Looking at Mega Brands most recent audited financial statements (December 31, 2012), in many ways they look financially stable. Their current ratio (current assets/current liabilities) is in decent shape, their debt:equity ratio (total liabilities/total equity) is improving year over year, they had positive earnings for the past two years, and they have a positive cash balance. So the transaction I’m about to describe wasn’t done in a panic, it was done to take a reasonably healthy company and make it stronger. Imagine for a second that you are the CEO or CFO of Mega Brands. You don’t like paying 10% interest since that requires more cash than you feel is really deserved for debt repayment. You need your other cash resources for day-to-day operations, and you don’t have excess assets that you can sell to generate cash. What do you do?
Well, you look closely at your balance sheet and you remember that in 2010 Mega Brands issues a whole bunch of warrants. Warrants are just like a stock option. It is a financial instrument that gives the investor the right to purchase a common share of the company at a set price. For general background on options and warrants, see this. The investors originally paid to get the warrants ($0.50/warrant) and then have to pay again if they exercise their option to purchase the common share (called the strike price, $9.94/share in this case). Obviously no investor would exercise their warrant if the common share was trading at a price below the strike price. These particular warrants expire about two years from now and in most cases, finance theory suggests that a holding strategy is optimal.
Mega Brands wanted to raise some cash and had ~240,000,000 warrants still outstanding. If they could convince all those warrant holders to exercise their warrants, pay the exercise price Mega Brands would receive ~$115 Million. That essentially enough to cover all the long term debt which would then wipe out the debt with the 10% interest payment. Early news releases don’t suggest any modified terms, rather Mega Brands executives just had some friendly chats with the major holders of the warrants (i.e. institutional investors) and explained the situation. The warrants were already in the money since the common shares were trading above $13. Remember that a warrant holder receives a common share (market value ~$13/share) by paying $9.94/share. That’s a good deal. Further, the executives explained that the cash they raised would be used to repay that expensive 10% debt thereby reducing the interest cost and increasing cash available for expansion and dividends. Win-win for the company and the warrant holders. No surprise then that approximately 1/2 of the warrant holders have agreed to early exercise.
What will be the impact on the financial statements? Let’s do this on a single share basis, but in reality closer to 600,000 shares will be issued. First Mega Brands receives the exercise price from the warrant holders (Dr Cash $9.94) removes the warrant value from equity since the warrants no longer exist (remove at the initial value Dr Warrants (equity) $10) and recognize the new common share being issued in exchange (Cr Share capital $19.94). Then Mega Brands will turn around and use that cash to reduce their debt, Cr Cash XX, Dr Long term debt XX. So when the next financial statements get released we should see an increase in equity and an equal decrease in liabilities.
Warrants and options are very common financial instruments. Mega Brands move to tap into them as a way to raise cash is interesting and a little unusual but quite admirable.
The full financial statements are here. I encourage you to look at the balance sheet (page 5), and Notes 15 and 16 in particular (pages 33-35).
Note: this blog was originally posted on my site hosted by Pearson Education(http://php2.pearsoncanada.ca/highered/inthenews/accounting_in_the_news/)