Exchangeable bond

Here is a question on exchangeable bond from Schweser qbank, Cameron Inc. has $10 million of bonds outstanding that are convertible into common shares. The current price per share is $44 and the stated conversion price is $49 per share. Cameron also has exchangeable bonds issued for $20 million that are to be exchanged for shares of Adam Inc. worth $20 million (therefore no gain or loss is realized on the exchange). Based solely on the facts provided above, what effect should the convertible bonds and exchangeable bonds have on an analyst’s assessment of Cameron’s fundamental debt to total capital ratio? Convertible Bonds Exchangeable Bonds A) Increase Decrease B) Decrease No effect C) No effect No effect D) No effect Decrease Your answer: C was incorrect. The correct answer was D) No effect Decrease As the conversion price is above the current share price by a reasonable margin (5/44 = 11%), it is unlikely that the bonds will be converted. Thus, there will be no effect on the debt to total capital ratio. The exchangeable bond transaction has no gain or loss so there is no effect on equity. But the liabilities will be reduced by $20 million and so this will decrease the debt to total capital ratio. ---------------------------------------------------------------------------------------------------------- I understand the effect of the convertible, but not quite sure about the explanation on the exchangeable bond, the CFAI text didn’t cover exchangeable bond in too much details. I understand the no effet on equity, but does it have to be removed from liabilities, it didn’t give any indication how likely the bonds will be exchanged for shares, how do we gauge whether the exchange will take place?

You can treat exchangeable bond as a bond with equity conversion feature (of some other entity). In this case it is a company Adam Inc. (may be a subsidiary). Also per the description since the problems states that the exchangeable bonds are to be exchanged without any assumption of not doing so, we have to go with the going concern assumption. any thoughts??

I think that the possibility of exercising the conversion feature of the convertible is unknown (perhaps the stock has 200% annual volatility). I think the possibility of exchangeability is similarly unknown although exchange of the bond certainly reduces debt to total capital.

Joey, I agree the possibility of exchange for the exchangeable bond is unknown, so how can they reason that this amount be removed from liability? Is it one of those questions where the question writer wrote the question while enjoying himself with a bottle of rum?

Not my favorite beverage, but sounds about right.