What are the reasons for companies to issue convertible bonds, and what are the advantages and disadvantages associated with them?
The correct answer and explanation is:
Correct Answer:
Companies issue convertible bonds for various strategic financial reasons. The primary reasons include raising capital at lower interest rates, delaying equity dilution, and attracting a broader range of investors. These instruments come with both advantages and disadvantages for the issuing company.
Explanation:
Convertible bonds are hybrid financial instruments that start as debt and offer the bondholder the option to convert them into a predetermined number of shares of the issuing company. Companies issue these bonds mainly to raise capital more cheaply than with traditional debt. Because of the conversion feature, investors are typically willing to accept a lower interest rate compared to regular bonds. This helps the company reduce its interest expenses.
Another key reason is the delayed dilution of equity. Instead of issuing new shares immediately and affecting existing shareholders’ ownership, the company postpones dilution until bondholders choose to convert their bonds into stock. This feature is particularly attractive to companies that expect their share price to rise in the future, as it allows them to benefit from future growth before issuing more equity.
Convertible bonds can also appeal to a wider range of investors. They offer fixed income with the added upside potential of capital appreciation if the company performs well and its stock price increases.
However, there are disadvantages. If the company’s stock performs well and many bondholders convert their bonds into shares, this can lead to significant equity dilution. This may reduce the earnings per share and potentially lower the value of existing shareholders’ stakes. Additionally, the company takes on debt obligations that must be serviced until conversion or maturity. If the bonds are not converted, the company must repay the principal at maturity, which can impact cash flow.
In summary, issuing convertible bonds provides companies with flexible financing options, but it involves trade-offs between interest cost savings and potential future dilution.