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Warrants and Convertible Securities 1039

price (i.e., the common stock price at which immediate conversion would make sense) is equal to $42.55, which is the bond price of $920 divided by the conversion ratio of 21.6216. The prevailing market price of 27.375 is far below this parity level, meaning that the conversion option is currently out of the money. Of course, if the conversion parity price ever fell below the market price for the common stock, an astute investor could buy the bond and immediately exchange it into stock with a greater market value.

As indicated in the sixth column of Exhibit 24.16, most convertible bonds are also callable by the issuer. Of course, a firm will never call a bond selling for less than its call price (which is the case with the Cypress Semiconductor note). In fact, firms often wait until the bond is selling for significantly more than its call price before calling it.19 If the company calls the bond under these conditions, investors will have an incentive to convert the bond into the stock that is worth more than they would receive from the call price; the situation is referred to as forcing conversion. Two other factors also increase the investors' incentive to convert their bonds. First, some instruments have conversion prices that step up over time according to a predetermined schedule. Since a stepped-up conversion price leads to a lower number of shares received, it becomes more likely that investors will exercise their option just before the conversion price increases. Second, a firm can help to encourage conversion by increasing the dividends on the stock, thereby making the income generated by the shares more attractive relative to the income from the bond.

Another important characteristic when evaluating convertible bonds is the payback or breakeven time, which measures how long the higher interest income from the convertible bond (compared to the dividend income from the common stock) must persist to make up for the difference between the price of the bond and its conversion value (i.e., the conversion premium). The calculation is as follows:

Payback =-

Bond Income - Income from Equal Investment in Common Stock

For instance, the annual coupon yield payment on the Cypress Semiconductor convertible bond is $40, while the firm's dividend yield is zero. Thus, assuming you sold the bond for $920 and used the proceeds to purchase 33.607 shares (= $920/$27.375) of Cypress Semiconductor stock, the payback period would be

It is also possible to calculate the combined value of the investor's conversion option and issuer's call feature that are embedded in the note. In the Cypress Semiconductor example, with a market price of $920, the convertible's yield to maturity can be calculated as the solution to

or y = 6.29 percent (reported as 6.3 percent in the thirteenth column of Exhibit 24.16). This computation assumes eight semiannual coupon payments of $20 (= 40 + 2). Since the yield on a Cypress Semiconductor debt issue with no embedded options and the same (B1) credit rating

19An empirical study of this issue revealed that almost all of the convertible securities studied were called later than the theoretically optimal time. See Jonathan E. Ingersoll, Jr., "An Examination of Corporate Call Policies on Convertible

Securities," Journal of Finance 32, no. 2 (May 1977): 463-478.

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