Warrant is unique compared to other types of securities because they may be converted into common stock. A controller or CFO needs to have a good under-standing of warrants along with their valuation, their advantages and disadvantages, and when their issuance is recommended.
Here is a basic overview of warrant. Follow on…
What is Warrant?
A warrant is the option given holders to buy a predetermined number of shares of stock at a given price. Warrants may be detachable or non-detachable. A detachable warrant may be sold separately from the bond with which it is associated. Thus, the holder may exercise the warrant but not redeem the bond.
Your company may issue bonds with detachable warrants to purchase additional bonds so as to hedge the risk of adverse future interest rate movements since the warrant is convertible into a bond at a fixed interest rate. If interest rates increase, the warrant will be worthless, and the issue price of the warrant will partially offset the higher interest cost of the future debt issue. A non-detachable warrant is sold with its bond to be exercised by the bond owner simultaneously with convertible bonds.
Your company may sell warrants separately (e.g., American Express) or in combination with other securities (e.g., MGM).
To obtain common stock, the warrant must be given up along with the payment of cash called the exercise price. Although warrants usually mature on a specified date, some are perpetual. A holder of a warrant may exercise it by purchasing the stock, sell it on the market to other investors, or continue to hold it. The company cannot force the exercise of a warrant. If desired, the company may have the exercise price of the warrant change over time (e.g., increase each year). If a stock split or stock dividend is issued before the warrant is exercised, the option price of the warrant will be adjusted for it.
Warrants may be issued to obtain additional funds. When a bond is issued with a warrant, the warrant price is usually established between 10 and 20 percent above the stock’s market price. If the company’s stock price increases above the option price, the warrants will be exercised at the option price. The closer the warrants are to their maturity date, the greater is the likelihood that they will be exercised.
Valuation of Warrant [What is a Warrant Worth?]
The theoretical value of a warrant is computed by a formula. The formula value is typically less than the market price of the warrant because the speculative appeal of a warrant allows the investor to obtain personal leverage:
Value of a Warrant = [Market price per share – Exercise price] × Number of shares that may be bought
A warrant for XYZ Company’s stock gives the owner the right to buy one share of common stock at $25 a share. The market price of the common stock is $53.The formula price of the warrant is $28 (($53 – $25) × 1). If the owner had the right to buy three shares of common stock with one warrant, the theoretical value of the warrant would be $84 ($53 – $25) × 3).
If the stock is selling for an amount below the option price, there will be a negative value. Since this is illogical, a zero value is assigned.
Assume the same facts as in Example 26.1, except that the stock is selling at $21 a share. The formula amount is – $4((=$21 – $25) × 1). However, zero will be assigned.
Warrants do not have an investment value because there are no interest, dividends, or voting rights. Therefore, the market value of a warrant is only attributable to its convertibility feature into common stock. However, the market price of a warrant is typically more than its theoretical value, which is referred to as the premium on the warrant. The lowest amount that a warrant will sell for is its theoretical value.
The value of a warrant depends on the remaining life of the option, dividend payments on the common stock, the fluctuation in price of the common stock, whether the warrant is listed on the exchange, and the investor’s opportunity. There is a higher price for a warrant when its life is long, the dividend payment on common stock is small, the stock price is volatile, it is listed on the exchange, and the value of funds to the investor is great (because the warrant requires a lesser investment).
ABC stock has a market value of $50. The exercise price of the warrant is also $50. Thus, the theoretical value of the warrant is $0. However, the warrant will sell at a premium (positive price) if there is the possibility that the market price of the common stock will exceed $50 prior to the expiration date of the warrant. The more distant the expiration date, the greater will be the premium, since there is a longer period for possible price appreciation. The lower the market price relative to the exercise price, the less the premium will be.
Assume the same facts as in the previous example, except that the current market price of the stock is $35. In this case, the warrant’s premium will be much lower since it would take longer for the stock’s price to increase above $50 a share. If investors expect that the stock price would not increase above $50 at a later date, the value of the warrant would be $0.
If the market price of ABC stock rises above $50, the market price of the warrant will increase and the premium will decrease.
In short words, when the stock price exceeds the exercise price, themarket price of the warrant approximately equals the theoretical value so the premium disappears. The reduction in the premium arises because of the lessening of the advantage of owning the warrant compared to exercising it.
Advantages and Disadvantages of Warrant
The advantages of issuing warrants are:
- They serve as ‘‘sweetener’’ for an issue of debt or preferred stock.
- They permit the issuance of debt at a low interest rate.
- They allow for balanced financing between debt and equity.
- Funds are received when the warrants are exercised.
The disadvantages of issuing warrants are:
- When exercised they will result in a dilution of common stock which in turn lowers the market price of stock.
- They may be exercised when the business has no need for additional capital.