CA FINAL SFM

VALUATION OF BONDS
Bond Convertibles Terminology:

No.
1.

Terminology

Description

Conversion Ratio

Specifies the number in shares of the issuing firms equity shares that can
be obtained by surrendering the convertible security.

2.

Conversion Price

It is the price paid per share to acquire the underlying equity shares
through conversion.

3.
4.

Conversion

This ratio shows the percentage increase necessary to reach a parity price

Premium

relationship between the underlying equity shares and the convertible.

Convertible Parity It is that price relationship between the convertible and the equity shares
at which neither a profit nor a loss would be realized by purchasing the
convertible, converting it, and selling the common shares that were
received in conversion, ignoring commissions.

5.

Conversion Value

It is the current value of the shares for which the bonds can be exchanged.

6.

Yield Sacrifice

Refers to the investor buying a convertible bond at a higher price than

the corresponding bond of similar tenure thereby sacrificing the yield.
This higher price is paid with an expectation that the same can be
recovered by selling equity shares at a much higher price than
expectation later on conversion.

7.

Floor Price

Floor price for a convertible is estimated as that value at which the

instrument would sell in the market to offer the yield of an equivalent
non - convertible instrument. The bonds represents the insurance
inherent to a convertible bond.

8.

Straight Value

The value of a convertible bond disregarding the conversion feature is

called its straight value.

9.

Minimum Value

It is the greater of its straight value and conversion value.

1|Page

CA FINAL SFM
Practical Question:
KCC has a convertible bond issue that is currently selling in the market for Rs.950 (FV Rs. 1000).
Each bond can be exchanged for 100 shares at the holders option. The bond has a 7% coupon,
payable annually, and it will mature in 10 years. KCC debt is BB rated. Debt with this rating is
priced to yield 12%. Stock in KCC is trading at Rs.7 per share.
1. What is the straight value of the bond/floor value of the bond?
2. What is the stock value or conversion value of the bond?
3. What is the option value?
4. What is the conversion ratio of the bond?
5. What is the conversion price?
6. What is the conversion parity?
7. What is the conversion premium?
8. What is the down side risk of the bond?
Solution:
1. Straight Value/Floor price of the bond:
PV of Inflow
Years

Cash Flows

D.F @ 12%

D.C.F

1-9

70

5.3282

372.974

10

1070

0.3220

344.54
717.5

2. Conversion Value:
1 debenture = 100 share
Price of 1 share = Rs. 7
Therefore, Conversion Value = 7 x 100 = Rs. 700
3. Option Value:
Option Value = Market Price Minimum Value (Higher of Straight value or Conversion value)
= 950 717.5
= Rs. 232.5

2|Page

CA FINAL SFM

4. Conversion Ratio:
Since 1 bond can be exchanged for 100 shares, the conversion ratio = 100: 1.
5. Conversion Price:
Market Conversion Price =

950

= Rs. 9.5/Share

100 Shares
If we were to buy this convertible debenture and hold the same till maturity at which time we
would convert into shares, then the effective price at which we would convert because we have
bought it at Rs.950 would be Rs. 9.5.
6. Conversion Parity:
It means the relationship between convertible & equity shares such that no profit or loss is made
if the convertible is bought with the intent to convert.
7. Conversion Premium:
Conversion Premium = 9.5 7 = Rs. 2.50 / share
As the current market price = 7 and market conversion price = 9.5 the equity shares needs to
move up by 2.5 so as to have conversion parity.
Therefore, Conversion Parity Price = Rs. 9.5
Therefore, the market conversion price and conversion parity price is one and the same.
8. Downside Risk/ Premium over straight value:
(If you buy the bond & the shares becomes worthless)
Downside Risk = 950 717.50 x 100
717.50
Therefore, Downside Risk = 32.40%

3|Page