Question

When issuing convertible bonds or bonds with warrants attached, the company can change the exercise price of the (embedded) warrants. If it increases the exercise price, will the cost of debt go up or down? Explain the effect step by step, thus what happens to the Time Value Premium if it increases the exercise price, then explain the impact of the Time Value Premium on…, etc.

Answer 1

1. When a warrant is issued by the company, and when a warrant is exercised, the number of shares increases. A call option is a contract between investors and does not affect the number of shares of the firm.
2. a.
If the stock price is less than the exercise price of the warrant at expiration, the warrant is worthless. Prior to expiration, however, the warrant will have value as long as there is some probability that the stock price will rise above the exercise price in the time remaining until expiration. Therefore, if the stock price is below the exercise price of the warrant, the lower bound on the price of the warrant is zero.
b. If the stock price is above the exercise price of the warrant, the warrant must be worth at least the difference between these two prices. If warrants were selling for less than the difference between the current stock price and the exercise price, an investor could earn an arbitrage profit (i.e. an immediate cash inflow) by purchasing warrants, exercising them immediately, and selling the stock.
c. If the warrant is selling for more than the stock, it would be cheaper to purchase the stock than to purchase the warrant, which gives its owner the right to buy the stock. Therefore, an upper bound on the price of any warrant is the firm’s current stock price.
3. An increase in the stock price volatility increases the bond price. If the stock price becomes more volatile, the conversion option on the stock becomes more valuable.
4. The two components of the value of a convertible bond are the straight bond value and the option value. An increase in interest rates decreases the straight value component of the convertible bond. Conversely, an increase in interest rates increases the value of the equity call option. Generally, the effect on the straight bond value will be much greater, so we would expect the bond value to fall, although not as much as the decrease in a comparable straight bond.
5. When warrants are exercised, however, the number of shares outstanding increases. This results in the value of the firm being spread out over a larger number of shares, often leading to a decrease in value of each individual share. The decrease in the per-share price of a company’s stock due to a greater number of shares outstanding is known as dilution.
6. In an efficient capital market the difference between the market value of a convertible bond and the value of straight bond is the fair price investors pay for the call option that the convertible or the warrant provides.
7. There are three potential reasons: 1) To match cash flows, that is, they issue securities whose cash flows match those of the firm. 2) To bypass assessing the risk of the company (risk synergy). For example, the risk of company start-ups is hard to evaluate. 3) To reduce agency costs associated with raising money by providing a package that reduces bondholder-stockholder conflicts.8. Because the holder of the convertible has the option to wait and perhaps do better than what is implied by current stock prices.
9. Theoretically conversion should be forced as soon as the conversion value reaches the call price because other conversion policies will reduce shareholder value. If conversion is forced when conversion values are above the call price, bondholders will be allowed to exchange less valuable bonds for more valuable common stock. In the opposite situation, shareholders are giving bondholders the excess value.
10. No, the market price of the warrant will not equal zero. Since there is a chance that the market price of the stock will rise above the $21 per share exercise price before expiration, the warrant still has some value. Its market price will be greater than zero. As a practical matter, warrants that are far out- of-the-money may sell at 0, due to transaction costs.