Financing with Convertibles and

Warrants“Virginia May Chocolate Company”

University Maastricht

Faculty of Economics and Business Administration

Financial Management and Policy

Maastricht, December 2nd, 2008

Stroeken, B. (i420778)

Richter, I. (i351091)

Buse, T. (i423505)

Study: International Business

Course code: 3020B

Group number: 5

Tutor name: A. Corelli

Subgroup number: 3

Case 5

Table of Content

Introduction.................................................................................................................................3

Question 1: Virginia May’s Capital Structure and WACC.........................................................3

Question 2: Conversion and Bond Vallues for 11% Convertible Bonds....................................3

Question 3: Crucial Factors for Callable Convertible Securities................................................4

Question 4: Conversion Year of Bond........................................................................................4

Question 5: After-Tax Cost of 11% Convertible Issue...............................................................5

Question 6: Before-Tax Return of 11% Convertible Issue.........................................................5

Question 7: New Market Value Capital Structure and New WACC..........................................5

Question 8: Consistency of Market Value Line and Other Data................................................6

Question 9: Virginia’s May After-Tax Cost of the Bonds with Warrants..................................6

Question 10: Valuation of Warrant and Convertible Issue.........................................................6

Question 11: Recommendation for Financing Alternatives........................................................7

Question 12: Before-Tax Return and After-Tax Cost of 10.5% Convertible.............................8

Appendix.....................................................................................................................................9

References.................................................................................................................................16

Introduction

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This paper’s aim is to evaluate and guide Virginia May Inc. to its best case future financing

alternatives. By thoroughly reviewing the situation at hand and the company’s financing

options, this study will recommend the corporation’s board of directors on how to raise its

needed capital for expansion in the most rational and efficient manner. This paper will more

specifically, and in depth, review the given options of warrants and convertible bonds to serve

as the company’s debt part of its capital structure, and will assess which of these options will

minimize Virginia May’s WACC over a period as long as the next 25 years.

Question 1: Virginia May’s Capital Structure and WACC

The current market capital structure of Virginia May is based on the market values of notes

payable, long-term debt and total common equity as can be seen in Table 1 of the Appendix.

The book value of notes payable is assumed to equal its market value that amounts to

$40.000.000 whereas the market value of long-term debt is $195.650.379. Multiplying the

share price of $17,45 times 9.000.000 outstanding shares leads to the market value of equity

which equals $157.050.000. As a result, Virginia May’s current market value of

$392.650.379 is obtained. Taking into account the weights, costs and tax rates of the different

capital structure components facilitates the calculation of the company’s WACC that amounts

to 10,58%. The WACC is obtained according to the formula given in the case.

Question 2: Conversion and Bond Values for 11% Convertible Bonds

Table 2 of the Appendix depicts the missing figures of the case’s Table 3. The straight

conversion value, the bond value as well as the call price are calculated there. Based on Table

2, the graph in Figure 1 (Appendix) depicts the relationship between conversion value,

straight bond value, call price, maturity value and estimated market value of the 11 percent

convertible issue over time. This graph shows that around year 15 the straight conversion

value of the bond equals the estimated market value. At this point in time, the owner of the

bonds should call its convertibles and convert the bonds into equity.

Question 3: Crucial Factors for Callable Convertible Securities

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Convertibles represent a call option for the firm. There are several factors that affect a

company’s decision to call bonds. If interest rates are falling, then the company should call

the bond to refinance its debt at a lower level of interest rates. Refinancing means paying off

an existing loan with the proceeds of a new loan that is cheaper, i.e. the firm calls the

convertibles with the higher coupon rate and finances it by issuing new bonds with a lower

coupon rate. A better credit rating benefits a firm as well since it decreases the cost of debt

and thus the firm’s interest payments. Furthermore, a firm can reduce financial leverage by

converting bonds into stocks which lowers the firm’s debt ratio and improves its borrowing

capacity. In theory firms would call the convertibles if the conversion value equals the market

value. If the conversion value is above the call price, the call forces conversion into equity.

However, prior research has shown that management only commits to call conversion if the

conversion value exceeds the call price by 20-30% since it wants to ensure that the stock price

cannot drop below the conversion value during the call period of 30 days. This policy is

conducted due to the firm’s concern about a negative stock market response to a forced

conversion. Nevertheless, there is a trade-off between the increased value of conversion to

bondholders and the lower value to existing shareholders due to the stock price decrease on

forced conversion. In case the call price lies above the conversion value the firm does not

exercise the convertibles.

Looking at the investor’s perspective, in general it can be stated that a conversion of bonds

into stocks takes place whenever the investor thinks he/ she obtains a greater payoff from the

conversion. Thus, holders of convertibles tend to convert bonds into stocks voluntarily when

conversion value exceeds call price. This implies that the dividend payments received from

the stocks are expected to be greater than the bonds’ coupon rate. Investors prefer to convert

under these circumstances to avoid being forced to convert at a later point in time with a

lower conversion value. Furthermore, low dividends and high growth prospects for a

company also induce bondholders to convert debt into equity as they can expect to reap a

capital gain based on a stock price increase.

Question 4: Conversion Year of Bond

The assumption that Virginia May would call the 11% convertible issue after the first interest

payment date on which the conversion value of the bond is 40% greater than the bond’s par

value implies a face value of $1400. According to the formula for the conversion value given

in the case, straight conversioin value equals market value after 14,25 years. However, as

already mentioned in Question 2, the firm will call the bonds in year 15, since it is not

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possible to call bonds between two interest payment dates. The detailed calculation is

illustrated in Appendix’s Table 3 which is supported by the graph in Figure 1 as well.

Question 5: After-Tax Cost of 11% Convertible Issue

Virginia May’s 11%-yielding convertible bond would have a 8,23% after-tax cost if called in

year 15 of its lifetime. It is worthwhile to mention here that the calculations presented in

Table 4 of the Appendix have been adjusted to the company’s stock assumed annual growth

rate of 5%.

Question 6: Before-tax return of 11% Convertible issue

Investors can expect a return of 12,19% on 11% convertible bonds that are called in year 15.

The figures and formula used to come to this conclusion can be found in Table 4 of the

Appendix. The difference between the investor’s return and the company’s cost of that same

return is a simple tax shield benefit that the company enjoys through its use of leverage.

Question 7: New Market Value Capital Structure and New WACC

The company’s new current market capital is based on a few figures, most of which to be

found in or under the Virginia May’s balance sheet for the year ending on the 31st of

December 1992. First thing to consider are the company’s $40.000.00 of notes payable. Then

comes its market value of long-term debt, which amounts to $195.600.379, the market value

of its equity, namely $157.050.000 ($17,45 x 9.000.000 outstanding shares) and last but not

least, its newly issued 11% convertible bonds for a total amount of $60.000.000. The sum of

these respective figures amount to a current capital structure worth nothing less than

$452.650.379. Based upon this new structure, the new WACC is now 9.85%.

This is all further explained down in Table 5 of the Appendix. There, the new WACC is

calculated with both short- and long-term costs of capital that are expected to increase. Due to

the higher amount of debt, the outstanding equity becomes more riskier and thus the cost of

equity as well. The higher level of leverage also raises financial distress costs which increases

the cost of debt. Therefore, it is not reasonable to assume that the component cost remain

constant.

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Question 8: Consistency of Market Value Line and Other Data

Any investor would suffer a loss of $210 in this specific case ($1,282-$1,072). This results in

the market value line in Figure 1 of the Appendix not being in line with the other data. Surely

investors are very aware of this risk, and rationality would lead these investors not to pay a

premium on top of the call price or the bond’s conversion value.

At a specific point in time (15 years), the straight conversion value and the market value of

the convertible will match each other. This occurs because the dividend payments belonging

to the underlying stock are expected to grow and additionally, the call protection period ends,

which also lowers the market value relative to the straight conversion value.

Question 9: Virginia’s May After-Tax Cost of the Bonds with Warrants

Looking at Table 6 in the Appendix, the after-tax cost of the bonds with the warrants to

Virginia May is 7,58% whereas the before-tax return to investors equals 11,74%. Both

numbers are based on the formula given in the case and do not consider the dilution effect

which implies the creation of newly issued shares. When the dilution effect is taken into

account the after-tax cost to the company changes to 7,01% and the before-tax return to

investors is 11,12%. Currently, Virginia May has 9.000.000 outstanding shares. By issuing

60.000 bonds with a par value of $1.000 it raises funds of $60.000.000. Each bond has 80

detachable warrants that represent a call option for one share of the corporation. If all

investors use the warrants to obtain more shares, then 4.800.000 new shares have to be issued

(60.000 bonds*80 warrants) which results in a dilution ratio of 0,652 (9.000.000 shares/

(9.000.0000 shares + 4.800.000 newly issued shares).

Question 10: Par Value, Overvalued or Undervalued

Table 7 of the Appendix provides on overview for investors’ pre-tax returns, as well as the

after-tax costs to Virginia May. The 11% convertible offers a before-tax return of 12.19%,

which clearly is the most interesting amongst the three financing alternatives.

This return is slightly higher than the 12% yielding straight BB bond. The convertibles and

bonds with warrants bear a somewhat higher risk, since these carry an equity part within

them. Moreover, the possible tax deferral on the convertibles’ and warrants’ capital gains,

would not be enough to justify the lower return compared to that of the straight debt.

Therefore, the financing alternatives will be traded at a significant discount since investors

would not be willing to pay par value. In order to make these three financing alternatives

more attractive to investors, some of their characteristics would need restructuring. For

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instance, a higher conversion ratio, that is the debt that can be converted into stocks and an

extension of the call protection would make both convertibles more attractive to investors. For

bonds with detachable warrants, more warrants could be included to one bond. Additionally,

if these bonds had higher coupon rates, combined with a longer time to expiration of the

bonds, these features would be very appealing to potential investors. In brief, both the

convertibles as well as the bonds with detachable warrants should be more attractive, in which

case they will not have to be traded at discount to guarantee a minimum demand for these

securities.

Question 11: Recommendation to Virginia May’s Board of Directors

The recommendation to the board of directors goes beyond the mere analysis of the

company’s costs and investors’ returns on each of the financing alternatives. The implications

they will respectively have on the company’s capital structure cannot be ignored, as the

impact these will have on Virginia May are of great importance as well.

The first question raised is whether to issue bonds with warrants or convertibles and in the

latter case, choose between the 9 or 11% ones. Convertibles have no dilution effect, since in

converted bonds are financed with existing stock, while warrants imply the issuing of new

stock. Therefore, warrants always increase the shares outstanding, thereby diluting the capital

structure and harming the existing shareholders. Moreover, convertibles as compared to bonds

with warrants have the advantage of being more flexible since they are callable while

warrants usually are not. Furthermore, the flotation costs of warrants are in average

significantly higher than of convertibles. To answer the question whether to issue bonds with

detachable warrants or convertibles, the recommended answer clearly goes to convertibles,

since these do not harm the existing shareholders, which in turn will not put the stock price

under any more pressure and offer greater flexibility that are associated with lower costs. The

decision on exactly which convertible to issue also implies several concerns. The 9%

convertible has a higher conversion ratio than the 11 percent issue. Since both bonds have the

same call protection, maturity and par value, one has to look further for their difference in

characteristics. The major distinctions are the conversion ratio, the coupon payment and the

call premium. The higher conversion ratio for the 9% convertible equalizes the lower coupon

payment and the lower call premium and vice versa for the 11% convertible. The option to

convert might be more valuable to an investor than the small difference in before tax-return

(11.46 for the 9% and 12.19 for the 11% convertible) to investors while the after-tax costs are

almost the same (8.23 for the 11 percent and 8.27 for the 9 percent convertible). Additionally,

due to the higher conversion ratio of the 9 percent bond, the convertible can be called at an

earlier point in time, because at an already lower stock price investors would be willing to

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convert. This course of action would result in an earlier cleaning up of the capital structure,

thereby exchanging debt for equity and reducing the company’s distress costs. Furthermore,

the attractiveness to investors is of huge importance since the convertibles would have to be

traded at discount, would the demand for these be too low. A lower amount of newly issued

debt that can be issued, would imply a lower amount of cash available and ready to be

invested in promising projects. Therefore, due to the higher conversion ratio of the 9 percent

convertible and the earlier cleaning up of the capital structure, the just slightly lower before-

tax return to investors coming with an almost equal after-tax costs to the company, Mr.

Barnhardt should opt for, and recommend the 9% convertible to the board of directors of

Virginia May. A final remark would be that although this convertible is the most attractive

one to investors, it still offers less than the 12% straight debt, as mentioned earlier on, in

question 10. Hence, a major focus and ultimate goal here is on how to improve the

attractiveness to investors, and at the same time not harming the company with a convertible

that has to be offered at a discount.

Question 12: Before-Tax Return and After-Tax Cost of 10.5% Convertible

The return to investors as well as the company’s after-tax costs would be subject to change,

were Virginia May to change the convertible’s coupon rate from 11 to 10.5%.

The corporation’s after-tax costs would decrease from 8.23 percent to 7.97 percent in case of

the lower coupon rate and the lower call premium. The before-tax return to investors also

decreases from 12.19 percent in case of an 11 percent convertible to 11.73 percent in case of

the 10.5 percent convertible. Detailed calculations on after-tax costs and the before-tax return

to investors can be found in Table 8 of the Appendix.

Additionally, the weighted average cost of capital of Virginia May when issuing a 10.5

percent coupon rate with a lower call premium would decrease, down to 9.82%. Slightly

lower than the otherwise 9.85% which are yielded by the 11% coupon bonds. These

calculations can be found in Table 9 of the Appendix. The final remaining question is to find

out whether enough investors would ultimately be willing to purchase the 10.5% coupon

convertible despite its low return on investment, and if this is the case, then at which discount

the bond should be selling.

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Appendix

Question 1: Virginia May’s Capital Structure and WACC

Book Value Market Value CalculationNotes Payable $40.000.000 $40.000.000Long Term Debt $220.000.000 $195.600.379Equity $214.288.000 $157.050.000Current Market Value $392.650.379

Virginia May's Current Capital Structure

Book Value = Market Value(PV of annuity + PV par value)*(number of bonds)

Stock Price*Outstanding shares

CalculationsPresent Value of Bond 90/0,105*(1-(1/ (1,105)^15)) + (1000/ (1,105)^15) = $889,09

Number of Bonds Issued 220.000.000/1000 = 220.000

Market Value of Long-Term Debt 220.000*889,09 = $195.600.379

Market Value of Equity 900.000*17,45 = $157.050.000

Weight Cost Taxes TotalCost of Notes Payable 0,102 0,085 0,6 0,0052Cost of Long Term Debt 0,498 0,105 0,6 0,0314Cost of Equity 0,400 0,173 1 0,0692Current WACC 10,58%

Virginia May's Current After-Tax WACC (based on D/C ratio = 0,50)

Weight Cost Taxes TotalCost of Notes Payable 0,102 0,085 1 0,0087Cost of Long Term Debt 0,498 0,105 1 0,0523Cost of Equity 0,400 0,173 1 0,0692Current WACC 13,02%

Virginia May's Current Pre-Tax WACC (based on D/C ratio = 0,50)

Table 1: Virginia May’s Current Capital Structure and Current WACC

Question 2: Conversion and Bond Values for 11% Convertible Bonds

Year Bond Value Call Price Maturity Value Est. Market Value0 698 922 1100 1000 10005 891 925 1096 1000 113210 1137 932 1072 1000 128215 1451 943 1048 1000 145120 1852 964 1024 1000 185225 2364 1000 1000 1000 2364

Conversion and Bond Values for 11% Convertible BondsStraight Conversion Value

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Calculations

Straight Conversion Value (17,45*(1,05)15)*40 = $1451

Bond Value (110*(1/0,12-(1/(0,12*(1,12)^10)+(1000/(1,12)^10) = $943

Call Price 1000+110-(110/23)*13 = $1048

Table 2: Conversion and Bond Values for 11% Convertible Bonds

Figure 1: Relationship Between the Different Values in Table 2

Question 4: Conversion Year of Bond

Stock Price * (1+g)^t * Conversion Ratio = Conversion Value17,45 * 1,05^t * 40 = 1400698 * 1,05^t = 1400

1,05^t = 2,01t = 14,25

Year of Conversion of Virginia May's 11% convertible issue

Table 3: Year of Conversion of Virginia May’s 11% convertible issue

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Questions 5 & 6: After-tax Cost and Before-tax return of 11% Convertible Issue

Periods 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15Coupons -$1.000 $66 $66 $66 $66 $66 $66 $66 $66 $66 $66 $66 $66 $66 $66 $1.517

After-Tax Cost 8,23%

Periods 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15Coupons -$1.000 $110 $110 $110 $110 $110 $110 $110 $110 $110 $110 $110 $110 $110 $110 $1.561

Before-Tax Return 12,19%

After-Tax Cost of 11% Convertible Issue

Before-Tax Cost of 11% Convertible Issue

151000 = ∑(110*0,6)/(1+kc)^t + (36,27 * 40)/(1+kc)^15

t=1

151000 = ∑(66)/(1+kc)^t + (1451)/(1+kc)^15

t=1

k = 8,23%

151000 = ∑(110)/(1+kc)^t + (36,27 * 40)/(1+kc)^15

t=1

151000 = ∑(110)/(1+kc)^t + (1451)/(1+kc)^15

t=1

k = 12,19%

After-Tax Cost of 11% Convertible Issue Formula

Before-Tax Cost of 11% Convertible Issue Formula

Table 4: After-Tax Cost and Before-Tax Cost of 11% Convertible Issue

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Question 7: New Market Value Capital Structure and New WACC

11% ConvertibleValue Weights Tax WACC

Common Stock 157050000 0,347 9,85%LT Debt 195600379 0,432 0,6Notes 40000000 0,088 0,6 LeverageConvertibles 60000000 0,133 65,30%Total Capital 452650379 1

Table 5: Virginia May’s Current WACC with 9% and 11% Convertible Bonds

Question 9: Virginia’s May After-Tax Cost of the Bonds with Warrants

Periods 1 2 3 4 5 6 7 8 …. 24 25Coupons -$1.000,00 $60,00 $60,00 $60,00 $60,00 $60,00 $330,77 $60,00 $60,00 $60,00 $1.060,00

$60,00 Coupon paymentAfter-Tax Cost 7,58% $270,77 Value of 80 warrants

After-Tax Cost for Bond with 80 Warrants - without Dilution Effect

Hint: The years 9 – 23 have a coupon payment of $60 as well.

Value of Warrant in Year 6

$23,38 $20,00 $3,38 $270,77

Value of Warrant in Year 6 - without Dilution Effect

Stock Price Year 6 Excercise Price 80 Warrants per Bond

Value of Warrant in Year 6 Dilution Effect

$176,59

Value of Warrant in Year 6 - with Dilution Effect

$23,38 $20,00 $3,38 $270,77

Stock Price Year 6 Excercise Price 80 Warrants per Bond

Periods 1 2 3 4 5 6 7 8 … 24 25Coupons -$1.000,00 $60,00 $60,00 $60,00 $60,00 $60,00 $236,59 $60,00 $60,00 … $60,00 $1.060,00

$60,00 Coupon paymentAfter-Tax Cost 7,01% $176,59 Dilution Effect

After-Tax Cost for Bond with 80 Warrants - with Dilution Effect

Hint: The years 9 – 23 have a coupon payment of $60 as well.

Periods 1 2 3 4 5 6 7 8 … 24 25Coupons -$1.000,00 $100,00 $100,00 $100,00 $100,00 $100,00 $370,77 $100,00 $100,00 … $100,00 $1.100,00

$100,00After-Tax Cost 11,74% $270,77

Before-Tax Cost for Bond with 80 Warrants - without Dilution Effect

Hint: The years 9 – 23 have a coupon payment of $100 as well.

Value of Warrant in Year 6$23,38 $20,00 $3,38 $270,77

Value of Warrant in Year 6 - without Dilution EffectStock Price Year 6 Excercise Price 80 Warrants per Bond

12

Value of Warrant in Year 6$176,59$23,38 $20,00 $3,38 $270,77

Value of Warrant in Year 6 - with Dilution EffectStock Price Year 6 Excercise Price 80 Warrants per Bond Dilution Effect

Periods 1 2 3 4 5 6 7 8 … 24 25Coupons -$1.000,00 $100,00 $100,00 $100,00 $100,00 $100,00 $276,59 $100,00 $100,00 … $100,00 $1.100,00

$100,00After-Tax Cost 11,12% $176,59

Before-Tax Cost for Bond with 80 Warrants - with Dilution Effect

Hint: The years 9 – 23 have a coupon payment of $100 as well.

Table 6: After-Tax and Before-Tax Cost with 80 Warrants – with and without Dilution Effect

Question 10: Par Value, Overvalued or Undervalued

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Periods 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15Coupons -$1.000 $63 $63 $63 $63 $63 $63 $63 $63 $63 $63 $63 $63 $63 $63 $1.514

After-Tax Cost 7,97%

Periods 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15Coupons -$1.000 $105 $105 $105 $105 $105 $105 $105 $105 $105 $105 $105 $105 $105 $105 $1.556

Before-Tax Return 11,74%

After-Tax Cost of 10.5% Convertible Issue

Before-Tax Cost of 10.5% Convertible Issue

151000 = ∑(105*0,6)/(1+kc)^t + (36,27 * 40)/(1+kc)^15

t=1

151000 = ∑(63)/(1+kc)^t + (1451)/(1+kc)^15

t=1

k = 7,97%

151000 = ∑(105)/(1+kc)^t + (36,27 * 40)/(1+kc)^15

t=1

151000 = ∑(105)/(1+kc)^t + (1451)/(1+kc)^15

t=1

k = 11,74%

After-Tax Cost of 10.5% Convertible Issue Formula

Before-Tax Cost of 10.5% Convertible Issue Formula

Table 7: After-Tax Cost and Before-Tax Cost for 10.5% Convertible Issue

Question 12: Before-Tax Return and After-Tax Cost of 10.5% Convertible

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old new old newafter tax 8.23% 7.97% 10.58% 9,82%before tax 12.19% 11.74% 13.02% 11,88%

Cost of convertible issue WACC

Table 8: Summary of Cost of Convertible Issue and WACC

Weight Cost Taxes TotalCost of Notes Payable 0,088 0,085 0,6 0,0045Cost of Long Term Debt 0,432 0,105 0,6 0,0272Cost of Equity 0,347 0,161 1 0,055910.5% Convertible 0,133 0,0797 1 0,0106New Current WACC 9,82%

After-tax WACC

Before-tax WACCWeight Cost Taxes Total

Cost of Notes Payable 0,088 0,085 1 0,0075Cost of Long Term Debt 0,432 0,105 1 0,0454Cost of Equity 0,347 0,161 1 0,055910.5% Convertible 0,133 0,0758 1 0,0100New Current WACC 11,88%

Table 9: Virginia May’s New Current Weighted Cost of Capital

Summary

9% Convertible 11% Convertible

Before-Tax Return 11.46% (Conversion/Call in Year 10) 12.19% (Conversion/Call in Year 15)

After-Tax Costs 8.27 % (Conversion/Call in Year 10) 8.23% (Conversion/Call in Year 15)

Bond incl. 80 detachable Warrants without Dilution Effect Bond incl. 80 detachable Warrants with Dilution Effect

Before-Tax Return 11.74% (Warrants expire in Year 6) 11.12% (Warrants expire in Year 6)

After-Tax Costs 7.58% (Warrants expire Year 6) 7.01% (Warrants expire Year 6)

Comparison of Financing Alternatives

Table 10: Comparison of Financing Alternatives

References

15

Brigham, E. F., Daves, P. R., Intermediate Financial Management, Eighth International

Student Edition, Thompson South-Western, New York.

Financing with Convertibles and Warrants, Virginia May Chocolate Company, 1994. The

Dryden Press.

Ross, S. A., Westerfield, R. W., Jaffe, J., Corporate Finance, Seventh International Edition,

McGraw-Hill, New York.

Smithson, Charles W., The Uses of Hybrid Debt in Managing Corporate Risk. Journal of

Applied Corporate Finance, Volume 4.4, 1992. Morgan Stanley.

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