100%(1)1 out of 1 people found this document helpful
This preview shows page 6 - 11 out of 31 pages.
at maturity in seven years•If the value of the shares exceeds $100 million on or anytime before maturity, investors may elect to convert the bond and receive shares
Convertible Bond Component PartsConvertible Bond Component Parts-3%0%3%6%2022242628-3%0%3%6%2022242628-3%0%3%6%2022242628Bond with 6% couponCall option on $20 stock with $24Call strike priceConvertible=+Breakeven priceFuture share priceEconomicValue
Convertible Bond Example•A company issues a $100 million convertible with a seven-year maturity and a 3% annual coupon. Investors are given the right to receive either $100 million repayment at maturity or, at their option, give up receipt of this cash amount in exchange for receiving a predetermined number of shares of the issuer’s common stock•On the date of convertible issuance, the company’s stock price is trading at $25, and the company agrees to a “conversion price” for the convertible of $31.25, which is 25% above $25. This percentage is called the “conversion premium,” because the conversion price is set at a premium (in this case, a 25% premium) to the company’s share price on the date of convertible issuance•The conversion price determines the number of shares that the investor has the right to convert into. This determination is made by dividing the total proceeds of the offering by the conversion price•The result, in this example, is $100 million / $31.25 = 3.2 million shares
Convertible Example (cont.)Convertible investors, therefore, have a choice to make: either take $100 million in cash at maturity or give up the cash right in exchange for receiving 3.2 million shares anytime at or before maturityIf, for example, the issuer’s share price increases to $45 at maturity in seven years, convertible investors might elect to give up the right to receive $100 million in cash in exchange for 3.2 million shares because the value of these shares would be 3.2 million x $45 = $144 millionIn practice, most investors wait until maturity to make the conversion decision due to the value of the options embedded in the convertible, but they have the right to convert earlier.
Zero Coupon ConvertiblesA Zero Coupon Convertible (ZCC) is similar to a coupon-paying convertible except, instead of paying interest coupons each year, the issuer increases the principal amount of the convertible by an amount equal to the unpaid coupon, creating an “accretion” of the bondAlthough there are approximately the same number of underlying shares for a ZCC and a coupon-paying convertible, and ZCCs’ unpaid coupons are “paid” by increasing the principal amount of the convertible, a ZCC offers additional benefitsAn issuer is able to receive tax deductions in relation to the annual accretion of the convertible, creating a positive cash flow bond financing (no cash payments for coupons, but tax deductions equal to the deductions the issuer would receive if a coupon paying convertible had been issued)Also, there is a lower probability of conversion on the portion of the