Was asked this question during interview: What is the impact of a convertible bond issuance on share price?
I answered it will be negative impact. On conversion, more shares will be issued by the company resulting in earnings/EPS dilution.
Can someone correct me?
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Not very much impact until the bond coverts into common shares, which doesn't happen until much later, and this is typically optional for the investor, so in the short term, EPS dilution is very unlikely, and thus minimal impact on share price. Also sometimes, instead of issuing new shares the company can use treasury stock for the conversion, but that still increases the oustanding shares.
On the other hand, depending on the leverage ratio of the firm, if it's a huge bond offering that could reduce earnings due to a large increase in financial expenses from the bond payments, then yes, the offering WOULD have a negative imapact on earnings, and so in anticipation of this, marginal investors are likely to sell-off, or at least short the stock as soon as the bond is issued, putting downward pressure on the price. And this would happen for any any bond, not just convertibles if leverage ratios are high.
Just to piggyback thadonmega:
There is interest expense on the outstanding convertible bonds in the meantime. But the rates on converts are lower (I believe in all cases, unless someone corrects me) than other forms of leverage.
There is also what's called a "net share settlement" feature to some converts whereby the par value of the convert is settled with cash (and not by issuing new shares), so dilution is minimized.
Harking back to a basic principal of corporate finance (ROIC > WACC), as long as the incremental return on the capital deployed via the convertible offering is greater than the interest rate (and eventually the dilution arising from conversion), the value of the equity rises.
Whether that has any effect on the company's share price is entirely up to the market. But in general the market has (from what I've seen) reacted positively to convertible issuances.
That's basic "principle," by the way. How embarrassing.
I think this is a basic dilution question. You guys are making this sound too complicated. The firm's equity value at closing will not have changed (i.e. capital structure decisions have no impact on free cash flow or firm value).
Therefore, dilution depends on if the conversion feature is in the money (i.e. conversion price is below share price), which is generally not the case for newly issued convertible debentures.
Having said that, you will pick up a minor increase in value due to present value of interest tax shield.
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