www.safeecollege.com1 concept of valuation. 7. convertibles it is a financial security with call...

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Concept of Valuation

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7. Convertibles

It is a financial security with Call Option to buy shares, of the issuer.

Example:

• Compulsory Convertible Preference Share• Foreign Currency Convertible Bonds• Partly Convertible Debentures• Optionally Fully Convertible Debentures

Convertible Bonds

Bonds (Host Contract)

Call option to buy shares of the issuer.

(Embeded Contract)

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Pricing of Convertible Bond

Value of Bond Value of Call Option or a Stock

+

Value of a coupon paying bond.

Straight Value of a Bond

Use either Black Shole Model or Risk Neutral Approach.

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a) Conversion Price and Conversion Ratio :

A Convertible financial security either Conversion Price or Conversion Ratio or Both.

Conversion Price is a price per share at which conversion will take place.

Conversion Ratio is that total number of shares to be received after conversion of one Convertible Bond

Conversion Price = Face Value of Bond

Conversion Ration

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b) Conversion Value : It is a value of a convertible bond if it is converted into

shares.

CV = Current MPS × Conversion Ratio

The minimum Value of a Convertible bond should be Greater of two figures :

a) Conversion Valueb) Straight Value of Convertible Bond

(This is the value of a convertible bond as if there is no conversion feature)

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c) Market Conversion Price :

It is the market price per share if we buy one convertible bond in the market and then we convert into shares.

= MP of one Convertible bond

Conversion Ratio

d) Conversion Premium Per Share :

= Market Conversion Price × Current Market Price

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e) Market Conversion Premium Ratio :

Alternative 1

= Conversion Premium Per Share

Current MPS

Alternative 2

= Market Price of Convertible Bonds - Conversion Value

Conversion Value

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f) Premium Pay Back Period : (Break even time or Period)

= Market Conversion Premium per share

Favourable income differential per share

= Face Value of Bond × Coupon Rate

= Dividend Per Share × Conversion Ratio

Conversion Ratio

Premium pay back period does not consider Time Value.

My Income

Income of person buying only shares

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g) How to calculate Downside risk of a Convertible Bond :

Investor use Straight Value of the bond as a measure of downside risk and it is calculated as % of Premium over Straight Value of Bond.

= Market Price of Straight Value of

Convertible Bond - Bond

Straight Value of Bond