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 Mays 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: Virginias 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 papers 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 companys financing
options, this study will recommend the corporations 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 companys debt part of its capital structure, and will assess which of these options will
minimize Virginia Mays WACC over a period as long as the next 25 years.
Question 1: Virginia Mays 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 Mays 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 companys 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 cases 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
companys 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 firms interest payments. Furthermore, a firm can reduce financial leverage by
converting bonds into stocks which lowers the firms 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 firms 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 investors 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 bonds 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
possible to call bonds between two interest payment dates. The detailed calculation is
illustrated in Appendixs Table 3 which is supported by the graph in Figure 1 as well.
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Question 5: After-Tax Cost of 11% Convertible Issue

Virginia Mays 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 companys 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 investors return and the companys 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 companys new current market capital is based on a few figures, most of which to be
found in or under the Virginia Mays balance sheet for the year ending on the 31 st of
December 1992. First thing to consider are the companys $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.

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 bonds 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: Virginias 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
instance, a higher conversion ratio, that is the debt that can be converted into stocks and an
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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 Mays Board of Directors
The recommendation to the board of directors goes beyond the mere analysis of the
companys costs and investors returns on each of the financing alternatives. The implications
they will respectively have on the companys 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
convert. This course of action would result in an earlier cleaning up of the capital structure,
thereby exchanging debt for equity and reducing the companys distress costs. Furthermore,
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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 beforetax 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 companys after-tax costs would be subject to change,
were Virginia May to change the convertibles coupon rate from 11 to 10.5%.
The corporations 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.

Appendix

Question 1: Virginia Mays Capital Structure and WACC

Table 1: Virginia Mays Current Capital Structure and Current WACC

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

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

Table 3: Year of Conversion of Virginia Mays 11% convertible issue

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

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

Question 7: New Market Value Capital Structure and New WACC

11

Table 5: Virginia Mays Current WACC with 9% and 11% Convertible Bonds
Question 9: Virginias May After-Tax Cost of the Bonds with Warrants

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

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

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

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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

13

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

14

Table 8: Summary of Cost of Convertible Issue and WACC

Table 9: Virginia Mays New Current Weighted Cost of Capital

Summary

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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