In Practice A Simple Approach to Decomposing Debt and Equity

The value of a convertible debt can be decomposed into straight debt and equity components using a simple approach. Since the price of a convertible bond is the sum of the straight debt and the call option components, the value of the straight bond component in conjunction with the market price should be sufficient to estimate the call option component, which is also the equity component:

Value of Equity Component = Price of Convertible Bond - Value of Straight Bond

Component

The value of the straight bond component can be estimated using the coupon payments on the convertible bond, the maturity of the bond and the market interest rate the company would have to pay on a straight debt issue. This last input can be estimated directly if the company also trades straight bonds in the market place, or it can be based upon the bond rating, if any, assigned to the company.

Convertible Debt: This is debt that can be converted into equity at a rate that is specified as part of the debt agreement (conversion rate).

For instance, assume that you have a 10-year convertible bond, with a 5% coupon rate trading at $ 1,050, and that the company has a debt rating of BBB (with a market interest rate of 8%). The value of the straight bond and equity components can be estimated as follows:

Straight Bond Component = $ 50 (PVA, 10 years,8%) + 1000/1.0810 = $798.69 Equity Component = $ 1,050 - $ 799 = $ 251

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