# Features of Warrants - Financial Management

As mentioned earlier in this chapter, a warrant is a company -issued option to purchase a specific number of shares of the issuing company’s common stock at a particular price during a specified time period. Warrants are frequently issued in conjunction with an offering of debentures or preferred stock. In these instances, like convertibles, warrants tend to lower agency costs.

In addition, during the 1980s, the various ways in which warrants were used as a financing device seemed to expand. For example, warrants were used in conjunction with bond swaps, equity offerings, and debt restructurings. In the 1987 bankruptcy reorganization of Global- Marine, an off-shore operator of oil and gas drilling rigs, warrants were issued to preferred and common stockholders (along with a small percentage of the new common stock). Also, small, high -risk companies in need of additional financing may offer warrants to prospective lenders in order to give the potential for high expected returns as compensation for the loan’s high risk.

## Features of Warrants

To illustrate some of the features of financing with warrants, consider the Federal National Mortgage Association (“Fannie Mae”), which in 1986 sold 500,000 units, consisting of a $1,000 debenture and 23 five-year warrants (expiration date February 25, 1991), to raise approximately$500 million (less issuance costs). Each warrant allowed the purchase of one common share at $44.25. The exercise price of a warrant is the price at which the holder can purchase common stock of the issuing company. The exercise price is usually between 10 and 35 percent above the market price of the common stock prevailing at the time of issue. The exercise price of the Fannie Mae warrants was$44.25, approximately 34 percent above the $33 per share market price of the common stock at the time of issue. The exercise price normally remains constant over the life of the warrant. One exception is the case of a stock split. When this occurs, the exercise price of the warrant is adjusted to reflect the new number of shares and share price. For example, in October 1989, Fannie Mae’s common stock was split 3 for 1. Accordingly, the exercise price of the warrants was reduced from$44.25 to $14.75 per share. Typically, the life of a warrant is between 5 and 10 years, although on occasion the life can be longer or even perpetual. When the management of Fannie Mae issued the warrants, they hoped that the common share price would rise above the$44.25 level and remain there, especially until after the warrants expired, because this would mean that the company could reasonably expect holders to exercise their warrants. If this happened, Fannie Mae would realize its goal of raising additional capital totaling approximately $509 million (500,000 units times 23 warrants per unit times$44.25 per warrant) at expiration.

In 1991, when the warrants expired, Fannie Mae’s stock price was well above the post -split exercise price of $14.75, and the warrants were exercised. In contrast,with convertible securities such as convertible bonds or preferred stock, the company does not receive additional funds at the time of conversion. If a warrant is issued as part of a “unit”with a fixed -income security, the warrant is usually detachable from the debenture or preferred stock; this means that purchasers of the units have the option of selling the warrants separately and continuing to hold the debenture or preferred stock. As a result, other investors can purchase and trade warrants. Prior to 1970, warrants were not usually used as a financing vehicle by large, established firms. In April of that year, however, AT&T sold$1.6 billion of 30-year debentures with warrants to buy 31.4 million common shares at $52 each through May 15, 1975. The use of warrant financing by AT&T undoubtedly caused other large, established firms to consider warrants. Also, before 1970, warrants were normally either listed on the American Stock Exchange or traded over the counter because the New York Stock Exchange would not list them. However, with the AT&T warrants, the NYSE changed its policy and began to list warrants of NYSE companies if the warrants met certain requirements, including a life greater than five years. For example, Fleet Financial, LTV Corp., Travelers, Zale, Biovail, INCO, Orbital Science, and Total Fina Elf have had warrants traded on the NYSE. Holders of warrants do not have the rights of common stockholders, such as the right to vote for directors or receive dividends, until they exercise their warrants. Reasons for Issuing Warrants The primary reason for issuing warrants with a fixed-income security offering is to lower agency costs. In addition, just as with convertible securities, warrants can permit a company to sell common stock at a price above the price prevailing at the time of original issue. Warrants also allow a company to sell common stock in the future without incurring significant issuance costs at the time of sale. Valuation of Warrants In general, the value of a warrant depends upon the same variables that affect call option valuation. Because a warrant’s value depends upon the price of the issuing company’s stock, it is a contingent claim, just like an option. In this connection, the formula value of a warrant (also called “the value at expiration”) is defined by the following equation: At the time of issue, a warrant’s exercise price is normally greater than the common stock price. Even though the calculated formula value may be negative, it is considered to be zero because securities cannot sell for negative amounts. For example, at the time of issue, the Fannie Mae warrants had an exercise price of$44.25 and the firm’s common stock price was $33 per share. Each warrant entitled the holder to one share, and the formula value was zero: Formula value = Max {$0; ($33 –$44.25) (1)} = $0 Once the stock price rises above the exercise price of the warrant, the formula value will be greater than zero. For example, on February 24, 1989 (approximately two years prior to expiration of the warrant), Fannie Mae’s stock price was$59 and the warrant price was $19.375. At this point, the formula value of the warrant was Formula value = Max {$0; ($59 –$44.25) (1)} = $14.75 and the warrant was selling for about 31 percent above the formula value. Prior to the warrant’s expiration, we see that the market price of the warrant is greater than the formula value, just as we discussed in the case of options. On the expiration date of a warrant, the market price of the warrant should be equal to the formula value, as was the case for options discussed earlier. For the Fannie Mae warrants, which expired on February 25, 1991, the market price of the stock (after the 3-for-1 stock split) was$45.375, and the market price of the warrants was $30.625. As we see, the market price of the warrants was equal to the formula value: Formula value = Max {$0; ($45.375 –$14.75) (1)} = \$30.625

Comparison of Convertible Securities and Warrants

Having covered the characteristics and valuation of convertible securities and warrants,we now summarize the similarities of and differences between these types of securities. In this comparison, we are assuming that the warrants are issued as part of a fixed-income security offering, such as the Fannie Mae warrants discussed earlier. The similarities include the following:

1. Both convertibles and warrants tend to lessen potential conflicts between fixed-income security holders and stockholders, thereby reducing agency costs.
2. The intention is the deferred issuance of common stock at a price higher than that prevailing at the time of the convertible or warrant issue.
3. Both the convertibility option and the attachment of warrants result in interest expense or preferred dividend savings for the issuing company, thereby easing potential cash flow problems.

Some of the differences include the following:

1. The company receives additional funds at the time warrants are exercised, whereas no additional funds are received at the time convertibles are converted.
2. The fixed -income security remains on the company’s books after the exercise of warrants; in the case of convertibles, the fixed -income security is exchanged for common stock and taken off the company’s books.
3. Because of the call feature, convertible securities potentially give the company more control than warrants over when the common stock is issued.