Value of conversion benefits, Financial Management

Value of Conversion Benefits:

Having seen the measure used to analyze 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 one month 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 8:06:44 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
Process The process of Securitization involves the following steps: Transfer of assets by the originator (person holding the assets) to an entity (comp

CORPORATE GOVERNANCE Corporate governance can be stated in different ways, for example: The Private Sector Corporate Governance Trust (PSCGT) defines that corporate governan

Decentralization This is a company power structure in which authority and decision-making responsibility are diffused throughout various stages of an organization. Decentraliz

State the expectations theory of the term structure of interest rates. Expectations theory: The expectations theory of the term structure of interest rates specifies that

Define the concept of a real option. Discuss some real options a firm can be confronted with when investing in real projects. A positive APV project is accepted under the supposi

Q. What goals should always motivate the actions of a firm's financial manager and why? Answer:   Please note that a minimum of 250 words is required on all responses to the d

Provide three examples of mutually exclusive projects. Mutually exclusive projects are projects which participate against each other for our selection.  If a organization and fir

Why are most futures positions closed out through a reversing trade rather than held to delivery? Answer:  In forward markets, almost 90% of all contracts that are basically es

Keys Printing plans to issue a $1,000 par value, 10-year noncallable bond with a 5.00% coupon, paid semiannually. It should sell at par. The company''''s marginal tax rate is 40.00

Importance of Financial Management: Proper finance is the real key to the success of any business enterprise. Without proper finance no business can survive nor can it be expa