Understanding Convertible Debt: Features and Accounting Treatment

CONVERTIBLE DEBT By Dr. Fernando Diz

Learning outcomes What is convertible debt? Why do companies raise capital by issuing convertible debt? Using Black Scholes to value convertible debt? Distinctive features of the embedded option in convertible debt Commonly placed hedging-transactions when companies issue convertible debt. The whys of these transactions. Accounting for convertible debt and its associated hedging transactions

What is convertible debt Convertible debt is a debt instrument with an embedded option that allows the debt owner to convert $1,000 of principal into a fixed number of shares of common stock of the issuer. The number of shares per thousand dollars of principal is called the conversion ratio. Example: If a convertible has a conversion ratio of 15.69 shares / $1000, the implied conversion price is $1,000 / 15.69 shares or $63.73 / share. The specific terms of the convertible can change, and you should read the debt instrument indenture to understand its terms. Example TSLA: The conversion option is stock split adjusted .

Why do companies raise capital through the issuance of convertible debt? Mainly, because there is demand for their paper AND It is cheaper to the company in terms of interest servicing costs Although Hedge transactions are the equivalent of a cash purchase of insurance , which adds to the carrying cost of the convertible.

Distinctive features of options embedded in convertible debt Companies issue convertible debt with terms including: Alternative forms of consideration upon conversion settlements: Cash Cash and shares Only shares Right to decide the form of consideration by the company Exercise price given by the conversion ratio Changes of conversion rates upon the occurrence of different events like stock splits (see Tesla 2024 convertible)

Accounting Current rules are complicated, but we can summarize convertible debt accounting treatment as: 1. Convertible as a single unit = Convertible debt Liability for whole proceeds; Same accounting as for straight debt. 2. Convertible with embedded Derivative = contains conversion option that is required to be separated from host contract Measure embedded derivative fair value Reduce convertible debt liability by fair value of derivative Changes in fair value flow through P&L Amortize any discount/premium 3. Convertible issued at substantial premium relative to par Measure debt as principal amount Residual amount is allocated to equity

See Winnebago 1.5% 2025 Convertible Note example See Excel spreadsheet

Hedge transactions When corporations issue convertible debt, they often enter into so called hedge transactions These transactions are simply an over-the-counter call spread, where the company buys out-of-the-money calls with exercise price equal to the conversion price , and sell out-of-the-money warrants with a strike price that typically is 2x the current stock market price. See Winnebago Industries (WGO) 2025 1.5% Convertible Notes hedge transactions detailed in WGO 8-K report of October 29, 2019. Details on the hedging transactions are provided on Exhibits 10.2, 10.3, 10.4, 10.5, 10.6, 10.7, 10.8 and 10.9.

Hedge transactions The purpose of the hedge transactions is twofold: 1. The purchased call caps the amount of consideration given by the company (whether in cash or shares) to the conversion price times the number of shares underlying the convertible (PAR VALUE). It is meant to reduce the potential dilution and/or offset any cash payments the Company is required to make in excess of the principal due. 2. The sold warrants are meant to reduce the cost of the hedge and could have potential dilutive effects should the stock price at conversion be larger than the warrants exercise price. (See Tesla 2024 convertible)

Hedge transaction accounting In WGO 2025 1.5% Convertible, the Hedge transactions are classified as equity 1. The purchased calls are equivalent to purchasing the stock; i.e. a share repurchase activity. 2. The sold warrants are the equivalent to the issuing of shares. See WGO 2020 10K, page 62.