Case for Convertibles - Brennan and Schwartz

Case for Convertibles - Brennan and Schwartz - I THE CASE...

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Unformatted text preview: I THE CASE FOR CONVERTIBLE? THE CONVERTIBLE SECURITY by Michael]. Brennan and Eduardo 5. Schwartz University of Calzfomz’a, Los Angeles Until fairly recently, the popularity of convertible securities was something of a mystery to financial economiSts. To those well-versed in the literature of “efficient markets," there seemed no convincing reason why convertible bonds—which, af- ter all‘ represent nothing more than Straight debt securities combined with options on the company's stock—should provide issuing companies with financing bene- fits Why. the question was asked, should sophisticated investors be willing to pay more (thus costing the corporate issuer less) for these securities in combination than for separate offerings of straight debt and straight equity? The characteristic response from the business schools was to attribute the use of convertibles to a widespread. but relatively harmless delusion entertained by corporate treasurers and fostered (unwittingly or otherwise) by their financial ad- visors. This popular misconception, which continues to captivate a good number of invesrment bankers and their corporate clients, is that convertible bonds (or pre- ferreds) are a cheap source of capital because (1 ) they carry coupon rates below the market rates of interest on straight debt (or preferred) and (2) they allow compa- nies to sell stock at a premium over the current price. The astute corporate treasurer has probably long suspected that such an apparent “free lunch" is tainted And if he has had any exposure to theoretical finance and the modern conception of “cost of capi- tal," his suspicions will have been confirmed. For there is general agreement—among academics, at least—that the real economic cost of convertibles to the issuing corporation is not reflected by the explic- it interest rate (just as the dividend yield on common fails to represent the corporate “c05t of equity“). The real cost of a convertible bond is considerably higher than the coupon rate; and, because of the con- version rights, it is also higher than the company‘s borrowing rate on straight and, for that matter, on _________________________._—————————— ' This article was originally published in the Chase Fmanaal Quanerli' (Vol 1 No 3) and is reprinted Wllh the permission of the Chase Manhattan Bank 55 JOURNAL OF APPLIED CORPORATE FINANCE subordinated debt. In fact. because of its hybrid na- ture—part debt. part equity—the cost of convertible debt is best thought of as a weighted average of the explicit interest charges. and the implicit opportu- nity costs associated with the conversion or eqttity OPIIOI‘I. A New Explanation It is probably true to say that the slow spread of the "gospel" of modern finance has had a modest success in dispelling the popular illusions surround- ing convertibles And that many corporate managers now perceive convertibles to be more expensive than they look. To the perplexity of academics. how- ever. the popularity of convertibles has shown little sign of abating. Consequently. as "positive" financial economists. we have been faced with the task of find- ing a convincing explanation —one that is consistent with rational investors and sophisticated financial markets. In this article. after first examining the conven— tional arguments more closely. we offer a relatively new rationale for the use of convertibles. Instead of relying on the naivete of corporate financial officers or the marketing facility of investment bankers. our explanation centers largely on an important feature of convertibles: Ibe relazz'z 'e I’Izseizsz'rz'z 'z'n‘ oflbez'r 1 {due to the rz'sle of the issuing company. This insensitivity makes it easier for the bond issuer and purchaser to agree on the value of the bond — even when they disa- gree on the risk of the company—and. thus. to come to terms. It also protects the bondholder against the adverse consequences of management policies which would increase the risk of the company. The market. as a general rule. exacts a premium for bearing additional uncertainty. Companies una- ble to provide investors with assurance about the level and stability of their risks may be forced to bear interest costs on straight debt that are considerably higher than management‘s expectations would war- rant. The advantage of a well—designed convertible. as we will argue. is that its value is not much affected by changes in company risk; and that investors are willing to provide funds on better terms when their uncertainties about risk are allayed. The available evidence. moreover. supports our theory by suggesting that the companies issuing con- vertibles tend to be those for which uncertainty about risk is likely to be greatest; that is. the compa- nies for which the costs of straight debt appear prohibitively (and needlessly) expensive, it tr large. mature corporations with strong credit ratings. lit my» ever. there still appears to be no good reason it )I' is~ suing convertibles. The Call Question In the third section of this article. we explore the issue of when companies should call their ci )2:— vertibles. The call provision, which is a feature of most corporate bonds. takes on added significance in the case of convertibles because of the holders rights to convert into common stock But. if our theory is now better able to account for the corporate decision to issue convertibles. some mystery still surrounds the call decision— both the conventional corporate praCtice and the market's response to the announcement of calls. Our theory provides a fairly simple rule for the corpora- tion to follow in exercising its call option: namely. to call a convertible as soon as the conversion price ex- ceeds the call price. while providing enough of a margin to ensure conversion. The actual call policies of corporations. howev- er. depart significantly from this apparently optimal policy Convertible securities. whether bonds or preferreds. are not generally called until their premium over the call price is significantly larger Moreover. when corporations actually do call their convertibles. their stock prices tend to decline. which seems to suggest that the decision to call convertibles is in general a mistake. \X‘e provide answers to both of the questions. \X'hy do companies delay so long in forcing conver- sion? \X'hy does the market respond negatively when they finally do? But neither are completely satisfying We can account for companies~ actual call behavior only as the result of a common. but misguided con- cern with the effects of conversion on reported .(undiluted) earnings per share. In response to the 56 second of these puzzles. our best guess is that the market has come to associate forced conversions with companies anticipating hard times. As a result. announcements of convertible calls may be convey— ing negative information about management's out- look for the company. In the final part of the article. we present the outlines ofa model we have recently devised for the pricing and valuation of convertible securities. Our model. which incorporates the insights of the Black- Scholes Options Pricing Model (now widely used by J()l RNAI. U} APPLIED (.HHPURATIL |>’|\ \\('I professional option traders on the Chicago Ex- change). permits analvsis ofthe contributions of var- ious features to the value of convertibles In designing a convertible bond contract. the corporate treasurer (and or his investment banker) faces the complex problem of juggling conversion and call price schedules. coupon rates. maturitv and other bond characteristics. The potential application of our model is to assess the value of a convertible with a given set of features or. alternatively. to esti- mate the effect of a change in one or more provi- sions on the value of the bond. It is also useful in arriving at decisions to force conversion THE COMMON MISCONCEPTION The idea that the convertible offers a cheap source of finance stems from arguments of the fol- lowing kind Suppose. as might reasonablv be the case. that ifa companv can float senior debt at 1~i per- cent. it can also issue a convertible debenture with a conversion premium of 13 percent carrving a cou- pon rate of onlv 11 percent The 13 percent conver— sion premium means that ifthe current stock price is Sat). the bondholder has the right to convert into common at 5-H). or 13 percent above the current stock price Now if. as the conventional argument runs. the companv performs poorlv and the stock price does not rise. the bondholders will not find it advantageous to exercise their conversion option. The issuing com— panvwill then have obtained debt financing at a cost of 11 percent. or 500 basis points below the going rate for senior debt. On the other hand. if the firm prospers and the share price rises. bondholders will convert For each 51000 raised. the companvwill have to issue 217+ ($1000 5+6) shares. In this case. man— agement will in effect have sold common Stock at the conversion price of 3+6. or 1 5 percent above the stock price at the time the fimds were raised. Thus. whether the bond is converted or not. the companvwill have done better with convertibles than with the alternative source of funds. Or so it seems. The argument is beguiling because it involves sleight of hand. Notice that it compares the converti- ble to Straight debt onlv when the companv per- forms poorlv. but compares the convertible to common stock when the firm performs well. This is similar to the argument that it is beSt to buy fire in- surance on onlv 50 percent of the value of vour house. If the house burns down. 50 percent insur- 57 ance is better than none; and if the house does llt )l burn down. 30 percent insurance is cheaper than full insurance. This argument is clearlv fallacious since it ne- glects to point out that 30 percent insurance is worse than full insurance ifthe house burns downand more expensive than no insurance if the house does not burn down. Similarlv. the convertible will turn out to be more expensive than common stock ifthe c<_)mpa- nv does poorlv. because the debt will still have be serviced If the companv does verv well. the converti- ble will have been more expensive than straight debt. . for then the convertible bond purchasers will partici— pate in the stockholders' profits. It is clear that the case for the convertible CLlllllt ll be made on the basis of this "heads vou win. tails vt )Ll also win" kind of argument The convertible bond- holder is perhaps best thought of as a kind of fair- weather stockholder and foul-weather bondholder To compensate for the fact that he is nm the ideal npe of business partner. the convertible purchaser accepts less advantageous terms for the debt or stock with which he will finallv end up: thus is the convert— ible coupon below the straight debt coupon. and the Conversion price above the current stock price A somewhat stronger case can be made for the cost advantage ofthe convertible if it is assumed that the companv's stock is significantlv overpriced or underpriced. Suppose. for example. that the stock at 3+0 is so overpriced that management can be sure that the bond will not be converted Bv issuing the convertible. the companv would then be selling 1+ percent debt at a CQSt of only 11 percent This is certainlv an attractive proposition. But how often can management be sure that the conver— sion option is worthless. unless thev are fraudulentlv concealing information about the companv? More- over. in such circumstances. it would almost certain- lv be better to sell the overpriced stock itself. Suppose. on the other hand. that the stock is so underpriced that management can be sure that the bondholders will convert. Then. bv issuing the con- vertible. the companv is in effect selling stock at the higher conversion price In these circumstances. however, it would be even better to issue straight debt. retiring it with proceeds of a Stock issue after the stock price has risen. In general. arguments for convertibles based on the assumed mispricing of the common stock come down to nothing more than the observation that the convertible is a hvbrid securitv—part stock. part .l()l H\ \l. (ll APPLIED! ()Rl’HHA'l'l. H'\\'\(',l, ___...._.........._._..._.J \I \l‘llx'll'l l"\ l:‘\ H 'llll l’lv‘lt l l‘r. 'll ll Mllvlv‘lle bond Therefore. ifthe stock is undervalued and so a costly source of funds. the convertible will be less tindeiyalued But straight debt. in this case. will be even less undervalued 1f the stock is overvalued. the convertible will also be overvalued. and therefore a less costly source of funds than straight debt, Common stock. however. will be even less costly. In short. the argument that the company‘s stock is im- properly valued does not provide a sensible justifica— tion for issuing convertibles. \VHY, THEN . CONVERTIBLES? If the traditional argument for convertibles does not deserve serious attention. is there another explanation for their popularity? And. furthermore. is this explanation consistent with the financing be- havior of Companies in American capital markets? The institutional explanation of convertibles is that certain financial institutions are restricted as to the amount of common stock they can hold. and that convertibles provide a means by which such inStitu- tions can increase their equity position. There may be an element of truth in this But the further sug- gestion that such institutions bid up the price of con~ vertibles so that companies can reduce their financ- ing costs by appealing to this restricted segment of the market is unlikely to be true. A more reasonable account of capital market be- havior would show that firms in aggregate supply enough convertibles to satisfy the demand ofthis seg- ment of the market. so that there are no “scarcity rents" —or. in this case. major cost reductions —to be had. After all. chocolate manufacturers do not expect to make more money on sugarless chocolate because diabetics are prohibited from consuming the regular kind. By the same logic. this preference for con- vertibles by some institutions should not provide any significant cost reduction to companies issuing them. A more convincing rationale for converti- bles—one that has received a good deal of support in the academic finance community—centers on the effect of changes in risk on the value of securities. Recall that. as a general rule. the higher the risk asso- ciated with a company's operations (and the greater the market‘s uncertainty about that risk). the higher the interest cost that a company will be forced to pay. At least. on its straight debt. In the case of conveni- bles. however. higher risk may not mean a corres- pondingly greater burden of financing costs for the issuing company. That is. the use of convertibles may \\i> \l.\\ \(ili\lli\’l (()\\'l-‘l\"l'llii.l' l\ \I Ill 1 \lll i ll llillv‘ lll\\til\‘l‘l"\il’\’l ()\l:l\‘ 'llll" lv‘l\l\ ml 58 \( ilil‘li ll l \'l 'll ll \‘lt)(;l\ l\ l\ l‘ll “ )i‘. l\lv ll ll" ( t >\ll’\\\ \ t’)l"l‘l-;\'i li )Ks effectively shelter companies of high and indetermi- nate risk from prohibitively high costs of straigl‘i: debt capital. To see why this is true. note that a convertible is roughly equivalent to a package of straight debt and warrants Instead of issuing a 31.000 bond which is convertible into 217+ shares at a conversion price i if 5+6. a corporation could issue a package ofone Si .000 straight bond and 21.'~i warrants with an exercise price of 8+6; and the consequences would be Llllllt ist identical, Such bond-warrant combinations are in- deed a quite popular alternative to convertible by inds How. then. would warrants in combination with a debt offering affect investors" perception of the risks involved in holding such securities? Although there are exceptions to this rule. companies with higher operating and financial risk tend to have more volatile stock prices. As noted earlier. compa- nies with higher risk and. hence. greater price vola- tility pay higher rates for straight debt. And increases in the market's perception of a company's risk will cause a reduction in the value of its straight bonds The effect of increased risk and volatility on a warrant. however. is the opposite. Remember that the holder of a warrant profits from increases in the stock price above the exercise price. but is protected against declines below the exercise price, That is. there is an “asymmetry” in the return to the warrant which increases as the spread of possible future stock prices widens. In other words. as the risk and price volatility ofthe company increases. the value of the warrant increases. For instance. a warrant on the shares of an electronics company will be worth con— siderably more than a warrant (with the same con- ditions) on a utility‘s shares. In the case ofa convertible securitv. then. the ef— - fect of an increase in risk on the cost of a straight debt offering is offset. to an extent. by its effect on the value of the warrant. As a result. the value of an appropriate— ly designed convertible security (or its equivalent package of straight debt and warrants ) will be largely unaffected by the risk of the issuing firm. ” Practically. this means that two companies at dif- ferent points along the risk spectrum. facing very dif— ferent costs of straight debt. could issue convertibles with nearly identical maturities. conversion premiums and coupon rates. Such a case is illustrat— ed in Table 1. Note that while the terms of the con- vertible debt sold by the medium- and high-risk companies are almost identical. the proportions of the convertibles value which are accounted for by JOL'RNAL OF APPLIED CORPORATE Fl'\-\\(lh \\ ll\ l'llllt". l\lltl". lll \l’wll l llll ll I't lv‘l l‘k)llkll\(>l l‘lll iil‘v' \\\; 1ilt tt’)\vltfilll’v1l l\lll\li,\. ltllil l'lll l’lLllllililli l‘\\ll\l \l ___________________.————— TABLE 1 (.01 l)0\ RlerZN REQl'lREll O.\ \E\\ 1551f) Ol' Sll‘vxlkil ll AND CONVERTIBLE DEBT _______________.———————-——— Company Risk ____.____——-—— Medium High _________________—————-— tonyei'ttble llebt ll i ll 1% straight Debt 1+ 1w. _______________._.—-—————— the straight debt element and by the conversion fea— ture will be quite different. For the higher-risk com- pany. less of the convertibles value will be accounted for by the straight debt component. and correspondingly more by the conversion or warrant element. \Ve are not suggesting. in this example. that con- vertibles offer higher-risk companies a"free lunch.” \Ve are arguing however. that the inclusion of war- rants in a debt package provides a kind of financing "synergy ” which allows companies with high and un- certain risk to raise capital on more advantageous terms Consider the further case of a company whose managers believe it to be one of medium risk. but which is perceived by the market to be high risk. Fac- ing a lo percent coupon rate. when companies of what it deems comparable risk are paying only 14 percent. the management of such a company may find straight debt prohibitively expensive. Although convertible debt will also appear expensive. because the company must pay 11 1 a percent coupon in- stead of the 11 percent it considers reasonable. the effect of the divergence in risk assessment between management and the market is much less for the convertible than for the straight debt. In such a situation. management will undoubt— edly prefer to issue the convertible. Notice that the role of the convertible in this situation is independ- ent of any mispricing of the stock. Even if the market and management agree that the stock is correctly priced. the convertible is still useful in resolving their disagreement over the risk of the company's operations The relevant risk is not only the risk of the company's existing operations. but also the risk of any future operations in which the firm may become involved over the life of the bond It has been pointed out that the management of a company with straight debt outstanding will have an incentive to in- crease the risk of the firm. since the downside risk is borne by the bondholders while the upside returns accrue solely to the stockholders. In reasonably sophisticated capital markets. purchasers of straight debt issued by companies for which this behavior is a real possibility will demand a correspondingly higher coupon rate to compensate for this anticipat- ed future risk. In this case also. the cost of Straight debt will look high relative to the risk of the company‘s existing operations Because of their option on the firm's equity. however. purchasers of a convertible issue are likely to be much less concerned by the prospect of in- creases in the future risk of the company For al- though an increase in risk would reduce the straight debt value of their bonds. it would also increase the value of the warrant element. Consequently. when there is doubt about the future policies of the com- pany. the convertible is likely to be the preferred in— strument. It should also be noted that because the convertible holders are protected against this type of expropriation. managements issuing convertible. rather than straight debt reduce their own incentive to increase the risk of the firm simply to transfer wealth from the bondholders to the existing stock- holders? For the reasons offered above. convertibles are most likely to be used by companies which the mar— ket perceives as risky. whose risk is hard to assess. and whose investment policy is hard to predict The Evidence ~The data on the corporate use of convertibles seem to be consistent with our theory. In a study i This e\amp|e is not meant to suggest that because the terms of the two Ltill'xt‘f‘lllllt issues are nearly identical the tost oi the tonyertible is identital loi the two companies Remember that tonvertible debt is a hybrid security partly straight debt and partly (a call option on the company st equuy The opportunity ti N of a tr invertible debt issue should thus be thought tll as a weighted average or Me u iii‘ipa'n s cost ol debt and (QUIH capital For the hlgllt‘f‘l'lsls compant in this lL the lJKl that it has both a higher ti ist oi straight debt and a higher implitit oi equm suggests that its convertible will have a higher implicit cost But \‘l‘l more HNPA inant the fact that a much greater poninn of the \‘alue of its U‘ll\(‘l'lll‘lk' rests in the warrant or equm tomponent means that the comertible by 'lklk‘l ltas been promised a more substantial equtty stake in the the higherrisl. tompan. this. of course. translates into a highei opportunity cost iit capital 3 This argument was first presented Iormally b\ .\lith.iel t \Xilliam H \letkling iii "Theon ol the hrm Managerial liehaiioi. Agency Losts [om-Hui off/mutual FLUHUHIIL\ \olunie 4 pp 4“; «iii lL‘ltset‘ .lll\l and (.apital \lrtti‘lure ilkl'tii 59 JUL R\Al. OF APPLIED (IURPURATL l-‘I\A\(Tl. published in 19M). \Vavne Mikkelson found that higl‘ili-levered and high-growth companies were more likeli to issue convertibles.“ High leverage is certainlv related to risk. and it is high—growth firms whose future investment is hardest to predict Mikkelson also found that the longer the term of the issue. the more likelv it was to contain a conversion feature This is also consistent with the theorv be- cause longer maturities involve greater risks of a shift in companies‘ investment policies Interestinglv enough. \likkelson also found that convertibles are much more frequentlv offered pub- licli than placed privater This is evidence against the institutional explanation of convertibles. which would have the demand for them coming primarilv from institutions It is also consistent with the stress our theorv lavs on uncertainti in risk assessment. since it is undoubtedlv easier for the financial institu- tit ins involved in private placements to assess the risks of individual companies than for the public at large. A more recent studv bv Donald Chew provides further confirmation of \iikkelson‘s findings In an attempt to identifv some of the financial character- istics which distinguish companies issuing con» vertibles from those issuing straight debt onlv. this studv reported that over the period 19"-19h’U. con- vertible issuers tended to have higher market and earnings variabilitv Thev were also. on average. con- siderablv smaller. vounger. and growing more rap— idlv All ofthese characteristics translate fairlv direct- lv into greater investor uncertaintv about risk. and higher potential rewards associated with the conver- sion privilege CONVERSION AND CALL POLICIES Having offered a corporate motivation for issu- ing convertibles. we now want to consider the ques» tion of conversion—first from the perspective of in- vestors. and then from the standpoint of manage- ment formulating call policies for convertible issues. A rational bondholder will not convert his bond as long as the coupon on the bond exceeds the divi- dends on the shares into which the bond is converti- ble—not unless the conversion privilege is about to expire or change adverselv. Bv postponing conver- sion the bondholder continues to enjov a greater in- come. and literallv keeps his options open. Indeed. even if the dividerd forgone exceeds the bond ct a2- piH]. the investor mavvet decide to postpone o >nv er- sion because of tl‘e greater flexibilitv he retains The issuing companv can. of course. induce bondholders to convert simplv bv raising the divi- dend on the comm in stock sufficientlv high At \i inie point the opportunitv cost of forgoing the higher dividend will ensare that bondholders voluntarili choose to convert Ifthe bond is callable. and ifthe conversion val- ue of the bonc exceeds the call price. the bondholders can also be induced to convert bi cal— ling the bond for redemption. For example. if each 31000 bond is convertible into 2% shares of stock. and the share price is 530. the conversion value of the bond is 2% X 560 = 51230, Suppose that each bond is callable at 51100. If the companv calls the bond. the bondholder may either redeem the bond at the call price of 51100 or convert the bond into common stock with market value of 512%, Faced with these alternatives. the bondholders wi l have no difficultv in deciding to convert the bond; and the companv would be said to have "forced conversit in" bi calling the convertible. \X'hen should a companv call its convertibles? Assuming that management's objective is to maxi— mize the value ofthe common stock the appropriate policv—at least. in meow—is to call as soon as the value of the convertible reaches the call price This will tvpicallv occur when the conversion value of the bonds is equal to the call price. Such a call policv minimizes the value ofthe convertible bv putting the lowest possible lid on its value. That is. bv forcing conversion or redeeming the issue. management effectivelv limits the value of the convertible bv elim- inating the warrant component—and the flexibilitv it provides the investor. Because the convertible represents a liabilirv of the existing stockholders. acting to minimize its value increases the value of the . common stock. There are a couple of considerations which would make the proposed call policv somewhat im- practical. First. bondholders tvpicallv must be given 50 davs notice of call. Secondlv. management mav wish to avoid the costs associated with issuing new securities ifthe bonds are redeemed rather than ct in— verted into stock. The effect of these considerations on the optimal policv is to delav the call until the o in- } Klikkelsiit‘. \\ H (,onvertihle \eturiu (,alls and \eiurinliolclei Returns E‘sldtlltt' on Agena (.tisis Etietisoi Capital structure Change and \uppli lillwls journal offnmnua/ FLUH(H7II(_\ i Wm i 60 Jill R\\l ill Al‘l’lillJH ()Ml‘llli \'l‘l Fl\\\( l. \ ersit in value is sufficiently above the call price— high enough such that management can be reasonably as— sured that fluctuations in the stock price during the call notice period will not cause the investors to redeem rather than to convert the bonds A study by_lonathan lngersoll has shown that its- ing this modification ofthe original rule. the optimal timing for calling a convertible would be when the conversion values were. at most. 0—8 percent above the call price.1 The actual call policies of corporations. howev— er. do not even approximate this proposed optimal policy in a 1%; suia‘ey of corporations with conver- tibles outstanding. Eugene Brigham found that only 1% percent planned to force conversion as soon as conversion could be assured (the optimal policy ); another 25 percent planned to encourage conver- sit )ll by raising dividends: and the remaining M per- cent had no clear plans to force conversion Inger- soll confirmed Brigham‘s results. finding that the median company among all firms calling converti- bles between Nuts and 19—3 waited until the conver- sion values of its bonds was 6.9 percent higher than the call price ; It is difficult to explain such behavior on a ra- tional basis. It has been suggested that. by forcing conversion. the company loses the advantage of the tax deductibility of interest payments on the bonds \\"hile. in principle. this tax advantage could be regained by making a new issue of bonds and retir- ing stock. this kind of recapitalization involves addi— tional underwriting costs. (Xiikkelson found that only 25 of his 115 corporations forcing conversion replaced the debt.) This tax-based rationalization of corporate call policies is further weakened by Ingersoll‘s finding that companies calling their convertible preferreds behaved in roughly the same way: the median corpo- ration delayed call until the conversion value exceed- ed the call price by 585 percent There is no ct >rporate tax advantage associated with preferred shares, Alternative explanations rely on notions of fair play and management concern with (undiluted) earnings per share. It is argued that it is unfair to de~ prive the hi )ndholders of the full benefit oftheir con— version privilege; and that if the company enforces its call rights. it may experience difficulty in selling convertibles in the future. The idea. however. that corporate treasurers are constrained by these misdi- rected scruples l which. after all. will reward ct )l‘lVCi‘I- ible holders only at the expense ofthe existing stt ick» holders) seems far-fetched. Furthermore. the sup— posedly adverse consequences for future issues can be ayoided by placing appropriate restrictions on the call privilege for those issues, Some converti— bles. for example. restrict the corporations right to call to periods during which the conversion value of the bonds exceeds the call price by a stated percent- age. In the absence of such provisions. though. self- imposed restrictions on the use of the call privilege seem just silly. Another motive for deferring conversion is management's concern with the effect on reported ttindilutedt earnings per share. Conversion of out- standing bonds or preferreds will typically reduce this figure. spreading the company's earnings over a larger number of shares. To the extent that manage- ment believes the market value of its shares re- sponds to announcements of accounting trans- actions without any economic consequences. it may wish to postpone this formal declaration that all fu- ture cash flows are now to be divided among a larger group of stockholders. In a reasonably sophisticated market. however. investors will have already antici— pated the conversion. recognizing that fully diluted EPS provides a better guide to the value of the com— pany‘s stock. Consequently. we remain a bit skeptical of the idea that excessive concern with the effect of reduced EPS on stock prices accounts for the wide- spread tendenq to put off conversion. There is. however. another reason for mana‘ gers‘ heeding reported earnings per share—one consistent with rational behavior: namely. their com— pensation may be tied to this figure, If such is the case. then tying the bonus to undiluted EPS is creat- ing the wrong incentive for financial managers. rewarding actions which detraCt from instead of con- tribute to stockholder value. It is interesting to note. however. that manage- ment's alleged concern with the stock price implica- tions of forcing conversion seems to find justification in Mikkelson‘s puzzling discovery that announce- ments of convertible bond calls are accompanied. on average. by a 2 percent drop in stock prices In the case of forced conversions on preferred issues. the average market response is a negative 1 5 percent It lttacrs ill \ latllllIlL’Clll-l laini- \aluatiott of Lonxerubli serum u financial hmmmits \olume a \umhet ,4 t\la\ Ill—Ti a It tilal'i‘ ties lwtmm. ; ylonathan ltTL‘et’sr ill .-\n h\.ll1lll1.llltll] of t UI'Dthlt tal'. Pt 1.. as on K wz‘tt't" blt \erurities limmm‘ o/ lit/mitt \olume A: pp 4M4“ »l~'_t 61 NH RNKIJH Al’l'lJH)LURI’IIRU'I |‘|'\\\(,l \l \\ ll\‘:l .. l‘llt ()‘\ lllel lLl ll‘fll i \ll \ \\ l l'll l \l \‘xl )l‘~.\l\lll ll lttt\\llllllll'( is unlikelv that these negative reactions are attributa— ble to a svstematic error bv the market in interpret- ing the reported earnings figures. Mikkelson tentativelv attributes this market re- sponse to the tax effect discussed earlier; that is. the negative response reflects the markets recognition of the loss of the interest tax shield associated with the bonds Some indirect support for this position is provided bv a studv demonstrating a positive stock price response to companies that issue debt to retire stock. which is essentiallv the reverse of converting outstanding bonds.” The problem with this explana- tion is that it implies that managements svstematical- lv make financial decisions which are contrarv to the interest of their shareholders; and we are reluctant to rest with such a conclusion A more palatable explanation. and the one that we favor. would attribute )likkelson‘s‘ findings to an "information effect." That is. the market mav have be- come conditioned to associate convertible calls with unfavorable events having nothing to do with the conversion For example. if managements. in antici- patit )ll of difficult times. have a tendeno~ to clear the decks of fixed and semi-fixed obligations bv forcing c<_)nversion. the market would then come to recog- nize forced conversions as unfavorable auguries. and mark down the stock prices accordinglv In summarv. corporate call policies and their effects remain obscure, Managers seem to delav too long in exercising their call privileges, Yet the stock price tends to decline when thev do exercise it. We have suggested that the delav mav be due to manage- ment's concern with the negative effect on reported EPS. The negative stock price reaction to the an- nouncement of a call mav be attributable to tax effects or to information effects. We favor the infor- mation hvpothesis because. unlike the tax hvpothe- sis. it does not implv that managers are acting against the shareholder interest. At this point. however. we do not have the evidence to make a confident choice among these alternatives. PRICING A CONVERTIBLE ISSUE At the outset. we stated that most ofthe existing models for valuing convertibles (and thus for pricing tt)\1t1']]t i\} it It) \ss< it l\ll l‘xl \l\ ll\'.l\ii \< ll'ilht: It) ()\\ l‘l-{slt >\ new convertible issues) are inadequate such models have been based on simplistic analvses which assume the future is known with certainty The price ofthe companv‘s stock is assumed to gri m at a given rate; and on the basis of this assumptit >12. conversion is assumed to take place a pre-deter- mined number of years after the securitv is issued The problem with such models is their failure to reflect the essential feature of the convertible: the conversion option gives the bondholder the right to wait until current uncertainties are at least pat‘tlztlb resolved before deciding to be treated as a fixed claim holder or as an equitv investor Bv assuming that the future evolution of the bond is known with certaintv. conventional valuation techniques assume awav the raz'son den? of the securitv Recent advances in the theorv of option pricing have ena- bled us to construct a richer model. one which takes account of future uncertainties, Our own research. in combination with the work on options bv Fischer Black and .\1vron Scht iles. has led to the development ofa more realistic means of valuing and analvzing convertible securities.‘ Our model relies on a fundamental principle underlving the Black-Scholes Options Pricing Model namelv that the expected rate of return on a convertible se— curitv should be equal to the expected rate of return on an equivalent risk portfolio consisting of bonds and the companv‘s common stock. L'nlike the older certaintv models. which are essentiallv static in na- ture. our model is a dvnamic. continually—adiusting formula which enables the user to determine the ef- fect of changes in several kev variables on the value of the convertible. Our valuation model takes the form of a faith complicated differential equation. which vields the value of convertible securities onlv with the aid of a computer. But though the equation itself would probablv have little meaning for readers unfamiliar with quantitative methods. a simplified account of what the model savs about how convertibles are valued bv investors can be compressed into a sentence or two. The major determinants of a convertibles value are: the coupon rate on the bond (or the pre- ferred dividend); the current level of interest rates it Ronald \lasulis [9% "The Effects o.’ Capital \tructure Change on Securm Prices A \[Ud\ of Exchange Offers loumal nff’mzmczal I-crmomicv \ol ls pp ‘\/- l -x ‘ Nee fisther Black and ,\l\‘ron \choles The Pricing of Options and (,orpo- rat: Liabilities [0107]“!()fFU/Xllca/EOJnnmt. \olume H]. \umbcr 5 (Mavlune 62 19-3 i. Robert Merton, "The Theorv of Rational Option Pricing [iv/f human tr Emnrmncs and \Iunugwnen/ \(lt’llct’ \Ultll‘ik‘ 4 \unibei l Apring lrs an... Michael Brennan and Eduardo schw art/ ‘(oniertiblt lsonvls \.ilu.tu ‘52 .li‘c‘ Up” mal \trategtes of Call and conversion. [om-Hui offlntmtt k oiumn *3 \utitbt' i (December 10“) J01 R’\A|. ()l APPLIH) (itml‘HHA'l'l. H'\A'\(,l tincluding the companv‘s‘ current vields on straight debt and preferred); the conversion price; the level and the volatilitv of the company‘s stock price; the dividend vield on the stock: the call provisions; and the maturitv of the issue. The general relationships betweeen a convertibles value and the major variables are these: The lower the coupon rate rela- tive to the companvs borrowing rates on straight securities. the lower the price of the convertible. The higher the stock price relative to the conversion price. and the greater the volatilirv of the underlving stock price. the higher the value of the convertible. Also. the lower the call price. and the sooner the call can be exercised. the lower the value And. finallv. the higher the common dividend. the lower the value of the convertible (since higher dividends mean less price appreciation ). There is nothing exceptional about the identification of these determinants. and the direc- tion in which thev affect convertible prices. The virtue of our model lies rather in its improved abilitv to analvze and quantifv the effects of changes in these crucial variables on the price of a given securitv For the sake of illustration. consider the exam- ple described in Table 2. Given the bond character- istics summarized in this table and the measure of the risk (and volatilitv) of the companv‘s common stock—and further assuming that both the investor _____________———-————— TABLE 2 BASIC CHR—XCTERISTICS OF A CONVERTIBLE ISSI‘E Financial Markets I £90 Treasurv Bill Rate 10 vear Government Rate The Issuing Firm 1 million shares of common stock No Senior Debt S-H 02 S 2.08 Capitalization Stock Pnce Dividend'Share The Convertible Issue Issue Size 80 million Coupon Rate 8% Conversion Pr1ce $34 Maturity 10 years Callable after 5 vears Recoverv in Bankrupth 3% of par value _____________————-—-—-— I-I 460/0 _________________—————-—- TABLE 3 BOND \‘ALI‘E SENSITIVITY ANALYSIS _______________._———-——— Effect of Bond Change on Value Bond Value _____________—————— Basic Characteristics 5 99' Non—callable 10373 55" Non-callable. non-convertible “H— - 21 1 Stock Price 10% increase 10-5 -i 0 Firm Risk 10% increase 100— 1 fl Coupon Rate 10% increase 103* 5 3 Conversion Pnce 10% decrease 10-? 8 15' Call Period Deferred 1 vear 100; (J h increase Call Race 10% increase 100:‘ 1) >~ __________________——————— and management follow the optimal conversion and call policies outlined earlier—our model estimates the values of the bond at $99- per $1000 of par value In Table 5. the results of a sensitivirv analvsis show the effect of changes in various parameters and bond characteristics on the value of the bond. For example. removal of the company's right to call the bond should increase its value bv 55 percent. or $53 per 51000. On the other hand. also removing the conversion privilege. which would make the bond :1 straight non-callable bond. would reduce its value bi 21.1 percent. Note the relative insensitivitv of the bonds value to the risk of the firm. In this case. a 10 percent in- crease in risk actuallv resulLs in a 1 percent increase in the value of the convertible. This supports the ration- ale for convertibles we offered above: thev are liker to be especially attractive to an issuing companv which is perceived as more risk by the market than by management. Such a companv would be burdened hv a penaltv coupon rate on a straight bond issue. where- as it mav actually benefit from the higher risk p61“ ceived bv the market if it issues a convertible. Table 5 also contains the kind of information which would be most valuable to an issuer in design— ing a convertible. because it enables management to determine the relative costs and benefits of various 63 JOI'RNAI, OF APPLIED CORPORATE FIN «\(ZI improvements and concessions in the basic terms of the issue For example. a (w a percent reduction in the conversion price from 5% to $3054 could be granted in return for a 10 percent reduction to «1% x s <1 52 i in the coupon rate As the variervof possible bond contracts U intinues to increase. effec- tive analvsis of the alternative possibilities demands a valuation model of this tvpe CONCLUSION 1. \\"e have shown the fallacv in the conventional argument that convertibles are a cheap source of funds That convertibles allow companies to borrow at below market rates and to sell stock at premiums over the present price does not mean that thev pro- vide cost advantages to the issuer The real opportu- nitv cost of convertible debt. reflecting its hvbrid character. should be thought of as a weighted aver— age of the compam 's cost of straight debt and the considerablv higher cost associated with the conver- sion or equitv option. 2 The most plausible rationale for the continu- ing popularitv of convertbles lies in their insensitivi— tv to companv risk. This allows them it i be issued on terms that look fair to management. even when the market rates the risk of the issuer higher than does management of the issuing companv I MICHAEL BRENNAA is Irwin Hearsh Professor of \lonev and Banking at l'CIA‘s Anderson Graduate scht )1 r] or .\l.inagernent Brennan is current- l_\ President-elect of the American Finance Association and was formerlv Editor of the journal of Finance Dr Brennan is currentlv the founding Editor of a new finance publication. O\ford l'niversin s Rei‘zett Q/‘Financm/ studies 64 This rationale receives Strong support frt m the available evidence, Companies issuing Convertible bonds tend to be characterized bv higher market and earnings variabilitv. higher business and or financial risk. stronger growth-orientatitins. and shorter cor- porate histories than their straight debt counter- parts Such companies stand to benefit most from convertible financing. 5. Although our theorv suggests that manage- ment should force conversion of convertibles soon after the value of the securin rises above the call price. companies tend to delav calling their c< inverti- bles well bevond this point. \X’e surmise that this ma} be due to management‘s misguided preoccupation with reported earnings-per-share, —l. \X'hen a convertible call is announced. the companvs stock price tends to drop. Alth >ugh a tax- based explanation of this market response has been offered. we favor the "information" hvpothesis suggesting that convertible calls are interpreted bv the market as management‘s effort to clean up the balance sheet in the face of impending difficulties 8. \X'e offer a brief introduction to the Brennan- Schwartz valuation model for pricing convertible se- curities. Bv incorporating some of the insights i if the Black-Scholes Option Pricing Model. the model rep- resents a significant advance over the older static models of convertible pricing. I EDL'ARDO SCHWARTZ is Professor of Finance at ['CL-‘x’s Anderson Graduate School of Management His published research deals with the pricing of convertible securities and options. corporate finance for regulated industries and bond pricmg models Dr Schwartz has co-authi ired two books (with Michael Brennan t .N‘ai'ings Bonds Tbewj‘ and Empirical Evidence and Pricing and lniesmieni Sii‘aregiesfor Guaranteed [Salim Length Life Insuranct JOI R\A|. ()l APPLIH) (IURPORR’I‘F. H'\A\(,L ...
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Case for Convertibles - Brennan and Schwartz - I THE CASE...

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