The nature of warrants in accounting and finance

December 18, 2014

Warrants can be used as sweeteners by companies issuing debt securities or preferred stock to entice potential creditors/investors. This article covers the basics of warrants.

1. Nature of warrants

A warrant gives its holder the right to buy a stated number of shares of the company at a specified price for a specified length of time.

For example, Company ABC issues bonds and provides the bold buyers with warrants.  One such warrant indicates that its holder can purchase one common stock of Company ABC within three (3) years at a price of $100 per share.  The price at which common stocks can be purchased according to the warrant is called the exercise price.  Typically, the exercise price is 10-20% higher than the current market value of common stock.  Warrant holders usually have to accept somewhat lower interest rates for bonds if they receive warrants.  Warrant holders are willing to do that because they hope (anticipate) that the stock price will grow higher than the exercise price and there is will a profit opportunity.  In our example, suppose at the time of bold issuance, the market price of Company ABC’s common stock is $80 (the exercise price is $100).  At this point, the warrant holders would not be interested in exercising their right to buy stock since it’s “under water” (i.e., stock price is lower than the exercise price).  However, if at some point the market value of the company’s stock grows to $120, the warrant holders can exercise their right to buy stocks at $100 per share.  Doing this will allow the warrant holders to generate a $20 profit per share: $120 market value (amount at which stock can be sold) less the exercise price of $100.

Warrants may be detachable and nondetachable.  A detachable warrant can be sold separately from the bond it relates to.  Nondetachable warrants cannot be sold separately.

Warrants can be used by smaller companies when they issue debt securities or preferred stock to attract potential creditors/investors.  Warrants in this case are called sweeteners.

2. Valuing warrants using the Black-Scholes model

One of the most widely used methods to estimate the fair market value of warrants is the Black-Scholes model.  The formula for its modified version is presented below:

C  =  S N(d1)  -  X e-rT N(d2)

where

C  =  price of the call option / warrant
S  =  price of the underlying stock
X  =  exercise price
r  =  risk-free interest rate
T  =  current time until expiration
N()  =  area under the normal curve
d1  =  [ ln(S/X) + (r + σ2/2) T ] / σ T1/2
d2  =  d1 - σ T1/2

A more detailed discussion of the Black-Scholes model is beyond the scope of this article.  However, it is important to understand that this model can be used to determine the fair value of warrants.  This fair value can be used in accounting to record warrants issued.

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