A convertible security is a debenture or a preference share that can be changed into a specified number of common shares at the option of the owner. The most notable feature of the convertible security is that it promises a fixed income associated with debenture or preference shares as well as a chance of capital gain associated with common shares.
When a company issues a convertible security, it will clearly indicate the conversion terms which specifies the number of common shares to be exchanged for the convertible security, the conversion price, and the conversion date.
The conversion price is the price paid for common shares at the time of conversion while the conversion ratio is the number of common shares that an investor can receive when he exchanges his convertible securities. The conversion ratio is given by:
Conversion ratio = Par value of convertible security
VALUATION OF CONVERTIBLE SECURITIES
The valuation of convertible securities is more complex than that of non-convertible (or straight) securities since they combine features of both common shares and fixed income securities. The market value of a convertible security will therefore depend on the market price of common shares, conversion value and the value of a straight debenture (or preference share).
The conversion value is equal to the conversion ratio multiplied by common shares market value
Conversion value = Conversion ratio x Share price
The straight debenture value is the value of the debenture if it was not convertible. It is equal to the present value of future cashflows expected from the debenture.