Understanding the True Cost of Issuing Convertible Debt and Other Equity-Linked Financing

by Roger Lister

Executive Summary
Convertible securities (CSs) combine debt and equity. In option terms, CSs are a call option on a specified number of shares whose exercise price is the debt claim forgone in exchange for the shares. CSs are also like a stock with a put option whose exercise price is the market value of the convertible. Some critics insist that CSs are uneconomic because they address several habitats of investors at the same time. Others say that they comprise flexible, non-dilutive, easily executed, and cheap finance, which appeals to many professional investors including hedge funds. The basic formula defines the cost of CSs but ignores tax and dividends. The formula produces a weighted average of the cost of the debt and the cost of a call option on the issuers shares. Managements task is to measure the cost of CSs with the formula while allowing for the real world influences that the basic model ignores. Cost-influencing factors include dividends, tax, and resolution of agency costs.

Introduction
Convertible securities (CSs) and other equity-linked instruments combine debt and equity. Depending on the terms and the issuers future performance, CSs can range from almost pure equity to an option-free bond. In option terms, a CS can be viewed in two ways. It amounts to a straight bond with a call option on a specified number of shares. It is also effectively a share with a put option whose exercise price is the market value of the convertible. Some iconoclasts persistently argue that CSs and other equity-linked instruments are essentially uneconomic. Classically championed by Tony Merrett and Allen Sykes, critics maintain that by jointly approaching the equity and fixed interest markets a company must offer costly conversion rights to attract the equity investor while giving virtually the same rights to the fixed interest investor who values them less. Likewise, issuers must give fixed interest investors an acceptable income. In short, CSs contradict the advantage of specialization whereby capital-raising is tailored to habitats of investors. The iconoclasts invoke studies like Ammann, Fehr, and Seiz (2006) to the effect that negative equity returns follow the announcement and issue of CS. A counterargument is that CSs are flexible, non-dilutive, easily executed, and cheap finance. CSs appeal to professional investors including hedge funds which exploit arbitrage opportunities. Rating agencies such as Fitch see sense in both viewpoints and hold that the desirability of CSs depends more strongly than other sources of finance on individual corporate circumstances and market context. Fitch (2006) concludes: Issuers must find continuing compelling reasons for such issuance...The lower costs of such issuance compared with the cost of issuing equity are certainly supportive, as are the gradual standardisation, transparency and consistency of documentation, market practice and the activities of the agencies. On the other hand, issuers and their advisers must always strive to satisfy several constituencies, including regulators, legal and tax authorities, the agencies and finally, investors. Investor appetite underpinned the buoyant corporate activity of recent years. However, that appetite arose in an environment of low interest rates that will not persist indefinitely. What is the true cost of CSs? Definition is less difficult than measurement. Having defined the parameters and influences on cost, management must frankly ask whether their measurements are so unreliable as to make them a dubious basis for decision-taking. Of course this applies across financial management, but it is particularly acute for the cost of capital.

Understanding the True Cost of Issuing Convertible Debt and Other Equity-Linked Financing

1 of 5 www.qfinance.com

The Cost Formula

The cost of a CS is a weighted average of the cost of its debt element and the cost of a call option on the issuers shares, since the investor in a CS is a lender and the holder of a call option on the value of the firm. The difference between a conversion right and a regular call option is that a CS holder gets new shares upon exercise. It follows that if the price at which the CS holder is entitled to shares is below market price, then the value of all corporate equity, including the convertors, is diluted. This explains why a convertible warrant is worth less than a straight call option on the companys shares whose exercise leaves existing equity intact. The market will discount each element to the present using appropriate required rates of return. The cost of CS is an average of the rates weighted by each elements share of total market value. The starting point is the textbook formula (see, for example, Copeland, Weston and Shastri, 2004, Chapter 15) which can be summarized as follows. These are the essential terms: kCV is the cost of convertible debt; B is the value of debt element; W is the value of equity element, being the value of a call option on the companys shares; B + W is the value of the convertible security; kb is the required rate of return on debt; and kc is the required rate of return on a call option on the companys shares. See below. Using the capital asset pricing model, kc = Rf + [E(Rm) # Rf] c where kc is the required rate of return on a call option on the companys shares with the same maturity as the CS; Rf is the risk-free rate of return for a bond with the same maturity as the CS; E(Rm) is the expected rate of return on a portfolio comprising all the shares in the market; c is the systematic risk of the call option expressing its correlation with the market. c is computed by reference to the of an underlying share of the company adjusted to option using the BlackScholes option pricing programme: kcv = kb BB + W + kc WB + W The basic BlackScholes option pricing scheme assumes that the issuer pays neither dividends nor tax (see, for example, Berk and DeMarzo, 2007, Chapters 21, 22, 23; Brealey and Myers, 2007, Part 6; and packages like the London Business Schools).

Factors Influencing Cost

In the real world, dividends, tax, and mitigation of agency costs influence the cost of a CS. Dividends: If a company pays dividends then the value of the call option C changes. A call option on a dividend-paying share suffers, since a cash dividend liquidates some corporate value and the proceeds go to shareholders but not option holders. The larger the dividends, the more the option suffers. Option holders who try to anticipate this by early exercise gain dividends but lose interest on the exercise price. Options on dividend-paying stocks with assumed-continuous or, more realistically, discrete dividends can now be valued (Chandrasekhar and Gukhal, 2004), but only with protracted and complex mathematics beyond the present scope. Tax: The impact of tax on cost is unique for every issuer, holder, and regime. Tax impinges on C, the value of the call, on , its systematic risk and on kb, the cost of debt. The impact in any particular case depends on: the issuer and holders tax regime; interacting intra-group regimes; corporate, inter-corporate, and personal taxes at critical decision points; the taxable status of issuer, holder, and associates; how issuer and holder prioritize tax allowances.

Some aspects of recent relevant tax regulations for the United Kingdom are illustrative. The issue price is split between debt and equity. The debt element is valued by discounting comparable straight debt at
Understanding the True Cost of Issuing Convertible Debt and Other Equity-Linked Financing 2 of 5 www.qfinance.com

the interest rate that would have been payable had the security contained no equity conversion feature. The difference between this value and the issue price of the security is treated as being either an equity instrument or an embedded derivative, according to whether the company can only issue shares or whether it has the discretion to pay cash. In the former case the conversion right is treated as an equity issue and is disregarded for tax. In the latter case it is in principle taxable as an embedded derivative. If so, a chargeable gain or allowable loss will arise when the company pays cash to the holders. The gain or loss is determined by a formula based on the difference between the book value of the equity element and the amount paid. Any difference between the deemed issue price of the debt element and the amount payable on its redemption is amortized and is tax-deductible over the life of the security. A company can get a high and timely tax deduction by paying high interest on a CS with a short life. This reduces kb, the cost of debt. However if CS holders are taxable, their personal tax may negate the deduction: if debt is tax-inefficient relative to equity, such investors will require compensation by way of a higher return. Furthermore tax benefits may be truncated by bankruptcy, voluntary conversion by bondholders, or a company decision to force conversion. If cross-border jurisdiction is involved it becomes necessary to examine how CSs would be categorized under relevant tax treaties, EC directives, and double taxation resulting from any inconsistent classification. Mitigation of agency costs: Agency costs are costs of conflict among different classes of investor and between managers and investors. They reflect opportunities for equity to exploit debt and for managers to invest sloppily, forgo good investments, shirk, and enjoy perks. Endangered parties impose monitoring costs on the shareholders. If the endangered party is a lender, then the cost of debt rises. With CSs an equity sweetener reduces the monitoring costs by aligning the interests of debt and equity. CSs can reduce the managerial incentive to over-invest in poor, low-return projects. For example, consider the second of two interdependent risky investments, which is only beneficial if the first succeeds. Either finance can be borrowed at the outset for both projects or CSs can be issued that will be sufficient for the first project while providing enough for the second on conversion. If all goes well, the second project will be duly financed by conversion. If the first project fails, the value of the CS will fall, nobody will convert, and management will be able to repurchase the debt at its low value in the open market. Indeed Mayers (2003) has observed a correlation between conversion and spates of corporate investment. If all had been borrowed upfront and if the first project failed, management might be tempted to invest the unused borrowings in easy, unprofitable projects.

A Trend and Its Reversal

A suitably selected trend illustrates in combination a number of the factors discussed. Such was the boom of 2003 (Economist,2003) and the subsequent fall. Figure 1. Annual global convertible issuance, data through March 10, 2004. (Source:Standard & Poors Global Fixed Income Research, Thomson Financial) The factors that prompted the surge in the early 2000s to issuance to a near-historic high are concerned with cost, capital structure, value, financial mobility, and market context: The market had no appetite for equity, and at the same time companies were suffering from unpalatable gearing levels. CSs with a low coupon provided financial mobility and some reassurance to anxious investors and garnered tax advantage. Hedge funds were attracted to CSs because they perceived a bargain insofar as the issue price underestimated the volatility of the equity, which meant that the call option, C in the basic formula, was undervalued. Hedge funds bought the convertible, sold the debt, and kept the undervalued call option. They then sold shares short to exploit underestimated volatility.

A reversal of the trend came when the volatility of equities declined; companies grew wise to the excessive cost of CSs that they were suffering;
3 of 5 www.qfinance.com

Understanding the True Cost of Issuing Convertible Debt and Other Equity-Linked Financing

for tax reasons dividends increased, and this hurt short sellers who had to pay the dividends to their purchaser.

Making It Happen
The decision to issue CSs follows the answers to a series of questions. Is there presently a hot convertible debt window in the market or are there contraindications? Do the causes of the window or the contraindications apply to us? What is our debt capacity? If we are near its limits will CSs bust us or will they enable us to stretch our borrowing? Can we tailor CSs to our real investment needs? Can we at the same time mitigate agency costs? What tax-planning opportunities do CSs offer? Should we prioritize other tax benefits? Measurement of the parameters of the cost of capital is notoriously difficult. How reliable are our estimates? For example, how stable is our beta and how reliable is our estimate of volatility?

More Info
Books:
Berk, Jonathan, and Peter DeMarzo. Corporate Finance. Boston, MA: Pearson Addison Wesley, 2007. Bhattacharya, Mihir. Convertible securities and their valuation. In Fabozzi, F. J. (ed). The Handbook of Fixed Income Securities. New York: McGraw-Hill, 2005, pp. 13931442. Brealey, R.A., and S.C. Myers, Principles of Corporate Finance. 9th ed. New York: McGraw-Hill, 2007. Copeland, Thomas, Fred Weston, and Kuldeep Shastri. Financial Theory and Corporate Policy. 4th ed. Boston, MA: Addison-Wesley, 2004. Tuckman, Bruce. Fixed Income Securities: Tools for Todays Market. 2nd ed. Hoboken, NJ: Wiley, 2002.

Articles:
Ammann, Manuel, Martin Fehr, and Ralf Seiz. New evidence on the announcement effect of convertible and exchangeable bonds. Journal of Multinational Financial Management 16:1 (2006): 43 63. Asquith, Paul. Convertible bonds are not called late. Journal of Finance 50:4 (1995): 12751289. Campbell, Cynthia J., Louis H. Ederington, and Prashant Vankudre. Tax shields, sample selection bias, and the information content of conversion-forcing bond calls. Journal of Finance 46:4 (1991): 12911324. Chandrasekhar, C.R., and Reddy Gukhal. The compound option approach to American options on jump-diffusions. Journal of Economic Dynamics and Control 28:10 (2004): 20552074. Economist. Options and opportunities. July 17, 2003. Online at: www.economist.com/finance/ displaystory.cfm?story_id=E1_TJNSDRJ Economist. Convertible bombs. November 14, 2002. Online at: www.economist.com/finance/ displaystory.cfm?story_id=E1_TQQGNJJ Fitch Ratings. Guide to hybrid securities. 2006. Online at: www.gtnews.com/feature/138_2.cfm Laurent, Sandra. Convertible debt and preference share financing: An empirical study. Working paper, 2005. Online at: ssrn.com/abstract=668364

See Also
Best Practice The Role of Short Sellers in the Marketplace Checklists Hedge Funds: Understanding the Risks and Returns Raising Capital by Issuing Shares
4 of 5 www.qfinance.com

Understanding the True Cost of Issuing Convertible Debt and Other Equity-Linked Financing

Swaps, Options, and Futures: What They Are and Their Function Understanding Price Volatility

To see this article on-line, please visit

http://www.qfinance.com/raising-finance-best-practice/understanding-the-true-cost-of-issuing-convertible-debt-and-other-eq?full

Understanding the True Cost of Issuing Convertible Debt and Other Equity-Linked Financing

5 of 5 www.qfinance.com