2. Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Chapter 18 Convertible Bonds and Convertible Preferred Stock

3. Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Features Common to Convertible Bonds Convertible into common stock at the holder's option Interest (coupon) and maturity date The importance of the call feature

4. Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Convertible Bond The three possible outcomes –conversion –retirement at maturity –default

5. Copyright © 2003 South-Western/Thomson Learning. All rights reserved. The Conversion Ratio Face value divided by the conversion price $1000 / $20 = 50 shares

6. Copyright © 2003 South-Western/Thomson Learning. All rights reserved. The Conversion Price Face value dividend by the number of shares into which the bond may be converted $1000 / 50 shares = $20

7. Copyright © 2003 South-Western/Thomson Learning. All rights reserved. A Convertible Bond's Value as Stock The conversion ratio times the price of the stock

8. Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Relationship Between the price of a stock and the conversion value of the bond

9. Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Value of a Convertible Bond as Debt The investment value of a convertible bond Model for the valuation of a bond

10. Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Value of a Convertible Bond as Debt

11. Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Minimum Price Minimum price of the bond combines –the value of the bond as stock and –the value as debt

12. Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Minimum Price

13. Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Actual Price of a Convertible Bond

14. Copyright © 2003 South-Western/Thomson Learning. All rights reserved. The Premiums The premiums paid over –The bond's value as stock –The bond's value as debt

15. Copyright © 2003 South-Western/Thomson Learning. All rights reserved. The Premiums

16. Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Breakeven Analysis Determines how long the convertible bond's interest advantage covers the premium over the bond's value as stock

17. Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Convertible Preferred Stock The features associated with convertible bonds apply to convertible preferred stock Except –the instrument is equity –lacks the safety associated with debt

18. Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Put Bonds The investor has the option to sell the bond back to the issuer The option is exercised if interest rates rise The put feature reduces –interest rate risk –reinvestment rate risk