Question

Emerson Electrical Engineering Inc. is issuing new 20-year bonds that have warrants attached. If not for the attached warrants, the bond would carry an 11% interest rate. However, with the warrants attached the bonds will pay a 9% annual coupon. There are 25 warrants attached to each bond, which have a par value of $1000. The exercise price of the warrants is $25 and the expected stock price 10years from now (when the warrants may be exercised) is $50.77.

a) What is the investor's expected overall pre-tax rate of return for this bond-with-warrants issue?

b) The CEO of Emerson is wondering the possibility of replacing the bonds with warrants by convertible bonds. As the CFO for the company, please state your suggestions and explain.

Answer 1

a). Par value = 1,000; coupon rate = 9%; coupon = 9%*1,000 = 90 (assuming annual payment)

If warrant is exercised then the investors will gain 50.77 - 25 = 25.77 per warrant.

Total gain = 25.77*25 = 644.25

So, in year 10 if the warrants are exercised, the investors will get $644.25 in addition to that year's coupon payment.

The investor's pre-tax rate of return can be found using the bond cash flows and IRR function, as follows:

Time (n)	Cash flow (CF)
0	-1000
1	90
2	90
3	90
4	90
5	90
6	90
7	90
8	90
9	90
10	734.25
11	90
12	90
13	90
14	90
15	90
16	90
17	90
18	90
19	90
20	1090
IRR	11.79%

Investor's pre-tax rate of return for the bond = 11.79%

b). The decision of replacing bonds with warrants by convertible bonds depends on the kind of funding/capital structure and dilution, the company is looking at. Convertible bonds when converted into equity replaces debt with equity whereas bonds with warrants if converted bring in new equity while debt remains intact. Also, flotation costs associated with bonds with warrants are higher than with convertible bonds. So, if the company is interested in raising funds via debt then bonds with warrants would be better.