, the price of the bond with warrants attached may be too high. If the implied price is below the estimated market value, the bond may be quite attractive. Firms must therefore price their bonds with warrants attached in a way that causes the implied price of its warrants to fall slightly below their estimated market value. Such an approach allows the firm to sell the bonds more easily at a lower coupon interest rate than would apply to straight debt, thereby reducing its debt service costs.