Question

A convertible security (usually convertible bonds or convertible preferred stock) may be tendered at the option...

A convertible security (usually convertible bonds or convertible preferred stock) may be tendered at the option of the holder for shares of common stock in the issuing firm. In other words, the bonds or preferred stock may be converted to common stock.

Like warrants, convertibles can lead to diluted earnings, because new shares of common stock are issued. However, unlike warrants, convertibles:

Result in new capital for the firm

Do not result in new capital for the firm

Consider the case of Cheung Zap Inc.:

Cheung Zap Inc. just issued 5-year convertible bonds at a par value of $1,000. At any time before maturity, investors have the option to exchange their bonds for shares of Cheung’s common stock at a conversion price of $52.80.

Cheung’s convertible bonds pay a 6.60% annual coupon, but if Cheung had issued straight-debt bonds (no conversion), it would have had to pay 11.00% annual interest.

Based on the information available, complete the table:

Value
Conversion ratio of Cheung’s bond issue:   
Pure-debt value of this convertible debt issue:   
Value of the convertible option:   

Cheung’s common stock currently sells for $39 per share. Would an investor want to convert the bonds now?

No

Yes

Suppose analysts expect Cheung to pay a dividend of $2.50 per share at the end of the year and for the dividend to grow at a constant rate of 5.5% per year. What is the expected conversion value five years from now?

$1,448.06

$2,691.22

$724.03

$965.37

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