Question

Let’s say General Electric stock currently sells for $6.72 compared with the 1999 high of nearly $60 per share. It’s a dog with fleas, right? If a (face value $1,000) bond is convertible into common stock at a conversion price of $20, at any time, what is the conversion ratio? Is the conversion premium reasonable or expensive given what you know about GE right now? What is the floor value of the convertible security – explain fully? Assume that time = 5 years Kd = 10%.

Answer 1

Face Value = $1,000, Conversion Price = $20

Conversion Ratio = Par Value of Convertible Bond / Conversion Price of Equity

= 1000 / 20

Conversion Ratio = 50

The amount by which the price of convertible security exceeds the current market value of stock is called the Conversion Premium. It is calculated by the difference between current share value against the higher of conversion value.

Current Share value = 1000 x 20 = 20,000

Highest Share Value (1999) = 1000 x 60 = 60,000

Conversion Premium = 20,000 - 60,000

Conversion Premium = - $40,000

The conversion premium is very low in this case as the current conversion price is low compared to the higher conversion value. So the premium holder cannot be able to sell his securities. He can get them redeemed at par value.

Floor Value of Convertible Security:

Floor Value = PV _coupon + PV _{par value}

PV = Present Value

PV _Coupon = (r x (Par Value / r)) x PV _Factor

PV _Factor = 1 - (1/ (1+ r)ⁿ) , where n = 5 years and r = debt rate 10%

PV _Factor = 1 - (1/ (1+ 10%) ⁵)

= 1 - (1/ (1+0.10)⁵)

= 1 - (1/ (1.10)⁵)

= 1 - (1/ 1.61)

PV _Factor = 0.3789

PV _Coupon = (0.10 x 1000 / 0.10) x 0.3789

PV _Coupon = 378.9

PV _{par value} = Par value / (1+0.10) ⁵

PV _{par value} = 1000 / 1.61 = 621.12

Floor Value = 378.9 + 621.12

Floor Value = $1000