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

2. 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

3. 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

4. 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.

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

6. 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.

7. 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
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8. 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.

9. 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.

10. Calculating Premium Payback Period

11. 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.

12. 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.

13. 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.

14. 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.

15. 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.

16. 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

17. 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.

18. 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.

19. - = + 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 - = +

20. + - = 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 - +

21. 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

22. 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