SFM-Right Issue, Convertible & Detachable Warrant Bond

Right Issue
A rights issue is an issue for shares for cash, where the new shares are offered to existing
shareholders in proportion to their current shareholding.

The share price of the new shares in a rights issue should be lower than the current market
price of the existing shares. Pricing the new shares in this way gives the shareholders an
incentive to subscribe for them. There are no fixed rules about what the share price for a
rights issue should be, but as a broad guideline the issue price for the rights issue might be
about 10% - 15% below the market price of existing shares just before the rights issue.

The shareholders’ choices

When a company announces a rights issue, the shareholders have the following choices:
 They can take up their rights, and buy the new shares that have been offered to them.
 They can renounce their rights, and sell the rights in the market. By selling rights, the
shareholder is selling to another investor the right to subscribe for the new shares at
the issue price.
 They can take up some rights and renounce the rest. This is a combination of the two
options above.
 They can do nothing. If they do nothing, their existing shares will fall in value after
the rights issue (perhaps from the cum rights price to the theoretical ex-rights price),
and they will suffer a loss in the value of their investment.

The company might try to sell the new shares to which the ‘do nothing’ shareholders were
entitled, and pay them any surplus receipts above the rights issue price. However, the ‘do-
nothing’ shareholders are still likely to suffer a loss.

Convertible bonds
Convertible bonds are bonds that give their holder the right, but not the obligation, at a
specified future date to convert their bonds into a specific quantity of new equity shares.
1- If the bondholders choose to exercise the right, they will become shareholders in the
company, but will surrender their bonds.
2- If the bondholders decide not to exercise their right to convert, the bonds will be
redeemed at maturity

When convertible bonds are first issued, the market value of the shares into which the bonds
will be convertible is always less than the market value of the convertibles. This is because
convertibles are issued in the expectation that the share price will rise before the date for
conversion. Investors will hope that the market value of the shares will rise by enough to
make the market value of the shares into which the bonds will be convertible higher than the
value of the convertible as a ‘straight bond’.

From the desk of : Muhammad Farooq Aarbiani

SFM-Right Issue, Convertible & Detachable Warrant Bond

The amount by which the market value of the convertible exceeds the market value of the
shares into which the bonds will be convertible is called the conversion premium.

What Is a Detachable Warrant?

A detachable warrant is a derivative that is attached to a security which gives the holder the
right to purchase the underlying asset at a specific price within a certain time frame. Often
combined with various forms of debt offerings, detachable warrants can be removed by the
holder and sold separately in the secondary market. So an investor who holds detachable
warrants can sell them while keeping the underlying security, or they can sell the underlying
securities while holding on to the warrants.

Convertible debt and debt issued with stock warrants are similar in that:
(1) both allow the issuer to issue debt at a lower interest cost than would generally be
available for straight debt;

(2) both allow the holders to purchase the issuer's stock at less than market value if the stock
appreciates sufficiently in the future;

(3) both provide the holder the protection of a debt security if the value of the stock does not
appreciate; and

(4) both are complex securities which contain elements of debt and equity at the time of
issue.

Convertible debt and debt with stock warrants are different in that :
(1) if the market price of the stock increases sufficiently, the issuer can force conversion of
convertible debt into common stock by calling the issue for redemption, but the issuer
cannot force exercise of the warrants;

(2) convertible debt may be essentially equity capital, whereas debt with stock warrants is
debt with the additional right to acquire equity; and

(3) the conversion option and the convertible debt are inseparable and, in the absence of
separate transferability, do not have separate values established in the market; whereas debt
with detachable stock warrants can be separated into debt and the right to purchase stock,
each having separate values established by the transactions in the market.

From the desk of : Muhammad Farooq Aarbiani

SFM-Right Issue, Convertible & Detachable Warrant Bond

Q1

Century Ltd, has 500,000 shares in issue, face value of each share is Rs.10, & currently
traded in market at Rs.45 each. Company wants to raise an amount of Rs.5 million through
right issue term of issue is 1 for 4.

Required

a) Compute following
 Issue price for each share
 Theoretical Ex-right price of share
 Value of a right
b) Suppose Mr.A is an shareholder of Century Ltd and hold 50,000 shares. Compute
the impact on Mr. A’s wealth if he chose following options.
 Subscribed all rights shares
 Sell all the rights in stock market
 Sale 20,000 rights in stock market & subscribed right shares through remaining
rights
 Do nothing
c) Now suppose company wants to raise above fund to invest in a project for which
they already made investment appraisal which show positive NPV of Rs.1 million
Compute following
 Theoretical Ex-right price
 Value of a right

Q2

Century Ltd, has 500,000 shares in issue, face value of each share is Rs.10, & currently
traded in market at Rs.45 each. Company wants to raise an amount of Rs.5 million through
8% convertible debenture, redeemable at par after 4 years. There is an option for debt
holders to convert at the end of 4th year each bond into 2 ordinary shares of company.
Currently market yield of similar straight bond is 10%.

a) Compute following
 Conversion premium for century ltd at the time of issuance of debenture
 Compute implicit price/cost of conversion option for debenture holder at the time
of investment in debentures
b) Now compute value of conversion option for bond holder at the end of 4th year
 If company’s share price rise to Rs.60 each
 If company’s share price is fall to Rs.35 each

From the desk of : Muhammad Farooq Aarbiani

SFM-Right Issue, Convertible & Detachable Warrant Bond

Q3

An investor has bought an annuity which pay Rs.1000 for every year for 20 year. Investor
required rate of return is 5%

Required

a) compute future value of annuity

b) compute current price of this annuity

Q4

An investor has bought a perpetuity which pay annual at each year end interest of Rs. 1000
the required rate of return of investor is 8%

Required

a) compute price of perpetuity

b) if the term of perpetuity contain that first payment of next year will be Rs.1000 and
then it will grow by 3% each year then what will be the price of this perpetuity

Q5 Spring 2013/Sept 2013 (Investment portfolio)

Q6
Using Eq. (22.3), compute the theoretical value of each of the following warrants:
WARRANT N Ps E
(a) 5 $100 $400
(b) 10 10 60
(c) 2.3 4 10
(d) 3.54 27.125 35.40

Q7
Jenni Shover, Inc., has warrants outstanding that allow the holder to purchase three shares of
common stock for a total $60 for each warrant that is held. Currently, the market price per share
of Jenni Shover common stock is $18. However, investors hold the following probabilistic beliefs
about the stock six months hence.

Market price per share $16 $18 $20 $22 $24

Probability 0.15 0.20 0.30 0.20 0.15

Required
a. What is the present theoretical value of the warrant?

From the desk of : Muhammad Farooq Aarbiani

SFM-Right Issue, Convertible & Detachable Warrant Bond

b. What is the expected value of stock price six months hence?

c. What is the expected theoretical value of the warrant six months hence?

Q8
Suppose you have just bought a warrant that entitles you to purchase two shares of common
stock for $45. The market price of the common stock is $26 per share, whereas the market price
of the warrant is $10 in excess of its theoretical value. One year later the common stock has
risen in price to $50 per share. The warrant now sells for $2 more than its theoretical value.

Required
a. If the common stock paid $1 in dividends for the year, what is the return on investment in the
common stock?
b. What is the return on investment in the warrant?
c. Why do the two rates of return differ?

Q9
Red Herring Pizza has outstanding warrants, where each warrant entitles the holder to
purchase two shares of stock at $24 per share. The market price per share of stock and market
price per warrant were the following over the last year:
OBSERVATION
1 2 3 4 5 6
Stock price $20 $18 $27 $32 $24 $38
Warrant price 5 3 12 20 8 29

Required:
Determine the theoretical value per warrant for each of these observations. At what price per
common share is the warrant premium over theoretical value the greatest? Why

Q10

From the desk of : Muhammad Farooq Aarbiani