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

A company issues convertible unsecured loan stock that gives the holder the right, on a fixed future date, to exchange each bond for a set number of ordinary shares. Which statement best describes the main advantage to the issuing company compared with straight debt?

The main advantage is a lower coupon than equivalent straight debt, because investors value the embedded right to convert into ordinary shares. Principal is still repayable if not converted, interest is usually tax-deductible, conversion dilutes existing holders, and the stock ranks above equity.

  1. AThe coupon rate is usually lower than on equivalent straight debt because holders value the conversion optionCorrect
  2. BThe company never has to repay any principal
  3. CInterest on the stock is never tax-deductible
  4. DThe conversion right removes all dilution risk for existing shareholders
  5. The stock ranks behind ordinary shareholders on liquidation

Explanation

Investors pay for the option to convert, so they accept a lower coupon than on straight debt. Principal must still be repaid if conversion does not occur. Interest is normally tax-deductible, conversion causes dilution, and the stock ranks ahead of equity.

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