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A bond is convertible into 50 shares of common stock. The bond trades at 110 and...

A bond is convertible into 50 shares of common stock. The bond trades at 110 and the stock trades at $21. Which of the following are true?
I. The stock trades above parity
II. The stock trades below parity
III. Converting the bond would be profitable
IV. Converting the bond would not be profitable

II & III

I & III

II & IV

I & IV

Solutions

Expert Solution

A convertible bond can be converted into 50 shares of commond stock.

Price of the bond=$110

Price of the stock=$21

To evaluate the right option out of the following, certain calculations are needed:

1) Conversion ratio= Par value of bond/Price of equity

=110/21

=5.23

According to the conversion ratio, an investor should get 5.23 common stock in conversion of bond. But, he is getting 50 common stock. Hence, the investor is definitely in profit by getting around 44.77 more common stock than actual conversion ratio.

2) Conversion parity price=Value of convertible security/Conversion ratio

=110/50

=2.2

The conversion parity price of the stock should be $2.2. But, in reality it is trading at around $21. Which is quite higher than the conversion parity price.

CONCLUSION:

The stock trades above parity price of $2.2, while the current market price is $21. Hence the stock is traing above the parity price.

And, the investor is at a profit as according to the conversion ratio, the investor would get 5.37 shares on conversion. But, according to the conversion policy the investor is getting 50 common stocks.

So the correct answer is

1 and 3

that is,

The stock is trading above parity and converting the bond would be profitable.

jeff jeffy answered 2 years ago
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