Scribd
Upload
87 views19 pages

Lecture - 03 Convertibles 13102022 111838am

The document discusses conversion ratios, prices, and premiums for convertible securities. It provides an example where convertible preferred stock is issued by Tsetsekos Company, with a conversion ratio of 1:1 and dividend of $2.10 per share. The conversion price would be $46.20 at a 10% premium or $54.60 at a 30% premium over the $42 common stock price. The preferred stock should include a call provision to allow the company to force conversion if the stock price rises above the conversion price.

Uploaded by

dua nadeem
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PPTX, PDF, TXT or read online on Scribd
87 views19 pages

Lecture - 03 Convertibles 13102022 111838am

The document discusses conversion ratios, prices, and premiums for convertible securities. It provides an example where convertible preferred stock is issued by Tsetsekos Company, with a conversion ratio of 1:1 and dividend of $2.10 per share. The conversion price would be $46.20 at a 10% premium or $54.60 at a 30% premium over the $42 common stock price. The preferred stock should include a call provision to allow the company to force conversion if the stock price rises above the conversion price.

Uploaded by

dua nadeem
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PPTX, PDF, TXT or read online on Scribd
You are on page 1/ 19

Nudrat Fatima

Senior Lecturer
nufatima.buic@bahria.edu.pk
Conversion Ratio and Conversion Price:
The conversion ratio, CR, for a convertible security is defined as the
number of shares of stock a bondholder will receive upon conversion.

The conversion price, Pc, is defined as the effective price investors


pay for the common stock when conversion occurs.
Conversion Ratio and Conversion Price
• The relationship between the conversion ratio and the
conversion price can be illustrated by Silicon Valley
Software Company’s convertible debentures issued at
their $1,000 par value in July of 2013. At any time prior to
maturity on July 15, 2033, a debenture holder can
exchange a bond for 18 shares of common stock. The bond
cost a purchaser $1,000, the par value when it was issued.

• What are the conversion ratio and conversion price?


Example # 1

Example: Peterson Securities recently issued convertible


bonds with a $1,000 par value. The bonds have a
conversion price of $40 a share. What is the convertible
issue’s conversion ratio?
Conversion Ratio and Conversion Price
• The conversion price is typically set some 20% to 30% above the
prevailing market price of the common stock on the issue date.
• The conversion price and conversion ratio are fixed for the life of the
bond,
• Sometimes a stepped-up conversion price is used.
For example, the 2010 convertible debentures for Breedon Industries
are convertible into 12.5 shares until 2019, into 11.76 shares from 2020
until 2030, and into 11.11 shares from 2030 until maturity in 2040. The
conversion price thus starts at $80, rises to $85, and then goes to $90.
Breedon’s convertibles, like most, have a 10-year call-protection period.
Conversion Ratio and Conversion Price
Another factor that may cause a change in the conversion price
and ratio is protecting the convertible against dilution from
stock splits, stock dividends, and the sale of common stock at
prices below the conversion price.
The typical provision states that if common stock is sold at a
price below the conversion price, then the conversion price must
be lowered (and the conversion ratio raised) to the price at
which the new stock was issued. Also, if the stock is split or if a
stock dividend is declared, the conversion price must be lowered
by the percentage amount of the stock dividend or split.
For example
• For example, if Breedon Industries were to have a 2-for-1
stock split during the first 10 years of its convertible’s life,
then the conversion ratio would automatically be adjusted
from 12.5 to 25 and the conversion price lowered from $80 to
$40. If this protection were not contained in the contract, then
a company could always prevent conversion by the use of
stock splits and stock dividends. Warrants are similarly
protected against dilution.
Use of Convertibles in Financing

Two important advantages:


(1) Convertibles, offer a company the chance to sell debt with a low-interest rate in
exchange for giving bondholders a chance to participate in the company’s success if
it does well.
(2) Convertibles provide a way to sell common stock at prices higher than those
currently prevailing. Some companies actually want to sell common stock, not debt
but feel that the price of their stock is temporarily depressed.
How can the company be sure that conversion will occur if the
price of the stock rises above the conversion price?
• Typically, convertibles contain a call provision that enables the issuing
firm to force holders to convert.
• Suppose the conversion price is $50, the conversion ratio is 20, the
market price of the common stock has risen to $60, and the call price
on a convertible bond is $1,050. If the company calls the bond,
bondholders can either convert it into common stock with a market
value of 20($60) =$1,200 or allow the company to redeem the bond for
$1,050. Naturally, bondholders prefer $1,200 to $1,050, so conversion
would occur.
How can the company be sure that conversion will occur if
the price of the stock rises above the conversion price?

• The call provision thus gives the company a way to force


conversion, provided the market price of the stock is greater
than the conversion price.
• Note, however, that most convertibles have a fairly long
period of call protection—10 years is typical.
• Therefore, if the company wants to be able to force conversion
fairly early, it will have to set a short call-protection period.
• This will, in turn, requires that it set a higher coupon rate or a
lower conversion price.
From the standpoint of the issuer, convertibles have three
important disadvantages:

(1) Even though the use of a convertible bond may give the company the
opportunity to sell stock at a price higher than the price at which it could be sold
currently, if the stock greatly increases in price then the firm would be better off if
it had used straight debt (in spite of its higher cost) and then later sold common
stock and refunded the debt.
(2) Convertibles typically have a low coupon interest rate, and the advantage of
this low-cost debt will be lost when conversion occurs.
(3) If the company truly wants to raise equity capital and if the price of the stock
does not rise sufficiently after the bond is issued, then the company will be stuck
with debt.
Convertibles and Agency Costs
• A potential agency conflict between bondholders and stockholders is asset substitution,
also known as
“bait and switch.”
• Suppose a company has been investing in low-risk projects, and because risk is low,
bondholders charge a low interest rate.
What happens if the company is considering a very risky but highly profitable
venture that potential lenders don’t know about?
• The company might decide to raise low–interest-rate debt without revealing that the
funds will be invested in a risky project. After the funds have been raised and the
investment is made, the value of the debt should fall because its interest rate will be too
low to compensate debtholders for the high risk they bear. This is a “heads I win, tails
you lose” situation, and it results in a wealth transfer from bondholders to stockholders.
REPORTING EARNINGS WHEN WARRANTS OR
CONVERTIBLES ARE OUTSTANDING
• If warrants or convertibles are outstanding, the Financial Accounting Standard
Board requires that a firm report basic earnings per share and diluted earnings per
share.

• 1. Basic EPS is calculated as earnings available to common stockholders divided


by the average number of shares actually outstanding during the period.
• 2. Diluted EPS is calculated as the earnings that would have been available to
common shareholders divided by the average number of shares that would have
been outstanding if “dilutive” securities had been converted.
• SEC rules; firms are required to report both basic and diluted EPS.
Question?
1. What are the three possible methods for reporting EPS
when warrants and convertibles are outstanding?

2. Why should investors be concerned about a firm’s


outstanding warrants and convertibles?
Convertible Premiums

• The Tsetsekos Company was planning to finance an expansion. The principal executives of
the company all agreed that an industrial company such as theirs should finance growth by
means of common stock rather than by debt. However, they felt that the current $42 per share
price of the company’s common stock did not reflect its true worth, so they decided to sell a
convertible security. They considered a convertible debenture but feared the burden of fixed
interest charges if the common stock did not rise enough in price to make conversion
attractive. They decided on an issue of convertible preferred stock, which would pay a
dividend of $2.10 per share.
• a. The conversion ratio will be 1.0; that is, each share of convertible preferred can be
converted into a single share of common. Therefore, the convertible’s par value (and also the
issue price) will be equal to the conversion price, which in turn will be determined as a
premium (i.e., the percentage by which the conversion price exceeds the stock price) over the
current market price of the common stock. What will the conversion price be if it is set at a
10% premium? At a 30% premium?
• b. Should the preferred stock include a call provision? Why?

You might also like

pFad - Phonifier reborn

Pfad - The Proxy pFad of © 2024 Garber Painting. All rights reserved.

Note: This service is not intended for secure transactions such as banking, social media, email, or purchasing. Use at your own risk. We assume no liability whatsoever for broken pages.


Alternative Proxies:

Alternative Proxy

pFad Proxy

pFad v3 Proxy

pFad v4 Proxy