Scribd
Upload
28 views4 pages

Lecture 3

The document discusses convertible securities, including their advantages of offering companies low interest rates while allowing bondholders to participate in company success through conversion. It defines conversion ratio and price, and provides examples of how these terms are used. It also discusses how conversion ratio and price can be adjusted over time, conversion value calculation, and how convertibles can help mitigate the agency problem of asset substitution.

Uploaded by

umarjamil032
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as DOCX, PDF, TXT or read online on Scribd
28 views4 pages

Lecture 3

The document discusses convertible securities, including their advantages of offering companies low interest rates while allowing bondholders to participate in company success through conversion. It defines conversion ratio and price, and provides examples of how these terms are used. It also discusses how conversion ratio and price can be adjusted over time, conversion value calculation, and how convertibles can help mitigate the agency problem of asset substitution.

Uploaded by

umarjamil032
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as DOCX, PDF, TXT or read online on Scribd
You are on page 1/ 4

Advantages of using Convertibles in Financing

• Convertibles, like bonds with warrants, offer a company the chance to sell debt with a low-
interest rate in exchange for giving bondholders a chance to participate in the company’s success
if it does well.

• Convertibles provide a way to sell common stock at prices higher than those currently prevailing.

Conversion Ratio and Conversion Price


The conversion ratio, CR, for a convertible security is defined as the number of shares of stock a
bondholder will receive upon conversion.

The conversion price, Pc, is defined as the effective price investors pay for the common stock when
conversion occurs.

Example: Peterson Securities recently issued convertible bonds with a $1,000 par value. The bonds
have a conversion price of $40 a share. What is the convertible issue’s conversion ratio?

CR = 1000 / 40

CR = 25 Shares

Conversion Ratio and Conversion Price


Silicon Valley Software Company’s convertible debentures issued at their $1,000 par value in July
2013. At any time prior to maturity on July 15, 2033, a debenture holder can exchange a bond for
18 shares of common stock. The bond cost a purchaser $1,000, the par value when it was issued.
What are the conversion ratio and conversion price?

CR = Given up par value / Pc

CR = 18

Pc = given up par value / Shares Received

Pc = 1000 / 18

Pc = $ 55.55

• The conversion price is typically set some 20% to 30% above the prevailing market price of the
common stock on the issue date.

• The conversion price and conversion ratio are fixed for the life of the bond, except for protection
against dilutive actions the company might take, including stock splits, stock dividends, and the
sale of common stock at prices below the conversion price.

• The typical protective provision states that if the stock is split or if a stock dividend is declared,
the conversion price must be lowered by the percentage amount of the stock dividend or split.

Example

If Silicon Valley Software (SVS) were to have a 2-for-1 stock split, then the conversion ratio
would automatically be adjusted from 18 to 36 and the conversion price lowered from $55.56 to
$27.73.

If SVS sells common stock at a price below the conversion price, then the conversion price must
be lowered (and the conversion ratio raised) to the price at which the new stock is issued.

Conversion Value

The conversion value at Year t is equal to the expected stock price multiplied by the conversion
ratio:

Conversion Value = Stock price x Conversion Ratio

Price = P0 (1+g)n OR P0= D1 / i – g

CVt0 = P0 x CR

CVtn = P0(1+g) n (CR)

Convertibles and Agency Costs


A potential agency conflict between bondholders and stockholders is asset substitution, also known as
“bait and switch.”

When a company has been investing in low-risk projects, bondholders charge a low interest rate.
What happens if the company is considering a very risky but highly profitable venture that potential
lenders don’t know about?

Convertibles and Agency Costs


The company might decide to raise low-interest-rate debt without revealing that the funds will be invested
in a risky project.

After the funds have been raised and the investment is made, the value of the debt should fall because its
interest rate will be too low to compensate debt holders for the high risk they bear.

This will result in a wealth transfer from bondholders to stockholders.

Convertibles and Agency Costs


If debt holders think a company might employ the bait-and-switch tactic, they will charge a higher
interest rate, and this higher interest rate is an agency cost.

Convertible securities are one way to mitigate this type of agency cost.

Suppose the debt is convertible and the company does take on the high-risk project.

If the value of the company turns out to be higher than expected, then bondholders can convert their debt
to equity and benefit from the successful investment.

Therefore, bondholders are willing to charge a lower interest rate on convertibles, and this serves to
minimize the agency costs.

REPORTING EARNINGS WHEN WARRANTS OR CONVERTIBLES ARE OUTSTANDING

You might also like