5 - Convertible Debt

Question 1

What is meant by a convertible bond having an embedded call option?

Answer 1

security holders have the right to convert the security into a predetermined number of shares of common stock

Question 2

conversion ratio is?

Answer 2

no. of shares received for converting 1 bond

or FV bond / conversion price

Question 3

conversion price is?

Answer 3

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

Question 4

conversion value is? (Pa = Parity)

Answer 4

Pa = share value at right now( or time of conversion) x conversion ratio

Question 5

based on conversion value and conversion price, when would you convert and when would you keep bond?

Answer 5

• convert = conversion value > conversion price

- keep bond = conversion value < conversion price

Question 6

conversion premium is?

Answer 6

P - Pa or (P - Pa)/Pa

how much extra the security hold is will to pay for the option to convert,

Question 7

what is the bond floor value?

Answer 7

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)

Question 8

What is the investment premium?

Answer 8

P - Bond floor or (P - Bond floor) / Bond floor

Question 9

Explain the two different conversion types and call types

Answer 9

conversion types

• voluntary
• mandatory

call types

• hard (security can be callable at any time by issuer)
• soft (only holder can call)

Question 10

What is a call trigger?

Answer 10

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)

Question 11

what does the parity/ conversion value show us in regards to the overall value of the convertible?

Answer 11

it tells us the equity component of the convertible bond

Question 12

in the extreme case where the investor can by the convertible bond for the bond floor price, what has he gained for free?

Answer 12

the conversion right

Question 13

what is the investment premium?

Answer 13

MV convertible bond - Bond floor value

Question 14

if there is a higher conversion premium what can be said about the yield advantage?

Answer 14

there is a higher yield advantage

Question 15

Why are we interested in knowing the straight bond value? what can change this value?

Answer 15

• 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

Question 16

describe behaviour of convertible bond in relation to stock price?

Answer 16

Acts like a bond -busted convertible → conversion price > stock price

Conversion option has value common stock equivalent → conversion price ≤ stock price

Question 17

what amount should a CB never sell for less than?

Answer 17

convertible bonds should NEVER sell for less than their conversion value

Pa = share value at right now( or time of conversion) x conversion ratio

Question 18

what are the 2 floor values of a CB?

Answer 18

floor value of a convertible bond is either its straight bond value or its conversion value

which ever one is greater

Question 19

What is the main benefit of a CB?

Answer 19

provides upside potential while minimising downside risk

Question 20

Why do firms issue CB over straight debt or equity, describe difference when stock price increase and when it decreases?

Answer 20

• 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)

Question 21

In an efficient market what is a CB worth?

Answer 21

straight bond value and conversion option

Question 22

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?

Answer 22

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

Question 23

what type of firms use CBs most? why? (6)

Answer 23

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

Question 24

what happens to market value of firms that announce CBs? why?

Answer 24

decreases
as per pecking order, markets read debt issue negatively
prefer use of internal financing

Question 25

Why do firms still issue CBs if they have negative market impact when announced? main reason

Answer 25

cheap financing

Question 26

what is the up side of CBs for issuers then they can call at anytime? 2

Answer 26

• control D/E ratio

- control when share issue takes place

Question 27

Why to convertible bonds callable by the issuer holds more value?

Answer 27

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