Financing convertibles with warrants

Financing with Convertibles and Warrants “Vi “Virginia rginia May Chocolate Chocolate Company” Company”

University Maastricht Faculty of Economics and Business Administration Financial Management and Policy Maastricht, December 2nd, 200 !troe"en, B# $i%20&&' (ichter, )#

$i*+0-'

Buse, .#

$i%2*+0+'

!tudy/ )nternational Business ourse code/ *020B 1rou number/ + .utor name/ A# orelli !ubgrou number/ * ase + Table of Content

)ntroduction#################################################################################################################################* 3uestion / 4irginia May5s aital !tructure and 6A#########################################################* 3uestion 2/ onversion and Bond 4allues for 7 onvertible Bonds####################################* 3uestion */ rucial Factors for allable onvertible !ecurities################################################% 3uestion %/ onversion 8ear of Bond########################################################################################% 3uestion +/ After9.a: ost of 7 onvertible )ssue###############################################################+ 3uestion ;/ Before9.a: (eturn of 7 onvertible )ssue#########################################################+ 3uestion &/ ine and ?ther Data################################################; 3uestion -/ 4irginia5s May After9.a: ost of the Bonds =ith 6arrants##################################; 3uestion 0/ 4aluation of 6arrant and onvertible )ssue#########################################################; 3uestion / (ecommendation for Financing Alternatives########################################################& 3uestion 2/ Before9.a: (eturn and After9.a: ost of 0#+7 onvertible############################# Aendi:#####################################################################################################################################(eferences#################################################################################################################################;

Introduction

2

.his aer5s aim is to evaluate and guide 4irginia May )nc# to its best case future financing alternatives# By thoroughly revie=ing the situation at hand and the comany5s financing otions, this study =ill recommend the cororation5s board of directors on ho= to raise its needed caital for e:ansion in the most rational and efficient manner# .his aer =ill more secifically, and in deth, revie= the given otions of =arrants and convertible bonds to serve as the comany5s debt art of its caital structure, and =ill assess =hich of these otions =ill minimi@e 4irginia May5s 6A over a eriod as long as the ne:t 2+ years#

Question 1: Virginia May’s Caital !tructure and W"CC

.he current mar"et caital structure of 4irginia May is based on the mar"et values of notes  ayable, long9term debt and total common euity as can be seen in .able  of the Aendi:# .he boo" value of notes ayable is assumed to eual its mar"et value that amounts to %0#000#000 =hereas the mar"et value of long9term debt is -+#;+0#*&-# Multilying the share rice of &,%+ times -#000#000 outstanding shares leads to the mar"et value of euity =hich euals +�+0#000# As a result, 4irginia May5s current mar"et value of  *-2#;+0#*&- is obtained# .a"ing into account the =eights, costs and ta: rates of the different caital structure comonents facilitates the calculation of the comany5s 6A that amounts to 0,+7# .he 6A is obtained according to the formula given in the case#

Question #: Conversion and $ond Values for 11% Convertible $onds

.able 2 of the Aendi: deicts the missing figures of the case5s .able *# .he straight conversion value, the bond value as =ell as the call rice are calculated there# Based on .able 2, the grah in Figure  $Aendi:' deicts the relationshi bet=een conversion value, straight bond value, call rice, maturity value and estimated mar"et value of the  ercent convertible issue over time# .his grah sho=s that around year + the straight conversion value of the bond euals the estimated mar"et value. At this oint in time, the o=ner of the  bonds should call its convertibles and convert the bonds into euity#

Question &: Crucial Factors for Callable Convertible !ecurities

*

onvertibles reresent a call otion for the firm# .here are several factors that affect a comany5s decision to call bonds# )f interest rates are falling, then the comany should call the  bond to refinance its debt at a lo=er level of interest rates# (efinancing means aying off an e:isting loan =ith the roceeds of a ne= loan that is cheaer, i#e' the firm calls the convertibles =ith the higher couon rate and finances it by issuing ne= bonds =ith a lo=er  couon rate# A better credit rating benefits a firm as =ell since it decreases the cost of debt and thus the firm5s interest ayments# Furthermore, a firm can reduce financial leverage by converting bonds into stoc"s =hich lo=ers the firm5s debt ratio and imroves its borro=ing caacity# )n theory firms =ould call the convertibles if the conversion value euals the mar"et value# )f the conversion value is above the call rice, the call forces conversion into euity# Co=ever, rior research has sho=n that management only commits to call conversion if the conversion value e:ceeds the call rice by 209*07 since it =ants to ensure that the stoc" rice cannot dro belo= the conversion value during the call eriod of *0 days# .his olicy is conducted due to the firm5s concern about a negative stoc" mar"et resonse to a forced conversion# oo"ing at .able ; in the Aendi:, the after9ta: cost of the bonds =ith the =arrants to 4irginia May is &,+7 =hereas the before9ta: return to investors euals ,&%7# Both numbers are based on the formula given in the case and do not consider the dilution effect =hich imlies the creation of ne=ly issued shares# 6hen the dilution effect is ta"en into account the after9ta: cost to the comany changes to &,07 and the before9ta: return to investors is ,27# urrently, 4irginia May has -#000#000 outstanding shares# By issuing ;0#000 bonds =ith a ar value of #000 it raises funds of ;0#000#000# Each bond has 0 detachable =arrants that reresent a call otion for one share of the cororation# )f all investors use the =arrants to obtain more shares, then %#00#000 ne= shares have to be issued $;0#000 bonds0 =arrants' =hich results in a dilution ratio of 0,;+2 $-#000#000 shares $-#000#0000 shares G %#00#000 ne=ly issued shares'#

Question 16: 7ar Value8 3vervalued or 9ndervalued

.able & of  the Aendi: rovides on overvie= for investors5 re9ta: returns, as =ell as the after9ta: costs to 4irginia May# .he 7 convertible offers a before9ta: return of 2#-7, =hich clearly is the most interesting amongst the three financing alternatives# .his return is slightly higher than the 27 yielding straight BB bond# .he convertibles and  bonds =ith =arrants bear a some=hat higher ris", since these carry an euity art =ithin them# Moreover, the ossible ta: deferral on the convertibles5 and =arrants5 caital gains, =ould not be enough to ustify the lo=er return comared to that of the straight debt# .herefore, the financing alternatives =ill be traded at a significant discount since investors =ould not be =illing to ay ar value# )n order to ma"e these three financing alternatives more attractive to investors, some of their characteristics =ould need restructuring# For  instance, a higher conversion ratio, that is the debt that can be converted into stoc"s and an

;

e:tension of the call rotection =ould ma"e both convertibles more attractive to investors# For   bonds =ith detachable =arrants, more =arrants could be included to one bond# Additionally, if  these bonds had higher couon rates, combined =ith a longer time to e:iration of the bonds, these features =ould be very aealing to otential investors# )n brief, both the convertibles as =ell as the bonds =ith detachable =arrants should be more attractive, in =hich case they =ill not have to be traded at discount to guarantee a minimum demand for these securities# Question 11: eco;;endation to Virginia May’s $oard of 4irectors

.he recommendation to the board of directors goes beyond the mere analysis of the comany5s costs and investors5 returns on each of the financing alternatives# .he imlications they =ill resectively have on the comany5s caital structure cannot be ignored, as the imact these =ill have on 4irginia May are of great imortance as =ell# .he first uestion raised is =hether to issue bonds =ith =arrants or convertibles and in the latter case, choose bet=een the - or 7 ones# onvertibles have no dilution effect, since in converted bonds are financed =ith e:isting stoc", =hile =arrants imly the issuing of ne= stoc"# .herefore, =arrants al=ays increase the shares outstanding, thereby diluting the caital structure and harming the e:isting shareholders# Moreover, convertibles as comared to bonds =ith =arrants have the advantage of being more fle:ible since they are callable =hile =arrants usually are not# Furthermore, the flotation costs of =arrants are in average significantly higher than of convertibles# .o ans=er the uestion =hether to issue bonds =ith detachable =arrants or convertibles, the recommended ans=er clearly goes to convertibles, since these do not harm the e:isting shareholders, =hich in turn =ill not ut the stoc" rice under any more ressure and offer greater fle:ibility that are associated =ith lo=er costs# .he decision on e:actly =hich convertible to issue also imlies several concerns# .he -7 convertible has a higher conversion ratio than the  ercent issue# !ince both bonds have the same call rotection, maturity and ar value, one has to loo" further for their difference in characteristics# .he maor distinctions are the conversion ratio, the couon ayment and the call remium# .he higher conversion ratio for the -7 convertible euali@es the lo=er couon  ayment and the lo=er call remium and vice versa for the 7 convertible# .he otion to convert might be more valuable to an investor than the small difference in before ta:9return $#%; for the -7 and 2#- for the 7 convertible' to investors =hile the after9ta: costs are almost the same $#2* for the  ercent and #2& for the - ercent convertible'# Additionally, due to the higher conversion ratio of the - ercent bond, the convertible can be called at an earlier oint in time, because at an already lo=er stoc" rice investors =ould be =illing to convert# .his course of action =ould result in an earlier cleaning u of the caital structure, thereby e:changing debt for euity and reducing the comany5s distress costs# Furthermore, &

the attractiveness to investors is of huge imortance since the convertibles =ould have to be traded at discount, =ould the demand for these be too lo=# A lo=er amount of ne=ly issued debt that can be issued, =ould imly a lo=er amount of cash available and ready to be invested in romising roects# .herefore, due to the higher conversion ratio of the - ercent convertible and the earlier cleaning u of the caital structure, the ust slightly lo=er before9 ta: return to investors coming =ith an almost eual after9ta: costs to the comany, Mr# Barnhardt should ot for, and recommend the -7 convertible to the board of directors of  4irginia May# A final remar" =ould be that although this convertible is the most attractive one to investors, it still offers less than the 27 straight debt, as mentioned earlier on, in uestion 0# Cence, a maor focus and ultimate goal here is on ho= to imrove the attractiveness to investors, and at the same time not harming the comany =ith a convertible that has to be offered at a discount#

Question 1#: $efore+Ta, eturn and "fter+Ta, Cost of 16'*% Convertible

.he return to investors as =ell as the comany5s after9ta: costs =ould be subect to change, =ere 4irginia May to change the convertible5s couon rate from  to 0#+7# .he cororation5s after9ta: costs =ould decrease from #2* ercent to &#-& ercent in case of  the lo=er couon rate and the lo=er call remium# .he before9ta: return to investors also decreases from 2#- ercent in case of an  ercent convertible to #&* ercent in case of  the 0#+ ercent convertible# Detailed calculations on after9ta: costs and the before9ta: return to investors can be found in .able  of the Aendi:# Additionally, the =eighted average cost of caital of 4irginia May =hen issuing a 0#+  ercent couon rate =ith a lo=er call remium =ould decrease, do=n to -#27# !lightly lo=er than the other=ise -#+7 =hich are yielded by the 7 couon bonds# .hese calculations can be found in .able - of the Aendi:# .he final remaining uestion is to find out =hether enough investors =ould ultimately be =illing to urchase the 0#+7 couon convertible desite its lo= return on investment, and if this is the case, then at =hich discount the bond should be selling#

"endi,



Question 1: Virginia May’s Caital !tructure and W"CC

.able / 4irginia May5s urrent aital !tructure and urrent 6A

Question #: Conversion and $ond Values for 11% Convertible $onds

-

.able 2/ onversion and Bond 4alues for 7 onvertible Bonds

Figure / (elationshi Bet=een the Different 4alues in .able 2

Question (: Conversion )ear of $ond

.able */ 8ear of onversion of 4irginia May5s 7 convertible issue

Questions * < -: "fter+ta, Cost and $efore+ta, return of 11% Convertible Issue

0

.able %/ After9.a: ost and Before9.a: ost of 7 onvertible )ssue

Question .: /ew Mar0et Value Caital !tructure and /ew W"CC



.able +/ 4irginia May5s urrent 6A =ith -7 and 7 onvertible Bonds

Question 5: Virginia’s May "fter+Ta, Cost of the $onds with Warrants

Cint/ .he years - H 2* have a couon ayment of ;0 as =ell#

Cint/ .he years - H 2* have a couon ayment of ;0 as =ell#

Cint/ .he years - H 2* have a couon ayment of 00 as =ell#

2

Cint/ .he years - H 2* have a couon ayment of 00 as =ell#

.able ;/ After9.a: and Before9.a: ost =ith 0 6arrants H =ith and =ithout Dilution Effect

Question 16: 7ar Value8 3vervalued or 9ndervalued

*

.able &/ After9.a: ost and Before9.a: ost for 0#+7 onvertible )ssue

Question 1#: $efore+Ta, eturn and "fter+Ta, Cost of 16'*% Convertible

%

.able / !ummary of ost of onvertible )ssue and 6A

.able -/ 4irginia May5s