Chapter 5: Q2DQ (page 621)

Why are investors willing to pay a premium over the theoretical value (pure bond value or conversion value)?

Short Answer

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Answer

Due to convertible security's conversion option a conversion premium is increased value that is included in convertible security. The justification for the premium is that once its converted, the investor will claim a greater value in equity shares than previously owned in securities.

Step by step solution

Introduction to conversion premium-

A conversion premium is an sum by which the price of a convertible security surpasses the current market price of the common stock into which it can be converted.

Investors will to pay a premium-

Investors are willing to pay a premium over the theoretical value for a convertible bond issue because of the future prospects for the related common stock. Consequently, if there are numerous years remaining for the conversion privilege, the investor will actually be able to receive a high interest rate and still have the current option of going to common stock if conditions legitimize.

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Assets
	Book value	Liquidation value
Accounts receivables	\(1,400,000	\)1,200,000
Inventory	\(1,800,000	\)900,000
Machinery and equipment	\(1,100,000	\)600,000
Building and plant	\(4,200,000	\)2,500,000
Total assets	\(8,500,000	\)5,200,000

Liabilities and stockholder’s claims
Liabilities
Accounts payable	\(2,800,000
First lien, secured by machinery and equipment	\)900,000
Senior unsecured debt	\(2,200,000
Subordinated debenture	\)1,700,000
Total liabilities	\(7,600,000
Stockholder’s claims
Preferred stock	\)250,000
Common stock	\(650,000
Total stockholder’s claims	\)900,000
Total liabilities and stockholder’s claims	$8,500,000

Assets
	Book value	Liquidation value
Accounts receivables	\(1,400,000	\)1,200,000
Inventory	\(1,800,000	\)900,000
Machinery and equipment	\(1,100,000	\)600,000
Building and plant	\(4,200,000	\)2,500,000
Total assets	\(8,500,000	\)5,200,000

Liabilities and stockholder’s claims
Liabilities
Accounts payable	\(2,800,000
First lien, secured by machinery and equipment	\)900,000
Senior unsecured debt	\(2,200,000
Subordinated debenture	\)1,700,000
Total liabilities	\(7,600,000
Stockholder’s claims
Preferred stock	\)250,000
Common stock	\(650,000
Total stockholder’s claims	\)900,000
Total liabilities and stockholder’s claims	$8,500,000

Why are investors willing to pay a premium over the theoretical value (pure bond value or conversion value)?

Short Answer

Step by step solution

Introduction to conversion premium-

Investors will to pay a premium-

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