There are different motives for issuing convertible debentures that are witnessed among the issuers. From the issuer’s point of view, the principal motive of financing with the help of convertible debentures is diminished cash interest payment.
Nonetheless, in substitution of the advantage of decreased interest payments, the stockholder’s equity value is diluted as a result of stock dilution. This is anticipated when the convertible debenture holders substitute the debentures with fresh stocks.
The popularity of convertible debentures among the issuers is increasing at a rapid pace and there are various explanations for their growing applications.
The explanation behind this can be broadly categorized into the following types:
Conventional or Traditional Explanations
Reviews offered by finance professionals have opined about two common motives for issuance of convertible debentures and they are the following:
- They enable the companies in issuing loans at a cheaper rate
- They offer the companies a chance for issuing equity shares at a premium on the present value in the future
However, these explanations are debatable due to the following reasons
Cheaper Debt: The coupon rate offered by debentures with warrants or convertible debentures is usully less in comparison to the common debentures.
Equity at a premium: The exchange price related to a convertible debenture or a subscription value for practicing the warrant is usually more in comparison to the price on which the stock or equity may be issued at the present time. Therefore, a number of finance professionals assume that debentures with warrants or convertible debentures allow a firm in issuing equity at a premium. This is also debatable because if the conversion price of a stock is $25, and the share price falls below $25, then the convertible debentureholders would not practice the conversion option. In such a situation, the firm is not guaranteed about an issue price of $25 in the future. Thus it can be concluded that convertible debentures are not dependable measures to issue stock or equity at a premium.
Contemporary Financial Explanations
Contemporary financial theories explain better reasons behind the recognition of debentures with warrants or convertible debentures. According to these theories, the motives for issuing convertible debentures are the following:
Financial Synergy: Debentures with warrants or convertible debentures are suitable while it is quite expensive or not easy to analyze the risk features of the issuer. Convertible debentures offer a security measure from erroneous risk analysis.
Cash Flow Matching: The companies opt for financing tools that are easily maintained. A nascent but risky company should look for convertible debentures due to the smaller interest burden at the beginning stage.
Agency Costs: Convertible debentures with warrants are able to extenuate difficulties faced by agencies related to financing.
Last Updated on : 27th June 2013