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LOS e: Describe two types of debt with equity features (convertible debt and debt with warrants) and calculate the effect of issuance of such instruments on a company’s debt ratios.

Olszaniecki Inc. issued $80 million of bonds convertible into regular common shares at a price of $56 per share. Current price is $75 per share. Immediately prior to any transactions, Olszaniecki’s total debt is $205 million and total equity is $400 million. It is expected that half of the bonds will be converted this year and the remaining half will be converted next year. All other things being equal, which of the following amounts represents Olzaniecki’s debt to total capital ratio after all of the bonds have been converted?

A)
0.207.

B)
0.273.

C)
0.260.

Debt after conversion = $205 million ? $80 million = $125 million

Equity = $400 million + $80 million = $480 million

Debt to Total Capital = Debt / (Debt + Equity) = $125 million / ($125 million + $480 million) = 0.207

Compared to a U.S. company that issues convertible debt, a company that issues an equivalent combination of conventional bonds with warrants attached will have:

A)	lower interest expense and higher total assets.

B)	greater interest expense and lower total assets.

C)	greater interest expense and greater equity.

Interest expense for bonds with warrants attached is higher because the value of the warrants is treated as equity and the bond portion as if it were issued at a discount. The cash interest plus the amortization of the discount will be greater than the (cash) interest expense for the convertible bonds (under U.S. GAAP). Since the discounted liability will be smaller and assets are the same at issuance, equity is greater for the bonds with warrants attached. Another way to think about this is that the estimated value of the warrants is added to equity, whereas the value of the conversion option on convertible bonds is not.

Cameron Inc. has $10 million of bonds outstanding that are convertible into common shares. The current price per share is $44 and the stated conversion price is $49 per share. Cameron also has exchangeable bonds issued for $20 million that are to be exchanged for shares of Adam Inc. worth $20 million (therefore no gain or loss is realized on the exchange). Based solely on the facts provided above, what effect should the convertible bonds and exchangeable bonds have on an analyst’s assessment of Cameron’s fundamental debt to total capital ratio?

Convertible Bonds

Exchangeable Bonds

As the conversion price is above the current share price by a reasonable margin (5/44 = 11%), it is unlikely that the bonds will be converted. Thus, there will be no effect on the debt to total capital ratio.

The exchangeable bond transaction has no gain or loss so there is no effect on equity. But the liabilities will be reduced by $20 million and so this will decrease the debt to total capital ratio.

Jones Inc. has a capital structure consisting of $8 million of liabilities and $10 million of equity. Included in liabilities is $1.2 million worth of exchangeable bonds. Immediately afterwards, Jones issues $0.7 million of redeemable preferred shares for cash proceeds and also calls its entire group of exchangeable bonds, netting a gain of $0.3 million on the bonds. Which of the following amounts is Jones’ revised debt to total capital ratio upon completion of the two new transactions?

The $0.7 million of redeemable preferred shares are treated as debt and will increase liabilities.

The exchange of the bonds results in a decrease in liabilities of $1.2 million and a gain of $0.3 million. The latter results in an increase in equity by $0.3 million (the net effect of the two transactions also decreases assets by $0.9 million).

Liabilities = $8 million + $0.7 million - $1.2 million = $7.5 million

Equity = $10 million + $0.3 million = $10.3 million

Debt to total capital ratio = Liabilities / (Liabilities + Equity) = $7.5 million / ($7.5 million + $10.3 million) = 0.421.

Which of the following will result in the lowest debt-to-total-capital ratio, assuming that all issues raise the same amount of funds?

Bonds with warrants attached will result in a lower debt-to-total-capital ratio than the other two choices because part of the funds raised will be allocated to equity and the balance sheet liability will be smaller by that amount. The remaining choices each result in the same initial balance sheet liability.