Question

Forum question:

1. What is convertible debt? Why would a company issue convertible debt?

2. How is convertible debt classified if it is mandatory to convert into a fixed number of shares? Would your answer be different if it is convertible at the investor’s option into a fixed number of shares?

Answer 1

Answer: (1) Convertible Debt - a convertible debt represent a hybrid security that has debt and equity features. This type of debt allows the conversion of its nominal value to either cash or specified number of comman shares of equal value.

A company issues a convertible debt to take advantage of reduced interest rates,since the presence of conversion option provides upside potential for the debtholder, and these debts tend to demand lower interest rates as compared to standard nominal debts.

Another advantage of issuing covertible debts rather than equity is the tax deduction of interest , which lowers the cost of capital for a company. Also, as the debts are converted to equity, a company has no more obligations.

(2). If covertible debt is mandatory to convert into a fixed number of shares

It shall be classified as Equity as issuer does not have an obligation to pay cash and holder is not exposed to any variabiity.

if it is convertible at the investor’s option into a fixed number of shares

It shall be classified as Liability as issuer does not have an unconditional right to convert to shares.