Question

Question text Which of the following statements about convertibles is most CORRECT? Select one: a. Investors are willing to accept a lower interest rate on a convertible than on otherwise similar straight debt because convertibles are less risky than straight debt. b. At the time it is issued, a convertible's conversion (or exercise) price is generally set equal to or below the underlying stock's price. c. The coupon interest rate on a firm's convertibles is generally set higher than the market yield on its otherwise similar straight debt. d. One advantage of convertibles over warrants is that the issuer receives additional cash money when convertibles are converted. e. For equilibrium to exist, the expected return on a convertible bond must normally be between the expected return on the firm's otherwise similar straight debt and the expected return on its common stock.

Answer 1

Solution: (e) For equilibrium to exist, the expected return on a convertible bond must normally be between the expected return on the firm's otherwise similar straight debt and the expected return on its common stock.

This statement is most correct because the return you expect from a convertible would be anywhere between the return you get from a debt instrument and return you expect from common stock. The returns before conversion into equity stock would be fixed returns ( coupon rate) and after conversion into equity would depend upon the performance of the stock.Hence for equilibrium to exist, the expected returns of a convertible could range anywhere between these two returns.

Other options are incorrect, explanations are given as under:

a)Investors are willing to accept a lower interest rate because they get the option to convert their holding into equity shares after a certain period if the price of the shares reaches a certain price.

b)Usually, the conversion price is set at a significant amount higher than the current price of the common stock to make conversion desirable only if a company's common shares experience a significant increase in value.

c). The coupon interest rate on a firm's convertibles is set lower than the market yield on its otherwise similar straight debt.

d)Issuer doesn't get additional money upon conversion of convertibles however when warrants are exercised the issuer gets additional money.