Calculating the Cost of Other Hybrid Securities

In general terms, hybrid securities share some of the characteristics of debt and some of the characteristics of equity. A good example is a convertible bond, which can be viewed as a combination of a straight bond (debt) and a conversion option (equity). Instead of trying to calculate the cost of these hybrid securities individually, they can be broken down into their debt and equity components and treated separately.

In general, it is not difficult to decompose a hybrid security that is publicly traded (and has a market price) into debt and equity components. In the case of a convertible bond, this can be accomplished in two ways:

• An option pricing model can be used to value the conversion option and the remaining value of the bond can be attributed to debt.

• The convertible bond can be valued as if it were a straight bond, using the rate at which the firm can borrow in the market, given its default risk (pre-tax cost of debt) as the interest rate on the bond. The difference between the price of the convertible bond and the value of the straight bond can be viewed as the value of the conversion option.

If the convertible security is not traded, we have to value both the straight bond and the conversion options separately.

Illustration 4.14: Breaking down a convertible bond into debt and equity components: Disney

In March 2004, Disney had convertible bonds outstanding with 19 years left to maturity and a coupon rate of 2.125%, trading at $1,064 a bond. Holders of this bond have the right to convert the bond into 33.9444 shares of stock anytime over the bond's remaining life.54 To break the convertible bond into

Convertible Debt: This is debt that can be converted into stock at a specified rate, called the conversion ratio.

54 At this conversion ratio, the price that investors would be paying for Disney shares would be $29.46, much higher than the stock price of $20.46 prevailing at the time of the analysis.

straight bond and conversion option components, we will value the bond using Disney's pre-tax cost of debt of 5.25%:55 Straight Bond component

= Value of a 2.125% coupon bond due in 19 years with a market interest rate of 5.25% = PV of $21.25 in coupons each year for 19 years56 + PV of $1000 at end of year 19

Lessons From The Intelligent Investor

Lessons From The Intelligent Investor

If you're like a lot of people watching the recession unfold, you have likely started to look at your finances under a microscope. Perhaps you have started saving the annual savings rate by people has started to recover a bit.

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