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When issuing convertible bonds or bonds with warrants attached, the company can change the exercise price...

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.

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Expert Solution

Convertible bonds has an embedded right with the investor to convert the bond in fixed number of shares at a certain time. Warrant gives a right to the investor to subscribe to the shares of the company at a given price on a specified date.

Hence it gives an additional benefit to the investor to enjoy the upside in the value of the shares.

Due to additional benefit with investor, issuer may issue bonds at premium. Issuing bonds at premium helps the issuer in receive higher funds from the investor. For Eg Issuer may issue Rs,. 100 bond 11% coupon at 110 price. Hence effective cost to the issuer = 110/11 ie 10%. The cost of debt has effectively gone down.

When the bond is issued the price of the bond will trade at 110. Post which, if the share price of the company increases, premium on bond also moves upwards. However, if the share price goes deep out of the money, hence convertible bond will start to trade like straight bond with no value to the embedded option.

The similar effect is on the warrant to the change in the price of the shares.  

jeff jeffy answered 1 year ago
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