FINANCE IN A CANADIAN SETTING Sixth Canadian Edition

Lusztig, Cleary, Schwab

CHAPTER NINETEEN

Options and Long-Term Financing

Learning Objectives1. Describe how rights work for existing shareholders.2. Explain the gains and losses involved in the exercise of rights.3. Identify what warrants are, and how they differ from options and rights.4. Discuss convertible securities, conversion price, and conversion ratio.5. Explain why a company issues convertible securities over common stock.

IntroductionReviewrightswarrantsconvertible securitiesConsider different situations where long-term financing instruments can be thought of as options

NotationS = market price per shareE = exercise price per sharet = time to expiry of an optionIV = intrinsic value of an optionN= number of options required to buy one share

RightsRights privileges granted to shareholders to acquire additional shares at a predetermined price, usually below the current market priceRights may be offered because:current market conditions are not conducive to traditional share issuesmanagement wants to give existing shareholders the opportunity to acquire sharesto give existing shareholders the opportunity to maintain their proportion of ownership in the company

RightsRights holders can take four courses of action:Exercise the rightsSell the rightsBuy additional rightsLet the rights expireNo commissions are levied on exercising rightsA secondary market can develop for rights

RightsThe intrinsic value (IV) is calculated using two methods:1. During the cum-rights period: IV = (S - E) N + 11 + N reflects the fact that the market price of the share includes the value of one right

Rights2. During the ex-rights period: IV = (S - E) NDepending on the time to expiry and other variables affecting option prices, rights generally trade above their intrinsic valueConceptually a shareholders wealth remains unaffected by a rights offering

WarrantsWarrants long-term options that firms make available on their own sharesGenerally issued in conjunction with issues of senior securitiesKnown as sweeteners to make the issue more marketableUsually can be detached from senior securities and traded in there own rightMost warrants have a seven-year life Usually issued out of the money

WarrantsLeverage makes warrants attractive to investorsThe ratio to measure the leverage potential is: LP = market price of the underlying share market price of the warranthigher the ratio the greater the leverage effectWarrants also have a time value and intrinsic value

WarrantsThe overvaluation of warrants is calculated by: Overvaluation = mkt. price of warrant + exercise price of warrant - mkt. value of underlying assetThe overvaluation will equal the time value when there is a positive intrinsic valueThe overvaluation can exceed the time value when the intrinsic value is nil

ConvertiblesConvertible instruments securities that, at the option of the holder, may be converted into common shares of the issuing firmConversion price or ratio the basis for switching a convertible security into common sharesThe conversion ratio is usually set above the market price of the common shares at the time of offering

ConvertiblesValuing convertible debt:Straight debt value (SDV) identifies the value of debt alonecalculated by the standard debt valuation formula Conversion value (CV) specifies how much the feature is worth if immediately convertedCV = conversion ratio x current market price per shareConvertible debt can not trade for less than the SDV or CVSDV and SV combine to provide a price floor for the convertible

ConvertiblesValue of Convertible Debt as a Function of Share Price

ConvertiblesFirms issue convertible debt because:new equity is required but current market conditions and share prices are unfavourableconvertible securities are viewed as deferred equity financing with expectation that conversion will eventually become attractive and dilution will be kept to a minimumcall feature built into the convertibles prevent them from exceeding their conversion priceunderwriting costs tends to be lower than straight equity financing

UnitsWhen firms attempt to package two or more types of securities together to make the offering more marketable they are called unitsUnits:restrict investors flexibilityare complex securities where firms are attempting to create innovative financing instruments

Summary1. Firms issue options either to provide current stockholders with an opportunity to subscribe to new share offerings on a preferential basis or as sweeteners to make new issues of senior securities more marketable.

Summary2. Rights are issued when a firm offers new shares to current shareholders on a privileged subscription basis. Normally, one right is issued for each outstanding share and, depending on the number of new shares to be offered, several rights may be required to obtain one new share. Rights generally have a life of only a few weeks and shareholders who choose not to exercise their rights may sell them in the marketplace.

Summary3. Warrants are options that are normally offered in conjunction with issues of senior securities. They normally have a life of several years and one warrant may entitle its holder to purchase more than one share.4. Convertible securities are debt or preferred shares that, at the option of the holder, can be converted into common shares. The basis for the conversion is determined through the conversion price or conversion ratio.

Summary5. On occasion, corporations package together two or more different types of securities and options and offer them as a unit in an effort to increase marketability.6. Common shares generally can be viewed as options on the firms assets with an exercise price equal to the value of the firms outstanding debt.