Convertible Bond Arbitrage

finance a la shmoop. what is convertible debt? okay so we presume you

know what debt is. if not go uh you know watch that video. we'll wait actually no [man smiles at camera]

we won't wait. so convertible debt is just normal debt

but with one potentially highly valuable added feature. its convertible into

something else. well we were Marvel superheroes that would be our superpower.

you know finance man or something like that.

anyway example time. drone Ranger Inc needs money to upgrade a factory so that

it can produce drones that don't just fly, they swim too. like Aquaman. Alright well

prevailing interest rates for its level of risk and credit worthiness are 7%. the

company needs to raise a hundred million bucks, and the idea of paying seven [graph shown]

million dollars a year for that debt is just too high a price, so the CEO boss

says no .no new factory for you but if the company could get the debt cheaper

well then she might run bulk. unfortunately the company's stock trades

today at a very low multiple of earnings. only 15 times the dollar share they'll

earn this year. so I don't want to raise the hundred million dollars by selling

equity. it would be dilutive to do so, meaning that they would have to print

too many shares to raise that hundred million dollars, specifically a hundred [Dilution defined]

million divided by 15 or six and a half-ish million shares. well some of the

company's investors or rather all of them believe that the company's stock is

and or will be worth more per share than it is today at some point in the future.

otherwise they wouldn't own the stock today, right?

so the wily CFO of the company wonders if there's a Miley Cyrus style best of

both worlds solution here where you could sell equity at a higher price in

the future in part for a price decline on the cost of renting the debt. and in [Cyrus shown swinging across screen]

fact there is and yeah you guessed that it's called a convertible bond, or

convertible debt. yeah different kind of conversion there.

all right well the drone rangers stock is 15 bucks a share today but through

careful negotiated back-and-forth with capital markets people at an investment

bank, the company learns that there actually is demand for its debt price to

pay only 3% interest. if that debt is convertible into equity at 30 bucks a

share. so what does that mean? well if the stock stays under 30 bucks so pretty [definitions on screen]

much forever, then the buyers of the debt or the lenders of the money to the

company got taken. that is they only got three percent interest on their money

when they should have gotten seven percent for loaning money as debt to the

company. but if the stock takes off and the over water underwater drones really

you know fly off the shelves, then the convertibility feature of the

debt will be exercised or used which would be a good thing. so the debt is

convertible at 30 bucks a share which means that a hundred million dollars

raised would cause the company to be diluted a hundred billion divided by 30

bucks, or you know 3.3 ish million shares, I eat it's half the dilution it would [equations]

have been at the company just sold shares at 15 bucks each.

it essentially wrote a call option to the buyers of the debt to be able to

call or buy its stock for 30 bucks a share or 30 times the current year's

earnings at some point you know whenever in the future. like being diluted at 30

times earnings is way less painful than being diluted at 15 times.

so yeah that's convertible debt in a nutshell. not what you find yourself in

during your midlife crisis when you desperately feel the urge to buy a [woman races by in sports car]

silver Beamer that cost three times our annual salary yeah. been there it was a

nice Beamer