This case study seeks to answer how much value is Coca-Cola capturing via the Coca-Cola Harmless Warrants structure and what its source is.
Scott P. Mason; Mihir A. Desai
Harvard Business Review (295007-PDF-ENG)
July 12, 1994
Case questions answered:
- What are the major differences between the regular debt warrant and harmless debt warrant structures? How does each behave when interest rates change?
- How much value is Coca-Cola capturing via the harmless warrant structure and what is its source?
- Try to check whether the 6.25 valuation of the warrant is correct.
- Are there any relevant “no arbitrage” relationships? Can you develop pricing relationships? In this case, you will need the following information, which I will discuss when we do the case. Let PC and PNC be the prices of a callable bond and an otherwise identical noncallable bond, respectively. Let C be the value of the issuer’s option to call the bond. Then, as we will show later in the course, by no-arbitrage we have: PC = PNC-C.
- What is the “otherwise identical noncallable bond” in the case? How can information about that bond be used? (You will definitely need to use this information in your analysis.)
- Is the yield of 9.75% on a bond that was never issued a credible number? Why do you believe or disbelieve it? What about the valuation of the warrant as 6.25? Do you believe that?
- Was it really worth it for Coca Cola to issue this unit?
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Case answers for Coca-Cola Harmless Warrants
- Holder has the right, not the obligation, to purchase more bonds at the stated price from the issuer
- Harmless Warrant: Requires the bondholder to surrender the bond the warrant was attached to in order to receive another of the same terms
- The 1984 issue is a regular bond with a regular warrant attached
- The 1985 issue is a bond with a harmless warrant attached and a call option for Coca-Cola
- The first thing we notice: call option and harmless warrant essentially cancel each other out. If Coca-Cola calls a bond, holders have a right, for a limited period, to exercise their warrant. In effect the two, therefore, we should find that the price of the warrant = price of the call option, otherwise there may be an arbitrage opportunity
- If interest rates go up: Coca-Cola will be happy with the lower rate, and the bondholders will be stuck
- Series A vs. B distinction doesn’t really matter because Coca-Cola is clearly solvent, but investors still slightly prefer to own the senior debt, so they won’t exercise their warrants
- Series B however no longer gives Coca-Cola the callable provision
- If interest rates go down: Coca-Cola will want to call the bonds, but the bondholders can effectively cancel out their call options by exercising their warrants
- Our team has been studying the last 2 debt issuances by the Coca-Cola Company and have noticed several inefficiencies in the pricing of the bonds issued by Coca-Cola. Ultimately, we believe that the 101 ⅜ pricing of the 1985 issue is too high based on the identical Treasury yield of 9.87 and that establishing a short position in the 1985 Coca-Cola bonds and a long position in 7-year Treasuries could provide an arbitrage opportunity.
- The most interesting feature of the 1985 issue is the harmless warrant attached to each bond in conjunction with the callability of these bonds. The 10x increase in Eurobond secondary market turnover and 4x increase in issuance is indicative that this is becoming an increasingly popular way to raise debt. For context, the 1984 issue features a regular warrant to buy 11 ⅜ notes due in 1991, with no call option for Coca-Cola unless if they are unable to raise $100M from the 1991 notes or certain tax events occur. The result leaves Coca-Cola in a perilous situation: if interest rates increase, then the warrants will not be exercised and investors will purchase debt at the risk-free rate after receiving their maturity payment on the 1988 notes. If interest rates fall, warrant holders will exercise their warrants to receive a premium yield compared to the market, and Coca-Cola will be forced to pay a higher interest rate on up to twice as much debt, potentially creating credit risk for Coca-Cola if too many warrants are exercised. As shown in Exhibit 4, Coca-Cola’s total debt increased from $500M to $1.3B from 1983 to 1984, likely due to this increase in medium-term debt.
- A harmless warrant is designed to avoid this problem, forcing the bondholder to surrender the bond they currently hold in order to receive another one. This structure allows Coca-Cola to avoid issuing too much debt at a higher rate in case interest rates drop. Because of the callability of the 1985 bond, however, we believe it should be priced like a plain vanilla bond. If interest rates rise, Coca-Cola is happy to pay the lower rate, and bondholders can’t do anything to increase their yield, so they prefer to stay with the Series A notes and won’t exercise their warrants. If rates fall, Coca-Cola will try to exercise their call option so they can issue cheaper debt, but bondholders will exercise their warrants and obtain the Series B. In effect, the call option and warrant cancel each other out, and the 1985 issue should behave like a plain vanilla bond. Because of Coca-Cola’s clear solvency, there should only be a negligible difference in value between Series A and B notes, but investors, nonetheless, will always prefer the more senior note, ceteris paribus. The relevant arbitrage relationship is therefore that between the call option and the warrant. Since they effectively cancel each other out, their implicit pricing should be equal, otherwise, there may be an arbitrage opportunity.
Interest Rates and the 1984 Issue
- If rates go up, people wouldn’t exercise their warrants and would prefer to buy other debt
- If rates go down, people will exercise their warrants and Coca-Cola could…