Question

Please read CA 16-3 (Stock Warrants - Various types) in the end of chapter materials of the e Text and answer questions 1, 2 & 3. Post your answer and respond to at least two of your classmates.

A copy of CA 16-3:

For various reasons a corporation may issue warrants to purchase shares of its common stock at specified prices that, depending on the circumstances, may be less than, equal to, or greater than the current market price. For example, warrants may be issued:

• 1.To existing stockholders on a pro rata basis.
• 2.To certain key employees under an incentive stock-option plan.
• 3.To purchasers of the corporation's bonds.

Instructions

(a)  For each of the three examples of how stock warrants are used:

• (a)Explain why they are used.
• (b)Discuss the significance of the price (or prices) at which the warrants are issued (or granted) in relation to (1) the current market price of the company's stock, and (2) the length of time over which they can be exercised.
• (c)

  Describe the information that should be disclosed in financial statements, or notes thereto, that are prepared when stock warrants are outstanding in the hands of the three groups listed above.

  (AICPA adapted)

Answer 1

(a)

    1.     The objective of issuing warrants to existing shareholders on a pro-rata basis is to raise new equity capital. This method of raising equity capital may be used because of preemptive rights on the part of a company's shareholders and also because it is likely to be less expensive than a public offering.

    2.     The purpose of issuing share warrants to certain key employees, usually in the form of a non-qualified share option plan, is to increase their interest in the long-term growth and income of the company and to attract new management talent. Also, this issuance of share warrants to key employees under a share-option plan frequently constitutes an important element in a company's executive compensation program. Though such plans result in some dilution of the shareholders' equity when shares are issued, the plans provide an additional incentive to the key employees to operate the company efficiently.

    3.     Warrants to purchase its ordinary shares may be issued to purchasers of a company's bonds in order to stimulate the sale of the bonds by increasing their speculative appeal and aiding in overcoming the objection that rising price levels cause money invested for long periods in bonds to lose purchasing power. The use of warrants in this connection may also permit the sale of the bonds at a lower interest cost.

(b)

    1.     Because the purpose of issuing warrants to existing shareholders is to raise new equity capital, the price specified in the warrants must be sufficiently below the current market price to reasonably assure that they will be exercised. Because the success of the offering depends entirely on the current market price of the company's shares in relation to the exercise price of the warrants, and because the objective is to raise capital, the length of time over which the warrants can be exercised is very short, frequently 60 days.

    2.     Warrants may be offered to key employees below, at, or above the market price of the shares on the day the rights are granted except for incentive share-option plans. If a share-option plan is to provide a strong incentive, warrants that can be exercised shortly after they are granted and expire, say, within two or three years, usually must be exercisable at or near the market price at the date of the grant. Warrants that cannot be exercised for a number of years after they are granted or those that do not lapse for a number of years after they become exercisable may, however, be priced somewhat above the market price of the shares at the date of the grant without eliminating the incentive feature. This does not upset the principal objective of share option plans, heightening the interest of key employees in the long-term success of the company.

    3.     Income tax laws impose no restrictions on the exercise price of warrants issued to purchasers of a company's bonds. The exercise price may be above, equal to, or below the current market price of the company's shares. The longer the period of time during which the warrant can be exercised, however, the higher the exercise price can be and still stimulate the sale of the bonds because of the increased speculation appeal. Thus, the significance of the length of time over which the warrants can be exercised depends largely on the exercise price (or prices). A low exercise price in combination with a short exercise period can be just as successful as a high exercise price in combination with a long exercise period.

(c)

    1.     Financial statement information concerning outstanding share warrants issued to a company's shareholders should include a description of the shares being offered for sale, the option price, the time period during which the rights may be exercised, and the number of rights needed to purchase a new share.

    2.     Financial statement information concerning share warrants issued to key employees should include the following: status of these plans at the end of each period presented, including the number of shares under option, options exercised and forfeited, the weighted average option prices for these categories, the weighted average fair value of options granted during the year, and the average remaining contractual life of the options outstanding.

    3.     Financial statement disclosure of outstanding share warrants that have been issued to purchasers of a company's bonds should include the prices at which they can be exercised, the length of time they can be exercised, and the total number of shares that can be purchased by the bondholders.