Value of conversion benefits, Financial Management

Assignment Help:

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.

 


Related Discussions:- Value of conversion benefits

Types of treasury bills, Types of Treasury Bills Treasury bills are iss...

Types of Treasury Bills Treasury bills are issued at various maturities, generally up to one year. Thus, they are useful in managing short-term liquidity. At present, the GOI (

Residual income, Residual Income This is used for external reporting pu...

Residual Income This is used for external reporting purposes. This term refers to the net income which is available for distribution to the firm's common stock holders. In mana

Sources of funds, What are sources of funds for an assignment?

What are sources of funds for an assignment?

Standard deviation, Standard Deviation An investment must be evaluated ...

Standard Deviation An investment must be evaluated on two dimensions - rate of return and risk. An investor cannot enjoy a high return without any exposure to risk.  The higher

Calculated betas provide different information, Calculated betas provide di...

Calculated betas provide different information if they are obtained by using daily, weekly or monthly data. Which data is the most appropriate? Fernández and Carabias (2007) an

Cost principle - accounting principle, Cost Principle - Accounting Principl...

Cost Principle - Accounting Principle According to this principle all the non-monetary assets of the business are display in the books of accounts at the historical cost that

Calculate the amount invested in treasury bonds, You have an investment cap...

You have an investment capital of $1,000,000.  You plan to invest a portion of this money in Treasury bonds and the remainder in a stock portfolio.  Treasury bonds are expected to

Symmetric cash matching, We have earlier studied that the investor ma...

We have earlier studied that the investor may have to carry cash for some time because of discrepancies arising between the timing of the bond's cash-flow and the

Find capital allowances and associated tax benefits, Q. Find Capital allowa...

Q. Find Capital allowances and associated tax benefits? It is suitable to use the after-tax cost of borrowing as the discount rate since Doe Ltd is clearly in a tax-paying situ

Write Your Message!

Captcha
Free Assignment Quote

Assured A++ Grade

Get guaranteed satisfaction & time on delivery in every assignment order you paid with us! We ensure premium quality solution document along with free turntin report!

All rights reserved! Copyrights ©2019-2020 ExpertsMind IT Educational Pvt Ltd