Valuing Convertible Debt

Companies will issue convertible securities for a number of reasons. For example, convertible bonds and preferred stock may include this feature to attract investors, since the ability to convert these securities to common stock lowers their perceived risk.

When a company issues convertible debt securities, they need to assign a value to this transaction when first issued and when the holders of these securities convert them into shares of common stock. An overview of the two acceptable approaches to valuing this transaction is as follows:

• At Issuance: the method used to value convertible bonds when issued is the same process the company would use for non-convertible securities. If the security contains additional "substantive" embedded features, such as put and call options, the value of this feature must be taken into account. The amortization of any premium or discount would occur over the entire term of the security, since conversion is uncertain.

• At Conversion: there are two methods companies can use to value bonds when converted into common stock. The market value method uses the current price of common stock to record the transaction. Alternatively, the book value method can be used when the market price of the bonds or the company's stock is not available.

Companies are also required to make certain disclosures on their financial statements. For example, the notes to the balance sheet should include the principal amount of the liability, its unamortized discount, and the net carrying amount. The notes to the income statement should include the effective interest rate for the liability and the term over which amortization of a discount or premium occurs, the conversion price and the shares to be delivered when converted.

notes to financial statements, income statement, common stock, market value method, book value method