Bonds - Convertible Bonds

Question 1

Define convertible bonds. Compare to interest rates of non-convertible bonds. Less or more volatile than common stock and why? 65

Answer 1

Define: Corporate bonds that may be exchanged for a fixed # of shares of common stock issuing co’s stock
Interest rate: pay lower interest rates than nonconvertible
Less volatile than common stock: fixed int rate and maturity dates

Question 2

Advantages of Convertible Bonds: 65

Answer 2

1. Can be sold with lower coupon rate than nonconvertibles
2. Co can eliminate fixed int charge on conversion; reduces debt
3. Conversion over time so doesn’t affect stock price
4. Avoids immediate dilution of primary earnings per share that issuing shares would do
5. At issuance, conversion price is higher than MP of common stock

Question 3

Disadvantages of Convertible Bonds 66

Answer 3

1. When converted; shareholders equity is diluted; each share represents smaller fraction of ownership in co
2. Previous bond holders can vote or have a voice that cld shift control of co
3. Loss of leverage: reduce corporate debt
4. Decrease in deductible int costs increases taxable income

Question 4

Advantages to Investors of convertible securities 66

Answer 4

Offer safety of fixed income & potential appreciation in equity market…

1. If corporation experiences financial problems, convertible bondholders have priority over common stockholders
2. MP tends to be more stable during market declines then common stock
3. Because they can be exchanged for common stock, MP tends to move up if stock price goes up
4. Investor incurs NO tax liability on conversion

Question 5

What is calculation and define Conversion Price & Conversion Ratio66

Answer 5

Always in indenture agreement but # of shares not stated, it’s stated as a conversion price or conversion ratio
Calculation:
Common Stock:
Bond as a conversion price of $40/share, then
Par value of share (always $1,000)/conversion price ($40) = Conversion ration ($25)

Preferred Stock: Same calc except instead of $1000 par value it’s $100 par value.

Conversion Price:
Stock price at which convertible bond can be exchangd for shares of common stock.
Stated in indenture agreement either a conversion ratio or conversion price

Conversion Ratio:

Question 6

What is Conversion Parity & how to calculate Parity price of Common stock?66

Answer 6

Parity: Convertible bond = common stock value

Parity price of common stock: MP of bond/conversion ration (# of shares)

Question 7

Corporation issues a bond convertible at $50.
What is the conversion ratio?
What is the Parity price of the common stock if the bond is selling at 104?

Investor position if:
Common stock is selling below the parity price?
Common stock is selling above the parity price? 67

Answer 7

Conversion Ratio: Par ($1000)/50 - 20 or 20:1

Parity Price: 104 * $1000 (par) = $1,040 convertible into 20 shares or $52/share

If common stock is selling below 52:
Convertible bond is worth more than stock

If common stock is selling above 52:
Investor can make money by acquiring the bond, converting to common, and selling the shares

Question 8

RST bond is convertible to common at $50. If RST bond is currently trading for $1,200 what is the parity price of the common? 68

Answer 8

Par Value: $1,000
Conversion Price = 50
Conversion Ratio = $1,000/50 = 20

Parity common stock price:
MP/Conversion Ratio = $1,200/20 = $60