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IAI Actuarial Core Principles · Business Finance · Capital structure and dividend policy

A company is considering raising finance by a convertible bond rather than a straight bond of the same maturity. Which statement about the convertible bond is correct?

A convertible bond normally carries a lower coupon than a comparable straight bond, because investors are compensated by the valuable option to convert into shares. It remains debt until conversion, and conversion can dilute existing shareholders.

  1. AIt will normally carry a higher coupon than the straight bond because holders take extra risk
  2. BIt will normally carry a lower coupon than the straight bond because holders receive an option to convert into sharesCorrect
  3. CIt removes any possibility of dilution of existing shareholders
  4. DIt must be repaid in cash at maturity regardless of the share price
  5. It is classed as ordinary share capital before conversion

Explanation

The conversion option has value to the investor, so the issuer can offer a lower coupon than on a straight bond. Dilution can occur if the holders convert. Before conversion it is a debt instrument, not share capital. Option B is correct; the cash-repayment statement is wrong because holders may convert instead of being repaid.

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