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    Valuation Concepts Module 12 PDF

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    Jisselle Marie Custodio
    This document provides a detailed learning module on convertibles, exchangeable bonds, and warrants. [1] It defines these types of options and discusses their key features and valuation. [2] Convertibles provide the holder a fixed return and option to exchange for common stock, making them attractive long-term financing. [3] Exchangeables allow exchange for another company's stock, providing potential diversification benefits. Warrants are used as "sweeteners" to obtain better financing terms.

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    Valuation Concepts Module 12 PDF

    Uploaded by

    Jisselle Marie Custodio
    184 views4 pages
    This document provides a detailed learning module on convertibles, exchangeable bonds, and warrants. [1] It defines these types of options and discusses their key features and valuation. [2] Convertibles provide the holder a fixed return and option to exchange for common stock, making them attractive long-term financing. [3] Exchangeables allow exchange for another company's stock, providing potential diversification benefits. Warrants are used as "sweeteners" to obtain better financing terms.

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    This document provides a detailed learning module on convertibles, exchangeable bonds, and warrants. [1] It defines these types of options and discusses their key features and valuation. [2] Convertibles provide the holder a fixed return and option to exchange for common stock, making them attractive long-term financing. [3] Exchangeables allow exchange for another company's stock, providing potential diversification benefits. Warrants are used as "sweeteners" to obtain better financing terms.

    Copyright:

    © All Rights Reserved
    Download as PDF, TXT or read online from Scribd
    Download as pdf or txt
    184 views4 pages

    Valuation Concepts Module 12 PDF

    Uploaded by

    Jisselle Marie Custodio
    This document provides a detailed learning module on convertibles, exchangeable bonds, and warrants. [1] It defines these types of options and discusses their key features and valuation. [2] Convertibles provide the holder a fixed return and option to exchange for common stock, making them attractive long-term financing. [3] Exchangeables allow exchange for another company's stock, providing potential diversification benefits. Warrants are used as "sweeteners" to obtain better financing terms.

    Copyright:

    © All Rights Reserved
    Download as PDF, TXT or read online from Scribd
    Download as pdf or txt
    of 4

    GORDON COLLEGE

    College of Business and Accountancy


    Olongapo City

    ACC113 – Valuation Concepts and Method


    DETAILED LEARNING MODULE

    Title: Convertibles, Exchangeable and Warrants


    Module No: 11

    I. Introduction
    This module includes discussion on options and its three common types. Centered on relating
    option features to firms financing needs, this modules discusses terms and other related topics
    on options.

    II. Learning Objectives


    After studying this module, you should be able to:
    A. Describe the features of three common types of options that may be used by firms in their
    financing – the convertible security, the exchangeable bond, and the warrant.
    B. Understand why securities with option features may be attractive for a firm’s long-term
    financing needs.
    C. Explain the different terms used to express value for convertible securities – conversion
    value, market value, and straight-bond value.
    D. Calculate the value of convertible securities, exchangeable bonds, and warrants, and
    explain why premiums over different values occur.
    E. Understand the relationship between an option instrument and its underlying security.

    III. Topics and Key Concepts

    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.
    o Straight debt or equity cannot be exchanged for another asset, but options are
    exchangeable.
    o An option is part of the broader category of derivative securities.

    Convertible Security – A bond or a preferred stock that is convertible into a specified number
    of shares of common stock at the option of the holder.
    o This provides the convertible holder a fixed return (interest or dividend) and the option
    to exchange a bond or preferred stock for common stock.
    o 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.
    o 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.
    o 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.
    Illustration: ABC 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

    o Antidilution and the Convertible Security


    ▪ Conversion terms are not necessarily constant over time.
    ▪ The conversion price is usually adjusted for any stock splits or stock dividends
    to protect the convertible bondholder from antidilution (known as the
    antidilution clause).
    o 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.

    Illustration: If the market value per share of common stock in ABC were trading at $42
    per share, then the conversion value is: 3.33 shares x $42 = $140 per share of preferred
    stock

    o Premium Over Conversion Value – The market price of a convertible security minus
    its conversion value; also called conversion premium.

    Illustration: If the market value per share of preferred stock in ABC were trading at
    $154 per share, then the conversion premium is: $154 – $140 = $14 premium per share
    of preferred stock (or a 10% premium).

    o Other Issues with Convertible Securities


    ▪ Virtually all convertible securities provide for a call 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.
    ▪ The potential dilution effect is recognized by investors who evaluate earnings
    based on a diluted earnings per share.

    o Use of Convertible Securities


    ▪ In many cases, convertible securities are employed as “deferred” common
    stock financing.
    • Does not immediately dilute earnings.
    • Securities are converted at a higher price than if they would have been
    directly issued. This has the impact of reducing the dilution effect.
    ▪ The interest or dividend rate is likely to be less than that of straight debt or
    preferred stock. The greater the growth prospects of the firm’s common stock,
    the lower the stated rate the firm will need to pay.

    o 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.
    ▪ The company has an incentive to call only when the conversion price exceeds
    the call price by around 15% and when the common dividend rate is less than
    the interest or preferred. dividend rate investors are earning.
    ▪ Firms attempt to stimulate conversion by including the “step-up” feature to the
    conversion price or increasing the common dividend.

    o Convertible Value
    ▪ Convertible Bond Value = Straight Bond Value + Option Value
    ▪ Volatility in cash flows of firm
    • Decreases straight bond value
    • Increases option value
    ▪ Suggests that convertibles are useful when a company’s future is highly
    uncertain

    o Straight Bond Value


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

    Exchangeable Bond - A bond that allows the holder to exchange the security for common stock
    of another company – generally, one in which the bond issuer has an ownership interest.
    o These issues usually occur when the issuer owns common stock in the company in
    which the bonds can be exchanged.
    o Exchange requests are satisfied either by open market purchases or directly using the
    firm’s investment holdings of the other company’s stock.
    o 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.

    Warrants - A relatively long-term option to purchase common stock at a specified exercise


    price over a specified period of time.
    o 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.
    o The warrant contains provisions for:
    ▪ the number of shares that can be purchased per warrant.
    ▪ the price at which the warrant can be exercised.
    ▪ the warrant expiration date.
    o Warrant holders are not entitled to any dividends nor do they have any voting power.
    o The exercise price is generally adjusted for any common stock dividends and splits.

    IV. Activity. What is the importance of learning features such as conversion features,
    exchangeability feature and warrants? Present your answer in the point of view of both lender
    and borrower.

    V. Teaching and Learning Materials and Resources


    A. Fundamentals of Financial Management 13th Edition by Van Horne and Wachowicz
    B. Laptop and Web Camera
    C. Google Meet/Zoom
    D. Google Quiz

    VI. Learning Tasks


    A. Readings on Term Loans and Leases
    B. Attendance and participation on webinar-style discussion

    VII. References
    A. Van Horne and Wachowicz (2009). Fundamentals of Financial Management 13th Edition.
    Pearson Education Limited.

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