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Executive Summary This chapter describes the basic features of warrants and convertibles. The important questions are: How can warrants and convertibles be valued? What impact do warrants and convertibles have on firm value? What are the differences between warrants, convertibles and call options? Under what circumstances are warrants and convertibles converted into common stock? Chapter Outline 24.1 Warrants 24.2 The Difference between Warrants and Call Options 24.3 Warrant Pricing and the Black-Scholes Model (Advanced) 24.4 Convertible Bonds 24.5 The Value of Convertible Bonds 24.6 Reasons for Issuing Warrants and Convertibles 24.7 Why are Warrants and Convertibles Issued 24.8 Conversion Policy 24.9 Summary and Conclusions 24.1 Warrants Warrants are call options that give the holder the right, but not the obligation, to buy shares of common stock directly from a company at a fixed price for a given period of time. Warrants tend to have longer maturity periods than exchange traded options. Warrants are generally issued with privately placed bonds as an “equity kicker”. Warrants are also combined with new issues of common stock and preferred stock, given to investment bankers as compensation for underwriting services. In this case, they are often referred to as a Green Shoe Option. 24.1 Warrants The same factors that affect call option value affect warrant value in the same ways. 24.2 The Difference Between Warrants and Call Options When a warrant is exercised, a firm must issue new shares of stock. This can have the effect of diluting the claims of existing shareholders. Dilution Example Imagine that Mr. Armstrong and Mr. LeMond are shareholders in a firm whose only asset is 10 ounces of gold. When they incorporated, each man contributed 5 ounces of gold, then valued at $300 per ounce. They printed up two stock certificates, and named the firm LegStrong, Inc.. Suppose that Mr. Armstrong decides to sell Mr. Mercx a call option issued on Mr. Armstrong’s s