Why companies issue convertible bonds and warrants?

Answer 1

Why do companies issue Warrants and Convertibles? You hear many arguments for issuing warrants and convertibles, but most of them have a "head I win, tails you lose" flavor. For example, here is one such argument: A company that wishes to sell common stock must usually offer the new stock at 10 percent to 20 percent below the market price for the flotation to be a success. However, if warrants are sold for cash, exercisable at 20 percent to 50 percent above the market price of the common, the result will be equivalent to selling common stock at a premium rather than a discount; and if the warrants are never exercised, the proceeds from their sale will become a clear profit to the company.There is something immediately suspicious about an argument like this. If the shareholder inevitably wins, the warrant holder must inevitably lose. But that doesn't make sense. Surely there must be some price at which it pays to buy warrants. Suppose that your company's stock is priced at $100 and that you are considering an issue of warrants exercisable at $120. You believe that you can sell these warrants at $10. if the stock price subsequently fails to reach $120, the warrants will not be exercised. You will have to sold warrants for $10 each, which with the benefit of hindsight proved to be worthless to the buyer. If the stock price reaches $130, say, the warrant will be exercised. Your firm will have received the initial payment of $10 plus the exercise price of $120. on the other hand, it will issued to the warrant holders stock worth $130 per share. The net result is a standoff. You have received a payment of $130 per share in exchange for a liability worth $130. Think now what happens if the stock price rises above $130. Perhaps it goes to $200. in this case the warrant issue will end up producing a loss of $70. This is not a cash outflow but an opportunity loss. The firm receives $130, but in this case it would have sold stock for $200. on the other hand, the warrant holders gain $70: they invest $130 in cash to acquire stock that they can sell, if they like, for $200. Our example is oversimplified- for instance, we have kept quiet about the time value of the money and risk- but we hope it has made the basic point. When you sell warrants, you are selling options and getting cash in exchange. Options are valuable securities. If they are properly priced, this is a fair trade- in other words; it is a zero NPV transaction. Managers often use similar arguments to justify the sale of convertibles. For example, several surveys have revealed two main motives for their use. A large number of managers look on convertibles as "cheap debts". A somewhat higher proportion regards them as a deferred sale of stock at an attractive price. The difference between the market value of the convertible and that of the straight bond is therefore the price investors place on the call option. The convertible is cheap only if this price overvalues the option. A convertible bond gives you the right to but stock by giving a bond. Bondholders may decide to do this, but then again they may not. Thus issue of convertible bond may amount to a deferred stock issue. But if the firm needs equity capital, a convertible issue is an unreliable way of getting it. Notice that convertibles tend to be issued by the smaller and more speculative firms. They are almost invariably unsecured and generally subordinated. Now put yourself in the position of a potential investor. You are approached by a small firm with an untried product line that wants to issue some junior unsecured debt. You know that if things go well, you will get your money back, but if they do not, you could easily be left with nothing. Since the firm is in the new line of business, it is difficult to assess the chances of trouble. Therefore you don't know what the fair rate of interest is. Convertible securities and warrants make sense whenever it is unusually costly to assess the risk of debt or whenever investors are worried that management may not act in the bondholder's interest. You can also think of convertible issue as a contingent issue of equity. If a company's investment opportunities expand, its stock price likely to increase, allowing the financial manager to call and force conversion of a convertible bond into equity. Thus the company gets fresh equity when it is most needed for expansion. Of course, it is also stuck with debt if the company does not prosper. The relatively low coupon rate on convertible bonds may also be a convenience for rapidly growing firms facing heavy capital expenditures. They may be willing to give up the conversion option to reduce immediate cash requirements for debt service. Without the conversion option, lenders might demand extremely high (promised) interest rates to compensate for the probability of default. This would not only force the firm to raise still more capital for debt service but also increase the risk of financial distress. Paradoxically, lenders attempt to protect themselves against default may actually increase the probability of financial distress by increasing the burden of debt service on the firm.