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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.
Full Transcript
- 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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