a hybridsecurity thatispublicly traded(and has amarket
price)intodebtandequitycomponents.Inthecaseoftraded
convertible bonds, this can be accomplished in two ways:
- An option pricing model can be used to value the
conversionoptionandtheremainingvalueofthebondcanbe
attributed to debt.
2.Theconvertiblebondcanbevaluedasifitwereastraight
bond, using therate at which the firmcan borrow in the
market, given its default risk (pretax cost of debt) as the
interestrateonthebond.Thedifferencebetweenthepriceof
theconvertiblebondandthevalueofthestraightbondcanbe
viewed as the value of the conversion option.
Iftheconvertiblesecurityisnottraded,wehavetovalueboth
the straight bond and the conversion options separately.
ILLUSTRATION2.6: Breaking Downa Convertible Bond
into Debt and Equity Components: Disney
In March 2004, Disney had convertible bonds outstanding
with 19 yearslefttomaturityandacouponrateof2.125%,
tradingat$1,064abond.Holdersofthisbondhavetheright
toconvertthebondinto33.9444sharesofstockanytimeover
the bond’s remaining life.
48 To break the convertible bond into straight bond and
conversionoptioncomponents,wewillvaluethebondusing
Disney’s pretax cost of debt of 5.25%:
49