• 5 Marks

FM – MAY 2019 – L2 – Q2c – Sources of finance: debt

Explain convertible debt and its advantages over bank loans with similar maturity.

If an existing public company chooses to issue shares, the financial market usually interprets this as a sign that the company’s share price is somewhat overvalued. To avoid this negative impression, a company may choose to issue convertible bonds, which bondholders are likely to convert to equity anyway should the company continue to do well.

Required:
Explain convertible debt and identify FOUR (4) attractions to a company of convertible debt compared to a bank loan of a similar maturity as a source of finance. (5 marks)

  • Convertible debt: Convertible loan notes are bonds that, at the option of the holder, can be converted into ordinary shares. If not converted, it will be redeemed like ordinary or straight debt on maturity. (1 mark)
  • Attractions of convertible debt compared to a bank loan:
    • Self-liquidating: Provided that the conversion terms are pitched correctly and expected share price growth occurs, conversion will be an attractive choice for bondholders as it offers more wealth than redemption. This occurs when the conversion value is greater than the redemption value, or when the conversion value is greater than the floor value on the conversion date. If the debt is converted into ordinary shares, it will not need to be redeemed, unlike a bank loan of similar maturity.
    • Lower interest rate: It will be lower than the interest rate on ordinary debt such as a bank loan because of the value of the option to convert. The returns on fixed-interest debt will not increase with corporate profitability, so debt providers will have a limited share of the benefits from the investment of the funds they have provided. When debt has been converted, however, bondholders become shareholders and will potentially have unlimited returns, or at least returns that are higher than the returns on debt finance.
    • Increase in debt capacity on conversion: Gearing increases when convertible debt is issued, but if conversion occurs, the gearing will fall not only because the debt has been removed, but will fall even further because equity has replaced the debt. The debt capacity of the company will therefore be enhanced by conversion, compared to redemption of a bank loan of a similar maturity.
    • More attractive than ordinary debt: It may be possible to issue convertible debt even when ordinary debt such as a bank loan is not attractive to lenders, since the option to convert offers a little extra that ordinary debt does not. This is the option to convert in the future, which can be attractive to optimists, even when the short- and medium-term economic outlook may be poor.
    • Stable and long-term funding source: Convertible debt can provide a stable source of long-term funding that aligns the interests of the company and investors.
    • Converted at a premium usually: Convertible debt is often issued at a premium, which can reduce dilution effects compared to issuing equity directly.
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