Convertible Debt

Question 1

what is convertible debt

Answer 1

Convertible debt gives debtholders the option to
convert debt into equity securities (shares).

Convertible debt is equivalent to a straight debt + an option
to acquire shares.

Question 2

what is conversion ratio

Answer 2

Conversion ratio is the number of shares into which
each debt (bond) can be converted

Question 3

what is the conversion price

Answer 3

Conversion price is equal to the face value of debt
which must be given up to receive one share on
conversion

Question 4

What is the Conversion premium

Answer 4

Conversion premium is the difference (in percentage)
between the conversion price and the share price

Question 5

What are the 2 components of convertible debt

Answer 5

straight (or pure) debt

special call option on equity of the firm with exercise price equal to the value of straight debt given up if debt is converted

Question 6

Define bond value

Answer 6

The value of convertible as straight risky debt
(i.e. if never converted).

Question 7

Define conversion value

Answer 7

The value of convertible debt if
converted immediately.

Question 8

What is a call provision

Answer 8

Call provision allows firm to call the convertible debt
securities

If convertible debt is called, debtholders can either: accept the call amount or convert debt into equity.
If the call amount> conversion value, debtholders will take
the call amount.

Question 9

What are the main motives for issuing convertible debt

Answer 9

Convertible debt allows firms to pay a lower coupon
than on straight debt if the option element of
convertible debt is valued by investors.

Suppose a company wants to issue equity today,
It decides to issue convertible debt at a positive
premium with respect to the today’s price. If
share price rises and conversion occurs, firm has
effectively issued equity at a premium

Question 10

Problems with issuing convertible debt

Answer 10

If share price rises and conversion occurs, the current
shareholders have to sell an equity stake in their firms
for below-market value

If share price falls and no conversion occurs, the
firm would have been better off issuing equity (today) at an higher price than its later market price

Question 11

What are the other rational motives for issuing convertible debt

Answer 11

Convertibility reduces agency cost of debt, in
particular those related to risk-shifting.

Convertible debt can also reduce risk assessment
problems

Convertible debt can minimize the asymmetric
information-financial distress costs.