Ch.

21: Convertible Debentures and Warrants

CHAPTER 21

CONVERTIBLE DEBENTURES AND WARRANTS

Problem 1

The following are the facts about the fully convertible debenture:
Fully convertible debenture:
Interest rate 10%
Number of debentures (lakh) 50
Par value (Rs) 1000
Conversion period (years) 2
Conversion ratio: shares/per debenture 5
Conversion price (Rs) 200
Current share price (Rs) 120
Conversion value (now): conversion ratio × share
price 600

At the current share price is Rs 120, the conversion value is: Rs 120 × 5 = Rs 600, which is less than Rs 1000. The
debenture holders would be expecting the share price to increase so that they could gain on conversion. Since the
conversion is compulsory, after two years, the company will have to issue: 50 × 5 = 250 lakh shares. This will dilute
the earnings per share and control - the ownership of the company will be shared by the debenture holders becoming
the shareholders.
The features of the partly convertible debentures are as follows:

Partly convertible debenture:

Convertible:
Interest rate 10%
Number of debentures (lakh) 50
Par value (Rs) 2000
Convertble portion - par value 1000
Conversion period (years) 2
Conversion ratio: shares/per debenture 5
Conversion price (Rs) 200
Current share price (Rs) 120
Conversion value (now): conversion ratio × share
price 600
Non-convertible:
Non-convertible portion - par value 1000
Maturity of non-convertible portion (years) 10
Annual interest (Rs) 100
Maturity value (Rs) 1000
Discount rate (assumed) 12%
Value of NCD (Rs) 887
Discount rate (assumed) 10%
Value of NCD (Rs) 1,000

As is the case with the fully convertible debenture, there would be dilution of earnings and ownership upon conversion.
The debenture holders will gain from conversion only if the share price at that time is higher than the conversion price
9Rs 200).
The non-convertible part of debenture is like a straight debenture and can be easily valued if we knew the discount
rate. If the discount rate is equal to the interest rate and the debenture is redeemed at par, the value of the debenture
will be Rs 1000. However, if the discount rate is higher than the interest rate, the value will be lower than Rs 1000. The
value of the debenture will be higher if the discount rate is lower than the interest rate.
I. M. Pandey, Financial Management, 9th Edition, New Delhi: Vikas.

Problem 2

The existing assets (market value) are valued at Rs 1,200 crore and equity at Rs 800 crore. Hence, the equity-to-assets
ratio is 0.67 and debt-to-assets ratio 0.33. The equity variability is 4.5. Assuming that debt is risk-free, asset variability
will be: 4.5 × 0.67 + 0 × 0.33 = 3.
The four crore debentures will bring additional amount of Rs 400 crore as debt. Each debenture gets one warrant for
Rs 10. Thus, there would be additional flow of cash of Rs 40 crore which will be a part of equity since warrant holders
can exercise their option of converting their warrants into shares. The new equity price will be Rs 42 (32 + 10) and
equity amount will be Rs 840 crore and new debt Rs 800 crore. The new equity/assets ratio will be: 0.512. Thus, the
revised variability of equity will be: 3 = equity variability × 0.512 + 0 × 0.488 = 3/(1/0.512) = 5.86.
A warrant is similar to a call option. We can use the Black-Scholes formula to value a warrant. Note that after
warrants are exercised, the equity shares will increase which causes dilution. The call value is adjusted for the dilution
effect to determine the value of the warrant. Calculations are shown below.
Equity market value (25 crore shares), (Rs crore) 800
Share price (Rs): 800/25 32
Debt (Rs crore) 400
Total assets (market value) (Rs crore) 1200
Debenture issue (Rs 100 each), (Rs crore) 400
Number of debentures (crore) 4
Number of warrants (one debenture/one warrant/one
share) 4
Warrant price (Rs) 10
Warrant money (Rs crore) 40
Exercise price (Rs) 15
Expiry period (years) 2
Share price variability (before debenture issue) 4.5
Risk-free rate 10%

Equity/Assets (before warrant issue): 800/1200 0.667

Debt/Assets (before warrant issue): 400/1200 0.333
Asset variability (stdev.) (assuming risk free debt) 3

Share value after warrant issue (Rs): 32 + 10 42

Equity value after warrants issue (Rs crore): 800 + 40 840
Assets after debenture issue (Rs crore): 1200+400+40 1640
Equity/Assets (after warrant issue) 0.512
Debt/Assets (after warrant issue) 0.488
Revised variability of equity 5.86

Value of Warrant by Black-Scholes formula:

Revised share price after warrant issue (Rs) 42
Exercise price (Rs) 15
Expiry period (years) 2
Revised variability of equity 5.86
Risk-free rate 10%
d1 4.2901
d2 -3.9932
N(d1) 1.0000
N(d2) 0.0000
Call value 42.00
New shares after warrants are exercised (crore) 4
New shares/existing shares (w) 0.16
Total shares after warrants are exercised 29
Dilution factor 0.862
Warrant value (Rs): (1/(1 + w) × call value 36.21
Ch. 21: Convertible Debentures and Warrants

CASES

Case 21.1: Tata Steel

Tata steel is planning to implement a massive modernisation and expansion programme involving a cost of Rs 1,500
crore. A part of this cost will be financed through convertible debenture. The company is issuing 12% debenture of the
face value of Rs 1,200, consisting two parts. Part A of Rs 600 is convertible and Part B of remaining Rs 600 is non-
convertible and will be redeemed after 8 years. Interest is payable half-yearly. The conversion ratio is 1; that is, each
convertible debenture of Rs 600 will be converted into one share of Rs 100 at a premium of Rs 500. The debentures
will be compulsorily convertible into share after 6 months of the date of allotment. Thus the conversion price is Rs 600.
Will the debenture holders benefit at the time of conversion? It will depend on the market value of the share at the time
of conversion. The current market price of the share is Rs 1,265. Assuming that the share price at the time of
conversion (after 6 months of the allotment) remains at Rs 1,265, the debenture holders will gain and the difference
between the market price of the share and the conversion value (that is, conversion ratio x conversion price) will be the
debenture holders conversion premium. Thus
1,265 - (1 × 600)
Conversion premium = = 111
. or 111%
(1 × 600)
Debenture holders will have tremendous benefit. They will benefit from conversion provided the share price is more
than Rs 600 (conversion value). Will the share price be more than Rs 600 or Rs 1,265?

The sales growth and the profitability of the company as given below has been good. The sales are likely to up further.
Its debt-equity ratio is around 1:1. The current price of the share is about 2.4 times of the book value and P/E ratio is
more than 23 times. With improved performance the P/E ratio could be expected to increase. Assuming that it remains
at 23 at the time of conversion, and EPS also does not change, then the price should stay around Rs 1,265. Thus from
the investor’s point of view, the convertible debenture is quite attractive. The company is able to issue deferred equity
at a high premium. At the time of this issue, CCI was controlling the pricing of shares. The formula used by CCI would
consider past profits, the book value and the market value. It was very unlikely that CCI would have allowed such a
high premium if the company would have issued shares instead of convertible debentures.

Tisco’s Financial performance: 3-year Projection

1987 1988 1989 average 1990
Sales growth 10.1% 7.6% 16.3% 11.3% 17.5%
Profit margin 5.6% 5.8% 9.2% 6.8% 7.6%
ROE 10.2% 16.5% 13.3%
D/E 0.74: 1 0.65: 1 0.93: 1
I. M. Pandey, Financial Management, 9th Edition, New Delhi: Vikas.

Case 21.2: Western Hatcheries

The sales and profits of the company have shown significant growth. Sales have grown at a compound annual rate of
55% and net profits at 102% during 1983-84 to 1987-88. The prospects for 1988-89 are very bright. Given the past
performance of the company, the expansion project should add to its growth and profitability. Thus the company is
likely to add considerable value to the shareholders which should reflect in the price of the company’s share. The share
price is likely to be high at the time of conversion (unless there is any downturn in the market itself). This will benefit
the shareholders. The benefit to the company is that it can issue deferred equity at premium (by adding the conversion
feature to the debenture) at a time when the company’s share price is not quoting in the market. Until the debentures
are converted into equity, the company can take advantage of interest tax shield.