Question

What is meant by a dilutive security? Briefly explain why corporations issue convertible securities. Discuss the similarities and the differences between convertible debt and debt issued with stock warrants. Finally, explain how the conversion feature of convertible debt has a value to (a) the issuer and (b) the purchaser.

Answer 1

-> A dilutive security is a financial instrument which can potentially improve the number of shares outstanding. Examples include stock options, warrants and convertible bonds, which will increase the number of common shares if exercised. Such securities reduce or dilute the Basic EPS.

-> There are 2 main reasons for corporations to issue convertible securities :

a) Delaying the dilution : Instead of directly issuing equity shares/common stock which will instantly reduce the EPS of the company, the company issues convertible securities like convertible bonds to delay the dilution and obtain the needed funds at the same time.

b) Lower the interest on debt : Since convertible bonds consists of 2 components : Interest & Conversion option, the interest rate on convertible debt is much lower than on normal debt.

-> Similarities :

i) Both the instruments give security to the debt instrument holder in case the share value fails to appreciate.

ii) Both securities allow the debt instrument holder to purchase the stock of the company at a price which is lower than the market value.

iii) Both securities allow company to issue debt at a rate lower than the normal interest rate on debt.

Differences :

i) In case of convertible debt, it is usually very difficult to separate the debt from the conversion option and hence the fair values of same are usually not available, however in case of debt with stock warrants, each of the component has different values as set by the market and hence can easily be separated.

ii) Convertible debt is usually seen as equity capital. IFRS even asks companies to account for the equity portion separately. Whereas debt with stock warrants just has an extra right for acquiring equity.

iii) In case of debt with stock warrants, the issuer has no authority. He cannot force the holder to exercise the option. Whereas in case of convertible debt, if the company's stock price sufficiently increases, issuer can convert to common stock by calling issue for redemption.

-> Conversion issue has value to to the issuer and purchaser in the following manner :

(A) Issuer - The issuer gets 2 main benefits. First, it can issue debt at a much lower interest rate which is very beneficial in case large sums of money is required. Secondly, it can delay the dilution of its EPS and show a good financial position of the company.

(B) Purchaser - Purchaser gets the benefit of first earning a fixed and safe return for a particular period and after that he also gets to become the stock holder and be entitled to dividends of the company.