Occasionally it is said that issuing convertible bonds is
better than issuing stock when the firms shares are
undervalued. Suppose that the financial manager of Decent
Furniture Company does in fact have inside information
indicating that the decent stock price is too low. Decent
furniture earnings will in fact be higher than investor’s
expectations. Suppose further that the inside information
cannot be released without giving away a valuable
competitive secret. Clearly, selling shares at the present
low price would harm Decent’s existing shareholders. Will
they also lose if convertible bonds are issued? If they do
lose in this case, is the loss more or less than it would
be if common stock is issued?
Now suppose that investors forecast
earnings accurately, but still under value the stock
because they overestimate Decent’s actual business risk.
Does this change your answer to the questions posed in the
preceding paragraph? Explain.
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Answer Posted / Priyanka Kumari
If the financial manager issues convertible bonds, existing shareholders may not necessarily lose as much compared to selling common stocks at a low price. Convertible bonds offer the advantage of deferred equity and interest payments, which can help shield investors from immediate dilution. However, if the company fails to meet expectations in the future, bondholders might still face losses when the bonds convert into shares.
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