Corporate Finance Session 8 - Warrants & Convertibles
(1) Warrants
Warrants = stock options issued by a company on its own stock $
- A stock option (CALL) is a derivative giving you the right, not the obligation, to BUY a
stock at a certain fixed price called the « strike price »
o That means that, no matter what the price is in 3 months, if my strike price is
$220, I can buy the stock at $220: it’s beneficial for me if the price goes up
o People who buy calls bet the price is going up
- A stock option (PUT) is a derivative giving you the right, not the obligation, to SELL a
stock at a certain fixed price called the « strike price »
o That means that, no matter what the price is in 3 months, if my strike price is
$220, I can sell the stock for $220: it’s beneficial for me if price goes down
o People who buy puts bet the price is going down
- You’ll also pay the person on the other side to sell you/buy the stock from you for a
fee no matter what (eg $10 fee, which this counterparty will then hedge)
- Companies sell these options themselves via warrants: for example, Tesla ISSUING
those options on its own stocks is a Capital Structure decision as it creates new
claims towards the company cashflows
3 examples:
- When you offer stock options to your employees/managers, those are warrants
because they are company-issued and imply the issuance of new shares in time
o And those new shares will be issued at a fixed price you promise your
workforce (obviously if you’re using these to pay them)
- Options can also sold jointly with bonds // with preferred shares to financial investors
- Options can also created upon conversions of convertible debt
/!\ Issuing warrants is a capital structure decision which increases the number of shares
outstanding once they’re exercised
Does that lead to dilution? Let’s first look at the Modigliani-Miller framework to
understand what would happen to the share price and why.
Dilution is, as ever, the biggest source of confusion… even Damodaran himself says the share
price would be brought to sink !! In the MM world though, the issuance of warrants should
not affect stock price — but what happens in the real world?
Why does everyone think price would fall, and why is it wrong?
, Risk-neutral probability = adjusting the announced probability by determining how it
fits with the current market value of shares. Here, we see the market value is exactly
the average of both scenario prices that can realize in the future.
o Hence, instead of giving £30M the 0.6 probability like it should have, we
reduce it just to 0.5 to adjust to current market value
Previously, we assumed everything was idiosyncratic risk and discounted everything
with the risk-free rate: here, we’re not doing that.
o We could really adjust by adjusting our discount rate (which is hard) or
adjusting the probabilities to make risk-neutral/risk-adjusted
o Assuming I’m risk averse, I then grant a lower probability to the good state
than what it actually is (from 60% to 50%)
I want to issue warrants and immediately buy-back equity with that cash > not
changing anything on the Asset Side of the company balance sheet as I immediately
replace a part of my common Equity
(1) Warrants
Warrants = stock options issued by a company on its own stock $
- A stock option (CALL) is a derivative giving you the right, not the obligation, to BUY a
stock at a certain fixed price called the « strike price »
o That means that, no matter what the price is in 3 months, if my strike price is
$220, I can buy the stock at $220: it’s beneficial for me if the price goes up
o People who buy calls bet the price is going up
- A stock option (PUT) is a derivative giving you the right, not the obligation, to SELL a
stock at a certain fixed price called the « strike price »
o That means that, no matter what the price is in 3 months, if my strike price is
$220, I can sell the stock for $220: it’s beneficial for me if price goes down
o People who buy puts bet the price is going down
- You’ll also pay the person on the other side to sell you/buy the stock from you for a
fee no matter what (eg $10 fee, which this counterparty will then hedge)
- Companies sell these options themselves via warrants: for example, Tesla ISSUING
those options on its own stocks is a Capital Structure decision as it creates new
claims towards the company cashflows
3 examples:
- When you offer stock options to your employees/managers, those are warrants
because they are company-issued and imply the issuance of new shares in time
o And those new shares will be issued at a fixed price you promise your
workforce (obviously if you’re using these to pay them)
- Options can also sold jointly with bonds // with preferred shares to financial investors
- Options can also created upon conversions of convertible debt
/!\ Issuing warrants is a capital structure decision which increases the number of shares
outstanding once they’re exercised
Does that lead to dilution? Let’s first look at the Modigliani-Miller framework to
understand what would happen to the share price and why.
Dilution is, as ever, the biggest source of confusion… even Damodaran himself says the share
price would be brought to sink !! In the MM world though, the issuance of warrants should
not affect stock price — but what happens in the real world?
Why does everyone think price would fall, and why is it wrong?
, Risk-neutral probability = adjusting the announced probability by determining how it
fits with the current market value of shares. Here, we see the market value is exactly
the average of both scenario prices that can realize in the future.
o Hence, instead of giving £30M the 0.6 probability like it should have, we
reduce it just to 0.5 to adjust to current market value
Previously, we assumed everything was idiosyncratic risk and discounted everything
with the risk-free rate: here, we’re not doing that.
o We could really adjust by adjusting our discount rate (which is hard) or
adjusting the probabilities to make risk-neutral/risk-adjusted
o Assuming I’m risk averse, I then grant a lower probability to the good state
than what it actually is (from 60% to 50%)
I want to issue warrants and immediately buy-back equity with that cash > not
changing anything on the Asset Side of the company balance sheet as I immediately
replace a part of my common Equity
