Question

CA16-3 WRITING (Stock Warrants—Various Types) For various reasons a corporation may issue warrants to purchase shares of its common stock at specified prices that, depending on the circumstances, may be less than, equal to, or greater than the current market price. For example, warrants may be issued:

1. To existing stockholders on a pro rata basis.

2. To certain key employees under an incentive stock-option plan.

3. To purchasers of the corporation’s bonds.

Instructions

For each of the three examples of how stock warrants are used:

(a) Explain why they are used.

(b) Discuss the significance of the price (or prices) at which the warrants are issued (or granted) in relation to (1) the current market price of the company’s stock, and (2) the length of time over which they can be exercised.

(c) Describe the information that should be disclosed in financial statements, or notes thereto, that are prepared when stock warrants are outstanding in the hands of the three groups listed above

Short answer

1. Purpose of issuing warrants is to generate capital, attract and motivate employees, and stimulate the bond’s sale.

2. The bond’s exercise price ds depends upon the period after which it can be exercised.

3. Warrants issued are reflected in the equity section of the balance sheet

Step-by-step solution

Definition of Bondholders

Bondholders are the creditors of the company or individual who possesses the debt securities issued by the business entity. Amount due to bondholders is reported on the balance sheet of the company.

Use of warrants

1. The main purpose of issuing warrants to existing shareholders on a pro-rata basis is to generate capital for the business entity. Such a method is used because of the rights possessed by the company's shareholders, and it proves to be cost-effective compared to the public offering.
2. The business entity issues share warrants to some of the key employees to increase their interest in the firm’s growth and attract talented people to management. Such a plant motivates the employees to carry out operating activities more efficiently.
3. Warrants are issued to the company’s bondholdersto stimulate the sale of bonds.

Significance of price

1. The main purpose of issuing a warrant is to generate capital from existing shareholders. The warrants are issued at lower than the current market price to increase the probability of the exercise. The offer’s success depends upon the market price of the shares and the price at which such warrants can be exercised. Such warrants are exercised over a short period, usually 60 days.
2. Warrants to existing company employees are offered at, below, or above the market price of the shares on the grant date. If the purpose of the share option plan is to provide a good incentive, the business entity must issue the warrants that can be exercised within a shorter period at or near market price at the date of granting. If the warrants are not exercisable in a short period, they must be issued above the market price at the grant date, and the incentive feature must not be eliminated.
3. Laws of income taxes do not impose any restrictions on the exercise price of the warrants to the company’s existing bondholders. The warrant’s exercise price can be equal to, above, or lower than the market price of the shares. Exercise price depends upon the time duration. The longer the time duration of the warrant, the higher the exercise price, and the lower the exercise price, the lower the duration of the warrant.

Disclosure on the financial statement

1. The warrants issued to existing shareholders must be reflected in the description of the shares. The description includes information such as the shares offered for sale, price of the option, time duration, and the number of rights required to purchase each share.
2. Financial statement presentation of the share warrants issued to the company employees must include the status of the individual plan at the end of the fiscal year. Such status includes the number of shares options outstanding, the number of options exercised by employees and forfeited, the weighted average price of these options, the weighted average fair value of the options, and the average remaining life of the outstanding options.
3. Financial statement presentation of the share warrants issued to the company’s bondholders includes the exercise price of the warrants, time duration, and the number of shares that each bondholder can purchase.