Conv Bonds

Convertible Bonds

Structuring a convertible issue

Definitions

• Convertibles bonds are used by firms to raise funds. • Convertible securities are bonds (preferred stocks) that are exchangeable into common stock at the option of the holder and under specified terms and conditions. • Thus the convertible holder owns an option to convert the bond to common shares.

Definitions

• The exercise of the conversion option does not bring any additional cash to the firm. The debt on the balance sheet is simply replaced by common stock. The reduction of the debt ratio brings in additional debt capacity. • The conversion of bonds therefore creates additional shares which leads to the dilution for the existing shareholders.

Example of a convertible

• National Electric Company needs to raise cash for funding its capital investments to meet the increased demand. It decides to issue convertible bonds. The issue is structured as follows. • Issued at par value of € 1000, coupon €30 paid yearly, maturity 10 years. The bond is convertible into 50 shares of the company, at any time up to its maturity. The firm can call back the bond any time after three years from the date of issue. The redemption value is fixed at par.

NEC Convertible

• NEC issues 90,000 convertibles. • The current trading price of the NEC shares is €16. • The conversion price is fixed at €2O, which is 25 percent higher than the current trading price. • Currently the number of outstanding shares is 11 million. • If all the convertible holders exercise the conversion option 4.5 million new shares will be created. The shareholders equity will increase by €90 million. • Conversion price=Par value of bond/shares received. • Generally, the conversion ratio is fixed for life, although sometimes a stepped up conversion price can be used.

Parameters of a convertible

• • • • Coupon/interest rate Maturity. Conversion ratio Period when conversion option can be exercised. • Call provision • Par value/...