Question

Paul Duncan, financial manager of EduSoft Inc., is facing a dilemma. The firm was founded 5 years ago to provide educational software for the rapidly expanding primary and secondary school markets. Although EduSoft has done well, the firm’s founder believes an industry shakeout is imminent. To survive, EduSoft must grab market share now, and this will require a large infusion of new capital.

Because he expects earnings to continue rising sharply and looks for the stock price to follow suit, Mr. Duncan does not think it would be wise to issue new common stock at this time. On the other hand, interest rates are currently high by historical standards, and the firm’s B rating means that interest payments on a new debt issue would be prohibitive. Thus, he has narrowed his choice of financing alternatives to: (1) preferred stock, (2) bonds with warrants, or (3) convertible bonds.

As Duncan’s assistant, you have been asked to help in the decision process by answering the following questions.

1. How can knowledge of call options help a financial manager to better understand warrants and convertibles?

Please give an original answer, don't copy. Minimum 150 words.

Answer 1

Options are financial instruments that help the investor to buy or sell and underlying asset at a fixed price. Call options gives the right but not the obligation to buy the underlying asset at a fixed price. The concept of warrants and convertibles is similar to that of options. Warrants are very close to call options. It gives the right but not the obligation to the investor to buy an underlying asset at a fixed price for a fixed time period. Convertibles on the other hand are bonds that can be used to buy shares of the same amount. Thus, in the given situation where Mr. Duncan does not want to issue new stock or issue debt, warrants and convertibles are the best financial instrument to raise money from the market.