Value of conversion benefits, Financial Management

Assignment Help:

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.


Related Discussions:- Value of conversion benefits

How can we measure the present value, How can we measure the Present Value ...

How can we measure the Present Value When we solve for present value, rather than compounding the cash flows to the future, we discount future cash flows to present value to ma

Return payment method, when asked to calculate return method given cash flo...

when asked to calculate return method given cash flow before depreciation how do you do it

A-b trust, It is a trust developed by a married couple with the purpose of ...

It is a trust developed by a married couple with the purpose of minimizing estate taxes. An A-B trust is a trust that splits into two on the death of the first spouse. It is produc

Determine what is current ratio - position ratios, Determine Current ratio...

Determine Current ratio  or working capital ratio CA = Current assets/Current liabilities (times) Current ratio measures the short term solvency or liquidity; it demonstra

Describes the concept of time value of money, Q. Describes the Concept of T...

Q. Describes the Concept of Time value of Money? 'Time value of money' signifies that the value of a unit of money is different in different time periods. The worth of a sum of

What are the time dimensions of the income statement, What are the time dim...

What are the time dimensions of the income statement, the balance sheet, and the statement of cash flows?  Hint: Are they videos or still pictures?  Explain. The income stateme

Capital structure definition, CAPITAL STRUCTURE DEFINITION According to...

CAPITAL STRUCTURE DEFINITION According to Gerstenberg, Capital structure refers to 'the makeup of a firm's capitalisation'.  In other way, it signifies the mix of different sou

On-the-run treasury issues, On-the-run treasury issues are the most r...

On-the-run treasury issues are the most recently auctioned issues of a given maturity. They include Treasury bills of 3-month, 6-month and 1-year maturity;  treas

What are the characteristics of an efficient market?, What are the characte...

What are the characteristics of an efficient market? The term market efficiency denotes to the ease, speed, and cost of trading securities. In an efficient market the securitie

Illustrate about foreign exchange earnings, Q. Illustrate about foreign exc...

Q. Illustrate about foreign exchange earnings? In theory foreign exchange earnings must not be hedged as the chances of an adverse movement are equivalent to those of a favoura

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