Both of the methods of finance mentioned are very similar. Convertible debentures are ordinary debentures but also holders have the option to convert into ordinary shares in a fixed ratio at certain dates. Debentures with warrants differ in that as the option is separated from the fixed interest security, the warrant will entitle the holder to purchase ordinary shares at a fixed price at certain dates. A warrant can be bought and sold separately without the debenture, whereas the option for the convertible is an integral part of that security. Convertibles often contain a clause whereby the company can force conversion if the share price rises to a certain level; the company cannot force warrant holders to exercise their option.
The following factors would be relevant in deciding which finance to raise:
1. The cost to the company. The cost of both methods of finance to the company will consist of 2 components – annual interest payments on the debenture and the growth in the value of the option. To minimize the cost of capital, the finance chosen must be the most attractive to potential investors. Factors which an investor would consider in choosing which security is preferable would be, for example, taxation, availability of funds to exercise warrants, the ability to sell warrants separately etc.
2. Additional finance requirements. If debentures and warrants are used, then, assuming the share price rises sufficiently to induce holders to exercise the option, additional finance will be obtained by the company. The problem with using warrants as a future source of finance is that it is difficult to time the date of exercise of the warrants with the need for funds. Therefore, it may be better to issue convertibles and raise more finance in the future by an issue of equity.
3. Gearing. Both methods of finance will increase gearing initially, although the effect will be less than if ordinary debentures had been issued because the value of the option enables a lower annual interest payment to be made. They will however have different effects on gearing when the options come to be exercised. If convertibles are used the debt finance is completely removed, being replaced by equity. Once the warrants are exercised, however, the company will still have debt finance outstanding.
4. Redemption – If all holders convert into equity then the company will not have to finance the redemption of the convertible debentures. The debentures issued with warrants must however be redeemed, and this may cause an unnecessary drain on funds when more finance will probably be required rather than less.
There are certain factors a company should take into account in deciding the terms of issue (price, interest, etc.) for convertible debentures.
All investors will have a risk-determined rate of return for any security, and this will have to be estimated for the proposed issue of convertibles so that the terms of the issue may be set to provide that return. Unfortunately, the risk cannot be determined in isolation, as the terms of the issue will be an important factors; for example the split of the return given between the more secure interest and the more risky capital gain (via the option to convert) will have a marked effect on risk.
The individual terms of issue and the factors to take into account in deciding how to set them are as follows:
a. Issue price – Normally, this will simply be taken as the par value, and the maturity value will also normally be set at par if investors do not covert.
b. Coupon interest – The annual interest rate on the debenture will provide part of the investor’s total return, so to a certain extent the figures will depend on the value of the option to convert which is offered. The interest must be competitive though, firstly with other convertible issues, but more importantly with the company’s own dividend yield. If the shares offer a higher yield and the same growth prospects as the convertible the issue would not be successful.
c. Conversion price – The conversion price is the issue price of the security dividend by the number of shares received on conversion, that is, the conversion ratio. The higher the conversion price is, the lower will be the prospective capital gains to the investor. The company would therefore like to set a high conversion price, and hence low conversion ratio, subject of course to the requirements of giving the investor a satisfactory return. The factors which will affect the value of the conversion option and hence the level at which the conversion price can be set will be the current market price of the share, their expected growth rate and their level of risk.
The issue of convertibles ultimately involves a trade-off between the return offered by annual interest and that by capital growth through conversion.