Financial Management · Sources of finance and their relative costs

Convertible Bonds, Warrants and Preference Shares for ACCA FM

Updated 11 October 2026 · Fact-checked

Hybrid finance mixes debt and equity features. A convertible bond pays interest and can be swapped for shares. Conversion value is share price × shares per bond: today's price gives the current value, the forecast price gives the value at conversion. Preference shares pay a fixed dividend; warrants are options to buy shares.

Understand Hybrid Finance and Convertibles, Preference Shares

Companies raise money as debt or equity. Hybrid finance sits between the two. It has some features of each, so it appeals to different investors and can lower the cost of raising funds.

A convertible bond (or convertible loan note) is a bond that pays fixed interest. At a future date the holder can choose to convert it into a set number of ordinary shares, or take redemption in cash. The investor gets a safe income now and a chance to share in growth later. Because of that upside, the company can usually offer a lower coupon than on ordinary debt.

The conversion ratio is the number of shares received per bond. The conversion price is the nominal bond value ÷ the conversion ratio. There are two conversion values. The current conversion value is the current share price × the conversion ratio. The future conversion value is the forecast share price at the conversion date × the conversion ratio. The holder converts only if the future conversion value beats the cash redemption value. If it does not, the holder takes the cash. The floor value is the bond's value as plain debt: the present value of interest and redemption, discounted at the pre-tax cost of similar straight (non-convertible) debt. The conversion premium is the market price of the bond minus its current conversion value.

Warrants are options sold with a bond or share issue. They give the holder the right to buy shares at a fixed exercise price before an expiry date. They pay no interest or dividend. The company gets cash when they are exercised. They are often added to a bond issue to make it more attractive and cut the coupon.

Preference shares pay a fixed dividend, usually a fixed percentage of nominal value. Preference dividends are paid before ordinary dividends and, on liquidation, preference holders are repaid before ordinary holders. They usually have no vote. Dividends are paid from after-tax profit, so there is no tax relief. Most are cumulative: missed dividends build up and must be paid before ordinary shareholders get anything. Some are redeemable and some are convertible. For cost of capital, treat irredeemable preference shares like a perpetuity.

Key rules to remember

Conversion ratio: Conversion ratio = Nominal value of bond ÷ Conversion price; Gives the number of ordinary shares received per bond. If the question states the ratio, use it directly.
Future share price: Future share price = Current share price × (1 + g)ⁿ; g is the expected annual growth rate and n the years to conversion. Use this to forecast the price at the conversion date.
Current conversion value: Current conversion value = Current share price × Conversion ratio; Use this in the conversion premium. It is not used for the conversion decision.
Future conversion value: Future conversion value = Forecast share price at conversion date × Conversion ratio; Compare with the redemption value. The holder takes the higher of the two.
Floor value: Floor value = PV of interest + PV of redemption value, discounted at the cost of similar straight debt; This is the minimum value of the bond as debt. Use the gross (pre-tax) interest and discount at the investor's required pre-tax return on similar straight debt. Do not use after-tax interest or the company's after-tax cost of debt.
Conversion premium: Conversion premium = Market price of bond − Current conversion value; It can be given per share: market price ÷ ratio − current share price.
Cost of irredeemable preference shares: Kp = Annual preference dividend ÷ Ex-div market price; No tax adjustment, because preference dividends are not tax deductible.
Cost of convertible debt: Cost = IRR of: current price (outflow at t0), interest after tax (t1–n), and the higher of redemption or future conversion value (t n); Apply tax relief to the interest, then find the IRR by interpolation using two discount rates.

How to solve Hybrid Finance and Convertibles, Preference Shares questions

Use this method for any convertible, warrant or preference share question.

1Identify the instrument and what is asked: value, cost, conversion decision or reason for issue.
2List the data: nominal value, coupon, redemption date and price, conversion ratio, current share price, growth rate, tax rate.
3Forecast the share price at the conversion date: current price × (1 + g)ⁿ.
4Calculate conversion value = forecast price × conversion ratio. Compare it with the redemption value and pick the higher one as the final cash flow.
5For a cost or value, set up the cash flows: price now as an outflow, after-tax interest each year, the final amount at the end.
6Find the IRR using two rates, one above and one below, and interpolate. For a preference share, use dividend ÷ price.
7State the answer with units and add a short comment on the investor's choice or the company's reasons.

Quickest way: Compare, then run the IRR

When to use it: Use this for 2-mark objective test questions and as the first step in a 20-mark question.

Compute conversion value and redemption value first. Whichever is higher sets the final cash flow.
If the question asks only for the decision, stop there.
For a preference share, divide the dividend by the price at once. No tax, no IRR.
For cost of convertible debt, choose two trial rates that bracket the IRR, for example the pre-tax cost of similar straight debt and a higher rate. Then interpolate: L + [NPV(L) ÷ (NPV(L) − NPV(H))] × (H − L).
Check that the answer lies between the two trial rates. If not, re-run with trial rates that bracket it.

Common mistakes in Hybrid Finance and Convertibles, Preference Shares

Using the current share price to work out the conversion value at the conversion date.
Students forget conversion happens in the future.
Fix: Grow the share price to the conversion date first, then multiply by the conversion ratio. Use the current price only for the current conversion value in the premium.
Taking tax relief on preference dividends.
Students treat them like interest.
Fix: Preference dividends are paid from after-tax profit. Cost = dividend ÷ price, with no tax adjustment.
Always assuming the bond converts.
Students ignore the holder's choice.
Fix: Compare future conversion value with redemption value. Use the higher of the two in the final cash flow.
Confusing the floor value with the conversion value.
Both are called a value of the bond.
Fix: Floor value is the bond as debt. Conversion value is the shares received. The market price usually sits above both because the holder also has the conversion option, but this is a rule of thumb, not a certainty.
Mixing up warrants and convertibles.
Both involve shares being issued later.
Fix: A convertible is swapped for shares and the debt disappears. A warrant is an option to buy shares for cash and is a separate item. The bond stays in place.
Forgetting tax on interest when finding the cost of convertible debt.
Students use the gross coupon.
Fix: Multiply interest by (1 − tax rate) in the IRR cash flows.

Worked examples

Example 1

A company has 8% convertible bonds with a nominal value of ₹100. Each bond can be converted in 4 years into 20 ordinary shares or redeemed at par. The current share price is ₹4 and is expected to grow at 10% a year. What is the conversion value at the conversion date, and will the holder convert?

Show the solution

Forecast the share price: ₹4 × 1.10⁴ = ₹4 × 1.4641 = ₹5.8564.
Conversion value = ₹5.8564 × 20 = ₹117.13.
Redemption value = ₹100.
Compare: ₹117.13 is greater than ₹100.

Answer: The conversion value is ₹117.13 per bond. It exceeds the ₹100 redemption value, so the holder will convert.

Example 2

A company has 5% irredeemable preference shares of ₹1 nominal value. The ex-div market price is ₹0.80 per share. Calculate the cost of the preference shares and explain why preference shares usually cost more than debt for a similar company.

Show the solution

Annual dividend per share = 5% × ₹1 = ₹0.05.
Cost = ₹0.05 ÷ ₹0.80 = 0.0625, or 6.25%.
Preference dividends are not tax deductible, so there is no tax saving. Interest on debt usually is, which lowers the cost of debt.
Preference shares are usually riskier than debt: they rank after debt on liquidation and their dividends can be missed, so investors ask for a higher return.

Answer: The cost of the preference shares is 6.25%. Preference shares usually cost more than debt because there is no tax relief and investors bear more risk.

Exam tips

In a 2-mark objective test, the trap is usually the future share price. Check whether the question gives growth and a conversion date.
Always compare conversion and redemption values before the IRR. Writing both numbers shows the examiner your decision logic.
In written answers on why firms issue convertibles, give two or three points: lower coupon, cheaper than equity now, and delayed dilution of shares. Add one risk, such as gearing or dilution if the bonds convert.
Show the two trial rates and the interpolation clearly. Method marks are available in constructed-response questions.
If a question asks about preference shares, say whether they are cumulative, redeemable or convertible. This changes the risk and the cost.

Practice questions from Sources of finance and their relative costs

Hybrid Finance and Convertibles, Preference Shares in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Actuarial Core Principles (IAI)Hybrid Finance, Leasing and Other Methods

Hybrid Finance and Convertibles, Preference Shares: frequently asked questions

What is the conversion value of a convertible bond?

It is the value of the shares the holder would receive on conversion: share price × conversion ratio. The current conversion value uses today's share price. The future conversion value uses the forecast price at the conversion date. The holder converts only if the future conversion value is higher than the cash redemption value.

What is the difference between preference shares and ordinary shares?

Preference shares pay a fixed dividend and rank ahead of ordinary shares for dividends and in liquidation. They usually carry no vote. Ordinary shareholders get variable dividends and the residual profit, and they hold the votes.

Why do companies issue convertible bonds?

The coupon is lower than on straight debt because investors value the option to convert. If the bonds convert, the company need not repay cash and its gearing falls. The conversion price is usually set at a premium to the current share price, so dilution is delayed and is less than issuing equity now.

What is a warrant in ACCA FM?

A warrant is the right to buy new shares at a fixed price before an expiry date. It pays no dividend or interest. If exercised, the company receives cash and issues shares.

Do preference dividends get tax relief?

No. They are paid out of after-tax profit, so the cost of preference shares is the dividend ÷ market price, with no tax adjustment.