78106_19_Web_Ch19A_p01-03 - WEB EXTENSION Calling...

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WEB EXTENSION 19A Calling Convertible Issues M ost convertible issues have provisions that allow the issuer to call the issue prior to maturity. In such cases, the issuing firm must make the decision when, if at all, to call the convertible. When should a convertible be called? In general, there are two basic reasons for calling a convertible bond. 1. Interest rates have fallen in the market to such an extent that the firm could call the convertible and replace it with a new bond carrying a lower coupon rate. This is the same reason that we described in Chapter 5 for calling a nonconvertible bond. Chapter 20 illustrates the financial analysis required for making the decision to refinance a callable bond with a new, lower-coupon bond. 2. The firm s stock price has risen to such an extent that the conversion value of the convertible bond exceeds the call price. As we explain in this extension, convert- ing in this situation maximizes the value of the existing shareholders. 19.1 C ALLING A C ONVERTIBLE B OND B ECAUSE THE C ONVERSION V ALUE E XCEEDS THE C ALL P RICE As noted previously, a decline in interest rates can motivate a firm to call and refinance a bond at lower interest rates. For the remainder of this extension, we assume that this is not the case interest rates have not fallen to such an extent that refinancing is optimal. This assumption allows us to focus on the option value of the convertible bond. Consider a simple example. A company is financed only with equity (9 million
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This note was uploaded on 05/03/2010 for the course FRR 3032 taught by Professor Mr.wroshr during the Spring '10 term at Crafton Hills College.

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78106_19_Web_Ch19A_p01-03 - WEB EXTENSION Calling...

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