How do convertible bonds influence a company's financial leverage and capital structure?

Convertible bonds can have a significant impact on a company's financial leverage and capital structure. Let's explore this in detail:

1. Increased Financial Leverage:

• Convertible bonds are a type of debt instrument that can be converted into a specified number of the company's common shares. When a company issues convertible bonds, it initially increases its financial leverage because it is taking on debt that will need to be repaid in the future.

2. Lower Initial Dilution:

• One of the advantages of convertible bonds is that they often result in lower initial dilution compared to issuing new common shares. This is because bondholders may not convert their bonds immediately, allowing the company to benefit from the debt without an immediate increase in the number of outstanding shares.

3. Potential Future Dilution:

• As bondholders convert their bonds into common shares, it can lead to dilution of existing shareholders' ownership. This dilution occurs because the number of outstanding shares increases, which can reduce each existing shareholder's percentage ownership in the company.

4. Impact on Capital Structure:

• Convertible bonds are classified as a hybrid security because they have characteristics of both debt and equity. When bondholders convert their bonds into common shares, it effectively shifts the capital structure of the company. The proportion of debt in the capital structure decreases, while the proportion of equity (common shares) increases.

5. Flexibility in Repayment:

• Convertible bonds offer flexibility in repayment. If bondholders do not convert their bonds, the company will need to repay the principal amount at maturity. However, if bondholders choose to convert, the company may not need to make a cash repayment.

6. Interest Expense:

• Companies that issue convertible bonds are required to pay periodic interest to bondholders. This interest expense can affect the company's profitability and financial health, depending on its ability to meet interest obligations.

7. Impact on Stock Price:

• The potential conversion of convertible bonds can have an impact on the company's stock price. If bondholders believe that converting their bonds into common shares will be financially advantageous, they may start to convert when the stock price is favorable.

8. Investor Attraction:

• The presence of convertible bonds in a company's capital structure can attract a broader range of investors. Some investors prefer the safety of bonds, while others are interested in potential equity upside through conversion.

In summary, convertible bonds can increase a company's financial leverage when initially issued but offer flexibility in terms of future conversions. They can impact the capital structure by shifting the balance between debt and equity. Companies need to carefully manage their convertible bond issuance to strike the right balance between debt financing and potential dilution of existing shareholders. It's a financial strategy that requires careful consideration and planning.