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IAI Actuarial Core Principles · Business Finance · Structure and methods of financing a company

A company has in issue convertible debentures of Rs 100 face value, each convertible into 5 equity shares in three years' time or redeemable at par. The shares currently trade at Rs 16 and are expected to grow at 10% a year. Which statement correctly describes the expected position at the conversion date, and the holder's rational action?

The expected share price is about Rs 21.30 (16 x 1.1 cubed), giving a conversion value of roughly Rs 106.5 for 5 shares. That exceeds the Rs 100 redemption value, so the holder should convert rather than redeem.

  1. AExpected share price is about Rs 21.30, so conversion value is about Rs 106.6 and the holder should convertCorrect
  2. BExpected share price is about Rs 20.80, so conversion value is about Rs 104 and the holder should redeem
  3. CExpected share price is about Rs 21.30, so conversion value is about Rs 106.6 and the holder should redeem
  4. DExpected share price is about Rs 20.00, so conversion value is Rs 100 and the holder should be indifferent
  5. Expected share price is about Rs 17.60, so conversion value is Rs 88 and the holder should convert

Explanation

Expected price = 16 x 1.1^3 = 16 x 1.331 = Rs 21.296, about Rs 21.30. Conversion value = 5 x 21.296 = Rs 106.48, which exceeds the Rs 100 redemption value, so conversion is better. The other options use wrong growth factors or the wrong decision.

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