Ross et al.: Fundamentals
of Corporate Finance, Sixth
Edition, Alternate EditionV. Risk and Return 14. Options and Corporate
Finance© The McGraw−Hill^505
Companies, 2002OPTIONS AND CORPORATE SECURITIES
In this section, we return to financial assets by considering some of the most common
ways options appear in corporate securities and other financial assets. We begin by ex-
amining warrants and convertible bonds.
Warrants
Awarrantis a corporate security that looks a lot like a call option. It gives the holder
the right, but not the obligation, to buy shares of common stock directly from a company
at a fixed price for a given time period. Each warrant specifies the number of shares of
stock that the holder can buy, the exercise price, and the expiration date.
The differences in contractual features between the call options that trade on the
Chicago Board Options Exchange and warrants are relatively minor. Warrants usually
have much longer maturity periods, however. In fact, some warrants are actually per-
petual and have no fixed expiration date.
Warrants are often called sweetenersor equity kickersbecause they are often issued
in combination with privately placed loans or bonds. Throwing in some warrants is a
way of making the deal a little more attractive to the lender, and it is a very common
practice. Also, warrants have been listed and traded on the NYSE since April 13, 1970.
As of the end of 2000, however, there were only 11 issues of warrants listed.
In many cases, warrants are attached to the bonds when issued. The loan agreement
will state whether the warrants are detachable from the bond. Usually, the warrant can
be detached immediately and sold by the holder as a separate security.
For example, in February of 2000, Metricom, Inc., announced the sale of $300 mil-
lion in senior notes due in 2010. For each $1,000 principal amount of senior notes pur-
chased, the buyer received a warrant to purchase 4.75 shares of common stock at a price
of $87.00 per share. The warrants were exercisable beginning six months after issuance.
They expire on February 15, 2010. Unfortunately for purchasers, Metricom, operator of
the Ricochet wireless network, filed for bankruptcy in the summer of 2001, so the war-
rants became essentially worthless.
The Difference between Warrants and Call Options As we have explained, from
the holder’s point of view, warrants are very similar to call options on common stock. A
warrant, like a call option, gives its holder the right to buy common stock at a specified
price. From the firm’s point of view, however, a warrant is very different from a call op-
tion sold on the company’s common stock.
The most important difference between call options and warrants is that call options
are issued by individuals and warrants are issued by firms. When a call option is exer-
cised, one investor buys stock from another investor. The company is not involved.
When a warrant is exercised, the firm must issue new shares of stock. Each time a war-
rant is exercised, then, the firm receives some cash and the number of shares outstand-
ing increases. Notice that the employee stock options we discussed earlier in the chapter
are issued by corporations, so, strictly speaking, they are warrants rather than options.
To illustrate, suppose the Endrun Company issues a warrant giving holders the right
to buy one share of common stock at $25. Further suppose the warrant is exercised.
Endrun must print one new stock certificate. In exchange for the stock certificate, it re-
ceives $25 from the holder.
In contrast, when a call option is exercised, there is no change in the number of
shares outstanding. Suppose Ms. Enger purchases a call option on the common stock of
CHAPTER 14 Options and Corporate Finance 47714.7
warrant
A security that gives the
holder the right to
purchase shares of stock
at a fixed price over a
given period of time.