CONVERTIBLE SECURITIES CHAPTER TWELVE CONVERTIBLE SECURITIES Practical Investment Management Robert A. Strong

Convertible Preferred Stock Outline Convertible Bonds Characteristics Pricing of Convertible Bonds Why Companies Issue Convertible Bonds Unusual Features Convertible Preferred Stock Background on Preferred Stock The Conversion Feature

Accounting Implications: An Optional Technical Note Outline Warrants Characteristics Pricing of Warrants Warrants and Leverage Accounting Implications: An Optional Technical Note Dilution of Earnings Common Stock Equivalents and Other Potentially Dilutive Securities Computation of PEPS and FDEPS

Convertible Bonds: Characteristics Convertible bonds give their owner the right to exchange the bonds for a set quantity of some other asset. This other asset is normally shares of stock in the same company. The number of shares the bondholder receives per $1,000 par value when converting the bond is called the conversion ratio.

Convertible Bonds: Characteristics conversion price = par value conversion ratio conversion value ratio current stock price = X premium over conversion value = - market price conversion value

Pricing of Convertible Bonds Over time, a convertible bond will increasingly act like a share of stock or like a non-convertible bond. A bond whose conversion price is substantially above the current market price of the associated common stock is a busted convertible. A convertible in a company whose stock has appreciated is an example of a common stock equivalent.

Metamorphosis of a Convertible Bond common stock equivalent rising stock price Acts like a Stock conversion price new convertible bond stock price busted convertible declining or slow rising stock price Acts like a Bond time South-Western College Publishing ©1998 7

Pricing of Convertible Bonds Convertible bonds should never sell for less than their conversion value. With a busted convertible, the conversion feature has little value. Convertible bonds provide for upside potential while reducing downside risk.

Pricing of Convertible Bonds The premium payback period is the time required for the enhanced income from the bond (relative to the equivalent number of stock shares) to offset the premium over the conversion value. The premium payback period is sometimes called the break-even time.

Calculating Premium Payback Period

Why Companies Issue Convertible Bonds Convertible bonds can usually be offered at a lower interest rate than would otherwise be required. All convertible bonds are callable. If called, a convertible bond must be (1)sold, (2)redeemed, or (3)converted. Corporations like to issue convertible bonds because of the likelihood that they will never have to repay the debt.

Convertible Bonds: Unusual Features Interest payments: A few convertible bonds do not pay interest twice a year, but monthly or quarterly, for example. Underlying asset: Many convertible bonds are convertible into the securities of another company. Some are convertible into cash. LYONs: Many companies issue zero coupon bonds, or liquid yield option notes (LYONs). A number of these are convertible into the company’s common stock.

Convertible Preferred Stock Preferred stock is attractive to corporations because of the tax-exempt nature of most dividend income. From an investment perspective, preferred stock is a fixed income security. Preferred stock is identified by its annual dividend. The fundamentals of conversion are the same as those for convertible bonds.

Warrants: Characteristics A warrant is a nondividend-paying security giving its owner the right to buy a certain number of shares at a set price directly from the issuing company. Warrants have no voting rights. Outside the United States, warrants are often issued in conjunction with a new debt issue, thus enabling a lower interest rate than would otherwise be required on the issue. Warrants can be detachable or non-detachable.

Pricing of Warrants The exercise price is the price at which an investor holding warrants may buy the underlying shares. When the stock price rises above the exercise price, the warrant is in-the-money, and has intrinsic value. If the stock price is below the exercise price, the warrant is out-of-the-money. Speculators buy warrants because of the leverage they provide.

Pricing of Warrants 45º maximum value (= stock price) actual market exercise price 45º (= stock price minus minimum value exercise price) warrant price stock price South-Western College Publishing ©1998 16

Accounting Implications: An Optional Technical Note When common stock equivalents are present, accountants must determine both primary and fully diluted earnings per share. Primary earnings per share (PEPS) is based on common shares outstanding plus shares considered to be common stock equivalents. Fully diluted earnings per share (FDEPS) reflects the dilution of earnings per share that would occur if all possible convertible securities were converted.

Accounting Implications Convertible bonds and convertible preferred stock are considered common stock equivalents and are used in the PEPS calculation if their yield was less than two-thirds the yield of the average AA bond yield at the time the security was issued. A convertible that is not a common stock equivalent is classified as an other potentially dilutive security and may be used in the FDEPS calculation.

- = + Computation of PEPS primary earnings per share net income available to common shareholders adjustments for common stock equivalents preferred stock dividends weighted average number of common and common stock equivalent shares outstanding - = +

+ - = Computation of FDEPS fully diluted earnings per share adjustments for other potentially dilutive securities weighted average number of common shares, common stock equivalent shares and other potentially dilutive securities outstanding during the reporting period = net income available to common shareholders adjustments for common stock equivalents preferred stock dividends - +

Convertible Preferred Stock Review Convertible Bonds Characteristics Pricing of Convertible Bonds Why Companies Issue Convertible Bonds Unusual Features Convertible Preferred Stock Background on Preferred Stock The Conversion Feature

Accounting Implications: An Optional Technical Note Review Warrants Characteristics Pricing of Warrants Warrants and Leverage Accounting Implications: An Optional Technical Note Dilution of Earnings Common Stock Equivalents and Other Potentially Dilutive Securities Computation of PEPS and FDEPS