Zero coupon convertible Bonds Cornhill needs funds to the order of $ 3. 6 billion in cash to complete the acquisition of Pirelli. The company currently is planning to come up with an equity issue to raise $ 2. 1375 billion at $ 71. 25 per share. The remaining part of the fund requirements is furbished using zero coupon convertible debentures due in 2015, priced at $ 741. 923 per $ 1,000 principal amount. This offering price yields 2% p. a. ompounded semi-annually. Corning is raising the requirement using a combination of debt and equity to preserve the Debt/capitalisation ratio for the company. Corning by using this strategy would preserve the current Debt/Capitalisation ratio and also expand it’s equity base on conversion enabling it to raise further debt. If Corning uses only debt mode of financing it’s Debt/Capitalisation increases to 44. 06% and it could lower it’s credit rating leading to higher cost of debt.
This reduction in value of the call option has to be captured by Coopers while valuing the convertible bond else it would lead to Coopers over valuing the convertible bond. We have adjusted the Black Scholes model for computing value of the conversion option to incorporate the same. Value of bond without accounting for dividends794. 4567 Value of bond after accounting for dividends765. 2123 Volatility assumptions and sensitivity to volatility: Coopers should use standard deviation of the stock prices as the measure of volatility. Call option is highly sensitive to volatility.
This is on account of the fact that higher the volatility, wider is the distribution of the potential stock prices and hence higher value that can be obtained by capitalising on the high price and exercising the call option Forced conversion: Corning would attempt to force conversion in following cases: •To reduce its debt-equity ratio to raise further debt •When the redemption price of the bond was less than either its bond equivalent value (PV of principal and interest) or its equity equivalent value (current stock times the conversion ratio of the bond)