Description
A 7% annual coupon 10-year convertible bond has a par value of $1,000. Comparable bonds yield 8.5%. The current price of the issuing company's stock is $19 and the conversion ratio is 50 shares. Valued as a bond, what price would you expect to pay for this convertible bond?
Explanation & Answer
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convertible bonds, or converts, give the holder the option to exchange the bond for a predetermined number of shares in the issuing company. When first issued, they act just like regular corporate bonds, albeit with a slightly lower interest rate. Because convertibles can be changed into stock and thus benefit from a rise in the price of the underlying stock, companies offer lower yields on convertibles. If the stock performs poorly there is no conversion and an investor is stuck with the bond's sub-par return (below what a non-convertible corporate bond would get). As always, there is a trade-off between risk and return.
rate=7%
time=10yrs
par value=$1000
(8.5/100) x 1000=$85
The conversion ratio (also called the conversion premium) determines how many shares can be converted from each bond. This can be expressed as a ratio or as the conversion price, and is specified in the indenture along with other provisions.
=$700
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