Topic 3 Optional Financing

By Micheal West,2014-06-13 20:00
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Topic 3 Optional Financing



     Chpt 3: Optional Financing

     Option Financing: Derivative Securities

     ÆÚÈ?ÈÚ×Ê: ÆÚÈ?ÈÚ×Ê: ÑÜÉú?ðÈÚ???ß

     Learning Objectives

     ? ? ? ? Convertible Securities Use of Convertibles Value of Convertible Securities Exchangeable Bonds Warrants

     Option Financing

     Types of options used in corporate financing ?Factors that influence the value of the option

     Derivative Security

     Derivative Security -- A financial contract whose value derives in part from the value and characteristics of one or more underlying assets (e.g., securities, commodities), interest rates, exchange rates, or indices.

     Straight debt or equity cannot be exchanged for another asset, but options are exchangeable. ? An option is part of the broader category of derivative securities. ? We examine the convertible security, exchangeable bond, and warrant in this topic.

     Convertible Security

     Convertible Security (?Éת??Ö?È??? -- A bond (?Éת??Ö?È? ?Éת??Ö?È??? or a preferred stock that is convertible into a specified number of shares of common stock at the option of the holder.

     This provides the convertible holder a fixed return (interest or dividend) and the option to exchange a bond or preferred stock for common stock. ? The option allows the company to sell convertible securities at a lower yield than it would have to pay on a straight bond or preferred stock issue.

     Convertible Security

     Conversion Price -- The price per share at which common stock will be exchanged for a convertible security. It is equal to the face value of the convertible security divided by the conversion ratio ratio. Conversion Ratio -- The number of shares of common stock into which a convertible security can be converted. It is equal to the face value of the convertible security divided by the conversion price.

     Conversion Example

     FunFinMan, Inc., has an issue of 8%, $100 par value preferred stock outstanding. The security has a conversion price of $30 per share. What is the conversion ratio?

     Conversion Ratio $100 par value / $30 conversion price = 3.33 shares =

     Antidilution and the Convertible Security

     Conversion terms are not necessarily constant over time.

     ?C Example: The conversion price on 20-year convertible-debt might ??step-up?? over time from $30 during the first 5 years, $35 the next 5 years, and $40 for the remaining 10 years until maturity.

     The conversion price is usually adjusted for any stock splits or stock dividends to protect the convertible bondholder from dilution (known as the antidilution clause clause).

     Conversion Value

     Conversion Value -- The value of the convertible security in terms of the common stock into which the security can be converted. It is equal to the conversion ratio times the current market price per share of the common stock.

     For example, if the market value per share of common stock in FunFinMan, Inc., were trading at $42 per share share, then the conversion value is: 3.33 shares x $42 = $140 per share of preferred stock

     Premium Over Conversion Value

     Premium Over Conversion Value (??ת???Û (??ת???Û ÖµÒç?Û?? ÖµÒç?Û??-- The market price of a convertible security minus its conversion value; also called conversion premium.

     For example, if the market value per share of preferred stock in FunFinMan, Inc., were trading at $154 per share then the conversion premium is: share, $154 - $140 = $14 premium per share of preferred stock (or a 10% premium).

     Other Issues with Convertible Securities

     Virtually all convertible securities provide for a call price, price which allows the company to force conversion when the security market value is significantly above the call price. ? Almost all convertible bond issues are subordinated to other creditors, which allows a lender to treat convertibles as a part of the equity base when evaluating the financial condition of the issuer. In the event of liquidation, it makes no difference to the creditor if the issue is actually converted. In either case, the lender has a prior claim.

     Other Issues with Convertible Securities

     Investors in a company??s common stock tend to recognize the potential dilution in their position before actual conversion takes place ?C they evaluate earnings based on a diluted earnings per share share. ? For accounting reporting purpose, a company with convertible securities or warrants outstanding is required to report EPS in such a way that the reader of the financial statement can visualize the potential dilution. More specifically, it must report EPS on two bases: 1)the basic EPS and 2) the diluted EPS where EPS is calculated as if all potential dilutive securities were converted or exercised.

     Use of Convertible Securities


     In many cases, convertible securities are employed as ??deferred?? common stock financing. ?C By selling a convertible security instead of common stock, companies create less dilution in earnings per share, both now and in the future. ?C The reason is that the conversion price on a convertible security is higher than the issuing price on a new issue of common stock.

     Use of Convertible Securities

     Financing cost

     ?C The interest or dividend rate is likely to be less than that of straight debt or preferred stock. ?C The greater the growth prospects of the firm??s common stock, the lower the stated rate the firm will need to pay.

     Agency problems

     ?C When agency problem exists, straight debt holders are concerned about company actions that might result in wealth expropriation in favor of the equity holders. ?C The convertible bond mitigates this problem by giving the lenders a potential equity stake.

     Forcing or Stimulating Conversion

     Investors can exercise their option to convert to common stock at any time. ? Companies can force conversion by calling the issue.

     ?C If the call is to succeed, the conversion value must be significant higher (15%) than the call price so that the investor will convert rather than accept the lower call price. ?C In the opposite situation, the company would then have to redeem many of the bonds for cash, in part defeating the purpose of the original financing.

     Forcing or Stimulating Conversion

     Firms attempt to stimulate conversion by including the ??step-up?? feature to the conversion ??stepprice or increasing the common dividend.

     ?C By establishing an acceleration or ??step-up?? in the ??stepconversion price at steady intervals in the future, the company places persistent pressure on bondholders to convert, assuming that the conversion value of the security is relatively high. ?C Another means for stimulating conversion is to increase the dividend on the common stock, thereby making the common stock more attractive.

     Forcing or Stimulating Conversion

     Problem of overhanging

     ?C Occurs when the company fails to stimulating conversion due to the insufficient increment of the market price of it??s common stock since the convertible issuance. ?C Result in the deduction of the company??s finance flexibility.

     Convertible Value

     Convertible Bond Value = Straight Bond Value + Option Value

     Volatility in cash flows of firm

     ?CDecreases straight bond value ?CIncreases option value

     Suggests that convertibles are useful when a company??s future is highly uncertain

     Straight Bond Value

     The value of a nonconvertible bond with the same coupon rate, maturity, and default risk as the convertible bond.

     VSB =


     (1 + i/2)1



     (1 + i/2)2

     + ???? +


     (1 + i/2) 2*n


     2*n n



     (1 + i/2)t



     (1 + i/2)2*n

     i/2, n)

     = (I / 2)(PVIFA i/2, n) + F (PVIF

     Straight Bond Value of the Convertible

     Company C has a convertible debenture outstanding that provides an 8% coupon (interest is paid semiannually) and continues exactly 20 years until final maturity. A similar nonconvertible bond will currently provide a 5% semiannual yield to maturity What is the straight bond value of maturity. Company C??s convertible bond?


     = $40 (PVIFA5%, 20x2) + $1,000 (PVIF5%, 20x2) = $40 (17.159) + $1,000 (.142) = $686.36 + $142 = $828.36

     Why Care About ??Straight Bond Value???

     ? The convertible bond value equals straight bond value plus conversion option value value. The $828.36 represents a floor (minimum) below which the convertible value will not fall. This occurs when the conversion option value is essentially worthless. The straight bond value is subject to change as interest rates, firm risk, and time change. This, in turn, is likely to impact the convertible bond value.

     Relationships Among Premiums

     The leftmost portion of the graph represents a firm that is in

    financial distress. ? The stronger the financial health of the firm the greater the straight bond value until it reaches a ceiling level.

     Conversion value line

     Value of Convertible Security

     Market value of Convertible security


     Straight bond value

     Market Value of Common Stock

     Relationships Among Premiums -- Summary

     A convertible security offers holders partial protection on the downside (similar to the straight bond) based on the going-concern and liquidation values of the firm. ? A convertible security also provides holders with the ability to participate in the upward movement in common stock prices. ? The greater the volatility of common stock price, the greater the potential gain and the more valuable the option.

     Exchangeable Bond

     Exchangeable Bond(?É????Õ?È?) -- A bond that Bond(?É????Õ?È? ?É????Õ?È?) allows the holder to exchange the security for common stock of another company -generally, one in which the bond issuer has an ownership interest.

     These issues usually occur when the issuer owns common stock in the company in which the bonds can be exchanged. ? Exchange requests are satisfied either by open market purchases or directly using the firm??s investment holdings of the other company??s stock.

     Valuation of an Exchangeable

     Investors may realize diversification benefits since the bond and the common stock are from different companies. Potentially, diversification leads to a higher valuation for the exchangeable versus the convertible. A major disadvantage is that the difference between the cost of the bond and the market value of the exchanged common stock, at the time of exchange, is treated as a capital gain. A convertible gain is not recognized until the common stock is sold.



     Warrant (ÈÏ?ÉÈ?Ö?)-- A relatively long-term (ÈÏ?ÉÈ?Ö? ÈÏ?ÉÈ?Ö?) option to purchase common stock at a specified exercise price over a specified period of time. Warrants are employed as ??sweeteners??: ? To obtain a lower interest rate. ? To raise funds when the firm is considered a marginal credit risk. ? To compensate underwriters and venture capitalists when founding a company.

     Warrant Features

     The warrant contains provisions for: for:

     ?C the number of shares that can be purchased per warrant. ?C the price at which the warrant can be exercised. ?C the warrant expiration


     Warrant holders are not entitled to any dividends nor do they have any voting power. ? The exercise price is generally adjusted for any common stock dividends and splits.

     Example of Exercise of Warrants

     FunFinMan, Inc., is currently financed entirely with common stock. The firm is composed of $10 million in common stock ($5 par value) and $20 million in retained earnings. The company is considering issuing $20 million of 8%, 20-year debentures including 1 warrant per bond that can be converted into 5 shares of common stock at an exercise price of $40 per share. How will this impact the capitalization of the firm?

     Example of Exercise of Warrants (in millions)

     Before After* Financing Financing $ 0 $ 10 0 20 $ 30 $ 30 10 0 20 $ 30 $ 50

     Debentures 20 Common stock ($5 par) Additional paid-in capital Retained earnings Shareholders?? equity Total Capitalization

     Example of Exercise of Warrants (in millions)

     Before After* Financing Exercise

     Debentures Common stock ($5 par) Additional paid-in capital Retained earnings Shareholders?? equity Total Capitalization

     $ 0 10 0 20 $ 30 $ 30

     $ 20 10.5 3.5 20 $ 34 $ 54

     Valuation of a Warrant

     Theoretical value of a warrant: max [ (N)(Ps) - E, 0] N P

     N = number of shares per warrant Ps = market price of one share of stock E = exercise price associated with the purchase of N shares

     Warrant Value

     Market value line

     Theoretical value line

     Exercise price

     Associated Common Stock Price

     Example of the Valuation of a Warrant

     Theoretical value of a warrant: max [ (N)(Ps) - E, 0] N P

     N = 1 Ps = $10 , E = $5 1, max[(1 $10)-$5 max 1)($10 $5, 0] = $5 N = 1 Ps = $15 , E = $5 1, max[(1 $15)-$5 max 1)($15 $5, 0] =$10 $10 Stock appreciates 50%

     Warrant Value

     Theoretical warrant value appreciates 100%


     Minimum value is 0.


     Associated Common Stock Price

     Summary of the Example of Warrant Valuation

     The market value of a warrant equals or exceeds the theoretical value

    of the warrant. ? The greater market value is generated by the unlimited upside potential of the stock price combined with the limited downside risk to the warrant holder (minimum value is 0). ? The greater the time to expiration, the greater the opportunity of the upside potential of the stock and the greater the market value of the warrant.

     Homework ?C Questions

     Q1 ? Suppose that you are the financial manager of a closely held (owned by few shareholders)small electronics firm. You have a favourable investment opportunity and are considering raising funds to finance it, using subordinated convertible debentures or straight bonds with warrants attached. Equity funds are not a possibility, as you feel the current stock price has been unnecessarily penalized for recent start-up expense and the firm??s high debt ratio (relative to the industry). If you expect additional large future funds requirements, which financing alternative would you adopt? Why?

     Homework ?C Questions

     Q2 ? Why does the market price of an option such as a warrant usually exceed its value as common stock? Q3 ? With respect to valuation, is the investor better off with an exchangeable bond or with a convertible bond?


     Suppose you have just bought a warrant that entitles you to purchase two shares of common stock for $45. The market price of the common stock is $26 per share, whereas the market price of the warrant is $10 in excess of its theoretical value. One year later the common stock has risen in price to $50 per share. The warrant now sells for $2 more than its theoretical value.

     a. What if the common stock paid $1 in dividends for the year, what is the return on investment in the common stock? b. What is the return on investment in the warrant? c. Why do the two rates of return differ?


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