Can someone explain what a warrant is to me? I’m going through the EPS material and realized that I have no idea what one is. Thanks!
I remember from the CFA curriculum that they are very valuable. Policemen keep giving them to me though. I think that you have to invite people into your house or go visit other people in jail to get them. I haven’t figured out how they are worth anything yet. OK that was a little funny. A warrant is essentially a call option with a strike and an expiration date with one crucial difference. If the warrants are exercised, new shares are created. So an interesting thing to do is to think about what the effect is for current shareholders when warrants are issued. Suppose the stock is at 20 and there are warrants issued for $1 with strike 24 in six months and each warrant is convertible into one share of stock. Suppose there are 100 shares existing and you issue 100 warrants. There’s an extra dollar per share of cash in the company which in most situations would make the stock worth $1 per share more. So it seems that current stockholders benefit. But if the the company strikes oil worth $600, the stock will blow through the strike and instead of getting $6/share, each shareholder will only get $3/share from the oil strike. The effect of issuing warrants is roughly the same as forcing your existing shareholders to sell covered calls.
So when the warrant is exercised, the firm using the cash they receive from warrant holders to buy back shares from the market, and the remaining shares are newly created? So in your example, if share price increases to $30, obviously, warrant holders will exercise, so they pay $24 to redeem 100 shares, but in the market $2400 can only repurchase 80 shares, so does that mean the firm creates 20 new shares? Thanks a lot.
no - all things are possible and I can’t say it’s never been done, but issuing warrants and using the proceeds to buy back stock would just be odd. Warrants increase the number of shares on the market and someone issuing them feels fine with that dilution. If each warrant is good for one share you should think that the number of shares outstanding will increase by the number of warrants.
Actually isn’t yickwong referring to the FASB “treasury stock” method for calculating dilution?
Yes. But one is about accounting for dilution and the other is about capital structure.
huh? So the accounting for dilution is different from what will actually happen? Why don’t they just account for dilution as extra shares = warrants if the stock price is above strike price? What is the logic behind it?
yickwong Wrote: ------------------------------------------------------- > huh? So the accounting for dilution is different > from what will actually happen? > Why don’t they just account for dilution as extra > shares = warrants if the stock price is above > strike price? What is the logic behind it? Who knows what would actually happen? The “treasury stock” method of accounting is a pretty fanciful view of what might happen. Every derivatives book that values warrants I have ever seen assumes that warrants are completely dilutive - the proceeds from the exercise increase the value of the company and the number of shares outstanding goes up 1-1 with the number of shares created by the exercise of the warrant. While I don’t have solid empirical numbers on this, I’ll bet that’s much closer to reality than the “all proceeds used to repurchase stock as treasury stock”. Don’t tell anyone I told you this but accounting for dilutive securities has always been a rat’s nest. The treasury stock method is quite an optimistic viewpoint for stock holders. As a financial analyst, you shouldn’t care at all how FASB or IASB says you should calculate numbers like EPS (in fact, it’s pretty odd that those organizations take any position on this at all since it’s not their job to tell financial analysts anything). If you see a company with lots of treasury stock, it’s because they don’t want the world to see the effects of dilution accruing to the benefit of corporate insiders. Rule #1 about accounting - it’s all made-up BS created from odd compromises among accountants, politicians, and corporations. You should be able to read it and speak it because there’s lots of information there. But if you believe the information in that kind of literal sense, then you are being bullied by accounting rules and duped by everyone who uses them to advantage. So a few things to think about: 1) Why do we have rules like FASB 128? 2) Why do dilutive securities exist? 3) How would you calculate EPS in whatever made up case you can think of when there are warrants extant? 4) “Why don’t they just account for dilution as extra shares = warrants if the stock price is above strike price?” Hint: In my example above, compare the volatility of the stock price with the volatility of EPS when the stock price is near the strike price. Which should be more volatile, stock price or EPS?
Can someone explain the difference between a warrant and an option? thanks
Did you look it up, say, on Wikipedia?
“The treasury stock method is quite an optimistic viewpoint for stock holders.” For mature companies with no internal growth or acquisition prospects, it’s quite realistic. Otherwise, I agree…
Mature companies with no internal growth prospects or acquisition prospects with warrants? It probably happens…