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finance a la shmoop. what is convertible debt? okay so we presume you

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know what debt is. if not go uh you know watch that video. we'll wait actually no [man smiles at camera]

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we won't wait. so convertible debt is just normal debt

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but with one potentially highly valuable added feature. its convertible into

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something else. well we were Marvel superheroes that would be our superpower.

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you know finance man or something like that.

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anyway example time. drone Ranger Inc needs money to upgrade a factory so that

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it can produce drones that don't just fly, they swim too. like Aquaman. Alright well

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prevailing interest rates for its level of risk and credit worthiness are 7%. the

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company needs to raise a hundred million bucks, and the idea of paying seven [graph shown]

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million dollars a year for that debt is just too high a price, so the CEO boss

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says no .no new factory for you but if the company could get the debt cheaper

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well then she might run bulk. unfortunately the company's stock trades

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today at a very low multiple of earnings. only 15 times the dollar share they'll

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earn this year. so I don't want to raise the hundred million dollars by selling

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equity. it would be dilutive to do so, meaning that they would have to print

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too many shares to raise that hundred million dollars, specifically a hundred [Dilution defined]

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million divided by 15 or six and a half-ish million shares. well some of the

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company's investors or rather all of them believe that the company's stock is

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and or will be worth more per share than it is today at some point in the future.

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otherwise they wouldn't own the stock today, right?

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so the wily CFO of the company wonders if there's a Miley Cyrus style best of

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both worlds solution here where you could sell equity at a higher price in

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the future in part for a price decline on the cost of renting the debt. and in [Cyrus shown swinging across screen]

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fact there is and yeah you guessed that it's called a convertible bond, or

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convertible debt. yeah different kind of conversion there.

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all right well the drone rangers stock is 15 bucks a share today but through

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careful negotiated back-and-forth with capital markets people at an investment

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bank, the company learns that there actually is demand for its debt price to

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pay only 3% interest. if that debt is convertible into equity at 30 bucks a

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share. so what does that mean? well if the stock stays under 30 bucks so pretty [definitions on screen]

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much forever, then the buyers of the debt or the lenders of the money to the

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company got taken. that is they only got three percent interest on their money

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when they should have gotten seven percent for loaning money as debt to the

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company. but if the stock takes off and the over water underwater drones really

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you know fly off the shelves, then the convertibility feature of the

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debt will be exercised or used which would be a good thing. so the debt is

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convertible at 30 bucks a share which means that a hundred million dollars

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raised would cause the company to be diluted a hundred billion divided by 30

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bucks, or you know 3.3 ish million shares, I eat it's half the dilution it would [equations]

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have been at the company just sold shares at 15 bucks each.

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it essentially wrote a call option to the buyers of the debt to be able to

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call or buy its stock for 30 bucks a share or 30 times the current year's

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earnings at some point you know whenever in the future. like being diluted at 30

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times earnings is way less painful than being diluted at 15 times.

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so yeah that's convertible debt in a nutshell. not what you find yourself in

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during your midlife crisis when you desperately feel the urge to buy a [woman races by in sports car]

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silver Beamer that cost three times our annual salary yeah. been there it was a

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nice Beamer

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