CHAPTER 21

CONVERTIBLE DEBENTURES AND WARRANTS

Q.1. Define the following terms: (a) conversion price, (b) conversion value, and (c)

conversion premium.

A.1. A convertible debenture is a debenture that can be changed into a specified

number of ordinary shares at the option of the owner. It is also called hybrid

security. The conversion price is the price paid for ordinary share at the time of

conversion. The conversion ratio is the number of ordinary shares that an investor

can receive when he/she exchanges his convertible debenture.

The conversion value of a convertible debenture is equal to the conversion

ratio multiplied by the ordinary shares’ market price. The difference between the

convertible debenture’s market value and higher of the conversion or NCD value

(i.e., investment value of non-convertible debenture) is called the conversion

premium.

Q.2. What are the important features of a convertible security? What reasons are

generally given for issuing convertible securities?

A.2. Convertible security is either a debenture or a preference share that can be

exchanged for a stated number of ordinary shares at the option of the investor.

The most notable feature of convertible security is that it promises a fixed income

associated with security as well as chance of capital gains associated with equity

shares after the owner has exercised his conversion option.

Companies offer convertible securities to sweeten the debt and thereby

make it attractive. It is a form of deferred equity financing, and provides low cost

funds during the early stage of investment project. Investors generally prefer fixed

interest convertible securities to earn a definite, fixed income with the chance of

making capital gains. The convertible securities avoid immediate dilution of the

earnings for share.

Q.3. Convertible debentures generally carry lower rates of interest than the non-

convertible debentures. If this is true, does it mean that the cost of capital on

convertible debentures is lower than on non-convertibles? Why or why not?

A.3. Yes, the cost of capital on convertible debenture is lower on non-convertible

debentures. The company offers lower rate on convertibles because of the value

of the conversion feature as compared to non-convertibles. Investors generally

prefer fixed-income convertibles. After the project is complete and the company’s

earnings rise, the share is likely to increase. With an in-built option to convert, the

investor are likely to make capital gains This chance of making capital gains,

tempts investors to accept lower rate of interest today.

Q.4. How is a convertible security valued? Explain your answer with the help of a

graph.

A.4. The convertible security are traded (bought and sold) in the stock market until

they are converted into equity shares. The price at which the convertible security

sells is called its market value. A convertible security market value depends on

both investment and the conversion value. The difference between the convertible

debenture’s market value and the higher of the conversion or the NCD value

(investment value) is called conversion premium.

Market Conversion or

Conversion premium = Value – Investment value

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Conversion or Investment Value

Above graph shows the relationship between the convertible debenture’s

market, investment and conversion value, and the ordinary share price. The

conversion value, on the other hand, is related to the ordinary share price. It

increases as the ordinary share price increases. Typically, the market value is

higher than both the investment and conversion value. The difference between

investment and conversion value lines is known as conversion premium.

Q.5. What is a warrant? What are its characteristic features? Why are warrants issued?

A.5. A warrant is an option to buy a specified number of ordinary shares at an

indicated price during a specified period. Warrants are used by large, profitable

companies as a part of a major financing package. Warrants may also be used in

conjunction with ordinary or preference shares. The purpose is to improve the

marketability of issue.

Warrants have a number of features; few of them are explained hereunder.

1) The exercise price of a warrant is the price at which its holder can

purchase the issuing firm’s ordinary shares.

2) Exercise ratio states the number of ordinary shares that can be purchased

at the exercise price per warrant.

3) The expiration date is the date when the option to buy ordinary shares in

exchange for warrants’ expires.

4) A warrant can be either detachable (sold separately from the security to

which it was originally attached) or non-detachable (cannot be sold

separately).

5) Warrants entitle to purchase ordinary shares.

Generally, following are the reasons for issuing warrants.

1) Warrants help to make the issue of equity and debentures attractive.

2) Warrants are used to ‘sweeten’ the debenture issue by giving the investors

an opportunity to participate in capital gains when the share price

appreciates.

3) Warrants also provide a company an opportunity for deferred equity

financing. The company sells its ordinary shares in future at a premium by

setting exercise price higher than the prevailing share price.

4) The company to some extent is sure to obtain cash inflows in future when

investors exercise their warrants.

Q.6. Explain the difference between a convertible security and a warrant.

A.6. A convertible security and a warrant are used by large, profitable companies as a

part of a major financing package.

In the case of a convertible security and a warrant, the conversion

price/exercise price, conversion ratio/exercise ratio and conversion date/expiration

date is decided at the time of issue, to make the issue more attractive.

A convertible security is converted into equity shares on the conversion

date, and no cash inflows for the company occur at that time.

In the case of warrant, the buyer, i.e., investor has an option to exercise his

right for equity or preference shares holding, and company have cash inflows on

that date.

Both a convertible security and a warrant can be used as deferred equity

financing tool, and they help in the beginning of the project, to avail the benefits

of trading on equity.

Q.7. Explain the valuation of warrants with the help of a graph.

A.7. A warrant is an option to buy a stated number of company’s ordinary shares t a

given price on or before a specified maturity date.

The theoretical value of a warrant can be found out by knowing the

ordinary share’s market price, and warrants exercise price and exercise ratio.

Warrants’ theoretical value = (Share price – Exercise price) × Exercise ratio

If the share price is less than the exercise price, then the warrant’s

theoretical value will be negative.

The difference between the warrant’s market value and its theoretical

value is called the premium.

Premium can be calculated as:

Warrant’s market value – Warrant’s theoretical value

Premium = -----------------------------------------------------------------

Warrant’s theoretical value

Q.8. What is meant by zero-interest debentures and deep-discount debentures? How is

their cost determined? Illustrate your answer.

A.8. Zero-interest debentures (ZID) or Zero-coupon bonds do not carry an explicit rate

of interest. The difference between the face value of the bond and its purchase

price is the return of the investor. For example, a company may issue a ZID of

face value Rs 100 for Rs 52 today for a period of 5 years. Then, the rate of interest

is 13%, calculated as under:

FV = PV (1+i)n

100 = 52 (1+i)5

By trial and error method, i = 13%.

Deep-discount bond (DDB) or deep-discount debentures or zero-interest

bond are issued at a price much lower than the face value. Thus, there is an

implicit rate of interest. For example, a bond issued at a price of Rs 12,750 to be

redeemed after 30 years at its face value of Rs 5,00,000. The implied annual rate

of interest is 13%, calculated as under:

FV = PV (1+i)n

5,00,000 = 12,750 (1+i)30

By trial and error method, i = 13%.