R27.P1.T4.Hull_Ch13_15_19:Topic: WARRANT_DILUTION_HAIRCUT_FACTOR

[gargi.adhikari]

In reference to R27.P1.T4.Hull_Ch13_15_19:Topic: WARRANT_DILUTION_HAIRCUT_FACTOR:-
The BT Notes IMO rightly sates that the Reduction/Dilution factor , the Haircut Factor = N/ ( M + N)
where M= No of Warrants ; N = No of Outstanding Shares
But The John Hull Notes state the Haircut/Reduction Factor to be = M /(M +N) ... :-(
By Hull's own deductions,
the Reduction Factor should be N / ( M+ N) .....but instead Hull states it to be as M /( M +N ) ....

Much gratitude for any clarification on this...



JOHN HULL NOTES:-

 

[David Harper CFA FRM]

Hi @gargi.adhikari Hull has it correctly. He doesn't refer to a "haircut." We inserted that but I think our term is inaccurate (here is the underlying XLS https://www.dropbox.com/s/xps7lza4pf1k960/0622-dilution-haircut.xlsx?dl=0). In this case, there are two ways to look at the adjustment due to dilution:

• As a multiplier to (on?) the call option price, where N/(N+M) = 1,000,000/(1,000,000 + 200,000) = 0.8333, so that the diluted call option price is $7.040 * 0.833 "multiplier" = $5.87
• As a haircut to the call option price, where M/(N+M) = 200,000/(1,000,000 + 200,000) = 0.167, so that diluted call option price is $7.040 - (0.167 * $7.040) = $7.040 - $1.17 "haircut" = $5.87

I don't think our math is wrong. Rather, we are right to call N/(N+M) a multiplier but it's our mistake to refer to that as a haircut. In this context, the "haircut" is the 16.67% reduction (i.e., the $1.17 dollar reduction) not the 83.33% multiplier. Haircut is typically used in collateral, and it's used as in "a 16.67% haircut to the value" not so much as a multipler. I hope that's helpful, sorry the term haircut is inaccurate here!

 

[gargi.adhikari]

@David Harper CFA FRM Thanks so very much for the clarification David ! Clear as the sky now