Convertibles, Warrants, and Derivatives (Part B)
by
Charles Lamson
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Advantages and Disadvantages to the Corporation
Having established the fundamental characteristics of the convertible security from the investor viewpoint in the last post, let us now turn the coin over and examine the factors a corporate financial officer must consider in weighing the advisability of a convertible offer for the firm. Not only has it been established that the interest rate paid on convertible issues is lower than that paid on a straight debt instrument, but also the convertible feature may be the only device for allowing smaller corporations access to the bond market. For small risky companies, investor acceptance of new debt may be contingent on a special sweetener, such as the ability to convert to common stock. Convertible debentures are also attractive to a corporation that believes its stock is currently undervalued. you will recall from last post in the case of the Lamson Company, $1,000 Bonds were convertible into 20 shares of common stock at a conversion price of $50. Since the common stock had a current price of $45 and new shares of stock might be sold at only $44, the corporation effectively received $6 over current market price, assuming future conversion. Of course, one can also argue that if the firm had delayed the issuance of common stock or convertibles for a year or two, stock might have gone up from $45 to $60 and new common stock might have been sold at this lofty price. To translate this to overall numbers for the firm, if a corporation needs $10 million in funds and offers straight stock now at a net price of $44, it must issue 227,273 shares ($10 million shares/$44). With convertibles, the number of shares potentially issued is only 200,000 shares ($10 million dollars/$50). Finally if no stock or convertible bonds are issued now and the stock goes up to a level at which new shares can be offered at a net price of $60, only 166,667 shares will be required ($10 million/$60).  Table 2 demonstrates the company's ability to sell stock at premium prices through the use of convertible bonds. The table represents a composite picture of convertible bonds outstanding during recent times. The typical convertible bond had a 20 percent conversion premium at issue (last line of table). Table 2 Characteristics of convertible bonds  The table also provides other information on yield to maturity, years to maturity, size, and investment rating. Notice that the average size of convertibles is quite small, with an average offering of only 50.4 million dollars per issue. The typical non-convertible issue is well in excess of 100 million dollars. this is because many small companies with less than a top-grade credit rating are primary issuers of convertible bonds. Another matter of concern to the corporation is the accounting treatment accorded to convertibles. In the funny-money days of the conglomerate merger movement decades ago, corporate management often chose convertible securities over common stock, because the convertibles had a nondilutive effect on earnings per share. As is indicated in a later section on reporting earnings for convertibles, the rules were changed, and this is no longer the case. Convertibles are dilutive. Inherent in a convertible issue is the presumed ability of the corporation to force the security holder to convert the present instrument to common stock. We will examine this process.  Accounting Considerations with Convertibles Before 1969, the full impact of the conversion privilege as it applied to convertible securities, warrants (long-term options to buy stock), and other dilutive securities was not adequately reflected in reported earnings per share. Since all of these securities may generate additional common stock in the future, the potential effect of this dilution (the addition of new shares to the capital structures) should be considered. The accounting profession has applied many different measures to earnings per share over the years, most recently replacing the concepts of primary earnings per share and fully diluted earnings per share with basic earnings per share and diluted earnings per share. In 1997, the Financial Accounting Standards Board issued "Earnings per Share" Statement of Financial Accounting Standards No. 128, which covered the adjustments that must be made when reporting earnings per share. If we examine the financial statements of the XYZ Corporation in Table 4, we find that the earnings per share reported is not adjusted for convertible securities and is referred to as basic earnings per share. Table 4 XYZ Corporation  Diluted earnings per share adjusts for all potential dilution from the issuance of any new shares of common stock arising from convertible bonds, convertible preferred stocks, warrants, or any other options outstanding. The comparison of basic and diluted earnings per share gives the analyst or investor a measure of the potential effects of these securities. We get diluted earnings per share for the XYZ Corporation by assuming that 400,000 new shares will be created from potential conversion, while at the same time allowing for the reduction in interest payments that would occur as a result of the conversion of the debt to common stock. Since before-tax interest payments on the convertibles are $450,000, the aftertax interest cost ($270,000) will be saved and can be added back to income. Aftertax investment cost is determined by multiplying interest payments by 1 minus the tax rate, or $450,000 (1 - .40) equals $270,000. Making the appropriate adjustments to the numerator and denominator, we show adjusted earnings per share:  We see $0.24 reduction from the basic earnings per share figure of $1.50. The new figure is the value that a sophisticated security analyst would utilize.  *MAIN SOURCE: BLOCK & HIRT, 2005, FOUNDATIONS OF FINANCIAL MANAGEMENT, 11TH ED., PP. 562-566* end |
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