Warrant is long term right in which warrant holder can purchase certain number of common stock at pre-determined price within specific duration. It is right option to buy the common stock not the obligation. It is also called sweeter because it makes debt and preferred stock more attractive and marketable. Warrant is attached with bond and preferred stock generally to encourage investors to invest in it.
Debt and preferred stocks are less attractive investment as compare to common stocks. When marketability of preferred stock and bond are low at that time warrant can be attached to encourage investors to invest on it. Price of securities attached warrant is higher than the straight bonds.
Reasons for Issuing Warrants
Warrants are typically issued by companies to raise capital and encourage investors to purchase stock. In addition to receiving funds when the warrants are sold, they also receive funds when the warrants are used to purchase stocks. Investors are more likely to purchase warrants since they are typically priced lower than the underlying stock, particularly if the company is unproven.
In this case, the warrant may not be used, so you lose your money spent on it, but the company that issued the warrant does not lose anything. As reported by US News and World Report, warrants are more frequently issued by speculative companies than by well-established blue-chip firms. In order to succeed, new, unproven firms need more capital, but the risk may not appeal to some investors. Stock warrants can be used to test the waters before investing in a stock.
Following are the main reasons for issuing warrants:
a) To increase marketability of securities:
If there is chance low subscription of the fixed income securities than warrant can be attached as sweeter for the securities. Since it gives right option to buy the common stock investors can enjoy the capital gain yield when price of stock increase.
b)To reduce cost of capital:
When warrant is attached to fixed income securities cost of capital may be lower than non- warrant securities. If warrant option is not available and firm needs funds and have to issue debt or preferred stock cost will be higher.
c) To avoid dilution :
Sometimes debt and preferred stock financing can be under subscribe and firm have to issue common stock that dilute the earning per share and control position but if firm use the warrant company can sell fixed income securities easily and can avoid the dilution.
d) Future cash inflow:
Warrant provides another opportunity of future cash inflow by exercise of warrant. Company receives additional funds from the exercise of warrant which may prove beneficial to fulfill additional funds requirement.
e) Deferred equity financing:
Warrant can permit a company to sell common stock at price above the price prevailing at the time of original issue.