Think of a convertible bond ("CB") as a two-flavored neapolitan ice-cream. It's not plain vanilla (pun intended).
Modelling convertible debt in excel can be hairy. The debt portion takes into account the coupon payments as well as the loan principal being redeemed at maturity, while the equity reflects the swapping of the debt into shares of the company in the future.
Too technical?
Consider this:
A fast growing company is looking for additional funding to expand its business. There are a few options in the market but the founders prefer not to raise new equity - partly because the value of the shares at this juncture are lower and they do not want to dilute the company too early on.
One option is to borrow from the bank, which will likely charge them an interest rate of say 12%.
Another option is to raise the $1 million as a convertible bond i.e. allowing the lenders to change that liability into equity at some point of time in the future.
This becomes interesting for the lenders because not only do they receive the fixed income payments, but also stand to benefit if the value of the company's shares increase significantly in the future. The downside risks are mitigated, but at the same time, they get the upside.
This creates a kind of valuation gap because, all costs being equal:
A lender would always prefer to issue a CB rather than a plain vanilla bond to enjoy the upside; and
A company will always choose to a plain vanilla bond since the fixed income payments in both scenarios are effectively the same
As a shareholder, why else would I want to dilute equity?
So, in order to balance the risk-reward, the lenders will typically offer the company a lower coupon rate in a CB issuance. Let's assume in this case, a coupon rate of 8%.
To account for the value in the CB, we go back to our analogy of our two-flavoured neapolitan ice-cream - to value the liability and equity components separately.
The liability component
We treat the liability in a CB like a plain vanilla bond i.e. using the 12% as the interest rate (also the discount rate) and calculate the present value (PV) based on the fixed income payments of 8%. In this example, the bond matures in 5 years.
The value of the liability component in a convertible bond is calculated based on the present value of all fixed coupon payments from the CB, discounted by the interest rate of a plain vanilla debt.
There's no real way to value the future equity in the CB, hence, the value of equity here is the plug i.e. CB face value - value of the liability component. The proforma balance sheet at the onset looks like this:
Now, assuming there is no conversion during the term of the bond, the accounting treatment for the liability component in the CB would look like this. You can see that the outstanding liability is equivalent to the face value of the CB at the end of 5 years.
For every successive year that the CB is not converted, the value of the liability component increases, approaching the face value at maturity. This 'book value' is adjusted every year based on the difference between the actual coupon paid and the 12% interest rate i.e. what the company would have owed the lenders based on issuing a 12% plain vanilla bond.
Every year that the CB does not convert translates into sunk costs for the company
Also, for every year that the CB does not convert, the 12% interest rate also translates to "sunk costs", impacting the company's retained earnings as illustrated below:
What happens when the CB eventually converts?
Let's assume that the CB holder converts in year 3 before maturity. The liability component is extinguished and the company is free of debt. Next comes the treatment of equity on the books.
Firstly, the face value of the CB upon issuance is immediately recognized as the share capital i.e. a straight swap of debt into equity.
The valuation of the CB in the year of conversation reflects the sum of the equity and debt components. In this case it is calculated as:
Value of CB = equity component + liability componentThe difference between the value of the CB and its face value of $1,000,000 is accounted for as the "share premium".
Note that the straight bond interest component remains recognized as a sunk cost.
And that's all there is to it. To better understand how the math works, refer to the editable worksheet below:
It doesn't look rational that Tesla's valuation could be more than double that of two large automotive manufacturers, overnight.
As cool and sustainable as electric-powered cars sound, there is still a certain amount of runway before this eventually (if it does) go mainstream. In 2014, Nissan had initially targeted 1.5 million electric car sales by 2020. Today, total accumulated unit sales are just about 400,000.
Even so, for electric vehicles to dominate the market, that would require a tectonic shift in the demand and supply of oil globally. Until the cartels figure a way to decouple from this economic dependency, vehicles powered by traditional energy sources will likely remain a core part of the automotive sector. Hybrids however are an interesting case.
Investors are claiming that Tesla's revenue could possibly reach USD 1 trillion in 10 years - that's a really far horizon to forecast. And that's saying so much can happen in between...
Many people get caught up in the term LBO (Leveraged Buy Out) when it comes to modelling.
Plain terms
An LBO is nothing more than a buyout of a business that is heavily funded by debt, usually 65% or more. In contrast to traditional LBO deals in the US, the concept and structure of harnessing leverage in Asia are relatively simpler, sometimes involving a couple of debt tranches.
From a capital budgeting point of view, most buyers will seek to use debt funding as it is less costly than using (or raising) equity, but more importantly, financing an acquisition using more debt means that the amount of cash outlay can potentially be lower i.e. enhancing the returns to equity.
Cash flows are critical.
The choice and structure of debt funding used in an acquisition is largely predicated on the nature and quality of underlying cash flows. This is the most critical and fundamental aspect of all LBOs.
Ultimately, the increase in equity value from a buyout comes down to essentially three factors:
Growth
Multiple expansion
Deleveraging
Consider this illustrative scenario:
A company valued at 6.0x EBITDA at the point of acquisition based on a $100m EBITDA results in a deal value of $600m. Assuming the buyout was financed with 80% debt, the corresponding value of equity is $120m.
Profitability growth
Upon exit, let's assume that the EBITDA has grown by 20% to $120 and the company is valued higher at 7.0x, the resulting EV would be $840m. Because part of the acquisition debt has been repaid over the investment period, the net debt on exit has been reduced to 30% or $252m, giving an exit equity value of $588m.
From the above, we can easily observe that we have increased the value of equity from $120m to $588m, which translates to a nearly 5-fold return. To break this down, let's first look at EBITDA. The value we've created here from improving the operating cash profits can be quantified as:
Multiple expansion
Secondly, in the process of driving the top and bottom-lines i.e. size and profitability, the financial sponsors have also changed the overall "risk profile" of the business, such as: expanding to new markets, developing proprietary technology in new products, institutionalizing sales processes and improving the overall quality of customers, etc. These enhancement initiatives make the business better, or what bankers commonly call: equity positioning or equity re-rating. The idea behind this is to re-position the company more favourably amongst its competitors so as to justify a valuation multiple premium. In this case, we had assumed that on exit, the company will be valued at 7.0x EBITDA. The uplift in equity based on this can be calculated as:
Deleveraging
Lastly, it's the additional value created from financial engineering. This is nothing more than just the reduction in net debt of the company from entry to exit. The value created is simply the difference between the net debt amounts:
Putting it all together, we have:
We have therefore effectively quantified the three sources of value creation to be a total of $468m. Although deleveraging drives most the value here, collectively, both improvements to the EBITDA and re-rating of the business post investment is also significant.
Feel free to play around with the parameters using the below spreadsheet: