Convertible Debt Treatment in FCFE

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Permalink Reply by Sachidanand (Sacha) Singh on July 31, 2010 at 8:25am

In FCFE approach, as you have mentioned, in any year flow to equity is given by FCFF+Net borrowings = FCFF+New borrowings – repayments. We have a convertible debt that is falling due for repayment during the explicit projection period. To the extent that it is debt, it should be deducted in the year it is falling due from the FCFF. But only to the extent it is debt. A convertible is part equity and part debt. Compute the two parts of the convertible and deduct the debt part.

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Permalink Reply by Amardeep Singh on August 2, 2010 at 7:30am

Thanks Sir. In my case, entire debt would be converted to equity - hence no cash flow impact per se. Does it imply that I should not be deducting anything?

Further, can we interpret in a different way, like: new equity issued to raise cash and convertible debt repaid in cash? This interpretation would then have a cash flow impact. Please suggest.

Thanks.

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Permalink Reply by Sachidanand (Sacha) Singh on August 2, 2010 at 11:37am

Entire debt is convertible, that does not mean convertible debt can be equated to equity, unless it is compulsorily convertible Is the convertible debenture compulsorily convertible?

Second interpretation too should not have cash flow implication.

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Permalink Reply by Amardeep Singh on August 3, 2010 at 12:47am

Yes sir, the entire debt is compulsorily convertible to equity.

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Permalink Reply by Sachidanand (Sacha) Singh on August 3, 2010 at 12:49am

Then there cannot be any deduction from projected cash flows on account of debt repayment. (If we are valuing a share and not the company, we will need to take into account increases in number of shares - depends on conversion ratio.)

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Permalink Reply by MANOJ KUMAR AGGARWAL on August 12, 2010 at 8:47am

Sir, what do we have to do the the present value of future interest payments on compulsorily convertible debt having an coupon rate ( till full conversion) in FCFE ?

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Permalink Reply by Sachidanand (Sacha) Singh on August 12, 2010 at 8:52am

I do not think we need to get the PV of interest payments. Since it is FCFE, these will be outflows in respective years.

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Permalink Reply by MANOJ KUMAR AGGARWAL on August 12, 2010 at 8:59am

And in FCFF, what would be the situation, while valuing per equity share ?

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Permalink Reply by Sachidanand (Sacha) Singh on August 12, 2010 at 9:09am

Interest is paid to one of the capital providers (creditors) thus in FCFF it will be a part of the free cash flow each year.

Permalink Reply by MANOJ KUMAR AGGARWAL on August 12, 2010 at 9:48am

sir, I am sorry, there is some disconnect. In FCFF, value of per equity share is derived by discounting "value of operating assets plus depreciation minus increase in working capital minus capex". Then, present market value of interest bearing debt is subtracted. It is then divided by no. of diluted equity shares.

There is no adjustment of interest in this. Should we somehow adjust this interest or its present value for arriving at per equity share value ? Regarding no. of equity shares, I think, it will include shares arising from conversion. Kindly guide.

Permalink Reply by Sachidanand (Sacha) Singh on August 12, 2010 at 10:30am

FCFF implies discounting the free cash flow to firm. Free cash flow to firm will consist of cash flows available to all capital providers; creditors being one of them. Thus interest payment is not to be considered as an outflow in the detailed projection period. (In later years it gets captured in EBIT*(1-T)). Thus, we need not concern ourselves with PV of interest payment.

Having arrived at firm value just deduct market value (or fair value if debts are not traded) of debts to arrive at value of equity. Divide this equity value with no of shares to get value of one share.

No of shares will increase on account of conversion.

Permalink Reply by MANOJ KUMAR AGGARWAL on November 20, 2010 at 1:16pm

Is similarly, in FCFE, dividend on Compulsorily convertible preference shares would be shown outflows in respective years, till conversion, for calculating value of an equity share ?

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