Question

Describe the advantages and disadvantages to existing shareholders of funding expansion using convertible loan stock.

(This will be a presentation question, please guide thoroughly. Thank you!)

Answer 1

Advantages of issuing convertible bonds or loan stock to the existing shareholder:

1) The issuance of the convertible bond will help the existing shareholders to receive all the operating income after paying a fixed amount to the bond holders.

2) Also by issuing the Convertible bonds the voting rights will be in the hands of existing shareholder. In other words, if the existing shareholders are worried of dilution of the voting power than the company can finance through issuing convertible bonds.

3) Third one is the Tax advantage. By issuing convertible bonds the company will get tax advantage and the profit after tax will be higher for the existing shareholder to share as dividends.

Disadvantages of issuing convertible bonds or loan stock to the existing shareholders:

1)There are some disadvantages to convertible bond issuers, too. One is that financing with convertible securities runs the risk of diluting not only the EPS of the company's common stock but also the control of the company. If a large part of the issue is purchased by one buyer, typically an investment banker or insurance company, a conversion may shift the voting control of the company away from its original owners and toward the converters.

2)Many of the other disadvantages are similar to the disadvantages of using straight debt in general. To the corporation, convertible bonds entail significantly more risk of bank­ruptcy than preferred or common stocks. Furthermore, the shorter the maturity, the greater the risk

3)Also, note that the use of fixed-income securities magnifies losses to the common stockholders whenever sales and earnings decline; this is the unfavorable aspect of financial leverage.

4)Finally, heavy use of debt will adversely affect a company's ability to finance operations in times of economic stress. As a company's fortunes deteriorate, it will experience great difficulties in raising capital. Furthermore, in such times investors are increasingly concerned with the security of their investments, and they may refuse to advance funds to the company except on the basis of well­-secured loans. A company that finances with convertible debt during good times to the point where its debt/assets ratio is at the upper limits for its industry simply may not be able to get financing at all during times of stress.

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