Advantages of using Convertibles in Financing

• Convertibles, like bonds with warrants, 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.

• Convertibles provide a way to sell common stock at prices higher than

those currently prevailing.
 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.
 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?
Example Cont…

CR = 1000 / 40

CR = 25 Shares
 Conversion Ratio and Conversion Price
Silicon Valley Software Company’s convertible debentures
issued at their $1,000 par value in July 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?

Conversion Ratio and Conversion Price
CR = Given up par value / Pc
CR = 18

Pc = Given up par value / Shares Received

Pc = 1000 / 18
Pc = $ 55.55
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,
except for protection against dilutive actions the company might take,
including stock splits, stock dividends, and the sale of common stock at
prices below the conversion price.

• The typical protective provision states that 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.
 Example
If Silicon Valley Software (SVS) were to have a 2-for-1 stock
split, then the conversion ratio would automatically be
adjusted from 18 to 36 and the conversion price lowered from
$55.56 to $27.73.

If SVS sells common stock 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 is
issued.
Conversion Value
The conversion value at Year t is equal to the expected stock price
multiplied by the conversion ratio:

Conversion Value = Stock price x Conversion Ratio

Price = P0 (1+g)n OR P0= D1 / i – g

CVt0 = P0 x CR
CVtn = P0(1+g) n (CR)
Convertibles and Agency Costs
A potential agency conflict between bondholders and stockholders is asset
substitution, also known as “bait and switch.”

When a company has been investing in low-risk projects, 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?
 Convertibles and Agency Costs
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 will result in a wealth transfer from bondholders to stockholders.

Convertibles and Agency Costs
If debtholders think a company might employ the bait-and-switch tactic, they will
charge a higher interest rate, and this higher interest rate is an agency cost.

Convertible securities are one way to mitigate this type of agency cost.

Suppose the debt is convertible and the company does take on the high-risk project.

If the value of the company turns out to be higher than expected, then bondholders
can convert their debt to equity and benefit from the successful investment.

Therefore, bondholders are willing to charge a lower interest rate on convertibles,

and this serves to minimize the agency costs.
 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.
Problems Chapter 20 (15 Edition)
th
20-1
Neubert Enterprises recently issued $1,000 par value 15-year
bonds with a 5% coupon paid annually and warrants attached.
These bonds are currently trading for $1,000. Neubert also has
outstanding $1,000 par value 15-year straight debt with a 7%
coupon paid annually, also trading for $1,000. What is the
implied value of the warrants attached to each bond?

Price paid for bonds =Straight debt value + value of warrants

with warrants of bonds
VB= PMT [1-(1/1+i)n] + Par value
i (1+i)n
VB = 50 [ 1- (1/1.07) 15] + 1000
0.07 (1.07)15
VB = 455.39 + 362.44
VB = 817.83

Value of Warrants = $1,000 - $817.83

= $182.16
20-2
Breuer Investment’s convertible bonds have a $1,000 par value
and a conversion price of $50 a share. What is the convertible
issue’s conversion ratio?

CR = 1000 / 50

CR = 20 Shares
20-3
Maese Industries Inc. has warrants outstanding that permit the holders to purchase 1
share of stock per warrant at a price of $25.
a. Calculate the exercise value of the firm’s warrants if the common sells at each
of the following prices: (1) $20, (2) $25, (3) $30, (4) $100. (Hint: A warrant’s
exercise value is the difference between the stock price and the purchase price
specified by the warrant if the warrant were to be exercised.)
b. Assume the firm’s stock now sells for $20 per share. The company wants to sell
some 20-year, $1,000 par value bonds with interest paid annually. Each bond
will have attached 50 warrants, each exercisable into 1 share of stock at an
exercise price of $25. The firm’s straight bonds yield 12%. Assume that each
warrant will have a market value of $3 when the stock sells at $20. What
coupon interest rate, and dollar coupon, must the company set on the bonds with
warrants if they are to clear the market? (Hint: The convertible bond should
have an initial price of $1,000.)
20-3
A warrant’s exercise value is the difference between the stock price and the
purchase price specified by the warrant if the warrant were to be exercised.

Expiration value = Current price - Strike price.

Current Strike Expiration

Price Price Value
$ 20 $25 -$5 or 0
25 25 0
30 25 5
100 25 75
850 = CP [1-(1/1+i)n] + Par value
i (1+i)n
= CP [ 1- (1/1.12) 20] + 1000
0.12 (1.12)20
850 = CP (7.4694) + 103. 67

850 – 103.67 = CP (7.4694)

746.33 = CP (7.4694)
CP = 746.33 / 7.4694
CP = 99.9
CP = 100
CR = CP / Par value
CR = 100 / 1000
CR = 10%
20-4
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.
20-4 cont. ….
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?

Conversion price @ 10% premium = $42(1.10) = $46.20,

Conversion price @ 30% premium = $42(1.30) = $54.60
20-4 cont. ….
b) Should the preferred stock include a call provision? Why or why not?

• Yes, to be able to force conversion if the market rises above the call
price.
20-5
Fifteen years ago, Roop Industries sold $400 million of convertible bonds. The
bonds had a 40-year maturity, a 5.75% coupon rate, and paid interest annually. They
were sold at their $1,000 par value. The conversion price was set at $62.75, and the
common stock price was $55 per share. The bonds were subordinated debentures
and were given an A rating; straight nonconvertible debentures of the same quality
yielded about 8.75% at the time Roop’s bonds were issued.
a) Calculate the premium on the bonds—that is, the percentage excess of the
conversion price over the stock price at the time of issue.

The premium on bond = 62.75 - 55 / 55 = 0.141 = 14.1%.

 20-5
Fifteen years ago, Roop Industries sold $400 million of convertible bonds. The bonds had a
40-year maturity, a 5.75% coupon rate, and paid interest annually. They were sold at their
$1,000 par value. The conversion price was set at $62.75, and the common stock price was
$55 per share. The bonds were subordinated debentures and were given an A rating;
straight nonconvertible debentures of the same quality yielded about 8.75% at the time
Roop’s bonds were issued.
b) What is Roop’s annual before-tax interest savings on the convertible issue versus a
straight-debt issue?
Before-tax interest savings = 400,000,000(0.0875 - 0.0575) = $12 million per year.
However, the after-tax interest savings would be more relevant to the firm and
would be calculated as $12,000,000(1 - T).
 20-5
Fifteen years ago, Roop Industries sold $400 million of convertible bonds. The bonds had a
40-year maturity, a 5.75% coupon rate, and paid interest annually. They were sold at their
$1,000 par value. The conversion price was set at $62.75, and the common stock price was
$55 per share. The bonds were subordinated debentures and were given an A rating;
straight nonconvertible debentures of the same quality yielded about 8.75% at the time
Roop’s bonds were issued.
c) At the time the bonds were issued, what was the value per bond of the conversion
feature?
VB= PMT [1-(1/1+i)n] + Par value
i (1+i)n
VB = 57.5 [ 1- (1/1.0875) 40] + 1000
0.0875 (1.0875)40
VB = 634.21 + 34.90
VB = 669.11
 20-5 Cont. …..
d) Suppose the price of Roop’s common stock fell from $55 on the day the bonds were
issued to $32.75 now, 15 years after the issue date (also assume the stock price never
exceeded $62.75). Assume interest rates remained constant. What is the current price of
the straight-bond portion of the convertible bond? What is the current value if a
bondholder converts a bond? Do you think it is likely that the bonds will be converted?
Why or why not?
VB= PMT [1-(1/1+i)n] + Par value
i (1+i)n
VB = 57.5 [ 1- (1/1.0875) 25] + 1000
0.0875 (1.0875)25
VB = 576.43 + 122.82
VB = 699.25
 20-5 Cont. …..
d) What is the current value if a bondholder converts a bond? Do you think it is likely
that the bonds will be converted? Why or why not?

Conversion ratio = CR = $1,000/$62.75 = 15.936 shares.

If the stock price is $32.75, then the value of the bond in conversion is :

VB in conversion = 15.936($32.75) = $521.9

VB = 699.25

Because the value in conversion is less than the value as a bond, investors would not
wish to convert the bond
 20-5 Cont. …..
e) The bonds originally sold for $1,000. If interest rates on A-rated bonds had
remained constant at 8.75% and if the stock price had fallen to $32.75, then
what do you think would have happened to the price of the convertible bonds?
(Assume no change in the standard deviation of stock returns.)

The value of straight bond would start increasing because a bond’s value
approaches its par value as it gets closer to maturity.
 20-5 Cont. …..
f) Now suppose that the price of Roop’s common stock had fallen from $55 on the day the bonds
were issued to $32.75 at present, 15 years after the issue. Suppose also that the interest rate on
similar straight debt had fallen from 8.75% to 5.75%. Under these conditions, what is the current
price of the straight-bond portion of the convertible bond? What is the current value if a bondholder
converts a bond? What do you think would have happened to the price of the bonds?
When interest rate 5.75% = The coupon rate 5.75% ,
Then the straight bond value would be that of a par bond, which is $1,000.

VB in conversion = 15.936255($32.75) = $521.91

Although the value of the conversion feature would have dropped due to the decline in stock price
and the decrease in the remaining time for the conversion to be exercised, the value of the
conversion feature would still have a positive value (because an option value can never be zero or
below). Therefore, the bonds would probably have a price slightly above their par value of $1,000.
20-6
The Howland Carpet Company has grown rapidly during the past 5 years. Recently, its
commercial bank urged the company to consider increasing its permanent financing. Its
bank loan under a line of credit has risen to $250,000, carrying an 8% interest rate.
Howland has been 30 to 60 days late in paying trade creditors.
Discussions with an investment banker have resulted in the decision to raise $500,000 at
this time. Investment bankers have assured the firm that the following alternatives are
feasible (flotation costs will be ignored).
• Alternative 1: Sell common stock at $8.
• Alternative 2: Sell convertible bonds at an 8% coupon, convertible into 100 shares of
common stock for each $1,000 bond (i.e., the conversion price is $10 per share).
• Alternative 3: Sell debentures at an 8% coupon, each $1,000 bond carrying 100
warrants to buy common stock at $10.
John L. Howland, the president, owns 80% of the common stock and wishes to maintain
control of the company. There are 100,000 shares outstanding. The following are extracts
of Howland’s latest financial statements:
 Balance Sheet
Current liabilities $400,000
Common stock, par $1 100,000
Retained earnings 50,000
Total assets $550,000 Total claims $550,000
Income Statement
Sales $1,100,000
All costs except interest 990,000
EBIT $ 110,000
Interest 20,000
Pre-tax earnings $ 90,000
Taxes (40%) 36,000
Net income $ 54,000
Shares outstanding 100,000
Earnings per share $ 0.54
Price/earnings ratio 15.83
Market price of stock $ 8.55
Raise $500,000 Alternative 1: Sell common stock at $8
Assume that half of the funds raised will be used to pay off the
bank loan and half to increase total assets.
# of C. Stock issued = 500,000 / 8
# of C. Stock issued = 62,500
C. Stock = 62,500 x 1 = 62,500
Paid up Capital = 62,500 x 7 = 437,500
500,000
Current Liabilities = 400,000 – 250,000
Current Liabilities = 150,000
Total Assets = 550,000 + 250,000
Total Assets = 800,000
20-6 Cont. . Show the new balance sheet under each alternative. For
Alternatives 2 and 3, show the balance sheet after conversion of the bonds or
exercise of the warrants. Assume that half of the funds raised will be used to
pay off the bank loan and half to increase total assets.
Balance Sheet
Alternative 1
Total Current Liabilities 150,000
Long term debt -
Common Stock, Par $1 162,500
Paid in Capital 437,500
Retained Earnings 50,000
Total Assets $ 800,000 Total Claims $800,000
Alternative 2: Sell convertible bonds at an 8% coupon, convertible
into 100 shares of common stock for each $1,000 bond (i.e., the
conversion price is $10 per share).
Conversion Ratio = 500,000 / 10
CR = # of C. Stock issued = 50,000
C. Stock = 50,000 x 1 = 50,000
Paid up Capital = 50,000 x 9 = 450,000
500,000
Current Liabilities = 400,000 – 250,000
Current Liabilities = 150,000
Total Assets = 550,000 + 250,000
Total Assets = 800,000
20-6 Cont. . Show the new balance sheet under each alternative. For
Alternatives 2 and 3, show the balance sheet after conversion of the bonds or
exercise of the warrants. Assume that half of the funds raised will be used to
pay off the bank loan and half to increase total assets.
Balance Sheet
Alternative 2
Total Current Liabilities 150,000
Long term debt -
Common Stock, Par $1 150,000
Paid in Capital 450000
Retained Earnings 50,000
Total Assets $ 800,000 Total Claims $800,000
Alternative 3: Sell debentures at an 8% coupon, each $1,000
bond carrying 100 warrants to buy common stock at $10.
Debentures= LTD = 500,000 Total Funds Raised = Debenture + Warrant
# of bonds = 500,000 / 1000 Total Funds Raised = 500,000 + 500,000
# of bonds = 500 Total Funds Raised = 1,000,000
# of Warrants = 500 x 100
# of Warrants = 50,000 Current Liabilities = 400,000 – 250,000
Conversion of warrant at exercise price Current Liabilities = 150,000
$ 10:
C. Stock = 50,000 x 1 = 50,000 Total Assets = 550,000 + 750,000
Paid up Capital = 50,000 x 9 = 450,000 Total Assets = 1,300,000
500,000
20-6 Cont. . Show the new balance sheet under each alternative. For
Alternatives 2 and 3, show the balance sheet after conversion of the bonds or
exercise of the warrants. Assume that half of the funds raised will be used to
pay off the bank loan and half to increase total assets.
Balance Sheet
Alternative 3
Total Current Liabilities 150,000
Long term debt (8%) 500,000
Common Stock, Par $1 150,000
Paid in Capital 450000
Retained Earnings 50,000
Total Assets $ 1,300,000 Total Claims $1,300,000
20-6b
Show Mr. Howland’s control position under each alternative, assuming that
he does not purchase additional shares.

Original Plan 1 Plan 2 Plan 3

Number of shares 80,000 80,000 80,000 80,000
Total shares 100,000 162,500 150,000 150,000
Percent ownership 80% 49% 53% 53%
20-6C What is the effect on earnings per share of each alternative,
assuming that profits before interest and taxes will be 20% of total
assets?
Original Plan 1 Plan 2 Plan 3
Total assets $ 550,000 $800,000 $800,000 $1,300,000
EBIT $ 110,000 $160,000 $160,000 $ 260,000
Interest 20,000 0 0 40,000
EBT $ 90,000 $160,000 $160,000 $ 220,000
Taxes (40%) 36,000 64,000 64,000 88,000
Net income $ 54,000 $ 96,000 $ 96,000 $ 132,000
Number of shares 100,000 162,500 150,000 150,000
Earnings per share $0.54 $0.59 $0.64 $0.88
20-6d What will be the debt ratio (TL/TA) under each alternative?

Original Plan 1 Plan 2 Plan 3

Total liabilities $400,000 $150,000 $150,000 $ 650,000
Total assets $ 550,000 $800,000 $800,000 $1,300,000
TL/TA 73% 19% 19% 50%
 20-6e Which of the three alternatives would you recommend to Howland, and why?

• Alternative 1 results in loss of control (to 49 percent) for the firm since, he loses
his majority of shares outstanding. Indicated earnings per share increase, and the
debt ratio is reduced considerably (by 54 percentage points).
• Alternative 2 results in maintaining control (53 percent) for the firm. Earnings per
share increase, while a reduction in the debt ratio like that in Alternative 1 occurs.
• Under Alternative 3 there is also maintenance of control (53 percent) for the firm.
This plan results in the highest earnings per share (88 cents), which is an increase of
63 percent on the original earnings per share. The debt ratio is reduced to 50
percent.
• Conclusion. If the assumptions of the problem are borne out in fact, Alternative 1 is
inferior to 2, since the loss of control is avoided. The debt-to-equity ratio (after
conversion) is the same in both cases. Thus, the analysis must center on the choice
between 2 and 3.
 20-7
Niendorf Incorporated needs to raise $25 million to construct production facilities for
a new type of USB memory device. The firm’s straight nonconvertible debentures
currently yield 9%. Its stock sells for $23 per share, has an expected constant growth
rate of 6%, and has an expected dividend yield of 7%, for a total expected return on
equity of 13%. Investment bankers have tentatively proposed that the firm raise the
$25 million by issuing convertible debentures. These convertibles would have a
$1,000 par value, carry a coupon rate of 8%, have a 20-year maturity, and be
convertible into 35 shares of stock. Coupon payments would be made annually. The
bonds would be non-callable for 5 years, after which they would be callable at a price
of $1,075; this call price would decline by $5 per year in Year 6 and each year
thereafter. For simplicity, assume that the bonds may be called or converted only at
the end of a year, immediately after the coupon and dividend payments. Also assume
that management would call eligible bonds if the conversion value exceeded
20% of par value (not 20% of call price).
a) At what year do you expect the bonds will be forced into conversion with a call?

Stock data and stock required return:

rd = 9%. P0 = $23. g = 6%. Dividend yield = 7% rs = 13 %
Convertible bond data:
Par = $1,000, 20-year. Coupon = 8%. Conversion ratio = CR = 35 shares. Call =
Five-year deferment.
Call price = $1,075 in Year 5, declines by $5 per year.
Will be called when Ct = 1.2(Par) = $1,200.
Conversion Value = Conversion Ratio x price
Conversion Value = 35 x 23
Conversion Value = 805
What is the bond’s value in conversion when it is converted at this time year 0?

• Straight-debt value of the convertible at t = 0:

At t = 0
VB= PMT [1-(1/1+i)n] + Par value
i (1+i)n
VB = 80 [ 1- (1/1.09) 20] + 1000
0.09 (1.09)20
VB = 730.28 + 178.43
VB = 908.71
Find n (number of years) to anticipated call or conversion:
We need to find the number of years that it takes $805 to grow to $1,200 at
a 6% interest rate
FV = PV (1 + g)n
1200 = (CR)(P0)(1 + g)n
1200= ($23)(35)(1 + 0.06) n
1200= $805(1.06) n
(1.06) n= $1,200/$805 = 1.49
(1.06) n= 1.49
n ln(1.06) = ln(1.49)
n(0.05827) = 0.39878
n = 0.39878/0.05827 = 6.84 ≈ 7
What is the bond’s value in conversion when it is converted at this time?

• Straight-debt value of the convertible at t = 7:

At t = 0
VB= PMT [1-(1/1+i)n] + Par value
i (1+i)n
VB = 80 [ 1- (1/1.09) 13] + 1000
0.09 (1.09)13
VB =
VB =
 What is the cash flow to the bondholder when it is converted at this time? (Hint: The
cash flow includes the conversion value and the coupon payment, because the
conversion occurs immediately after the coupon is paid.)

Conversion value: The stock price should grow at the 6%. The conversion
value at Year t is equal to the expected stock price multiplied by the
conversion ratio:
Price = P0 (1+g)n OR P0= D1 / i – g
CVn = P0 (1+g)n x CR
For the expected time of conversion (N = 7), the conversion value is:
CV7 = $23(1.06)7(35) = $1,210.422.
Cash flow at the time of conversion = conversion value + coupon payment
CF7 = $1,210.422 + $80
CF7 = $1,290.422
 Warrants Gain Vs Stock Gain
Mr. Walter has the option to invest in Stock or Warrants. He has the
investment amount of $ 3,965. If he purchase shares, then price is
$65/share. If he purchase warrants, cost per warrant is $23. He is allowed
to purchase one share against each warrant. They agreed on exercise price
of each share is $40. Assume that share price will change to $75 at the time
you exercise the warrant. The number of warrants are 12.
• Required:
What is the rate of return for Stock and warrants to make decision by
investor, either to invest in stock or warrants ?
 Proforma: Warrants Gain Vs Stock Gain
Return on Stocks
No. of Share= (Investment) / (Purchasing Cost)
= 3965 / 65 = 61
Gain on Stock
Gain Per Share= (Market Price) - (Purchasing Price)
= 75 – 65 = 10
Total Gain on Stock= (No. of Shares) * (Gain Per Share)
= 61 * 10
= 610
Return On Stock = (Total Gain on stock) / (Investment)
= 610 / 3965
= 15.38%
 Proforma: Warrants Gain Vs Stock Gain
Return on Stock
1 No. of Share= (Investment) / (Purchasing Cost)
2 Gain on Stock
Gain Per Share= (Market Price) - (Purchasing Price)
Total Gain on
Stock= (No. of Shares) * (Gain Per Share)

3 Return On Stock (Total Gain on stock) / (Investment)

 Proforma: Warrants Gain Vs Stock Gain
Return on Warrants
# of Warrants = Total Investment / Cost per warrant
= 3965 / 23 = 172
Number of shares when warrants are exercised = # of warrants x conversion ratio)
= 172 x 1 = 172
Intrinsic Value = (Stock New Price-Exercise Price)
= 75 - 40 = 35
Exercise Value = (Number of shares) x Intrinsic value
= 172 x 35
= $ 6020
Gain on Warrant = Exercise Value – Total Investment
= 6,020 – 3,965
= $ 2,055
Return on Warrant= (Gain on Warrant) / (Investment)
= 2,055 / 3,965
= 51.82%
 Proforma: Warrants Gain Vs Stock Gain
Return on Warrants
WN1 # of Warrants = Total Investment / Cost per warrant
Number of shares
when warrants are (Number of warrants x conversion ratio)
WN2 exercised =

WN3 Intrinsic Value= (Stock New Price-Exercise Price)

WN4 Exercise Value = (Number of shares) x Intrinsic value

Gain on Warrant =
Exercise Value – Total Investment
Return on
WN5 Warrant= (Gain on Warrant) / (Investment)