CFA Practice Question

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CFA Practice Question

Companies are less likely to call convertible debt when stock prices are falling than when stock prices are rising. True or False?
Correct Answer: True

As stock prices exceed the call price, the firm may call the debt. Investors redeem the stock for cash or accept the cash call price. Call provisions protect the firm from issuing stock to the convertible debt holders at a lower-than-market price.

User Contributed Comments 11

User Comment
kalps CALL options allow the company to buy back the stock at below market price hence weill exercise when market prices are rising
o123 mmm...i think they're talking about the debt being called not the shares. But i guess youre right in essence.
the company calls the debt at a price around par which would be less than the considerable premium at which the debt would be trading due to the conversion feature.
surob E.g. Assume company has 5000 convertible bond securities at face value of $1000. Conversion rate is 10. Total value of convertible bond is 5 million.

If stock is, say, $100, when bonds are converted to stocks, the company needs 5000x10x100 = 5 million to buy stocks back and provide it convertible bond holders.
If $50, the company needs only 2.5 million to buy stocks. So, it will be less interested in calling convertible bonds and paying about 5 million to bond holders.
Hope make sense.
StanleyMo Let's say that TSJ Sports issues $10 million in three-year convertible bonds with a 5% yield and a 25% premium. This means that TSJ will have to pay $500,000 in interest annually, or a total $1.5 million over the life of the converts.

If TSJ's stock was trading at $40 at the time of the convertible bonds issue, investors would have the option of converting those bonds for shares at a price of $50 ($40 x 1.25 = $50). Therefore if the stock was trading at say $55 by the bond's expiration date, that $5 difference per share is profit for the investor. However there is usually a cap on the amount the stock can appreciate through the issuer's callable provision.
For instance, TSJ executives won't allow the share price to surge to $100 without calling the converts (recall the paragraph on forced conversion). Alternatively, if the stock price tanks to $25 the convert holders would still be paid the face value of the $1,000 bond at maturity. This means that convertible bonds limit risk should the stock price plummet, while limiting exposure to upside price movements of the underlying common stock.
LaurenBerry thanks surob
CHUCKYT If they call debt when stock price is above the exercise price, they avoid holders from converting and diluting EPS.
pranubal I could not understand this concept, if the stocks prices are falling, the it is advantageous for hte company to call the convertible debt right, then answer should be false right
ryanstowel Think of it from the companyâ
sshetty2 After seeing the other explanations, I'm thinking that the convertible debt is advantageous for the company compared to outstanding stock especially when the 'strike' price is below market value because it would then be dilutive if exercised.
On the other hand; if the convertible debt is callable, it would make sense for the company to make the decision to call this debt at the price of THEIR choosing instead of allowing the holder of the convertible debt the option to exercise at whatever price they choose (as the stock prices rises).
ibrahim18 Just note that the company cannot call bonds at a price below market price set. It has to be at a premium to market price.This provision is set in the bond contract. Imagine if you buy a callable convertible debt that can be recalled below market value, would you purchase? No. So, when prices are falling, the company has less incentive to buy back at the lower prices. It is profitable for the company to buy at lower prices, but hurts investors, that's why is is not allowed.

I hope this answers the question.
jzty Companies would like to do that if stock price goes down, but they are not allowed to do so by law. So the wording is not so clear.
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