Question

IV) Kamwala Plc whose shares are currently trading at K20 per share, has issued 100,000 units of convertible bonds, each with a nominal value of K100. The bond has a convertible market price of K90 and conversion price of K25. The coupon interest rate is 8% payable annually. The bond has four years to maturity and any bond not converted will be redeemed at K115 per K100 nominal value of the bond. The share price for Kamwala Plc on the conversion day is expected to be either K30 per share or K25 per share. Ignore taxation.

Required:

(a) Assuming the interest on the bonds has just been paid, calculate the conversion premium and comment on its meaning.

(b) Estimate the likely current market price on the conversion day per K100 unit of the bond if investors now require a pre-tax return of 12%.

Answer 1

Conversion price = K25
Convertible price = K90
Bond's par value = K100
Hence, Conversion ratio = 100/25 = 4

So, conversion value = Share price * Conversion ratio = 20 * 4 = K80
Conversion premium = (Convertible price - Conversion value)/Conversion value = (90 - 80)/80 = 12.5%

The conversion premium is the additional price factor by which a convertible bond exceeds the current share price. This premium exists because convertible bonds offer limited downside as compared to a normal stock. If the stock does well, you can opt for conversion ang gain in the market. However if the stock declines, your fall is limited to the interest received on the bond.

The extra bucks you pay for this feature is the conversion premium or 12.5% in this case.