Question

Options in Corporate Financing

Company B is a small, publicly traded technology company.  Company B is close to completing development of a new software/hardware product for schools that uses voice recognition to quickly translate a lecture into written notes that are projected onto a screen and automatically sent to students as PDF documents.  The lecturer can then annotate the notes with a drawing pad linked to the computer projection system.  These annotations are included in the PDF that is distributed after the lecture is complete.  

      The company needs about $30 million to complete development and begin production and marketing of this product.  The company is profitable with one other product that generates about $1,200,000 in cash flow annually.  For many reasons the company has been very secretive about its new product so its stock price is quite low, being based on the modest cash flows of its existing product.  Company officials and outside consultants agree that it is too early to reveal the new product’s details given what they know of competing products.

      The company has hired an investment banker to help it determine how to raise the $30 million.  The banker immediately recommends convertible bonds.  Current interest rates on bonds or notes for companies of this type are in the range of 8% to 10%, but convertible debt would probably have a coupon rate of 3% to 5% depending on the conversion price.  The higher the conversion price the higher the coupon rate.  

The banker says that convertible bonds are a win-win for the company in this situation.  The company can keep their product secret but issue stock at a higher price (the conversion price) than the current stock price.  In the meantime, the interest rate on the debt will be about 4% or 5%, which the company should be able to support from its cash flow.  The banker explains that if for some reason the product is not a success, and there is no conversion to stock, the company has issued debt at a very low rate. Probably 5% below the rate on non-convertible debt.  Win-win!

The company’s tax rate is about 28%.

1. Can the company afford the interest on $30 million of convertible debt?
2. Is the banker correct about this being a win-win situation for the company?  Is there a different perspective that company managers need to understand before making this decision?  Explain.
3. If convertible debt has a lower coupon rate because the conversion option has value.  Why don’t all companies issue convertible debt and save on interest costs?

Answer 1

a). At an interest rate of 4%, the annual interest on 30 million will be 1.2 million. At an interest rate of 5%, the annual interest on 30 million will be 1.5 million. The company has an annual cash flow of 1.2 million so the company clearly cannot afford the interest on the convertible debt.

b). It is not necessarily a win-win situation because the company has only one profitable product so it is a high risk company. Even at a low interest rate of 5%, it will struggle to service the annual debt payments. In case, some crisis happens in the company and it is unable to service the debt, it is looking at bankruptcy.

c). All companies don't prefer to issue convertible debt despite lower coupon rates because convertible bonds have liquidity risk. It can happen that the decrease in value for a convertible bond is more than the decrease in stock value. Additionally, with convertible debt, there is possible equity dilution which happens if the bondholders chose to convert. This may not be desirable for all companies.