Debt and hybrid instruments - Convertibles and warrants over...

Learning Outcomes

After reading this article, you will be able to describe the features and uses of convertible debt and warrant instruments for ACCA FM. You will learn to explain why companies issue these instruments, how holders choose between conversion and redemption, calculate values in exam scenarios, and differentiate convertibles from simple debt and equity.

ACCA Financial Management (FM) Syllabus

For ACCA Financial Management (FM), you are required to understand debt and hybrid instruments, including their valuation and implications for the business. Revision should focus on the following:

• Distinguishing between straight debt, convertible debt, and warrants
• Calculating the value and cost of convertible debt from both the company’s and investor’s viewpoints
• Explaining why companies may issue convertibles or warrants
• Understanding conversion conditions and their impact on company finances and exam calculations
• Describing the differences between convertibles and warrants in capital structure analysis
• Identifying the implications of hybrid instruments for gearing, dilution, and risk

Test Your Knowledge

Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.

1. Which feature distinguishes convertible loan notes from straight debt?
   1. They are always irredeemable
   2. They pay variable interest
   3. They can be exchanged for equity at a set date
   4. They are secured by company property
2. Why might a company issue loan notes with warrants attached rather than ordinary shares directly?
   1. To reduce coupon payments
   2. To immediately raise equity
   3. To defer equity issuance and potentially pay a lower interest rate
   4. To avoid risk of dilution

3. True or false? The market value of a convertible loan note before conversion can never fall below its straight debt value.

4. Briefly explain what happens to a company’s gearing ratio if most convertible loan notes are converted to shares.

Introduction

Debt and hybrid instruments such as convertibles and warrants are increasingly used by companies seeking flexible financing. These instruments offer features of both debt and equity, and understanding their characteristics is critical for ACCA FM exam success.

This article covers the essential principles of convertibles (debt that can become equity) and warrants (securities giving rights to buy shares), focusing on their features, exam-calculation methods, and implications for a company’s financial position.

Key Term: convertible debt
A type of loan note or bond that gives the holder the option to convert their debt holding into ordinary shares after a fixed period or at specific terms, usually set in advance.

Key Term: warrant
A security that gives the holder the right, but not the obligation, to purchase a specified number of shares at a fixed price within a certain period, typically attached as a "sweetener" to a debt issue.

Convertibles: Debt That Can Become Equity

Convertible loan notes (also called convertible bonds or debentures) start as debt, paying interest (the coupon), but include an option for the holder to convert the debt into shares at a specified time and ratio.

Key features:

• Holders receive fixed interest until conversion or redemption.
• On conversion, loan notes are exchanged for a pre-determined number of shares; if not, debt is redeemed in cash, sometimes at a premium.
• Conversion can only occur on agreed dates, for a fixed ratio or price.

Why companies issue convertibles:

• Lower interest rates: Convertibles tend to pay lower coupons than straight loans because of the added conversion option.
• Deferred dilution: Shares are only issued if holders convert, so dilution of existing shareholders is postponed.
• Attractive to investors: Offers upside if share price rises, but provides downside protection—if conversion is not favourable, holders can usually opt for cash redemption.

Key Term: conversion premium
The difference between the current market value of a convertible bond and the current value of shares that would be received on conversion.

Warrants: Debt With an Option to Buy Shares

Warrants are long-term options attached to a debt or offered separately. They allow the holder to buy shares from the company at a fixed price before expiry.

Features:

• The warrant can be exercised or sold independently of the bond.
• Unlike convertibles, exercising a warrant does not cancel the bond or reduce debt; the company receives cash for new equity when exercised.

Key Term: exercise price
The fixed price at which the holder of a warrant is entitled to purchase new shares in the issuing company.

Worked Example 1.1

A company issues 1,000 $100 par value convertible bonds, redeemable at par in 5 years. Each can be converted into 25 shares in Year 5. The current share price is $3, expected to grow at 6% per year. Should investors convert or seek redemption?

Answer:
Projected share price in Year 5 = $3 × (1.06^5) ≈ $4.02
Shares on conversion: 25 × $4.02 = $100.50 (market value of shares)
Redemption in cash: $100
Investors will choose conversion as the market value of shares slightly exceeds the cash redemption.

Worked Example 1.2

A company issues bonds with detachable warrants, each allowing the purchase of 10 shares at $2.50 within three years. The current share price is $2.10, expected to rise to $3.00 within two years. Are the warrants valuable?

Answer:
If share price reaches $3.00, exercising the warrant at $2.50 gives an immediate profit of $0.50 per share. Therefore, the warrant is likely to gain value if the share price does climb as predicted.

Valuing Convertibles and Warrants in Exam Scenarios

Valuation of convertible debt requires comparing two options at maturity:

1. The value of converting to shares (number of shares × forecast share price)
2. The cash (redemption) value if NOT converting

The higher value is used in calculations for the investor.

Floor value: Prior to conversion, a convertible bond's value will not generally fall below the present value of its expected interest payments plus redemption cash flow, discounted at the yield of a straight (non-convertible) bond.

Key Term: floor value
The minimum market value of a convertible bond, equal to its value as straight debt if conversion is not exercised.

Implications for Companies

Gearing: While convertibles are classified as debt until conversion, any conversion into equity reduces gearing by decreasing debt and increasing equity.

Dilution: Conversion increases the number of shares, reducing earnings per share for existing holders.

Cost: Companies benefit from lower initial borrowing costs but face potential dilution if share prices perform well.

Key Term: dilution
The reduction in existing shareholders’ percentage ownership as a result of additional shares being issued, for example when convertibles are converted or warrants are exercised.

Comparison Table: Convertibles vs. Warrants

Exam Warning

When calculating the value of convertible bonds in exam questions, check whether conversion is more attractive than redemption by comparing the value of shares received with the bond’s cashface value. Use the higher value for decision-making.

Revision Tip

Always state whether a convertible is valued as debt or as equity when discussing the company’s gearing ratio, especially in scenario or written exam answers.

Summary

Convertible debt and warrants are hybrid instruments used to raise finance flexibly. Convertibles provide debt holders with an option to become shareholders, while warrants grant rights to buy shares. Both can impact gearing, dilution, and long-term cost of capital. Exam questions often require you to evaluate between conversion and redemption or to calculate values under specific scenarios.

Key Point Checklist

This article has covered the following key knowledge points:

• Define and distinguish between convertible debt and warrants
• Explain the motivation for companies to issue hybrid instruments
• Describe how conversion or warrant exercise affects company finances and gearing
• Calculate the value of convertibles on conversion and redemption, using expected share prices
• Identify floor value and conversion premium concepts for convertibles
• Compare convertible debt and warrants and their impact on dilution
• Recognize relevant exam calculation methods and pitfalls

Key Terms and Concepts

• convertible debt
• warrant
• conversion premium
• exercise price
• floor value
• dilution