Download Strategic Financial Management - Warrants - Notes - Finance and more Study notes Financial Management in PDF only on Docsity!
5.5 Warrants
A warrant is an option to purchase a specified number of shares at a specified price during or at the expiry of a specified period. So, a warrant gives the holder the right to purchase from the company a fixed number of shares in future at a pre-determined price. The holder of the warrant may be allowed to transfer or sell his right in the secondary market or to keep the right as an investment. The holder of a warrant can choose whether or not to exercise the option. If it is exercised, then the investor becomes a shareholder in the normal way. If it is not, then the warrant lapses. The investor who chooses to exercise the warrant sends the required amount of cash and warrants to the issuing company at an appropriate time. In return, the company issues shares. Although, warrants are not a major source of funds, their characteristics may help the company to attain the desired capital structure.
Warrants are generally issued with other securities (a bond or a preference share) in a package. Warrants may be attached to a debt issue to work as a sweetener and to add to the marketability of the issue. For companies that are marginal credit risks, the use of warrants may induce investors to purchase a debt issue that would otherwise be difficult or impossible to sell. During period of monetary restraint, even some financially sound companies may decide to use warrants to make their debt issue more attractive to investors. If a firm is a financially risky proposition, warrants may enable it to obtain debt or preference share capital financing. In case of a new firm, warrants may provide an opportunity to the debt holder or preference shareholders to share in the future success of the firm. As the initial capital is generally considered risky, it suppliers expect an opportunity to share in the rewards they hope will result from the use of the funds they supply.
The warrants, which generally originate by being attached to a new issue of debt securities, may be permanently attached to issue or may be detachable. A non- detachable warrant cannot be sold separately from the bond but can only be detached when the bondholder exercises his option and purchases shares. Detachable warrants may be sold separately from the bond consequently, the bondholder does not have to exercise his option in order to obtain value from the warrant. He may, if he wishes, simply sell the warrant in the market.
5.5.1 Warrants and convertible securities
A warrant is different from convertible securities (convertible debentures as well as convertible preference shares). A convertible security requires surrender of the security in
exchange for the equity shares. A warrant, on the other hand, requires a surrender of the warrant plus the payment of additional cash, called the option price or the exercise price, in order to obtain the equity shares. Warrants are
issued by a company to investors who may exercise them to buy the shares or may re-sell them to other investors.
A convertible security issue gives the holder the right to receive equity shares through the exchange of the convertible for the equity shares; the warrant entitles the security holder to purchase equity share at a specified price. Both securities provide the purchaser with the opportunity for a speculative gain if the company is successful and the market price of the equity share increases. However, despite the similarities between these two methods of raising new equity capital, they are not perfect substitutes for one another. It is, therefore, important for the financial administrator to know when it is preferable to issue debt plus warrants and when a convertible issue is the better course of action.
If the warrant is converted then the capital structure is shifted to a relatively lower leverage position because new equity capital is issued without any change in debts. If convertible securities are converted then the reduction in leverage would be more pronounced because new equity share would be issued with a reduction in debt. Therefore, the warrant conversion reduces the leverage but not as much as the convertible securities reduce. Another effect of the warrant conversion is the dilution of earnings and control because a number of new equity shares would be issued, hence affecting the controlling position of the existing shareholders.
So, the warrants and convertible securities differ both from the point of view of flow of capital funds as well as effect on the EPS. In case of conversion of convertible securities, new equity share is issued, but there is no infusion of new capital into the company. That occurred when the convertible issue was sold initially. All that takes place when the securities are converted is an exchange of one security (the bond) for another (the equity share)โ a conversion of debt into equity. However, when warrants are exercised, the bonds with which they were issued when warrant holders exercise their option represent an inflow of new capital to the firm. These new funds can then be used to purchase additional
(i) Warrants are issued by attaching them to other securities. When issued in this fashion, warrants work as sweetener as they make the issue more attractive.
(ii) Warrants can be detached from the original secrity and can be traded as a separate instrument.
(iii) The number of equity shares that can be purchased is fixed and is stated on the face of the warrant instruments.
(iv) The exercise price for which the shares can be purchased in future is also fixed.
(v) Warrants issue generally have a specified period over which they can be exercised and become useless thereafter.
(vi) Warrants carry no voting rights and are not entitled to receive dividend or interest payment. A warrant is only an option to purchase shares, the warrant holder is not entitled to any dividends paid on the equity shares nor does he has any voting power. However, if bonus shares are declared, the option price of the warrant may be adjusted to account for the change.
5.5.3 Valuations of warrants
Just like other securities, warrants also have a value. An important consequence of unique characteristics of warrant is that these have a theoretical value in addition to its resale market value. The theoretical value of a warrant equals the difference between the market price of the equity shares purchased through warrants and the total option price paid for these shares to the company. The theoretical value, also called the minimum value, can be expressed as follows:
TV w = (MP โ OP) ร N
Where, TVw = Theoretical value of a warrant
MP = Market price of underlying equity shares
N = Number of equity shares that can be purchased with one warrant OP = Option or exercise price of the equity shares. In case, a warrant entitles to purchase only one equity share, then the TV w = (MP โ OP)
Thus, the theoretical value may be defined as a discount allowed on equity shares to the warrant holder. If an investor buys warrants for their theoretical value and exercise them, they end up paying the same price for the equity shares as they would if they were to buys these shares in the market. However, if the market price of the equity shares is equal to or below the option price, then the theoretical value of a warrant would simply be zero as warrants will never have a negative value. When the market price of equity shares fall below the offer price, the theoretical value is negative as per the above equation. However, the theoretical value of the warrant identifies a price below which the warrant is not likely to sell, the theoretical value is said to be zero whenever the market price of the equity shares is equal to or less than the offer price.
The warrant has a market value also and is generally higher then the theoretical value of the warrant. The theoretical value represents the minimum value of the warrant and will be equal to the market value only on the last day on which the warrant can be converted into equity shares. Prior to this date, the actual market value will be higher than the theoretical value, and the reason for this is obvious. If the right to convert the warrant can be exercised at any time during a given period then the investor has the option of holding the warrant instead of purchasing shares. Holding the warrant is equivalent to holding the equity shares, except that the investment in warrant is less and the warrant holder does not have the right of dividend and voting. It follows that an investor might prefer to purchase a warrant and not immediately exercising it. This option of not exercising the warrant, in addition to the opportunity of exercising it immediately
Fig-
It may be noticed that the market value of a warrant is close to the theoretical value at very high share price. The greatest difference arises when the market price equals the exercise price. In the above case, if the market price falls from Rs. 100 to Rs. 90, then the two shares will fall in value to Rs. 180 and the value of the warrant will also decline from Rs. 120 to Rs. 100 [i.e., TVw = (90 โ 40)2]. The loss on the warrant i.e. , Rs. 20 is equal to the loss on two share and there is no advantage of holding/purchasing of the warrant. Therefore, the market value of a warrant will approximate the theoretical value if the market price a share is very high. The market value of a warrant depends upon many factors such as:
(i) Share price: A higher share price will increase the value of a warrant as shown in Figure 1.
(ii) Offer price: A higher offer price will mean a lower value for the warrant as the warrant holder must pay more for the shares purchased.
(iii) Underlying risk: The total risk of the volatility of the share price also affects the market value of the warrant. Figure 1 shows that a warrant may have a value even when the share price is below the offer price; and it may happen if there is a possibility that the
market price will rise above the offer price before the expiry of t he conversion period.
(iv) Time to expiry: The longer the time to expiry, the higher would be the value of the warrant.
The dividend condition that the warrant holders are not entitled to any divided before exercising the right also affects the market value of the warrant. This dividend, however, is payable to the equity shareholders.
The behaviour of the market value line in Figure 1 may be summarized as follows: First , the market value of a warrant tend to stay at or above its theoretical value. Second , the market value will remain positive even when the theoretical value is zero because a positive price is required to induce trading. Third, the warrant premium reaches its highest level at about the exercise price of the underlying equity shares because the leverage effects and possibility of subsequent increase in market price of the equity share. The difference between the market value and the theoretical value, which is also known as warrant premium, has been shown as shaded area in Figure 1. It may be observed that the warrant premium is highest when the share price is at or close to the offer price and that the warrant premium decreases as the share price moves away, in any direction, from the offer price.
