In this blog, we will learn what convertible debentures are and how they help the organization issuing the debentures as well as the investors investing in them. It is one of the ways to attract investors and ensure the success of its debt issue. Let’s understand how. So the first question is: What is a convertible debenture? It is a type of debenture that can be changed into a specific number of ordinary shares at the discretion of the owner of the debenture.
Let’s consider an example. Let’s say a company issues 10 lakh convertible debentures at 12% interest. And these debentures are 100 rupees each. Each debenture is convertible into 2 equity shares of Rs 50 each after 2 years from the date of allotment. So at the time of the issue of the convertible debentures, the company will receive a cash inflow of 10 lakh rupees, or Rs 100 million. Now these debentures are going to be converted into equity shares after 2 years. The owner of debentures is going to get 12% interest on these debentures. So the organization will have to shell out 100 million, or 12 million, per year.
After 2 years, the owner can exchange 1 debenture for 2 equity shares of Rs 50 each. The price is locked in at the beginning. If the market value is more than 50, then he has already made capital gains, and he can continue to remain invested in the shares. The shareholder will be entitled to receive dividends. So the most attractive feature of a convertible debenture is the fixed income at the beginning as well as the chance to have capital gains afterwards.
Let us understand the terms: conversion ratio and conversion price of a convertible debenture. So let’s first look at the conversion ratio. The conversion ratio is the number of shares that an investor can receive when he or she exchanges the convertible debentures. For example, if a company has issued convertible debentures at rupees 100 each and each of the convertible debentures will be exchanged with two equity shares of rupees 50 each, then the conversion ratio becomes 100/50 = 2. That means you are getting 2 shares against each convertible debenture.
Now let us look at the conversion price. It is the price paid for the ordinary share at the time of conversion. In the example given earlier, the amount paid for each debenture was 100 rupees, and each share at the end of the tenure would be 50 rupees, so the conversion ratio is equal to 100/50 = 2, and the conversion price is 50 rupees. So if I have to put the formula for the conversion price, then it will be as follows:
Conversion price = par value of debentures/conversion ratio
Conversion ratio = par value of debentures/conversion price
Let us now look at the two terms: one is the market value of a convertible debenture, and the second is the conversion premium of a convertible debenture. So what is the market value of a convertible debenture? The convertible securities are bought and sold in the stock market until they are converted into equity. So even before the convertible debentures are converted into equity shares, the convertible debentures are sold and bought in the stock market. The value at which convertible debentures are sold is called their market value. Basically similar to regular bonds, convertible debentures are also traded on the stock exchange, and the value at which they are traded is known as the market value.
Now let us look at the definition of the conversion premium of a convertible debenture. So the conversion premium is defined as the difference between the convertible debentures and their market value (the value at which they are trading on the stock exchange and the higher value between the conversion value and the investment value). So between conversion value and investment value, whichever is higher, you deduct from the convertible debentures market value. (That is the conversion premium.) The investment value is also known as the NCD value, which is the non-convertible debenture value. So investment value is the value of the convertible debentures as if they were non-convertible debentures.
Conversion premium = (Market value – investment value)/ Investment value
So these are the two key terms for convertible debentures. One is market value, and the other is the conversion premium.