Cost of Convertible and Hybrid Securities

Concept of Convertible Debentures, Bonds, Preference Shares

Definition and Features

Convertible and hybrid securities occupy a unique place in business finance. They're designed to bridge the gap between debt and equity, giving investors and companies flexibility.

• Convertible Debentures: These are debt instruments that grant holders the right, but not the obligation, to convert their debentures into equity shares—usually at a predetermined rate and within a specific period. Until conversion, they earn a fixed interest, much like regular debentures.
• Convertible Bonds: Similar to convertible debentures, these are bonds (often issued internationally) that can be converted into a set number of shares of the issuing company. They carry the features of fixed-income securities with an added equity upside.
• Convertible Preference Shares: These shares provide a fixed dividend and carry the option to convert into equity shares. If the company's prospects improve, holders can participate in future profits by converting to equity.

All these instruments are hybrid because they combine features of both debt (fixed returns, priority in liquidation) and equity (potential ownership, capital appreciation).

Cost Estimation Approach and Challenges

a. Estimating the Cost of Convertible and Hybrid Securities

The cost of capital for these instruments captures the expected return required by investors and reflects the dual nature of the security.

• For convertible debentures/bonds, the cost is not simply the interest paid. It also factors in the equity conversion feature, which is valuable to investors. Companies typically estimate the cost by calculating the yield to maturity (YTM) if not converted, and the expected cost if converted, then taking a weighted average based on conversion probabilities.
• For convertible preference shares, the cost includes the fixed dividend until conversion and the expected return on equity after conversion. The calculation often involves projecting cash flows under both scenarios and discounting them at the required rate of return.

Remember, estimating the cost of hybrid securities is always more complex than for pure debt or equity, due to embedded options and future uncertainties.

General Formula (for Convertible Debentures/Bonds):

Cost = (Interest × (1 – Tax Rate) × Probability of No Conversion) +
(Expected Value on Conversion × Probability of Conversion)

For convertible preference shares:

Cost = (Dividend / Net Proceeds) × Probability of No Conversion +
(Expected Equity Return × Probability of Conversion)

b. Key Challenges in Estimation

• Valuing the equity conversion feature can be difficult, as it relies on uncertain future share prices.
• Estimating probabilities of conversion versus redemption is inherently subjective, often based on management's judgment or market trends.
• Tax treatment can differ: interest on debt is tax-deductible, but dividends are not in many jurisdictions. This affects after-tax cost calculations.
• Market volatility impacts the attractiveness of conversion, making static calculations less reliable over time.
• The need to adjust for flotation costs and other issuance expenses adds further complexity.

Role in Modern Financing Strategy

a. Strategic Importance of Convertible and Hybrid Securities

Why do companies choose these instruments? Their role is becoming more pronounced as businesses seek flexibility and investor appeal:

• Lower initial cost of capital: Convertible debt usually carries a lower coupon than straight debt, as the conversion option is attractive to investors.
• Deferred dilution: Equity dilution occurs only upon conversion, allowing firms to raise funds without immediately impacting existing shareholders.
• Appealing to diverse investors: Some investors seek stable returns (debt-like), while others want potential upside (equity-like). Hybrids cater to both profiles.
• Market timing: In volatile markets, convertible and hybrid instruments allow firms to raise capital even when pure equity or debt might be expensive or inaccessible.
• Financial restructuring: These instruments can be used to reorganize a firm's capital structure, manage leverage, or incentivize investors.

b. Example

Suppose ABC Ltd. issues 1,000 convertible debentures of ₹1,000 each, offering 8% interest, redeemable in 5 years, with a conversion option after 3 years into 50 equity shares per debenture.

1. Estimate the probability of conversion by analyzing past conversion trends and market conditions (say, 60% likely to convert).
2. Calculate cost if not converted:
   Interest paid = ₹80 per debenture; After-tax (assuming 30% tax) = ₹56.
   Net proceeds per debenture after flotation cost (₹20) = ₹980.
   Cost (no conversion) = ₹56 / ₹980 = 5.71%.
3. Calculate cost if converted:
   The value of shares on conversion is expected to be ₹1,200.
   Implied return = (₹1,200 – ₹980) / 3 years = ₹73.33 per year, as % of ₹980 = 7.48%.
4. Overall cost = (5.71% × 40%) + (7.48% × 60%) = 6.83%.

This weighted approach accounts for both scenarios, which is what examiners are keen to see in your answers.

As companies innovate in their search for capital, convertible and hybrid securities stand out for their adaptability. They reflect the evolving nature of financial markets and investor preferences.