Factors Influencing Cost
In the real world, dividends, tax, and mitigation of agency costs influence the cost of a CS.
Dividends: If a company pays dividends then the value of the call option C changes. A call option on a dividend-paying share suffers, since a cash dividend liquidates some corporate value and the proceeds go to shareholders but not option holders. The larger the dividends, the more the option suffers. Option holders who try to anticipate this by early exercise gain dividends but lose interest on the exercise price.
Options on dividend-paying stocks with assumed-continuous or, more realistically, discrete dividends can now be valued (Chandrasekhar and Gukhal, 2004), but only with protracted and complex mathematics beyond the present scope.
Tax: The impact of tax on cost is unique for every issuer, holder, and regime. Tax impinges on C, the value of the call, on β, its systematic risk and on kb, the cost of debt. The impact in any particular case depends on:
the issuer and holder’s tax regime;
interacting intra-group regimes;
corporate, inter-corporate, and personal taxes at critical decision points;
the taxable status of issuer, holder, and associates;
how issuer and holder prioritize tax allowances.
Some aspects of recent relevant tax regulations for the United Kingdom are illustrative. The issue price is split between debt and equity. The debt element is valued by discounting comparable straight debt at the interest rate that would have been payable had the security contained no equity conversion feature. The difference between this value and the issue price of the security is treated as being either an equity instrument or an embedded derivative, according to whether the company can only issue shares or whether it has the discretion to pay cash. In the former case the conversion right is treated as an equity issue and is disregarded for tax. In the latter case it is in principle taxable as an embedded derivative. If so, a chargeable gain or allowable loss will arise when the company pays cash to the holders. The gain or loss is determined by a formula based on the difference between the book value of the equity element and the amount paid.
Any difference between the deemed issue price of the debt element and the amount payable on its redemption is amortized and is tax-deductible over the life of the security.
A company can get a high and timely tax deduction by paying high interest on a CS with a short life. This reduces kb, the cost of debt. However if CS holders are taxable, their personal tax may negate the deduction: if debt is tax-inefficient relative to equity, such investors will require compensation by way of a higher return.
Furthermore tax benefits may be truncated by bankruptcy, voluntary conversion by bondholders, or a company decision to force conversion. If cross-border jurisdiction is involved it becomes necessary to examine how CSs would be categorized under relevant tax treaties, EC directives, and double taxation resulting from any inconsistent classification.
Mitigation of agency costs: Agency costs are costs of conflict among different classes of investor and between managers and investors. They reflect opportunities for equity to exploit debt and for managers to invest sloppily, forgo good investments, shirk, and enjoy perks. Endangered parties impose monitoring costs on the shareholders. If the endangered party is a lender, then the cost of debt rises. With CSs an equity sweetener reduces the monitoring costs by aligning the interests of debt and equity.
CSs can reduce the managerial incentive to overinvest in poor, low-return projects. For example, consider the second of two interdependent risky investments, which is only beneficial if the first succeeds. Either finance can be borrowed at the outset for both projects or CSs can be issued that will be sufficient for the first project while providing enough for the second on conversion. If all goes well, the second project will be duly financed by conversion. If the first project fails, the value of the CS will fall, nobody will convert, and management will be able to repurchase the debt at its low value in the open market. Indeed Mayers (2003) has observed a correlation between conversion and spates of corporate investment. If all had been borrowed upfront and if the first project failed, management might be tempted to invest the unused borrowings in easy, unprofitable projects.
A Trend and Its Reversal
A suitably selected trend illustrates in combination a number of the factors discussed. Such was the boom of 2003 (Economist, 2003) and the subsequent fall.
The factors that prompted the surge in the early 2000s to issuance to a near-historic high are concerned with cost, capital structure, value, financial mobility, and market context:
The market had no appetite for equity, and at the same time companies were suffering from unpalatable gearing levels. CSs with a low coupon provided financial mobility and some reassurance to anxious investors and garnered tax advantage.
Hedge funds were attracted to CSs because they perceived a bargain insofar as the issue price underestimated the volatility of the equity, which meant that the call option, C in the basic formula, was undervalued.
Hedge funds bought the convertible, sold the debt, and kept the undervalued call option. They then sold shares short to exploit underestimated volatility.
A reversal of the trend came when
the volatility of equities declined;
companies grew wise to the excessive cost of CSs that they were suffering;
for tax reasons dividends increased, and this hurt short sellers who had to pay the dividends to their purchaser.
The above trend and its reversal illustrate an underlying decision process. An issue of convertibles may be based on perceived market opportunity as above. Alternatively it may be a reaction against the relative costs of issuing straight equity or straight debt. Onerous regulation may further militate against either or both straight instruments.