Does the convertible issue’s lower coupon rate suggest that it is less risky than the straight bond? Is the cost of capital lower on the convertible than on the straight bond? Explain.

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Does the convertible issue’s lower coupon rate suggest that it is less risky than the straight bond? Is the cost of capital lower on the convertible than on the straight bond? Explain.

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Suppose a company simultaneously issues $50 million of convertible bonds with a coupon rate of 10% and $50 million of straight bonds with a coupon rate of 14%. Both bonds have the same maturity. Does the convertible issue’s lower coupon rate suggest that it is less risky than the straight bond? Is the cost of capital lower on the convertible than on the straight bond? Explain.

Explanation & AnswerSolution by a verified expert

Explanation

When a company issues convertible bonds, the yield or the cost of debt is lower as compared to the straight bond because the convertibility option acts as a sweetener for the actual bond issue. However, the actual return on the convertible bond should be equivalent to a straight bond. This is because the difference of 4% between the yields of the convertible and the straight bond is the capital gains yield on the conversion option. Since the capital gains yield is riskier than the yield on debt, the overall cost of capital of the convertible bond will be higher or at least equal to that of the straight bond.

Verified Answer

The convertible bond's lower yield does not imply that it is less risky than a straight bond.
 
The cost of capital on the convertible bond is higher than the cost of capital on the straight bond.

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