Principles of Corporate Finance_ 12th Edition

Chapter 24 The Many Different Kinds of Debt 631

bre44380_ch24_618-651.indd 631 10/05/15 12:54 PM

Forcing Conversion

Many issuers of convertible bonds have an option to buy (or call) the bonds back at their
face value whenever its stock price is 30% or so above the bond’s conversion price.^30 If the
company does announce that it will call the bonds, it makes sense for investors to convert
immediately. Thus a call can force conversion.
As we saw earlier, calling a bond does not affect the total size of the company pie, but
it can affect the size of the individual slices. If the convertible is callable, the company can
minimize the value of the bondholder’s slice by forcing conversion and terminating the bond-
holder’s option.^31

Why Do Companies Issue Convertibles?

You are approached by an investment banker who is anxious to persuade your company to
issue a convertible bond with a conversion price set somewhat above the current stock price.
She points out that investors would be prepared to accept a lower yield on the convertible,

◗ FIGURE 24.4 (a) The bond value when U.S. Steel’s convertible bond matures.

If firm value is at least equal to the face value of U.S. Steel’s debt, the bond is paid

off at face value. (b) The conversion value at maturity. If converted, the value of the

convertible rises in proportion to firm value. (c) At maturity the convertible bondholder

can choose to receive the payment on the bond or convert to common stock. The value

of the convertible bond is therefore the higher of its bond value and its conversion value.

Bond value

Default

Bond paid

in full

Value of stock if bond

is converted

Value of firm

Value of convertible

Value of firm

(a)

(c)

(b)

Value of firm

Conversion value

Default

Convert

Bond paid

in full

(^30) The U.S. Steel convertible is callable from 2017 at face value.
(^31) The financial manager might delay calling if interest payments on the convertible are less than the extra dividends that would be
paid after conversion. This delay would reduce cash payments to bondholders. Nothing is lost if the financial manager calls on the way
down. Note that investors may convert voluntarily if they would thereby increase their income.