A firm wants to raise capital by issuing some securities. Its current stock pric

Question

A firm wants to raise capital by issuing some securities. Its current stock price is $18. It can issue straight bond at a 10% interest rate. It also can issue convertible bonds at a 7% interest rate with face value of $1,000 and a conversion ratio of 50. The treasurer of this firm argues that convertible bond issues are the cheapest form of financing regardless of whether the company does well or poorly. Her argument is as follows. “If the stock price falls, for instance, to $12, the convertible bonds will not be converted into common stock shares. In this case, we can pay a 7% interest rather than a 10% if we had issued straight debt. If the stock price goes up, for example, to $25, the convertible bonds would be converted. This is also great since we can effectively sell stock at higher price, $20 than the $18 stock price if we had issued equity initially. Therefore issuing convertible bonds is always better than other security issues.” How would you respond to her argument? Do you agree or disagree? Justify your answer using the data provided.

Explanation / Answer

In the given case, we will have to perform the comparision of straight debt with convertible debt. The 2 scenarios which can possibly arise after the issuance of convertible bonds are that the share price may either rise or fall in the future.

Scenario One: The Share Price Rises:

Issuance of convertible debt may have resulted in lower interest cost of 7% as against the straight debt having an interest cost 10%. However, the company wouldn't be benefited if the share price rises in the future, as it will be required to sell a major portion of its equity at a price ($20) lower than its market price ($25) prevailing at the time of conversion. In such a case, the company would have been in a better position had it issued straight debt.

________

Scenario Two: The Share Price Rises:

In case of fall in the share price, the company would be benefited with the issuance of convertible bonds. It is so because, the convertible bondholders wouldn't exercise their conversion rights in case of decline in share price. In such a case, the company would continue to pay interest at a lower rate of 7% as applicable in the case of convertible bonds as against it would have been required to pay, had it issued straight debt. It is ,however, important to note that no company would like to have a situation of falling share prices.

Therefore, it is not correct to say that the issuance of convertible debt is always better than issuance of other types of securities.

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