Valuation Of Convertible Bonds You Purchased From Big Corps

Valuation Convertible Bondyou Purchased One Of Big Corps 8 10 Y

Valuation – convertible bond. You purchased one of Big Corp.’s 8%, 10-year convertible bonds at its $1,000 par value a year ago when the company’s common stock was selling for $20. Similar bonds without a conversion feature returned 12% at the time. The bond is convertible into stock at a price of $30. The stock is now selling for $35. Assume no dividends.

Paper For Above instruction

In this analysis, we evaluate the financial implications of investing in Big Corp.'s 8%, 10-year convertible bonds, focusing on the return generated upon exercising the conversion feature and comparing it with an alternative investment directly in the company's stock. The scenario involves a bond purchased at par value, with specific details about its conversion terms and the current stock price, providing an insightful case to analyze convertible bond valuation and potential returns.

Introduction

Convertible bonds are hybrid financial instruments that combine features of debt and equity, offering investors both fixed income and potential upside through conversion into stock. Their valuation is complex, depending on interest rates, the company's stock performance, and the specifics of the conversion terms. This paper determines the total return when exercising the bond’s conversion feature immediately and compares it with the hypothetical return from investing directly in the company’s stock.

Background and Context

On purchasing the bond, the investor paid $1,000, which is also the face value, with an annual coupon rate of 8%. The bond's maturity is ten years, and it can be converted into stock at a conversion price of $30. The company's stock was then priced at $20. One year later, the stock price has increased to $35, which is a key factor for the analysis. The comparable non-convertible bond's return, without the conversion feature, was 12%, used here as a benchmark for the bond's value at the time of purchase.

Calculating the Total Return upon Conversion

The first task is to calculate the total return if the investor exercises the conversion feature immediately and sells the stock. The conversion ratio is determined by dividing the face value of the bond by the conversion price:.

Conversion Ratio = $1,000 / $30 ≈ 33.33 shares

This means that each bond can be converted into approximately 33.33 shares of stock.

At the current market price of $35 per share, the total value of these shares upon conversion is:

Total Stock Value = 33.33 shares × $35 ≈ $1,166.67

Since the bond was purchased at par value ($1,000), and converted into stock worth approximately $1,166.67, the profit is:

Profit = $1,166.67 - $1,000 = $166.67

The total return percentage is calculated as:

Total Return = (Profit / Initial Investment) × 100

Thus:

Return = ($166.67 / $1,000) × 100 ≈ 16.67%

This indicates that exercising the conversion right and immediately selling the stock has yielded a return of approximately 16.67% over the period.

Investing Directly in the Stock

The second scenario compares the previous outcome with investing $1,000 directly in the stock at its original price of $20, and holding it for the same period. The number of shares purchased initially would be:

Shares Purchased = $1,000 / $20 = 50 shares

After one year, at the current stock price of $35, the total value of these shares would be:

Investment Value = 50 shares × $35 = $1,750

The return from direct stock investment over that period is:

Return = (($1,750 - $1,000) / $1,000) × 100 = 75%

This substantial increase indicates that the stock investment outperformed the return yielded through the conversion method, primarily due to the stock's significant appreciation over the year.

Discussion and Analysis

The calculations demonstrate that immediate conversion and sale of the stock would generate a return of approximately 16.67%, relatively lower than the 75% return from directly investing in the stock. This discrepancy underscores the importance of timing and stock appreciation in evaluating convertible bonds versus direct equity investments. Although convertible bonds often provide safety through fixed income and downside protection, their upside potential is limited compared to direct equity, especially during periods of high stock performance.

Furthermore, the initial convertible bond purchase offered an attractive fixed coupon rate of 8%, and the bond still provides interest income, unlike the stock investment which does not promise fixed returns. The bond's price both at issuance and current value reflects market conditions, interest rate environment, and company prospects. The fact that the stock price exceeded the conversion price indicates an increase in company valuation, making conversion more favorable.

Implications for Investors

Investors should consider their risk-return preferences and expectations about the company's future stock performance when choosing between convertible bonds and direct equity investments. Convertible bonds are attractive when the investor seeks income stability with some exposure to equity growth, especially if the company's future prospects are favorable. However, during rapid stock appreciation, direct investment in stocks may yield higher returns as seen in this example.

In addition, the option to convert adds flexibility, allowing investors to capitalize on stock appreciation without being fully exposed to equity risk. Conversely, the decision to convert should account for remaining bond maturity, interest payments, and future stock performance, which are variables that influence the total return outlook.

Conclusion

In conclusion, exercising the conversion feature in this scenario results in a 16.67% return, which underperforms the 75% return from direct stock investment over the same period. The analysis highlights the importance of understanding the trade-offs between fixed income and equity securities, as well as the timing of conversions. For investors, the choice hinges on their appetite for risk, income needs, and expectations of stock performance. Convertible bonds, while providing downside protection through fixed coupons, primarily serve as advantageous instruments when stock growth prospects align with market predictions, and timing of conversion is optimized to maximize returns.

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