Paul Duncan, financial manager of EduSoft Inc., is facing a dilemma. The firm was founded 5 years ago to provide educational software for the rapidly expanding primary and secondary school markets. Although EduSoft has done well, the firm’s founder believes an industry shakeout is imminent. To survive, EduSoft must grab market share now, and this will require a large infusion of new capital.
Because he expects earnings to continue rising sharply and looks for the stock price to follow suit, Mr. Duncan does not think it would be wise to issue new common stock at this time. On the other hand, interest rates are currently high by historical standards, and the firm’s B rating means that interest payments on a new debt issue would be prohibitive. Thus, he has narrowed his choice of financing alternatives to (1) preferred stock, (2) bonds with warrants, or (3) convertible bonds.
As Duncan’s assistant, you have been asked to help in the decision process by answering the following questions.
How can knowledge of call options help a financial manager to better understand warrants and convertibles?
Part 2: Create a slide PowerPoint presentation in which you summarize your answers from the mini case. Be sure to include graphs, charts, and trends as appropriate.
Sample Answer
Call Options, Warrants, and Convertibles
Knowledge of call options is fundamental to understanding the valuation and behavior of both warrants and convertible securities because both contain an embedded option feature.
A call option gives the holder the right, but not the obligation, to buy a specified asset (usually the underlying common stock) at a predetermined price (strike price) before a certain date (expiration date).
1. Warrants as Call Options
A warrant is essentially a long-term, slightly delayed-action call option issued by the company itself.
Similarity to Call Options:
Both give the holder the right to buy the common stock at a set price.
The value of both increases as the price of the underlying common stock increases.
The formula for the theoretical value of a warrant is based on the same principles as the Black-Scholes model for call options.
Key Difference:
When an investor exercises a warrant, the company issues new shares of common stock, and the firm receives the exercise price, generating new capital. In contrast, exercising a standard call option involves a transaction between two investors, and the company receives no new funds.
Financial Manager's Understanding: By viewing a warrant as a call option, the financial manager knows that the warrant's value (and thus the cost of issuing the debt/warrant package) will be heavily influenced by:
Stock price volatility: Higher volatility makes the option more valuable.
Time to maturity: Warrants typically have a long life (5-10 years or perpetual), giving them significant time value.
2. Convertible Bonds as Embedded Call Options
A convertible bond gives the holder the option to exchange the bond for a specified number of shares of the company's common stock.
Similarity to Call Options:
The conversion feature acts as a call option. The holder gets a fixed payment (the bond's face value) plus the right to convert it into equity if the stock price rises above the conversion price.
The bond's value is always at least its straight bond value (the floor) but increases significantly when the stock price rises above the conversion point.
Financial Manager's Understanding: The financial manager knows that by including the conversion feature, the company is effectively selling a call option to the investor. This allows the company to issue the bond at a significantly lower interest rate (lower coupon payment) than a straight bond, reducing its fixed cash outflow. The "cost" to the firm is the potential dilution of equity when the bond is eventually converted.
📊 PowerPoint Presentation Outline for EduSoft Inc.
Here is the content and structure for a 7-slide presentation to help Mr. Duncan decide on the best financing option.