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Finance: What is Convertible Debt? 43 Views


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Description:

What is convertible debt? Convertible debt is a type of bond that’s issued by a corporation. Ownership of these bonds means that the holder has the right to convert the bond to common stock shares in the company, or straight cash. These are safer than a simple stock investment because if the company’s stock tanks, the bond can be converted to cash instead.

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Transcript

00:00

finance a la shmoop. what is convertible debt? okay so we presume you

00:06

know what debt is. if not go uh you know watch that video. we'll wait actually no [man smiles at camera]

00:12

we won't wait. so convertible debt is just normal debt

00:15

but with one potentially highly valuable added feature. its convertible into

00:21

something else. well we were Marvel superheroes that would be our superpower.

00:26

you know finance man or something like that.

00:32

anyway example time. drone Ranger Inc needs money to upgrade a factory so that

00:37

it can produce drones that don't just fly, they swim too. like Aquaman. Alright well

00:43

prevailing interest rates for its level of risk and credit worthiness are 7%. the

00:49

company needs to raise a hundred million bucks, and the idea of paying seven [graph shown]

00:53

million dollars a year for that debt is just too high a price, so the CEO boss

00:57

says no .no new factory for you but if the company could get the debt cheaper

01:03

well then she might run bulk. unfortunately the company's stock trades

01:09

today at a very low multiple of earnings. only 15 times the dollar share they'll

01:14

earn this year. so I don't want to raise the hundred million dollars by selling

01:17

equity. it would be dilutive to do so, meaning that they would have to print

01:23

too many shares to raise that hundred million dollars, specifically a hundred [Dilution defined]

01:27

million divided by 15 or six and a half-ish million shares. well some of the

01:31

company's investors or rather all of them believe that the company's stock is

01:35

and or will be worth more per share than it is today at some point in the future.

01:40

otherwise they wouldn't own the stock today, right?

01:43

so the wily CFO of the company wonders if there's a Miley Cyrus style best of

01:49

both worlds solution here where you could sell equity at a higher price in

01:54

the future in part for a price decline on the cost of renting the debt. and in [Cyrus shown swinging across screen]

02:00

fact there is and yeah you guessed that it's called a convertible bond, or

02:03

convertible debt. yeah different kind of conversion there.

02:07

all right well the drone rangers stock is 15 bucks a share today but through

02:11

careful negotiated back-and-forth with capital markets people at an investment

02:15

bank, the company learns that there actually is demand for its debt price to

02:19

pay only 3% interest. if that debt is convertible into equity at 30 bucks a

02:25

share. so what does that mean? well if the stock stays under 30 bucks so pretty [definitions on screen]

02:29

much forever, then the buyers of the debt or the lenders of the money to the

02:33

company got taken. that is they only got three percent interest on their money

02:37

when they should have gotten seven percent for loaning money as debt to the

02:41

company. but if the stock takes off and the over water underwater drones really

02:47

you know fly off the shelves, then the convertibility feature of the

02:51

debt will be exercised or used which would be a good thing. so the debt is

02:57

convertible at 30 bucks a share which means that a hundred million dollars

03:01

raised would cause the company to be diluted a hundred billion divided by 30

03:06

bucks, or you know 3.3 ish million shares, I eat it's half the dilution it would [equations]

03:13

have been at the company just sold shares at 15 bucks each.

03:17

it essentially wrote a call option to the buyers of the debt to be able to

03:21

call or buy its stock for 30 bucks a share or 30 times the current year's

03:26

earnings at some point you know whenever in the future. like being diluted at 30

03:31

times earnings is way less painful than being diluted at 15 times.

03:35

so yeah that's convertible debt in a nutshell. not what you find yourself in

03:40

during your midlife crisis when you desperately feel the urge to buy a [woman races by in sports car]

03:43

silver Beamer that cost three times our annual salary yeah. been there it was a

03:48

nice Beamer

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