Price of shares post issue of warrants P1 T4 Ch15

[aditydev1997]

Since the company is the writer of the call option on stocks, the company gets paid (the warrant buyer will pay the price of warrant = w as premium) and hence I expected the market cap to increase by Mw (M = number of warrants). But instead, the chapter says the market cap is reduced by Mw. Is there something I am missing?

 

[Lu Shu Kai FRM]

Hi @aditydev1997 ,

I read the notes. I think you're looking at the issue the wrong way. The only way for market cap to increase is from its constituents - share price and shares outstanding.

Market Cap = Share Price * Shares Outstanding

The money earned from the sale of warrants goes into the capital funds of the company and not into increasing the market cap. Actually, issuing warrants is typically seen as a negative action (you can read it up yourself) and the additional issuance of shares (from the exercise of warrants by the investors) makes the supply of shares go up and worth less, which results in a decreased market cap.

Hope this is helpful!

 

[David Harper CFA FRM]

Thank you @lushukai you put it very well! I used to develop option (ESO) plans for companies in my former (consultant) life. This can be very tricky. Please understand @aditydev1997 that GARP's view here is directly from (based on) John Hull; I say that because there can be alternative approaches. This is a relatively basic approach. I think one thing you are missing is: the company grants the options (warrants) today but doesn't receive the exercise cash until later, and they will only be exercised if they are dilutive (in fact, most exercises are cashless: the employee/exercise does not pay the strike price in cash but instead instantaneously uses shares from some of the exercised options. The cashless exercise is proof that the options are dilution because they are tantamount to "free cash" or "free shares" when received).

Our note (XLS snippet below) replicates Hull's example 15.7. In regard to the amount illustrated by $1,173,373 (i.e., the total cost of the warrants), Hull does say ...

"Since we are assuming that there are no benefits to the company from the warrant issue, the total value of the company’s equity will decline by the total cost of the options as soon as the decision to issue the warrants becomes generally known." -- Hull, John C.. Options, Futures, and Other Derivatives (2-downloads) (p. 335). Pearson Education. Kindle Edition.

... such that the immediate dilution (recognized at grant) does reduce the market cap. Importantly, this assumes the market recognizes no benefit to the dilutive instruments.

But I want to add, it's not this simple. This is theory about the dilutive impact at grant. Say we go forward in time, say 5 years in this example, and the stock increases to $100.00. Say the ESO holders do not use the super-common cashless exercise, but instead use cash. They will pay $60.00 * 200,000 options = $12.0 million cash which adds to common O/S market cap of $100.00 * 1.0 million = $100,000,000; i.e., upon exercise in the future, the warrants (arguably) increase the value of the company by $12.0 million in cash and therefore the value of the equity. However, the number of shares increased (aka, dilution) and market capitalization is ultimately a function of the traded share price! Hence, not so simple ... but we can observe that, if the price of the stock goes up to $100.00, the company

• Did not raise 200,000 shares at the market price of $100,000, which would have generated $20.0 million in cash, but instead:
• Issued 200,000 shares and received only $12.0 million. That's dilution: total asset/equity value increases, but the value of each share drops because it has a smaller (%) claim. The new shares purchased at a discount are (effectively) a wealth transfer from the current shareholders to the new shareholders. Hope that's helpful!

 

[aditydev1997]

@lushukai thanks for the simple explanation
Also, @David Harper CFA FRM thank you for the in depth explanation. Was an interesting read

 

[Lu Shu Kai FRM]

100% agree with David, the actual dynamics is not that simple