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VALUATION OF RIGHTS, WARRANTS AND CONVERTIBLE CLAIMS Introduction Normally, any Company follows the accounting norms in valuation

of all the assets and liabilities, as laid down by the Institute of Chartered Accountants. Subject to these guidelines, the accounting practices vary from company to company. When a company is due to pay interest or repay the principal, these become contingent liabilities, due at specified future dates. They are paid out of current revenues if it is interest and out of profits or Debenture Redemption Reserves fund created for this purpose if it is repayment of principal of debt. If the contingent liabilities are some dues to be paid to the excise, customs or income tax authorities, or other claims pending, they are shown in the Balance Sheet under Notes or Auditor's Comments. These have to be met as they fall due for payment, and sometimes provisions are made, for them in advance by prudent companies and kept in special accounts. Normally a company if healthy and liquid if its current assets are two times the current liabilities so that if the current assets are sold as they are atleast 50% of the book value or market value of current assets can be realised and liabilities can be met in full. Then in the investors' perception, the company is rated as fully solvent for current purposes. What is Contingent Claim? Contingent claims due to options, warrants, convertible debentures and similar instruments are different from the ones referred to earlier. These claims arise in the event of the holders of debt instruments opting for equity a right or option given to them in the above instruments by the company. Then the claim of debtor is to become owner with the following implications: (1) (2) Tax benefits for interest income as a deductible expense will disappear for the company with its impact on net profits. The leverage enjoyed through the debt for equity capital may also vanish to the extent that the return on total capital employed is higher than the interest burden on debt and that privilege to trade on borrowed funds will not exist. Conversion of debt into equity will increase equity base and larger profits have to be earned for servicing this larger equity base. The cost of servicing equity is higher than servicing debt with the result that the company will have to earn larger profits through larger sales and/better profit margins.

(3) (4)

The above factors lead to changes in capital structure, average cost of capital and profitability. On the other hand, a company with larger equity and less debt has the following advantages: (1) Dividends or equity need not be paid if profits are not adequate but interest to creditors has to be paid, (2) The riskiness of the venture will come down due to reduction of debt burden and credit rating will improve for the company, (3) With a larger equity base, the potential for borrowing from banks and financial institutions and even from public at any future date will increase and company can expand and diversify better than before. These are the plus and minus points in the case of contingent claims. Pricing of Such Claims There is no standard method of pricing of such contingent claims. But the erstwhile CCI used some guidelines for fixing the pricing of securities, particularly for equity shares. But in the case of debentures, bonds and debt instruments, they are issued at par, with a face value of Rs. 100, normally except in the cases of discount bonds or Premium Notes. It is also laid down that if conversion facility is offered the company has to justify the premium or the price fixed to the SEBI before they are issued to the public, but no formulas are presented by the SEBI. If such claims are partly or fully convertible into equity shares as warrants and loyalty coupons, etc., then the issue of their pricing becomes relevant. The non-convertible part of pure debt instruments is taken at par, while the convertible part is priced as per the normal pricing mechanism of equity shares. This in essence involves first a decision on the part to be converted or the terms of the warrants such as period of time etc. The pricing of warrants and the convertible part of bonds are freely decided by the company and SEBI does not interfere, except for seeking disclosures and justifications for the premium or price fixed. Free Market Pricing This is dealt with in a separate chapter but under the current policy of Government free market pricing is permitted for any category of ownership funds. But the norms used by companies or merchant bankers can be set out as follows: (1) SEBI has permitted differential pricing if the company is going for rights cum public issue, with separate prices for rights to the existing shareholders from that offered under public issue. In case of FCD, PCD etc., with convertibles or warrants pricing for convertible portion is again freely decided by the company, subject to



(4) (5)

their confidence of acceptability by the public and justification to the SEBI. The principle adopted, as in foreign markets, is what the market can bear, or what investors perceive as reasonable for investment. In practice, the price fixation is based on the past price record of the share and its future projection based on some bench marks like EPS and P/E multiple. The average of the market prices for the last three years is one criteria if it is already listed and traded. The book value and earnings per share (EPS) and projection of its future price based on P/E multiple for the industry or for comparable companies are also sometimes taken into account.

What is a Convertible Security? A convertible security is a bond or debenture or preferred stock that can be converted into equity of a company. The original security is a debt instrument, which can be converted into an ownership instrument, after a time. The period of holding necessary for conversion, the ratio of conversion and other terms including the price are to be laid down in the beginning itself. Once the conversion terms are stated, they cannot be altered by the company unilaterally. The SEBI guidelines cover all the categories of convertible instruments and new financial products like warrants, loyalty coupons etc. As per these guidelines, a company can issue three types of debentures as debt instruments, viz.: (a) Fully Convertible Debentures: These are fully convertible into equity in phases at predetermined times, say 6 months or 12 or 18 months etc., and the terms of conversion including the conversion price are to be spelt out in the beginning itself including the compulsory nature of conversion. The company decides the periods and prices, at which they will be converted into equity. They may be converted in instalments or all at one instalment. Thus, fully convertible debentures can be converted in two instalments of 50% for 6 months hence and the other 50% at the end of 12 months or in three or more instalments such as 25% of the total each time. If the conversion period is within 18 months, these amounts will be treated as good as equity, as per the SEBI guidelines, for the purposes of debt equity Ratio and other legal and procedural requirements since withdrawn in March 1998. They do not have to follow the guidelines applicable to debt, namely, bonds or debentures, which are not convertible. FCDs with a conversion period of more than 36 months are not permissible to be issued except under special terms. Instruments of less than 18 months have to be treated as debt and rated by Credit Rating Agencies.

(b) Partly Convertible Bonds: These are the second category of debt which are convertible in part while the rest is non-convertible. Thus, a debt instrument can have a face value of Rs. 100 of which Rs. 60 is convertible at the end of 12 months at a specified price and in specific convertible ratio such as two equity shares for Rs. 60, each of Rs. 30, (for a share of face value of Rs. 10 and with a premium of Rs. 20). As the market price may be ruling higher than Rs. 30 per equity share, the conversion facility will appear attractive to the investors. During the first year, the bondholder gets interest at a fixed rate of say 14% and after that Rs. 60 out of Rs. 100 (for each bond) will become two equity shares on which dividend will be paid, if declared out of profits at the end of second year. Thus, it has the advantage of both debt and equity. The rest of 40% will remain as debt only and will continue to get interest at the specified coupon rate of 14% for the rest of its life, until redemption. As per the Companies Act and the Rules made thereunder all debt instruments say, bonds or debentures can have a maturity period of 5 to 7 years, extendable upto nine years in some cases, after which redemption becomes compulsory. Any such non-convertible bonds can be renewed, if the company wants after maturity at the specific written consent of the investors only. (c) Non-Convertible Bonds (NCDs): The third category of debt instruments is the non-convertible debentures called N.C.D. (also called khokhas for the non-convertable portion). This category will have to be held until the maturity or redemption date after 5 to 9 years. It is entitled to only interest per annum, payable half yearly or once in a year. This category is pure debt while the first category of fully convertible debentures is as good as equity and the second category is partly debt and partly ownership capital. All the above categories are to have specific terms, spelt out in the beginning itself before investors decide to put in their funds. No debt instrument or bond can be issued in India without redemption, under the law. Valuation of Rights Shares Companies can also issue rights shares which are a right to buy the equity shares of the company given at par or a premium to the existing shareholders in a particular proportion to their holdings. Under Section 81 of Companies Act, companies issuing further capital after two years of the formation of the company or after one year of the first allotment of the shares have to offer the same as rights to the existing shareholders. The premium used to be fixed on the basis of the average book value of the company and post-tax earning capacity of the shares normally

capitalised at 15% and even at 8% if the market price is substantially higher than the fair price. The average of the two prices worked out on the basis of book value and the earning capitalisation model is accepted. If earnings for share is Rs. 3 and capitalisation rate is 15%, then the fair price is 3/15 X 100 = 20 according to the earnings capitalisation formula. The price on the basis of book value is, say, Rs. 30.1 Then the average of these two prices Rs. 20 and Rs. 30, namely, Rs. 25 is taken as the fair price for fixing the premium (namely, Rs. 15 on a share with the face value of Rs. 10).2 The rights are quoted in the market. The price of the rights will depend on the ratio on which they are issued. If the ratio is 1:3 and the market price is Rs. 50, then valuation of rights is done as follows: Let the premium be Rs. 15, then,

50 3 25 175 44 4 4
The value of one right is Rs. 44 - 25 = 19 which is got for three shares (Rs. 6.33 for one existing share). Rights can be issued only if authorised by a special resolution of the company. The company making the rights has to inform the existing shareholders as to the use to which the additional funds are put, the future earning capacity of the company and other financial indicators such as sales, estimated gross profit or loss, etc. This information would enable the shareholders to decide to opt for the rights or not. Preference Shares Preference shares are of a hybrid category having ownership rights like equity and also a fixed income like creditor capital. They have preferred rights for payment of dividend, along with arrears, if any, if such provision is made in the Articles of Association. They are paid their fixed dividend before any dividend is declared to the equityholders. Besides they have also similar preferential right over equity to payment of capital and their share of assets in the event of winding up of the company. This right is, however, subject to the claims of creditors. 1. Book value is networth of the company divided by the number of equity shares. 2. The method of premium fixation adopted by the erstwhile CCI is given already.

This instrument is suitable to some investors who would like to take some risk but not as much as equityholders but more than debentureowners. They get an income which may, however fluctuate depending upon the profits of the company but fixed, if profits are adequate to service a|'| preference and equityholders. They may also get back their capital after a fixed period like debentures as per the present law. The return on preference shares is fixed by the Government at 14% since April 1987 although some companies offer a higher or lower rate with the permission of the government. The preference shareholders do not enjoy any voting rights except in respect of resolution affecting their rights or when their dividends due are in arrears for the past two financial years. There are various types of preference shares like redeemable and nonredeemable, cumulative and non-cumulative, participating and nonparticipating and convertible and non-convertible. Preference shares are redeemable generally after 12 years and for this purpose, the company is required to provide for transfer out of profits a sum to the reserves called Capital Redemption Reserve. If there is no provision to redeem these shares, they are non-redeemable. As these non-redeemable shares were not popular, they were abolished by the Companies Amendment Act of 1988. Preference shares which have a right to receive dividends in a cumulative fashion are called cumulative preference shares. These enjoy the right to receive dividends in all the years in which the dividends are skipped, as profits were inadequate in those years. The fixed dividend on preference shares should be paid later in a cumulative way when profits are adequate before any dividends are declared for equityholders. Those which have no such right are called non-cumulative preference shares. Preference shares are convertible, if there is a provision for their conversion into equity after a specified period in a particular ratio to the existing equity shares. Preference shares may not be convertible if no such provision is made. Preference shares are participating, if they can share in profits in excess of a guaranteed fixed return, if such a provision is made in the Articles of the company and specify the level of profitability such as an equity dividend of 20%. If these are not so participative, they are called nonparticipating. CCP

A new instrument called Cumulative Convertible Preference Shares was introduced by the Government in 1985, the features of which are as follows: (1) (2) (3) (4) The CCPs can be issued by any public limited company to raise finance for new projects, expansion and diversification, etc. The amount of issue of CCP will be to the extent of the equity issue to the public for subscription. The dividend payable is fixed at 10%. The entire issue of CCP would be convertible into equity shares between three and five years.

These issues have not proved popular with the companies as the dividend on their shares is not a tax deductible item as in the case of interest on debentures. Besides, the dividend of 10% for the first 3 to 5 years has not proved attractive to investors. But preference shares as a class are attractive to institutions and individuals in the high income brackets as the dividend income on them is tax exempt under Section 80L unlike interest income on debentures and company deposits. But companies themselves do not find these preference shares as an attractive alternative to raise funds, except in the special conditions when the c0(T1pany is unable to raise funds from fresh equities from the public or in the form of rights. Legal Provisions The Companies Act provides for issue of debentures, warrants and other bearer certificates, under Sections 114 to 120. These instruments may provide for an entitlement to the holder a specified number of equity shares. If these debentures or bonds are not convertible into equity or are not converted, the debenture or bondholder has no voting rights in the company and does not become an owner. But debentureholders are represented by the debenture Trustee in the meetings of equityholders (AGM or EGM). They are entitled under the Act, for asking for transfers and for Copies 0f Annual Reports. In respect of registers to be maintained under Sections 15 and 152 of the Companies Act, the debenturesholders are treated alike as shareholders. The closure of registers, the procedure for transfers of debentures are all similar to those of equity shares. The SEBI has also laid down that in the event of declaration of bonus by a company with convertible debentures or bonds, due for conversion within 12 months, provision has to be made to protect the rights of such holders to equity and subsequently to bonus, declared during the year. Convertible bonds thus enjoy some specific privileges and incentives.

Norms for NCD and Non-Convertible Portion of PCD These are pure debt instruments and are governed by norms of issue laid by SEBI. Briefly all debentures are to be credit rated for risk element involved and the capacity of the company to redeem the principal and service the creditors with interest etc. These debt instruments can be issued subject to the following conditions: (a) (b) (c) They are to be compulsorily redeemed. Debentures-issued for working capital should not exceed 20% of total current Assets. Debt to equity ratio should normally be 2:1 ratio, except for some capital-intensive projects. They are creditors of the company and cannot therefore attend the AGMs of the company. But their interests are protected under a debenture Trust Deed. All debt or debenture issues should be covered by a Trust Deed and a debenture Trustee is appointed to operate under the Trust deed, which governs the relations of the company and debentureholders. The Trust deed and debenture Trustee have to be approved by the SEBI. The company has to complete the above formalities within 6 months from the date of allotment of debentures and/or despatch of debenture certificates. The company has to create a Debenture Redemption Reserve Fund (DRR), out of the profits of the company, after the commercial production started. These reserves should reach a stage of 50% of the total debenture amount, before it can be used to redeem the debentures. Besides, their use can be started for repayment purposes, after the company has already redeemed at least 10% of the outstanding amount due from out of the current profits.




Conversion Value Conversion value of a convertible security is the conversion ratio of the security, times the market price, per share. Conversion price is the price at which the debenture will be converted into equity. If it is a convertible debenture, it has to be compulsorily converted at the specific price and time which should have been specified in the terms of issue. @ Conversion ratio of 1 : 2 means that a holder of one debenture is given two equity shares. Then market price of equity shares is to be multiplied by two to arrive at Conversion Value.

If the present market price of Cipla is Rs. 260 and the conversion price is fixed at Rs. 25o the premium on conversion is Rs. 10 (260 - 250). The minimum period of holding or conversion time is fixed at the beginning of issue and normally converted on allotment, six months hence etc. If the actual price is Rs. 280 in the market, the investor gains a premium of Rs. 280 - 250 = Rs. 30 per share. If the debenture amount is Rs. 500 and is to be converted into equity shares at Rs. 250 each, two equity shares will be allotted to him and his total premium or gain is Rs. 60 per debenture! If the debenture is a convertible one, the right to call before conversion by the company is not given, but the call provision may be incorporated in case of N.C.D. or bonds. In the case of NCD, or non-convertible bond, the company is allowed to offer a premium upto 5%, on the face value, at the time of redemption, as an incentive for holding the debenture until maturity. Conversion Premium As already referred, convertibles enjoy the benefit of a premium on conver-sion. If market price is say Rs. 280 and conversion price is Rs. 250, the premium enjoyed is Rs. 30. If suppose the market price has fallen to Rs. 220, there is no incentive to holders of convertibles on conversion. To offset such contingencies SEBI has permitted conversion only at an incentive price and not at a disincentive. Thus, whatever the market price, a company can offer conversion at the book value/face value or at a discount of Rs. 20 or so on market price. In some cases, the option of Call and Put is given to the holders of convert-ibles, if the period of conversion is after 36 months. Compulsion of conversion is only provided for, if it is made immediately on allotment, so that the market price and intrinsic value of share are all known and the premium on conversion is ensured. For all conversions, after the allotments, substantial discounts are provided for in the conversion terms. If the debenture is NCD, provision for buy back at face value through a financial institution or a lead bank is made, so that investors do not lose in the capital value of bond due to fall in its price, after allotment. PRICING OF CONVERTIBLES Valuation of Convertibles Whether it is a bond or debenture with an option of convertibility or compulsory conversion at the end of a perid of time, the value of that bond or debenture is related firstly to the value of equity into which it can be

converted and secondly to the value of residual non-convertible portion of the debenture instrument, which remains as debt instrument. Both the above components vary with the market conditions, time to expiry of the bond, prevailing interest rates or yields, etc. Let us take the first component of convertible bond convertible into equity (say C^. This C1 depends on the number of equity shares into which that convertible portion can be converted. The face value of bond say Rs. 75, convertible into 5 equity shares at Rs. 15 each. The bond face value is, normally Rs. 100 of which Rs. 75 is convertible at the end of three years into 5 equity shares at Rs. 15 per share, the residual Rs. 25 will remain as bond and carry coupon rate of 12%, payable annually (here denoted as C2). Thus, Bond face value Rs. 100 consists of two components namely C, + C2. For the First Three Years Rs. 100, the face value of the Bond carries With it an interest return of 12% per bond. At the end of three years, Rs. 75 is converted into 5 equity shares. If the market price is Rs. 20 and exercise price for converion is Rs. 15, then the convertible portion gains by Rs. 5 per share, say a total gain of 25 (5 * 5). Besides for the next two years, equity shares may show capital gains or losses plus dividends, if any declared for the rest of the period to maturity. The non-convertible portion of the Bond earns 12% per year namely Rs. 4 on Rs. 25 of the Bond 0f Rs.100. Graphical Presentation The price of the convertible bond and the conversation value of the F Ps , where, F is the principal bond are related by the equation C1 Pc value of the Convertible Bond Pc conversion price into equity. Ps Market price of equity. Upto Rs. 15, the exercise price or the conversion price is the same as the market price. Thus, pc = Ps; then C1 = F and the value convertible bond is the same as the market price. If Ps is greater than Pc, that is, if market price is more than conversion price, then C1 is greater than F. If Pc > Ps, that is, if conversion price of 15 is more than the market price (say Rs. 10), then the C1 < F. In the graph below, conversion value is shown on the Y-axis and price of equity share is represented on the X-axis.

If the price of equity in the market is Rs. 20, then the conversion value is Rs. 100 as against the face value of Rs. 75. During the first three years, when conversion has not become exercisable, it is as good as debt but the conversion value of the convertible bond will go up and down over the face value of Rs. 75 and after that, it depends on the market price of equity for 5 equity shares. Suppose the conversion portion of the Bond is Rs. 75 and the nonconversible bond is Rs. 25; the total bond value can be Rs. 125, as against face value of bond of Rs. 100. The conversion value of convertible debenture sets the minimum market price of the convertible bond. If actual market price is higher, then arbitraguers operate and buy equity shares and short sell the convertible bond. If the actual market price of the bond is less than its value as equity, the Arbitraguers will purchase the bond and sell short the equity and the shares later purchased through the bond would cover the short sale of equity. To give an example, the convertible bond may be selling at Rs. 60, when the equity based price is Rs. 75 based on Rs. 15 as exercise price for 5 equity shares, then arbitraguers will buy the convertible bond at Rs. 60 and exercise the option to get 5 equity shares at Rs. 15. The short position taken by the buyer will be covered by conversion option in which he makes a profit of Rs 15. The supply and demand factors operate to determine the price of the convertible bond, but is basically dependent on the conversion value of the convertible bond. Normally the convertible has also a debt component, namely Rs. 25 and hence its actual price will be Rs. 60 + 25 = Rs. 85 and at the exercise price of Rs. 15, the bondholder gets Rs. 75 + 25 = 100. Then the

conversion bond quotes at a premium over its face value, if the conversion value of the bond is less than the market price of corresponding equity shares. Role of Interest Rate As regards the convertible bond, the coupon rate offered on it is generally lower than the market rate offered on non-Convertible bonds of comparable maturity. The reason is that such bonds are quoted at a premium due to the value added incentive following from the conversion facility. The value of bond as debt, is lower than that of the convertible bond which includes partly equity component and partly debt component. Since interest paid on convertible debenture is fixed, the value of this bond varies inversely with interest rate. The higher is the interest rate, with coupon rate fixed at say 12/4%, the lower is the value of the convertible bond, for the same degree of risk and maturity. The market operators would buy convertible bond to attain the higher yield, if its price is lower than that floor. The operators can not force down the price any more beyond the floor price of the non-convertible debt, even if the value of the equity into which the convertible portion is to be converted were to decline. The reason is that at the floor point the whole Bond value is treated as equal to debt which sets the floor, but at the peak level, the limit is set by the market price of equity and conversion value of the convertible bond plus the face value of the nonconvertible portion of the convertible bond. There is thus insurance at the floor level but with opportunity of gain the upper end of the bond price. GRAPHICAL DEPICTION A warrant or convertible debenture or loyalty coupon which gives a right to a future equity is like non-voting share, if conversion is within 18 months in the case of convertible debentures and 3 years or less in the case warrants, loyalty coupons, etc., detachable or not. Prices of warrants are subject to the minimum and maximum limits. Condition Pm > Pe = Pm < Pe = PM = Current market price PC = Exercise price of warrant N = Number of common shares per warrant Minimum Value (PM - Pe) x N 0

Minimum value of warrant is zero, if market price is less than or equal to the exercise price. The maximum value is PM x N. The discussion assumes that there is a market for the warrants and they are detachable. The minimum exercise price may be the book value or something based on intrinsic value of the share. The maximum price is the market price. This is shown graphically below. The actual value lies along the dotted line in between the minimum and maximum values. Convertible bond is assumed to be tradeable and has a market value. So is the case with convertible preference shares. It has both investment value and conversion value. Investment value

(straight value) is based on the ytm in respect of a bond and dividend on preferred stock, in respect of Convertible Preference Share. Investment value is the face value for bonds; which is the minimum payable to bondholders. D The investment value of CPS is V , where D is dividend for preferred stock, and y is the current yield or appropriate discount rate. For Bonds, we take ytm, instead of y, for straight value. The conversion value will change with the market price. If the bond can be exchanged for 20 shares, and market price of each is 55, then the conversion value = 55 x 20 = Rs.1,100.

Investment value = Rs. 1,000 Market Stock price = Rs. 55 and Market Bond price Rs. 1,200.

Graphically, the values and market premium for a convertible bond are shown below: (i) Premium over conversion value is Bond Price- ConversionValue ConversionValue (ii) Premium over Investment value is Bond Price- InvestmentValue Bond Price (iii) Conversion parity price of stock Bond Price No.of shares on conversion

Examples Premium over conversion value


1200 1100 100 9.09% 1100 1100

This suggests that the stock must rise by about 9.09% for the breakeven point to be reached. If stock price is 55, then Rs. 55 + 0.0909 (55) = Rs. 60 Conversion parity of the stock is also the same, namely,

1200 Rs.60 20

Premium over Investment value is calculated as,

1200 1000 16.67 1200

This means that bond can fall in price by 16.67%, if the stock price fell and this provides floor price of bond. Suppose the stock price fell to Rs. 40. The conversion value is Rs. 40 x 20 = Rs. 800 but the bond floor price may remain at Rs. 1000. In the trading of convertibles, one has to look into the current yields on stock and bonds. Suppose the underlying stock is selling at Rs. 55 and annual dividend is Rs. 1.65, then

1.65 100 3% . Interest on Bond is 6% and 55 the current price of bond is Rs. 1200.
Current yield on stock Current yield on Bond

60 100 5% 1200

If the current yield on bond is higher than on stock, why do people buy convertibles? The bond will fall to Rs. 1,000 only and not to Rs. 800 [as 40 x 20 is Rs. 800] even when the stock falls to Rs.40. This means there is a downward protection for bondholder in capital losses. For the strategy f principal amount the bond is preferable; while the stock can fall to any extent, but not the bond. Resides, a convertible offers both the advantages of debt and ownership. However, if there is a capital appreciation the equity stock provides a better scope for appreciation than for bond. It will thus be seen that the investor preferences or the portfolio objectives are the guide for decision to invest in Common Stock, bond or a convertible bond. In periods of falling prices, bonds and convertible bonds, and in times of rising prices equity or convertible bond will be chosen depending upon the expectations of interest rates and market prices.

Brigham's Model on Convertible Bonds@ The risk-return features of convertible bonds vary widely. The factors which influence them are the coupon rate until conversion, number of years to convertibility and the expected market discount rate. Bondholder invests in the bond as a hedge against risk for the time being until conversion and appreciation on conversion. The return which the bondholder expects is the discount rate which equates the sum of the annual interest payment till Jhe

year of conversion and the terminal conversion value in year (N). The equation for the Bond price if it is convertible is M=

(l k )
t 1

Tv (l k )n

M = Price of bond Tv = Conversion value if converted I = Interest received yearly N = Number of years of holding (t = 1 to n) K = Discount rate expected This is graphically explained by Brigham, as shown below:

Take 12% Convertible Debenture of Tatas 14% Market Return MM = Face value = 100 B x M = Straight Debt value M is Maturity Date MM1 Market Price @ Brigham: "An Analysis of Convertible Debentures: Theory and Some Empirical Evidence" Journal of Finance, March, 1966. C x C1 is conversion value of convertible bond. It is assumed that equity stock price of the corresponding bond is growing at a constant price and C x C1 rises accordingly every year, until bond is called for conversion MM1 is the market price of bond, and this will rise with time in a similar

manner as conversion value, C x C,, but the latter rises faster as time approaches for call 0r conversion. Premium is shown by the shaded area say B*y, (as shown in the graph). VM is the call price to be paid if the company redeems before maturity and not converted. VM line falls, as it approaches maturity and joins M, on the final date and disappears. Call price is more than the face value, to give incentive for the bondholder to surrender bonds before maturity and no; converted. VM line falls, as it approaches maturity and as maturity approaches, the difference narrows down to zero on the date of maturity. On the call date, market value and conversion value become the same. If the bond is not called, it is paid at maturity or converted into stock. Both these alternatives are not as good as call. The decline in call premium shows VM is downward sloping. Premium is shown by the shaded area in the graph, Bx, or straight debt value. The premium on the bond will disappear, if it is to be called or if it is converted. The graph shows that the conversion value goes sharply up, as it approaches the conversion time (Mt). In practice premium on conversion from bond to equity will offset the lower interest rate offered on convertible bonds and hence they are more attractive than bonds which are not convertible. It will thus be seen that there is no simple formula for fixation of price for warrants, loyalty coupons and incentives offered by companies, selling debt instruments to public. Some salient features can however, be stated. First, the warrant will entitle the holder to equity shares at a price lower than the market price allowing a conversion premium. Second, warrant gives an option to the holder to buy the shares for a specified amount of money. These warrants have only rights and no obligations and will not put the holder to any loss. It has only incentive value and disincentive is not allowed as per the SEBI guidelines.