# Convertible Securities - Financial Management

Both debentures and preferred stock can have convertibility or conversion features.When a company issues convertible securities, its usual intention is the future issuance of common stock. To illustrate, suppose the Beloit Corporation issues 2 million shares of convertible preferred stock at a price of $50 a share. After the sale, the company receives gross proceeds of$100 million. Because of the convertibility feature, the company can expect to issue shares of common stock in exchange for the redemption of the convertible preferred stock over some future time period.

As a result, convertibles are sometimes described as a deferred equity offering. In the case of Beloit’s convertible preferred, each $50 preferred share can be exchanged for two shares of common stock; that is, the holder has a call option to buy two shares of the company’s common stock at an exercise price of$25 a share. Therefore, if all the preferred shares are converted, the company in effect will have issued 4 million new common shares, and the preferred shares will no longer appear on Beloit’s balance sheet. No additional funds are raised by the company at the time of conversion.

Features of Convertible Securities

As an introduction to the terminology and features of convertible securities, consider the $115 million, 25-year issue of 61⁄8 percent convertible subordinated debentures sold by Advanced Research, Inc. (ARI), a computer software company. Convertible securities are exchangeable for common stock at a stated conversion price. In the case of the ARI issue, the conversion price at the time of issue was$84. This means that each $1,000 debenture was convertible into common stock at$84 a share. (As the result of a spin-off to shareholders of its operations based in Colorado Springs as a separate company, the conversion price of the ARI bonds was reduced—three years after the initial issue—to $78, and the conversion ratio was increased to 12.82.) The number of common shares that can be obtained when a convertible security is exchanged is determined by the conversion ratio, which is calculated as follows: Conversion ratio = Par value of security/ Conversion price In the case of ARI’s convertible subordinated debentures, the conversion ratio at the time of issue was the following: Conversion ratio =$1,000/$84 = 11.9 Thus, each$1,000 ARI debenture could be exchanged for 11.9 shares of common stock. Although the conversion ratio may change one or more times during the life of the conversion option (as it did for the ARI bonds), it is more common for it to remain constant. Normally, the conversion price is set about 15 to 30 percent above the common stock’s market price prevailing at the time of issue. For example, at the time ARI issued its convertible debentures, the market price of its common stock was about $65 a share. The$19 difference between the conversion price and the market price represents a 29 percent premium. Holders of convertible securities are protected against dilution by the company. For example, suppose ARI were to split its common stock two for one. The conversion price (and therefore the conversion ratio) would be adjusted so that the holders would not be disadvantaged by the split. Specifically, in the ARI case, the new conversion price would be $39, and the new conversion ratio would be 25.64. Managing Long-Term Funding with Convertibles As a general rule, relatively small, risky companies whose common stock is publicly traded are the principal issuers of convertibles. These companies, for the most part, are rapidly growing and in need of funds to finance their growth. Investors, on the other hand, are frequently reluctant to lend money to small, risky companies without promises of high interest payments and assurances from the company that it will properly manage the debt. Recall that in Chapter we introduced agency problems and discussed the conflicts that can occur between a firm’s stockholders and its creditors. We said that creditors, to protect their interests, often insist on certain protective covenants in the company’s bond indentures. The agency costs to properly implement and monitor the covenants can be high, particularly for small, risky companies. As a result, because of potential conflicts between shareholders and bondholders and the associated agency costs, it is usually easier and cheaper to offer the bondholders an equity stake in the company —that is, a convertible security. With an equity stake, bondholders are less concerned about any company attempts to increase the returns to the shareholders by means of risky projects. In addition to agency costs, there are several other reasons for issuing convertibles. One is that cash flow benefits accrue to the issuing company in the form of lower interest payments or dividends; this occurs because investors are willing to accept the conversion privilege as part of their overall return. As an example, consider again the ARI 61⁄8 percent convertible subordinated debentures. At the time ARI sold those convertibles, the company would have had to pay about 9 percent interest on any nonconvertible debt it issued. Thus, the convertibility feature is saving ARI about$2.9 million a year [(0.09 – 0.06125)*$100 million] in interest expense. Typically, firms can issue convertible securities with interest rates or dividend yields about 3 percentage points below similar, nonconvertible issues, that is, issues without convertibility features. Another reason firms issue convertible securities is to sell common stock at a higher price than the prevailing market price at the time of issue. Suppose a company needs additional equity financing because of a relatively high proportion of fixed-income securities in its capital structure. If the company’s management feels the price of its common stock is temporarily depressed, one alternative is to consider issuing a convertible security. With the conversion price typically set about 15 to 30 percent above the market price at the time of issue, the use of a convertible security effectively gives the issuing company the potential for selling common stock above the existing market price. However, for the sale to be successful, conditions in the future must be such that investors will want to exercise their conversion option. Also, if the market price rises considerably above the conversion price, it may turn out that the company would have been better off to wait and sell common stock directly, rather than sell the convertible issue at all. A final reason for issuing convertible securities centers around the fact that the earnings resulting from projects funded by a particular external financing issue may not begin for some time after financing occurs. For example, the construction and start-up period for a major expansion may be several years. During this period, the company may desire debt or preferred stock financing. Eventually, once the expansion is fully operational and producing income, the company may want to achieve its original goal of additional common stock financing. The deferred issue of common stock minimizes the dilution in earnings per share that results from the immediate issuance of common stock. Valuation of Convertible Securities Because convertible securities possess certain characteristics of both common stock and fixedincome securities, their valuation is more complex than that of ordinary nonconvertible securities. The actual market value of a convertible security depends on both the common stock value, or conversion value, and the value of a fixed-income security, or straight-bond or investment value. Each of these is discussed here. Conversion Value The conversion value, or stock value, of a convertible bond is defined as the conversion ratio times the common stock’s market price: Conversion value = Conversion ratio *Stock price To illustrate, assume that a firm offers a convertible bond that can be exchanged for 40 shares of common stock. If the market price of the firm’s common stock is$20 per share, the conversion value is $800. If the market price of the common stock rises to$25 per share, the conversion value becomes $1,000. And if the stock price rises to$30 per share, the conversion value becomes $1,200. In the case of ARI’s convertible bonds, the conversion value was 11.9*$65 (the price per common share at the time of issue), or $774. Straight-Bond Value The straight-bond valueor investment value, of a convertible debt issue is the value it would have if it did not possess the conversion feature (option). Thus, it is equal to the sum of the present value of the interest annuity plus the present value of the expected principal repayment: where kd is the current yield to maturity for nonconvertible debt issues of similar quality and maturity; t, the number of years; and n, the time to maturity. Considering again ARI’s 61⁄8 percent, 25-year convertible debentures, the bond value at the time of issue is calculated as follows, assuming that 9 percent is the appropriate discount rate (and that interest is paid annually): Market Value The market value of a convertible debt issue is usually somewhat above the higher of the conversion or the straight -bond value; this is illustrated in Figure . Advanced Research: Convertible Debenture Valuation at Different The difference between the market value and the higher of the conversion or the straight-bond value is the conversion premium for which the issue sells. This premium tends to be largest when the conversion value and the straight -bond value are nearly identical. This set of circumstances allows investors to participate in any common stock appreciation while having some degree of downside protection because the straight-bond value can represent a “floor” below which the market value will not fall. The ARI convertible debentures described in this section were offered to the public at$1,000 per bond and quickly were bought up by investors. In this case, investors were willing to pay $1,000 for an issue having a conversion value of approximately$774 and a bond value of about $718. The$1,000 market value contained a premium of $226 over the conversion value (which was higher than the bond value). This premium can be thought of as the value of the implicit call option on a firm’s common stock associated with this convertible security. In practice, convertible securities are valued by adding the straight-bond value to the value of the conversion options to buy common stock. These conversion options can be valued using a variant of the Blac k-Scholes option pricing model. Converting Convertible Securities Conversion can occur in one of two ways: • It may be voluntary on the part of the investor. • It can be effectively forced by the issuing company. Whereas voluntary conversions can occur at any time prior to the expiration of a conversion feature, forced conversions occur at specific points in time. The method most commonly used by companies to force conversion is the exercise of the call privilege on the convertible security. For example, consider the Compaq Computer convertible bonds maturing in 2012,which the company decided to call for redemption in 1988. The bonds had a conversion ratio of 25.22, and the market price of the Compaq common stock at the time of the call was$61.25 per share. Therefore, the conversion value was approximately $1,545 per bond. The call price —which was set and agreed upon by both the borrower and the lender at the time of the original issue —was$1,047.25 per bond. Holders of the Compaq convertibles had two alternatives under these circumstances:

• Conversion, in which case the holder would receive common stock having a market value of $1,545 per bond • Redemption, in which case the holder would receive$1,047.25 in cash for each bond The conversion alternative was the obvious choice because even those investors who did not wish to hold the common stock could sell it upon conversion for more money than they would receive from redemption. By calling the bonds, Compaq was able to remove $150 million in long-term debt from its balance sheet without having to redeem the bonds for cash, and was able to save$7.9 million a year in interest expense.

Another way in which a company can encourage conversion is by raising its dividend on common stock to a high enough level that holders of convertible securities are better off converting them and receiving the higher dividend.

Convertible Securities and Earnings Dilution

If a convertible security (or warrant) issue is ultimately exchanged for common stock, the number of common shares will increase and earnings per share will be reduced (i.e., diluted), all other things being equal. Companies are required (by Accounting Principles Board Opinion 15) to disclose this potential dilution by reporting both primary and fully diluted earnings per share. Primary earnings per share are calculated based on the number of common shares outstanding plus common stock equivalents.

A common stock equivalent must meet certain tests, but it basically includes any convertible security that derives its value primarily from the common stock into which it can be converted. Fully diluted earnings per share are calculated based on the assumption that all dilutive securities are converted into common shares. In calculating primary or fully diluted earnings per share, earnings must be adjusted for the interest or preferred dividends saved as the result of conversion.