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Unformatted text preview: 1 Chapter 16 CONVERTIBLE BONDS AND CONVERTIBLE PREFERRED STOCK By Dr. M. Metghalchi Convertible bonds may be exchanged at the holder's option for a specified number of shares of the firm's stock. Nonconvertible debt lacks this conversion feature. A convertible bond's value in terms of stock depends on the number of shares into which it may be converted and the price of the shares. This conversion value is important because it sets a minimum price on a convertible bond. If the bond were to sell for a price that is less than its value as stock, an opportunity for arbitrage would exist. Investors would buy the bonds, convert, and sell the stock and thereby lock in the difference between the bond's price and its value as stock. The act of buying the bonds would drive up their price so that it would at least be equal to the bond's value as stock. A convertible bond's value as debt depends on the bond's coupon rate of interest and yields on comparable risky, nonconvertible bonds. This value sets a floor on the price of a convertible bond. If the bond were to sell for a price that is less than its value as debt, its yield would exceed the yield on comparable nonconvertible debt. Investors in bonds would buy the underpriced convertibles, which would increase their price to at least their investment value as non- convertible debt. Convertible bonds are less risky than stock as they are debt instruments. The firm must meet the terms of the bond's indenture. These bonds are usually riskier than nonconvertible debt because they pay less interest, are subject to greater price volatility, have weaker terms (e.g., weak sinking fund) than are found in nonconvertible debt, and usually are subordinated to other debt obligations. Convertible bonds grant bondholders the right to exchange each bond for a designated number of common stock shares of the issuing firm. The important terms are: Conversion ratio: CR = No. of stock shares acquired by converting bond to stocks 2 Conversion price: CP = Bond par value / Conversion ratio Conversion value: CV = Price per share of stock x Conversion ratio Example 1: (From Investments textbook by Hirschey and Nofsinger) The common stock of Houston Inc. pays a 35 cents dividend and has a market price of $55 per share. Houston also has a 6 percent convertible bond selling at 118 that is convertible into common at $50 per share. What are the conversion ratio, conversion value, and premium to convert? Should a holder of convertible bond convert? SOLUTION: The conversion ratio = 1000/50 = 20 The conversation value = is 20* 55 = $1,100 The premium to convert or call value option = $1,180 - $1,100 = $80 The convertible holder earns 6 % in interest each year, or $60. A conversion to 20 shares of stock would earn $7 per year dividends. Holding the convertible allows the investor to earn higher annual cash flow and save the conversion premium. If the investor continues to view the companys prospects favorably, the convertible bond should be held and not converted. companys prospects favorably, the convertible bond should be held and not converted....
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- Spring '11