Hello. I am having trouble grasping some concepts from LOS 39.e The issuance of bonds with warrants can also reduce the interest costs relative to conventional bonds but, given the balance sheet treatment of the liability, interest expense will be greater than the interest expense for equivalent convertible bonds. ( I am not sure exactly why, if anyone would care to explain) Your time is greatly appreciated (I know there isnt much of it left at this point) Regards, K
My understanding of this is as follows…but I could be wrong. The warrant usually results in the bond being issued at a discount. The interest costs will be lower, but for accounting purposes the two securities (bond and warrant) are treated seperately. The bond is placed on the balance sheet as if the warrant was not there due to the fact that a warrant can be separated from the bond and sold. The warrant is valued differently and placed on the balance sheet separately. This means that the value of the bond on the balance sheet reflects the higher interest expense due to the amortization of the discount, but economically speaking, the interest costs have been lowered.
^ looks good to me…
The warrants are typically options added to the bond to purchase company stock. Since these warrants have a value (typically), the bond can be sold at a discount.
Thanks for the input guys. Im still a little confused though. How does this compare with convertibles in terms of interest expense? Say for example, you have the choice of issuing a $100,000 4 year Conventional Bond, a $100,000 4 year Convertible Bond and a $100,000 4 year bond with warrant option (80% debt, 20% equity) are these bonds “equivalent” and if so what are the interest charges on the bonds. (5% coupon and the market rate at issuance at 6%) I would assume that the conventional and convertible are accounted for the same way, and discounted because the market rate is higher than the issuing rate. The interest is then amortized over the life of the debt. As for the bond with warrants, the warrant portion is treated as equity, and the bond portion is treated like a conventional bond. Does that mean that the bonds par value is in fact $80,000 and it will be sold at a discount? Why does Schweser say that “interest expense will be greater than the interest expense for equivalent convertible bonds.” In the example above i believe the bonds to be equivalent but the interest expense lower for the bond with warrants because a lesser portion is actually treated as a bond. Or am I confusing the coupon interest with the interest expense somehow?
kpagarani Wrote: ------------------------------------------------------- > Thanks for the input guys. Im still a little > confused though. How does this compare with > convertibles in terms of interest expense? > > Say for example, you have the choice of issuing a > $100,000 4 year Conventional Bond, a $100,000 4 > year Convertible Bond and a $100,000 4 year bond > with warrant option (80% debt, 20% equity) are > these bonds “equivalent” and if so what are the > interest charges on the bonds. (5% coupon and the > market rate at issuance at 6%) > The bonds are not economically equivalent. If they all paid the same coupon (and everything else equal) you like the bond+warrant most, convertible next, then bond as an investor and reverse as issuer. The bond+ warrant is better than the convertible for an investor because if the company gets healthier, the bond is worth more as is the warrant. The convert needs to be “converted” into equity if the company gets healthier so you don’t have the valuable bond anymore. > I would assume that the conventional and > convertible are accounted for the same way, Sort-of. The convertible is dilutive but interest expense is accounted for the same. >and > discounted because the market rate is higher than > the issuing rate. The interest is then amortized > over the life of the debt. >As for the bond with > warrants, the warrant portion is treated as > equity, and the bond portion is treated like a > conventional bond. > The value of the warrant is treated as interest expense just the same as if you had given people a cash rebate for buying the bond. This is bad for the company because they have to explicitly show the interest expense and the dilution. For a convert, they only have to show the dilution, but the interest expense is hidden. Your job as an analyst is to understand that. > > Does that mean that the bonds par value is in fact > $80,000 and it will be sold at a discount? Why > does Schweser say that “interest expense will be > greater than the interest expense for equivalent > convertible bonds.” Because the value of the warrants is accreted as interest expense. >In the example above i believe > the bonds to be equivalent Nope - check out above >but the interest > expense lower for the bond with warrants because a > lesser portion is actually treated as a bond. Noppe check out above >Or > am I confusing the coupon interest with the > interest expense somehow? I guess…
Agree with JoeyDVivre. “When warrants are attached, the value of the attributed warrant is treated as a bond discount and is amortized” This means that $5000/yr discount - interest exp should be added to lets say $4633 (6%,80k,5%)=~$9633 in case of BondwWarrant. But otherwise, $6000<217>=~$5783. This should answer kpag’s question. But found piece of text immediately following what is quoted here, I am not so in-line with. “Assuming the stated coupon rate is the same for a convertible and a equivalend bond with warrants attached, the cash interest will be the same for CONVRT and BW, and less than cash interest costs for a CONVN” The cash interest in case of BW and that in case of CONRT= $5000. But what troubles me is that “(this) is less than cash interest for conventional bond” per shweser. Now as Convertible and Convention of the same int and maturity and issued at the same time are given the same balance sheet treatment, why is the “cash interest in eq. conventional bond LESS”?
ov25 Wrote: ------------------------------------------------------- > Agree with JoeyDVivre. > > “When warrants are attached, the value of the > attributed warrant is treated as a bond discount > and is amortized” > > This means that $5000/yr discount - interest exp > should be added to lets say $4633 > (6%,80k,5%)=~$9633 in case of BondwWarrant. But > otherwise, $6000<217>=~$5783. > > This should answer kpag’s question. But found > piece of text immediately following what is quoted > here, I am not so in-line with. “Assuming the > stated coupon rate is the same for a convertible > and a equivalend bond with warrants attached, the > cash interest will be the same for CONVRT and BW, > and less than cash interest costs for a CONVN” > > The cash interest in case of BW and that in case > of CONRT= $5000. But what troubles me is that > “(this) is less than cash interest for > conventional bond” per shweser. > > Now as Convertible and Convention of the same int > and maturity and issued at the same time are given > the same balance sheet treatment, why is the “cash > interest in eq. conventional bond LESS”? Because it doesn’t say that. The sentence from schweser leaves out something. It should read something like: >. “Assuming the > stated coupon rate is the same for a convertible > and a equivalend bond with warrants attached, the > cash interest will be the same for CONVRT and BW, > and less than cash interest costs for a CONVN” + " because the conventional bond would need to be issued at a higher coupon rate because you aren’t giving away options (or toasters) with it"
agree… but the text ends as indicated in my quotes. But I just confirmed with Schweser that they meant that “Conventional bond must offer higher coupon and YTM than convertible or bond with warrants.” Thanks
Did you bring up the thing about toasters with Schweser? You could probably issue a bond at a lower yield if you gave away toasters with them.