Dollinger index

Securing Investors and Structuring the Deal 317

total return in case the venture turns out to be very profitable. In this case, the warrant

is sometimes called an equity kicker: It represents equity that is off the balance sheet if

the warrant is exercised,.

A callable warrant enables entrepreneurs to pay off creditors, thereby retiring the debt

and recovering the equity according to a fixed schedule. The price of the warrant can be

calculated for each period outstanding. Table 8.7 provides an example of the calculation

of the price of a callable warrant.^28

If the investor has a subordinated debenture with a face value of $1 million, a coupon

of 10 percent, and a warrant that guarantees a total return of 15 percent, calculating the

call price (or value) of the warrant requires two preliminary steps. First, the analyst must

determine the present value and cumulative present values of the interest payments. In

Table 8.7 the third column shows the present value of the cash flow from the interest

payments, discounted at 15 percent. Next, the analyst must calculate the future payment

that makes the entire cumulative present value equal to zero at the guaranteed (in this

TABLE 8.6 The Option to Abandon the Project

Rule I: VC Invest in Both Years

Good scenario

Bad scenario

Expected annual cash

Terminal value

Expected cash inflow

Investment

Expected net cash

PV@

40%

$1,933

102

1,018

186

1,204

(857)

$ 346

5

$ 950

50

500

1,000

1,500

$1,500

4

$950

50

500

500

$500

3

$950

50

500

500

$500

2

$950

50

500

500

$500

1

$950

50

500

500

(500)

$ 0

0

($500)

($500)

Bad scenario
Annual cash flow
Terminal value
Investment
Net cash flow
Expected (or average) value of scenarios
Expected net cash

Rule II: VC Has Option to Abandon in Year 1

Good scenario

Annual cash flow

Terminal value

Investment

Net cash flow

PV@

0 1 2 3 4 5 40%

($500)

(500)

(500)

(500)

($500)

$950

(500)

450

0

0

$225

$1,933

186

(857)

1,262

0

139

500

(361)

$ 451

$ 950

1,000

1,950

0

750

750

$1,225

$950

950

0

0

$475

$950

950

0

0

$475

$950

950

0

0

$475

Expected value of option to abandon (Rule I minus Rule II): $105

SOURCE: From “Aspects of Financial Contracting,” Journal of Applied Corporate Finance, 1988: 25–36. Reprinted by permission

of Stern Stewart Co., New York, NY.