Your company is contemplating issuing convertible bonds as opposed to straight bonds. You, the CFO, believe that the convertible bond is preferable since you can offer a lower coupon rate to your investors. You also believe that there will be more competitors and more disruptive technology that can impact your business moving forward, hence you want to manage your cash flows carefully.
You have some data and some questions about a convertible bond issued by one of your competitors. You have assigned one of your subordinates to work though some calculations to better understand the bond from the issuer’s and the investor’s perspective. Consider the convertible bond as follows:
Par value = $1,000
Coupon rate = 4.0%
Market price of convertible bond = $1,175
Conversion ratio = 40
Estimated straight value of bond = $1,015
Assume that the price of the common stock is $28 and that the dividend per share is $0.03 per year.
a. Calculate each of the following: (i) Conversion Value; (ii) Market Conversion Price; (iii) Conversion premium per share; (iv) Conversion premium ratio; (v) Premium over straight value; (vi) Favourable income differential per share, and (vii) Premium payback period
b. Suppose that the price of the common stock increases from $28 to $35.
1. What will be the approximate return realized from investing in the convertible bond?
2. What would be the return realized if $28 had been invested in the common stock?
3. Why would the return on investing in the common stock directly be different than investing in the convertible bond?
c. Suppose that the price of the common stock declines from $28 to $21.
1. What will be the approximate return realized from investing in the convertible bond?
2. What would be the return realized if $28 had been invested in the common stock?
3. Why would the return on investing in the convertible bond be different than investing in the common stock directly?
d. Beyond these calculations, are you convinced that it is advantageous to issue convertible bonds versus straight bonds and straight equity? Explain why or why not.
