5 - Convertible Debt Flashcards
What is meant by a convertible bond having an embedded call option?
security holders have the right to convert the security into a predetermined number of shares of common stock
conversion ratio is?
no. of shares received for converting 1 bond
or FV bond / conversion price
conversion price is?
FV of bond / conversion ratio (or no. of shares)
tells you how much you initially pay per share based on the bond’s face value
conversion value is? (Pa = Parity)
Pa = share value at right now( or time of conversion) x conversion ratio
based on conversion value and conversion price, when would you convert and when would you keep bond?
- convert = conversion value > conversion price
- keep bond = conversion value < conversion price
conversion premium is?
P - Pa or (P - Pa)/Pa
how much extra the security hold is will to pay for the option to convert,
what is the bond floor value?
PV of bond cash flows ignoring any possible conversion
remember to consider coupon payments
Bond = sum (CF/(1+r)^n) + Face value/((1+r)^n)
What is the investment premium?
P - Bond floor or (P - Bond floor) / Bond floor
Explain the two different conversion types and call types
conversion types
- voluntary
- mandatory
call types
- hard (security can be callable at any time by issuer)
- soft (only holder can call)
What is a call trigger?
a threshold the share price must reach before it can be called (i.e share must 130% of shares at issue before bond can be called)
what does the parity/ conversion value show us in regards to the overall value of the convertible?
it tells us the equity component of the convertible bond
in the extreme case where the investor can by the convertible bond for the bond floor price, what has he gained for free?
the conversion right
what is the investment premium?
MV convertible bond - Bond floor value
if there is a higher conversion premium what can be said about the yield advantage?
there is a higher yield advantage
Why are we interested in knowing the straight bond value? what can change this value?
- it represents the min of the CB value i.e. when conversion option is worthless
- interest rate of the firm, risk of the firm and time change
describe behaviour of convertible bond in relation to stock price?
Acts like a bond -busted convertible → conversion price > stock price
Conversion option has value common stock equivalent → conversion price ≤ stock price
what amount should a CB never sell for less than?
convertible bonds should NEVER sell for less than their conversion value
Pa = share value at right now( or time of conversion) x conversion ratio
what are the 2 floor values of a CB?
floor value of a convertible bond is either its straight bond value or its conversion value
which ever one is greater
What is the main benefit of a CB?
provides upside potential while minimising downside risk
Why do firms issue CB over straight debt or equity, describe difference when stock price increase and when it decreases?
- when stock price doesn’t increase; CB holders don’t convert, CB’s usually require a lower rate of return, therefore firm receives cheap debt financing (equity would have been cheaper, could have issued equity at higher price)
- When stock price does increase; CB holders will convert, and the stock issue will be at a higher price meaning the firm has a lower cost of equity capital. (straight debt would have been cheaper - shares are being issued at a discount)
In an efficient market what is a CB worth?
straight bond value and conversion option
when a bond is callable by the issuer in any time period, when would they opt to call the bond? why?
what does this mean for the CB holder?
when the CB value > call price
because if share price drops again they have to pay bond which costs more than stock that has decreased in value.
forced to convert to shares, removes value of holding a CB, making value equal to conversion value
what type of firms use CBs most? why? (6)
small firms with high growth rates and high Market to book value.
- no internal finance available
- high volatility make option more valuable
- calling bonds strengthens equity base
- cheap financing - at cost of stock dilution
- risk synergy (high risk = o>FV bond/ low risk = o
what happens to market value of firms that announce CBs? why?
decreases
as per pecking order, markets read debt issue negatively
prefer use of internal financing
Why do firms still issue CBs if they have negative market impact when announced? main reason
cheap financing
what is the up side of CBs for issuers then they can call at anytime? 2
- control D/E ratio
- control when share issue takes place
Why to convertible bonds callable by the issuer holds more value?
it sends a signal to the market that the company expects that the prices would increase in the future and would therefore want to limit their losses
