Value of conversion benefits, Financial Management

Having seen the measure used for analyzing the convertible bonds, let us now examine the merits and demerits of convertible bonds, and why or why not an investor chooses a convertible bond.

In our hypothetical bond XYZ, the market value of the stock is Rs.17. Suppose it rises to Rs.34 in a month's period. If an investor purchases the stock at Rs.17, a profit of Rs.17 i.e., 100% can be booked. On the other hand, in bonds the conversion value = Rs.34 x 50 = Rs.1,700. Since the market value of the bond is Rs.950, the investor in bond books a profit of Rs.750 i.e., 79%. The reason for lowering of the return in bond is due to investing Rs.2 additionally (over and above Rs.17) per share more for the stock. The investor realizes a gain based on a stock price of Rs.19 rather than Rs.17.

Let us consider the other possibility. If the stock prices drop to Rs.7 in one month period, the investor who invests in the stock will book a loss of Rs.10 per share i.e., return of 59%. The conversion value of the bond also drops to Rs.350 (Rs.7 x 50). The bond price will not fall to that level. We know that the minimum price of the bond is greater than its conversion value or its straight value, assuming that the straight value is Rs.788. This shows that the investor realizes a loss of 17%. The loss would be even less in fact because the convertible bond would trade at a premium to its straight value.

The analysis made so far is based on the assumption that the straight value of the bond does not change although it can change due to various reasons. When the rates of interest in the economy grow, the bond values decline and hence the straight value. Even if the interest rates remain constant, due to deterioration of the perceived creditworthiness of the issuer, the bond rate may fall. When the price of the stock drops precipitously, like in the above example, the perceived creditworthiness of the issuer may decline, causing a decline in the straight value. In any case, although the straight value may decline, it is still a floor price for the convertible bond price (albeit a moving floor). We can observe from our example that it has dropped from Rs.950 to Rs.390. 

From the above discussion, it is clear that there are both advantages and disadvantages of investing in convertible bonds. The disadvantage is that we have to pay premium for shares. An advantage is the reduction in downside risk (as determined by the straight value) with an opportunity to recoup the premium per share through the higher current income from owning the convertible bond.

Posted Date: 9/10/2012 7:48:27 AM | Location : United States

Related Discussions:- Value of conversion benefits, Assignment Help, Ask Question on Value of conversion benefits, Get Answer, Expert's Help, Value of conversion benefits Discussions

Write discussion on Value of conversion benefits
Your posts are moderated
Related Questions
what are the arguments in favour of profit maximization?

What are the major sections of the statement of cash flows? a.Cash flows from Operations b.Cash flows from investing activities c.Cash flows from financing activities

For a specified IOS and MCC, how do financial managers decide that which proposed capital budgeting projects to accept, and which to reject? For a specified IOS and MCC, all inde

Monte-Carlo Simulation Let us, for a shortwhile, leave the illustration for determining the price and consider a simpler illustration for understanding the Monte-Carlo method

The amount by which the market price exceeds the conversion value or the investment value is called as the premium.

what is the applicability of the operating cycle in a vegetaion farm in Uganda

what is leverage

What is trustworthy collateral from the lenders' perspective?Explain whether accounts receivable and inventory are trustworthy collateral. Assets that are readily marketable of

Q. Show the Signs of Overtrading? There are a number of usually recognised signs that a company may be overtrading. These are considered mutually with relevant financial data f

Market price is used for determining the duration of a mortgage-backed security in the coupon curve duration. This approach to calculate the duration of mortgage-bac