Stock Warrants
Concept of Warrants
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 an instrument that can be traded on the stock exchange like stocks and bonds.
A call or put warrant allows the holder to purchase or to sell an underlying asset at a set price (strike price or exercise price) by a specified date, but does not obligate him or her to do so. It expires on that date. There are some that can be used before that date and others that can only be used during that time frame. It is typically less costly than the underlying asset, referred to as the “premium.”
What are warrants in Finance
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. The purpose of a warrant is not to compensate a company, but to increase its capital and attract potential investors. A warrant is typically backed by the common stock of the issuer.
Due to the fact that the company must issue new shares upon exercising warrants, warrants have a dilutive effect in the form of shares in the company. Investors can redeem the warrant at a lower price if the issuer’s stock price increases above its warrant price, allowing them to buy the shares at the higher price.
Why do companies issue warrants?
Features of Warrants
Key features of warrants are as follows
Exercise price (E)
Exercise price is the price at which warrant holder can purchase common stocks of the company using warrant option. It is normally set 10p percent to 20 percent above the prevailing price. It is also called strike price.
Exercise Ratio (#)
It is the number of common stock that can be purchased using single warrant. For example, Exercise ratio 2 means warrant holder can purchase 2 common stocks using each warrant.
Expiration Date
Warrant should be exercise within the give time limit. If they are not exercised, it expires. Warrants have generally 3 to 5 years of life.
Detachability
Some warrant can be traded separately from the security are called detachable warrant and some are not are called non-detachable warrant. It should be mentioned at the time issue about the detachability of warrant.
Types of Warrants
Detachable and Non-Detachable
In the past, warrants were usually sold along with bonds, giving the buyer a better price. Bonds and stocks attached to detachable warrants are not required to be sold to sell the warrants. The holder of a warrant attached to a bond or stock is permitted to sell the warrant without selling the bond or stock. This makes detached warrants more appealing. The benefit is particularly great for warrants issued as preferred stock. When a warrant is attached to preferred stock, the dividend payments will sometimes be delayed. In such a situation, holders may be tempted to sell warrants and keep the stock if the warrants are detached. The warrants cannot be sold separately; they can only be sold in conjunction with the bonds or stock attached. It should be noted that these can also be called “wedded” warrants. Naked warrants do not come with any bonds or stock.
Covered Warrants
In the case of covered warrants, the shares are not issued by the companies, but rather by financial institutions. Because the institution that issued the warrant owns or can easily acquire the underlying shares, the warrants are simply “covered.”
Call and Put Warrants
An issuer of call warrants can sell its shares to the warrant holder. The holder of a put warrant can sell the shares back to the issuer. A strike or exercise price specifies the price at which the holder may buy or sell shares, also called “strike” or “exercise” price. The “expiry” date is specified in both instruments, which indicates when the transaction must be completed. Once a warrant has expired, it no longer has any value. Call warrants buy shares from the company at a future date for a predetermined price. Put warrants sell the company shares at a future date. Put warrants represent the value of stock that a buyer can redeem for a set price in the future from the issuing company.
Trading Warrants
Exercise of warrants isn’t the only way to make money from them. Moreover, warrants can also be bought and sold by investors, though it is challenging and time-consuming since they are not listed on stock exchanges. A warrant’s minimum value is the difference between the current market value of the underlying security and the warrant’s strike price. In the current market, this is the profit warrant holders would receive if they exercised their warrants. If traders think the price of the underlying security will rise in the future, however, warrants that trade on an exchange may sell for more than the minimum value, just like supply and demand and predictions of the market. As the expiration date approaches, the premium will generally decrease.
Analysis of Warrants
Value of warrant depends on price of common stock since it is the right to purchase the common stock. There are two types of warrants value: theoretical value and market value.
Theoretical Value
Theoretical value is calculated value based on market price of stock and exercise price. Theoretical value of warrant can be determined with following equation
TVw = Max [(Po-E) N, 0]
Where,
TVw = theoretical value of warrant
Po = current market price of stock
E = exercise price per share
N = exercise ratio (#)
Generally, Exercise price is set up higher than prevailing market price per share at the time issue so initially theoretical value of warrant could be zero but in long run it is expected that price of stock will increase and value of warrant also increase gradually.
Market value
It refers to the actual price of warrant which is determined by demand and supply. Market value of warrant is always greater than that of theoretical value. It is due to leverage opportunities that means, in warrant investment, investors can get high profit with the small increment in market price of ordinary stock.
Warrant premium
It is the difference between market value of warrant and theoretical value of warrant.
- Warrant premium = MVw – TVw
There is linear relationship between price of stock and theoretical value of warrant but market value of warrant premium depends upon various factors; market price of stock, exercise price, time of expiration and degree of price volatility on the underlying common stock. Theoretical value of warrant is zero till exercise price equal to market price but market price could be exists while market price of stock is lower than exercise price.
So, warrant premium gradually starts to increase till market price of stock equals to exercise price and after that warrant premium start to decrease. Warrant premium is the highest when exercise price equal to market price of stock. Relationship between theoretical value and market value of a warrant can be explained with the help of following graph.
Impact of Warrant on Financial Statement
Issue of warrants affects the balance sheet and income statement of the firm. When warrant is issued along with fixed income securities, Sources of funds increase that either increase equity or debt with cash balance of assets of the firm in balance sheet.
When debt is issued interest expenses also increase and affects the net operation income of firm in income statement. Impact of warrant can be analyzed before the exercise and after the exercise on balance sheet and income statement.
Impact on Balance sheet
Before exercise of warrant when securities are issued, equity and liability side increase along with cash balance of assets side of balance sheet of the firm. After the exercise of warrant additionally equity and cash balance increase of the balance sheet.
Example: Suppose Kumari bank Limited has following balance sheet before issue of long term debt
Balance sheet of KBL
| Liabilities and equity | Amount | Assets | Amount |
| Common Stock(10000 share @Rs. 100) | 10,00,000 | Current assets | 8,00,000 |
| Additional paid in capital | 4,00,000 | Fixed assets | 12,00,000 |
| Retain Earning | 2,00,000 | ||
| Current Liabilities | 4,00,000 | ||
| Total liability and equity | 20,00,000 | Total assets | 20,00,000 |
KBL is planning to raise additional capital Rs. 10, 00,000 through issue of 10 years 10 percent debenture. Each warrant entitles warrant holders to purchase 2 shares at Rs. 250. The current market price of share is Rs. 200. The warrant expires in 2 years. Par value of debenture is Rs. 1000. The firm is in 40 taxes and EBIT is assumed to be 30 percent of total assets.
Given, Additional Capital to be issued = Rs. 10, 00,000
Source of fund = Debenture with warrant
Maturity Period = 10 years
Coupon rate = 10%
Exercise ratio (#) = 2 shares
Exercise Price = Rs. 250
Market price of stock = Rs. 200
Situation 1: Before exercise of warrant but debenture is issued.
When debenture is issued debenture of liability side and cash balance increase in balance sheet. Cash Debenture
Balance of KBL before exercise of warrant
| Liabilities and equity | Amount | Assets | Amount |
| Common Stock(10000 share @Rs. 100) | 10,00,000 | Current assets | 18,00,000 |
| Additional paid in capital | 4,00,000 | (8,00,000+ 10,00,000) | |
| Retain Earning | 2,00,000 | Fixed assets | 12,00,000 |
| 10% Debenture | 10,00,000 | ||
| Current Liabilities | 4,00,000 | ||
| Total liability and equity | 30,00,000 | Total assets | 30,00,000 |
Situation 2: After exercise of warrant and purchase new additional share
When new share are issued for warrant, cash balance and common stock increase in balnce sheet. Cash Common stock
Balance of KBL After exercise of warrant
| Liabilities and equity | Amount | Assets | Amount |
| Common Stock(12000 share @Rs. 100) | 12,00,000 | Current assets | 23,00,000 |
| Additional paid in capital | 7,00,000 | (18,00,000+ 5,00,000) | |
| Retain Earning | 2,00,000 | Fixed assets | 12,00,000 |
| 10% Debenture | 10,00,000 | ||
| Current Liabilities | 4,00,000 | ||
| Total liability and equity | 35,00,000 | Total assets | 35,00,000 |
Working Note;
Number of new additional shares issued if all warrants are exercised = [Funds to be raised/Par Value]×#
= [1000000/1000]×2
= 2000 new shares
Exercise Price = Rs. 250
where,
- Par Value = Rs. 100 (100×2000 = Rs 2, 00,000)
- Premium = Rs 150 (250-100) [150×2000 = Rs. 3, 00,000]
Impact of Warrant on Income Statement
Warrant exercise affects the Net income and earnings per share of firm. It can be iilustrated by above example
| Particulars | Before Exercise | After exercise |
| EBIT ( 30% of total assets) | 30,00,000×0.3 = 9,00,000 | 35,00,000×0.3 = 10,50,000 |
| Less: Interest 10% | 1,00,000 | 1,00,000 |
| Earning bofore tax (EBT) | 8,00,000 | 9,50,000 |
| Less: Tax (40%) | 3,20,000 | 3,80,000 |
| Earning after tax or NI | 4,80,000 | 5,70,000 |
| EPS = | 48 per share | 47.5 per share |
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I am Smirti Bam, an enthusiastic edu blogger with a passion for sharing insights into the dynamic world of business and management through this website.
I hold a MBA degree from Presidential Business School, Kathmandu, and a BBA degree with a specialization in Finance from Apex College,
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