Convertible securities

Definition

Convertible securities are financial instruments, typically bonds or preferred shares, that can be converted into a predetermined number of common shares of the issuing company at specific times during their life. This feature allows investors to benefit from potential appreciation in the company's stock price while providing them with fixed-income returns until conversion.

5 Must Know Facts For Your Next Test

1. When convertible securities are converted into common stock, it can lead to dilution of existing shareholders' equity, affecting the earnings per share calculation.
2. Convertible securities often have lower interest rates compared to regular bonds due to their added conversion feature, making them attractive to investors looking for growth potential.
3. In calculating diluted earnings per share (EPS), the impact of potential conversions from convertible securities is included, allowing for a more accurate representation of a company's earnings performance.
4. Investors in convertible securities have the flexibility to switch to equity if they believe the company's stock will perform well, providing an opportunity for capital appreciation.
5. The terms of conversion, such as the conversion ratio and date, are crucial as they determine how and when investors can exchange their securities for stock.

Review Questions

• How do convertible securities influence the calculation of diluted earnings per share?
  • Convertible securities influence the calculation of diluted earnings per share by adding potential common shares that could be created through conversion. When calculating diluted EPS, companies must consider how many additional shares would be outstanding if all convertible securities were converted into common stock. This adjustment provides a clearer picture of a company's profitability and helps investors understand the impact of such securities on their ownership stake.
• Discuss the advantages and disadvantages of investing in convertible securities compared to traditional debt instruments.
  • Investing in convertible securities offers advantages such as lower interest rates compared to traditional debt instruments and potential for equity participation if the company's stock price rises. However, the downside includes exposure to dilution if conversions occur and less income certainty since dividends may not be guaranteed. Traditional debt instruments provide fixed returns but do not offer the same growth potential. Therefore, investors must weigh these factors based on their risk tolerance and investment goals.
• Evaluate how market conditions can affect the attractiveness of convertible securities for investors and their implications for earnings per share calculations.
  • Market conditions play a significant role in the attractiveness of convertible securities. In a bullish market, where stock prices are rising, investors may find convertibles appealing due to their conversion feature that allows them to participate in equity gains. Conversely, in a bearish market, these securities might be less attractive if stock prices are declining. This dynamic can impact earnings per share calculations since higher potential conversions during favorable conditions may dilute existing shares more significantly. Hence, understanding market trends is essential for investors evaluating these instruments' impact on overall financial performance.

Related terms

equity: Equity represents ownership in a company, typically in the form of common stock, which gives shareholders a claim on the company's assets and earnings.

dilution:

Dilution occurs when a company issues additional shares, which can decrease the ownership percentage and earnings per share of existing shareholders.

debt financing: Debt financing involves raising capital by borrowing, typically through issuing bonds or taking loans, which must be repaid over time with interest.