by Michael Brett
Calculating with convertibles
Our original sample balance sheet did not include one feature which has become increasingly common in company financing, and particularly property company financing: the convertible loan stock.
A convertible is mid-way between debt and equity finance. A typical convertible might be a loan stock carrying an interest rate — a coupon — of, say, 7.5% and with a life of 15 years. Initially it simply pays an interest rate of 7.5% (which the issuer can offset against profits for tax purposes) and appears in the accounts of the company as a liability like any other form of bond or debenture.
But between certain dates, holders have the option to convert the convertible loan stock into ordinary shares of the company on terms fixed at the time of issue. After all the stock has been converted (if it is), it disappears from the balance sheet as a liability and the share capital increases by the number of new shares created on conversion. If conversion does not prove worthwhile, after the end of the conversion period it reverts to being an ordinary loan stock.
Though traditionally convertibles were loan stocks, in recent years we have seen a number of convertible preference share issues. These work in much the same way: they pay a fixed dividend until they are converted into ordinary shares. But since they are technically share capital rather than debt, the income takes the form of a dividend rather than an interest payment and has to be paid out of income that has borne corporation tax — shareholders get a credit for basic rate income tax paid, in the same way as with the dividend on an ordinary share.
Because the value of a convertible will at least partially reflect the performance of the ordinary shares of the company, investors are prepared to accept a lower rate of interest than they would require on a straight loan.
On the other hand, the yield will almost certainly be higher at the outset than the yield on the ordinary shares, and this can give the convertible defensive qualities at a time when the ordinary share price may be volatile.
Cheap debt
Companies tend to look on convertible stocks as a cheap source of finance. Viewed as debt, the convertible costs less in interest than a straight loan stock. Viewed as deferred equity, it is seen as a way of issuing new shares at a premium, which helps to get round the asset dilution problem that usually arises with a straight rights issue in ordinary shares. Typically, when a convertible is first issued the terms provide for it to convert into ordinary shares at 10% to 15% above the then current market price.
Suppose the company’s share price is 175p. It might issue a convertible loan stock that converted into ordinary shares on the basis of one share for every £2 nominal value of loan stock. So the conversion price is 200p and if the company issues £2m nominal of the convertible loan this will ultimately (assuming full conversion) convert into 1m new ordinary shares.
In practice some investment analysts argue that companies are kidding themselves if they think convertibles provide cheap finance. Admittedly, there is the possibility of issuing shares at above the current market price.
But the other side of this coin is that the company is paying interest on the convertible stock, which is considerably higher than the dividend on the ordinary shares, until conversion takes place.
If the company’s share price rises fairly consistently in the years after the convertible is issued, a point is reached where the share price moves well ahead of the price at which the stock converts (and the value of the convertible stock in the market will, of course, rise to reflect this fact). Take our example of a company with a share price of 175p that issues a convertible that converts at 200p. Assume that five years later the share price has risen to 240p and stands at a discount of 20% to the company’s net asset value of 300p.
An abbreviated balance sheet looks like this:
An investment analyst will tend to look at the effects of conversion on asset value, even though the convertible stock has not yet been converted. So he will draw up a balance sheet showing what the position would be after full conversion. It looks like this:
The £2m of convertible has disappeared as a liability, boosting shareholders’ funds by £2m to £11m. Of this increase, £1m is the nominal value of the new shares issued, taking issued capital up from £3m to £4m, and £1m is accounted for in the share premium account since effectively shares of £1 nominal value were issued at £2. But though net assets are now up to £11m, they have to be divided among 4m shares, which gives a net asset value of 275p. So conversion dilutes net assets from 300p to 275p; this would be referred to as the “fully diluted NAV”. Similar sums can be done to calculate the dilution effect on earnings (if any).
It is not uncommon nowadays for convertible stocks to be traded in the euromarkets rather than the domestic stock market, and they are often considerably more complex than the example illustrated here. In particular, they may incorporate an investor “premium put” option.
In essence, this normally guarantees the investor a minimum return close to that on government stocks. The convertible carries a coupon of, say 7.5%. But after a certain period investors have the right to sell the stock back to the company at a price which provides them with an overall return of, say, 10% from the date of issue. So if the share price rises far enough to make conversion worthwhile, the investors convert. If the share price performs badly they can exercise the put option instead, meaing they get a return close to what they would have had from a conventional non-convertible bond.
