Warrants

A warrant is a corporate security that looks a lot like a call option. It gives the holder the right, but not the obligation, to buy shares of common stock directly from a company at a fixed price for a given time period. Each warrant specifies the number of shares of stock that the holder can buy, the exercise price, and the expiration date.

The differences in contractual features between the call options that trade on the Chicago Board Options Exchange and warrants are relatively minor. Warrants usually have much longer maturity periods, however. In fact, some warrants are actually perpetual and have no fixed expiration date.

Warrants are often called sweeteners or equity kickers because they are often issued in combination with privately placed loans or bonds. Throwing in some warrants is a way of making the deal a little more attractive to the lender, and it is a very common practice. Also, warrants have been listed and traded on the NYSE since April 13, 1970. As of the end of 2000, however, there were only 11 issues of warrants listed.

In many cases, warrants are attached to the bonds when issued. The loan agreement will state whether the warrants are detachable from the bond. Usually, the warrant can be detached immediately and sold by the holder as a separate security.

For example, in February of 2000, Metricom, Inc., announced the sale of $300 million in senior notes due in 2010. For each $1,000 principal amount of senior notes purchased, the buyer received a warrant to purchase 4.75 shares of common stock at a price of $87.00 per share. The warrants were exercisable beginning six months after issuance. They expire on February 15, 2010. Unfortunately for purchasers, Metricom, operator of the Ricochet wireless network, filed for bankruptcy in the summer of 2001, so the warrants became essentially worthless.

The Difference between Warrants and Call Options As we have explained, from the holder's point of view, warrants are very similar to call options on common stock. A warrant, like a call option, gives its holder the right to buy common stock at a specified price. From the firm's point of view, however, a warrant is very different from a call option sold on the company's common stock.

The most important difference between call options and warrants is that call options are issued by individuals and warrants are issued by firms. When a call option is exercised, one investor buys stock from another investor. The company is not involved. When a warrant is exercised, the firm must issue new shares of stock. Each time a warrant is exercised, then, the firm receives some cash and the number of shares outstanding increases. Notice that the employee stock options we discussed earlier in the chapter are issued by corporations, so, strictly speaking, they are warrants rather than options.

To illustrate, suppose the Endrun Company issues a warrant giving holders the right to buy one share of common stock at $25. Further suppose the warrant is exercised. Endrun must print one new stock certificate. In exchange for the stock certificate, it receives $25 from the holder.

In contrast, when a call option is exercised, there is no change in the number of shares outstanding. Suppose Ms. Enger purchases a call option on the common stock of warrant

A security that gives the holder the right to purchase shares of stock at a fixed price over a given period of time.

Ross et al.: Fundamentals of Corporate Finance, Sixth Edition, Alternate Edition

V. Risk and Return

14. Options and Corporate Finance

© The McGraw-Hill Companies, 2002

PART FIVE Risk and Return the Endrun Company from Mr. Swift. The call option gives Ms. Enger the right to buy (from Mr. Swift) one share of common stock of the Endrun Company for $25.

If Ms. Enger chooses to exercise the call option, Mr. Swift is obligated to give her one share of Endrun's common stock in exchange for $25. If Mr. Swift does not already own a share, he must go into the stock market and buy one.

The call option amounts to a side bet between Ms. Enger and Mr. Swift on the value of the Endrun Company's common stock. When a call option is exercised, one investor gains and the other loses. The total number of shares outstanding of the Endrun Company remains constant, and no new funds are made available to the company.

convertible bond

A bond that can be exchanged for a fixed number of shares of stock for a specified amount of time.

Earnings Dilution Warrants and (as we shall see) convertible bonds frequently cause the number of shares to increase. This happens (1) when the warrants are exercised and (2) when the bonds are converted, causing the firm's net income to be spread over a larger number of shares. Earnings per share therefore decrease.

Firms with significant numbers of warrants and convertible issues outstanding will generally calculate and report earnings per share on a diluted basis. This means that the calculation is based on the number of shares that would be outstanding if all the warrants were exercised and all the convertibles were converted. Because this increases the number of shares, diluted EPS will be lower than "basic" EPS, which are calculated only on the basis of shares actually outstanding.

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