Use the following excel walkthrough to generate the sequence of accounting adjustments to the balance sheet when a company issues a convertible bond.
Q: Is the coupon on the CB always lower?
A: Compared to a plain vanilla bond, a CB rewards an investor with an option to enjoy the equity upside. This equity upside is not free. Think of it this way: The investor of the CB has to give something back in exchange in order to enjoy the equity upside i.e. a lower coupon. Otherwise the company is better off simply issuing a plain vanilla bond.
Q: How can I understand the equity component of a CB on the balance sheet?
A: Because the company pays a lower interest (compared to a straight bond) on the CB, the actual liability on the CB instrument is actually lower on initial recognition. The difference between the face value of the CB and this liability basically tries to value the investor's equity interest in the business (taking into account a potential conversion at some point of time in the future).
Q: Why does the liability component increase every year?
A: Prior to conversion, the company accrues the interest on the CB treating it like a plain vanilla bond (row 35). However, the cash interest that is being paid to CB holders is actually much lower, hence the difference put to liability on the balance sheet. You can basically treat this as interest "owed" to the CB holder over the term of the bond assuming the conversion doesn't take place. Note also that the value of the liability component converges to the principal amount closer to the maturity date i.e. the CB increasingly 'looks like' a straight bond.
Q: Why is the equity premium lower than the initial equity component of the CB if a conversion event takes place earlier than the maturity date?
A: Regardless of how well the business may be doing, as long as a conversion event takes place earlier than the maturity date, the CB holder takes on more (equity) risk. This premium is a reflection of that equity risk.
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