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Why Should a Firm Force Conversion

Why Should a Firm Force Conversion

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Published by: ClassOf1.com on Aug 08, 2013
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FinancialAccounting
 
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Subect: Financial Accountin
Why Should a Firm Force Conversion?
The opportunity for a firm to force conversion arises when the conversion value of the bond islarger than the call price. Normally, a price cushion is required to reduce the likelihood of the firmpaying out cash. There are several reasons why a firm might want to force its investors to convertinto common stock by calling the bond. It might be a way to strengthen the capital structure so thatnew debt can be issued. Another reason for the firm to force conversion is that the cash outlays of outstanding common stock are less than with debt.For example, a growth stock may be paying zero dividends; thus, the after-tax interest paymentsare saved if conversion is forced. Assume a $1,000 bond paying 0.10 interests is convertible into 40shares of common stock. The common stock pays a $1-per-year dividend and is selling at a price of $50. The call price of the bond is $1,080. Should the company call? The corporate tax rate is 0.35.The company can call, since the conversion value, $50 × 40 = $2,000, is larger than the call price.If the bonds are called, the rational investors must convert rather than accept the call price.The conversion value is larger than $1,080. The bonds converted into common stock will require$40 per bond of cash outlays for dividends. The bonds now require $100 of interest outlays, whichare $65 after tax. The $40 is less than $65. The investors will receive $40 of dividends instead of $100 of interest; thus, they do not have their position improved by the call. The position of thepresent stockholders is improved by the c
all, since the firm’s cash outflow is reduced. In addition,
the downside protection offered by the bond (the put option held by investors) is eliminated.Earnings per share will also be affected by the conversion. Interest costs will be reduced, and thenumber of shares outstanding will be affected (the exact effect will depend on whether we are
 
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The Homework solutions from Classof1 are intended to help students understand the approach to solving the problem and not forsubmitting the same in lieu of their academic submissions for grades.
Financial Accounting Homework Help from Classof1.com 
Subect: Financial Accountin
computing earnings per share with or without dilution and on the nature of the conversionfeature). In some situations, the amount of debt not yet converted has become very small andcalling the debt is a reasonable way of eliminating an unnecessary financial complexity.There is a sound financial theory that convertible bonds should be called as soon as the marketprice of the bond is high enough above the call price to insure conversion. If called at lower prices,there might be cash outlays associated with the retirement of the debt. Just as an investor prefers tohold the convertible bond rather than convert because of the downside protection offered by the bond, the corporation wants to force conversion so that the legal obligation to pay interest andprincipal are replaced by the more flexible commitments to common stock.

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