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
Can you draw Capital asset pricing model with example and explain?????

Question: Consider the following information:   Stock A Stock B Beta 0.8 1.4 Share price, $

WHAT ARE THE MAIN VIEWS OF WACC PREVALENT IN THE FINANCIAL MANAGEMENT LITERATURE

Eatmore & Green Pty. Ltd (Australia) is a successful medium sized marketing consultancy for Australian agricultural products and Australian sourced organic, natural beauty/cosmetic


Constant Duration To improve a buy and hold strategy a constant average duration is imposed for the managed portfolio during the full interest rate cy

Organizational Cost Drivers It is the cost consequences that result from managerial choices concerning the company of activities as well as the involvement of persons inside an

Cash Management: - Cash management comprises maintaining optimum cash balance and efficient collection and disbursement of cash. Methods or else Devices of Cash Management: - Th

A 16% debenture of R5 000 is redeemable at a premium of 10% after 5 years. The fair rate of return on similar debentures is 14% before tax. Calculate the present value of the capit

Cash flow analysis helps an analyst to identify certain financial difficulties which cannot be identified using the above ratios.  A firm may be shown