FINANCE IN A CANADIAN SETTING Sixth Canadian Edition

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FINANCE IN A CANADIAN SETTING Sixth Canadian
Edition

• Lusztig, Cleary, Schwab

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• CHAPTER
• NINETEEN
• Options and Long-Term Financing

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Learning Objectives

• 1. 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.

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Introduction

• Review
• rights
• warrants
• convertible securities
• Consider different situations where long-term
  financing instruments can be thought of as
  options

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Notation

• S market price per share
• E exercise price per share
• t time to expiry of an option
• IV intrinsic value of an option
• N number of options required to buy one share

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Rights

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

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Rights

• Rights holders can take four courses of action
• Exercise the rights
• Sell the rights
• Buy additional rights
• Let the rights expire
• No commissions are levied on exercising rights
• A secondary market can develop for rights

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Rights

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

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Rights

• 2. During the ex-rights period
• IV (S - E)
• N
• Depending on the time to expiry and other
  variables affecting option prices, rights
  generally trade above their intrinsic value
• Conceptually a shareholders wealth remains
  unaffected by a rights offering

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Warrants

• Warrants long-term options that firms make
  available on their own shares
• Generally issued in conjunction with issues of
  senior securities
• Known as sweeteners to make the issue more
  marketable
• Usually can be detached from senior securities
  and traded in there own right
• Most warrants have a seven-year life
• Usually issued out of the money

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Warrants

• Leverage makes warrants attractive to investors
• The ratio to measure the leverage potential is
• LP market price of the underlying share
• market price of the warrant
• higher the ratio the greater the leverage effect
• Warrants also have a time value and intrinsic
  value

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Warrants

• The overvaluation of warrants is calculated by
• Overvaluation mkt. price of warrant
• exercise price of
  warrant
• - mkt. value of underlying asset
• The overvaluation will equal the time value when
  there is a positive intrinsic value
• The overvaluation can exceed the time value when
  the intrinsic value is nil

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Convertibles

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

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Convertibles

• Valuing convertible debt
• Straight debt value (SDV) identifies the value
  of debt alone
• calculated by the standard debt valuation formula
  
• Conversion value (CV) specifies how much the
  feature is worth if immediately converted
• CV conversion ratio x current market price per
  share
• Convertible debt can not trade for less than the
  SDV or CV
• SDV and SV combine to provide a price floor for
  the convertible

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Convertibles

• Value of Convertible Debt as a Function of Share
  Price

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Convertibles

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

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Units

• When firms attempt to package two or more types
  of securities together to make the offering more
  marketable they are called units
• Units
• restrict investors flexibility
• are complex securities where firms are attempting
  to create innovative financing instruments

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Summary

• 1. 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.

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Summary

• 2. 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.

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Summary

• 3. 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.

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Summary

• 5. 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.