Question

Which one of the following statements correctly describes the payback period as the term is applied to an investment in a convertible bond?

a.

It is the time remaining until the bond matures and the stockholder must convert in order to obtain anything of value.

b.

It is the time needed for the stock price to rise to its conversion parity.

c.

It is the time remaining until the investor will face a forced conversion of the bond.

d.

It is the time needed for the buyer to recover the conversion premium from the interest earned on the bond.

Answer 1

The correct option is option D .

So, we were receiving coupon payments form the bonds , which is the interest earned on investing our money to purchase the bonds issued by the issuer.

A convertible stocks trades at price which is at a premium to the market price of the stock.

Now, as we are converting the bonds into stocks we will have to pay a premium to purchase the stock. Earlier we were receiving coupon payments now we will be receiving dividends on the stock. So, the payback period is the time period we require to break even and recover the premium paid on the stock.

The cash-flow payback period is the time it would take for the convertible to earn interest equal to the conversion premium plus the stock dividends.