Investment: How To Calculate The Value Of Convertible Bond.

Investors often face a situation where they have to analyze long term investment opportunities to arrive at the most profitable decision. An opportunity may come when a company goes the route of convertible security to seek long term funds.

An investor must determine the value of the convertible security before a choice is made to either invest in it or in another option.

A convertible security is a bond or a preferred common stock which the holder may exchange for the common stock of the company during a specific period at a predetermined price.

The convertible bond has three separate values which must be analyzed before making a decision. These values are:

1. The conversion value (its assumed associated common stock exchange worth),
2. The straight bond value (it’s assumed that the bond has no conversion option)and,
3. The actual market price of the bond (it’s present selling price).
1. Conversion value: the conversion value indicates the value of the bond as if the holder had already activated the option of exchanging for the associated common stock within the conversion privilege.

The bond is analyzed as it were exchanged for the common stock. An example; assuming company XYZ allows the holder of its convertible bond to convert into the common stock (ordinary shares) at \$100 a share, each \$1,000 par-value bond may be exchanged for 25 shares of the associated stock.

This is calculated thus:

N = par value/CP.

Where,

N = the number of shares into which the bond is convertible,
Par value = the par value of the bond,
CP = the conversion price.

N = \$1,000/100

= 10 shares.

Since the holder can convert at any time, therefore owning the bond is the same as owning 25 shares of the common stock.

The conversion value is given as;

CV = N x P,

Where,

CV = the conversion value,
N = the number of shares into which the bond is convertible,
P = the prevailing price per common share.

Assuming that the prevailing price (P) \$105, the conversion value of the XYZ bond would be:

CV = 10 x \$105

= \$1,050.

In the example, the conversion value of \$1,050 is more than the par value of \$1,000. As the prevailing price of the associated common stock increases, the bond’s conversion value also increases. This is because the number of shares into which it’s convertible (N) remains constant. And the reverse is also true.

2. The straight bond value: The convertible bond of XYZ (company in the example) could also have a value independent of the conversion value. The bond still promises a stream of interest payments and a return on principal on maturity.

When the conversion value is taken out of the picture, the bond sells like any other bond without a conversion feature. Consequently, its value will rise as interest rates fall and falls as interest rates rise.

An example, XYZ bond has a face value of \$1,000, a redemption date for the bond is 20 years from the issue date, issued at a discount value of \$950 and the coupon rate in the trust indenture is fixed at 7%. The coupon is paid annually.

The bond holder receives 7% x \$1,000 face value = \$70 every year.

The holder will receive \$70 every year for 20 years.

An investor can determine the current yield by dividing the annual cash flow by the market price. In the example, the current yield will be:

\$70/\$950 = 7.37%.